Publication 535

Cat. No. 15065Z Contents

Department Introduction .................... . 1

of the What’s New for 2010 .............. . 2

Treasury Business

What’s New for 2011 .............. . 2 Internal

Revenue Expenses Reminders ..................... . 2

Service

1. Deducting Business

Expenses .................. . 2

2. Employees’ Pay .............. . 6 For use in preparing

3. Rent Expense ................ . 8

2010 Returns 4. Interest .................... . 11

5. Taxes ..................... . 15

6. Insurance .................. . 17

7. Costs You Can Deduct or

Capitalize .................. . 21

8. Amortization ................ . 26

9. Depletion ................... . 33

10. Business Bad Debts ........... . 38

11. Other Expenses .............. . 40

12. How To Get Tax Help .......... . 46

Index ......................... . 49

Introduction

This publication discusses common business

expenses and explains what is and is not deductible. The general rules for deducting business expenses are discussed in the opening

chapter. The chapters that follow cover specific

expenses and list other publications and forms

you may need.

Comments and suggestions. We welcome

your comments about this publication and your

suggestions for future editions.

You can write to us at the following address:

Internal Revenue Service

Business Forms and Publications Branch

SE:W:CAR:MP:T:B

1111 Constitution Ave. NW, IR-6526

Washington, DC 20224

We respond to many letters by telephone.

Therefore, it would be helpful if you would include your daytime phone number, including the

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You can email us at *taxforms@irs.gov. (The

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Although we cannot respond individually to

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Ordering forms and publications. Visit Internet IRS.gov www.irs.gov/formspubs to download forms and

publications, call 1-800-829-3676, or write to the

Mar 24, 2011
address below and receive a response within 10 You can file your tax returns electronically using Useful Items

days after your request is received. an IRS e-file option. The benefits of IRS e-file You may want to see:

include faster refunds, increased accuracy, and Internal Revenue Service

acknowledgment of IRS receipt of your return. Publication 1201 N. Mitsubishi Motorway

Bloomington, IL 61705-6613 You can use one of the following IRS e-file ❏ 334 Tax Guide for Small Business options.

❏ 463 Travel, Entertainment, Gift, and Car Tax questions. If you have a tax question, • Use an authorized IRS e-file provider. Expenses check the information available on IRS.gov or • Use a personal computer. ❏ 525 Taxable and Nontaxable Income call 1-800-829-4933. We cannot answer tax

questions sent to either of the above addresses. • Visit a Volunteer Income Tax Assistance ❏ 529 Miscellaneous Deductions

(VITA) or Tax Counseling for the Elderly

❏ 536 Net Operating Losses (NOLs) for (TCE) site. Individuals, Estates, and Trusts

For details on these fast filing methods, see your What’s New for 2010 ❏ 538 Accounting Periods and Methods income tax package.

❏ 542 Corporations The following items highlight some changes in Form 1099 MISC. File Form 1099-MISC, Misthe tax law for 2010. cellaneous Income, for each person to whom ❏ 547 Casualties, Disasters, and Thefts

you have paid during the year in the course of ❏ 587 Business Use of Your Home Standard mileage rate. For 2010, the stan- your trade or business at least $600 in rents, (Including Use by Daycare dard mileage rate for the cost of operating your services (including parts and materials), prizes Providers) car, van, pickup, or panel truck for each mile of and awards, other income payments, medical business use is 50 cents per mile. ❏ 925 Passive Activity and At-Risk Rules and health care payments, and crop insurance

Self-employed health insurance deduction. ❏ 936 Home Mortgage Interest proceeds. See the Instructions for Form

Effective March 30, 2010, if you were Deduction 1099-MISC for more information and additional

self-employed and paid for health insurance, reporting requirements. ❏ 946 How To Depreciate Property

you may be able to include in your deduction any

premiums you paid to cover your child who was Photographs of missing children. The Inter- Form (and Instructions)

under age 27 at the end of 2010, even if the child nal Revenue Service is a proud partner with the

was not your dependent. For 2010, the National Center for Missing and Exploited Chil- ❏ Sch A (Form 1040) Itemized Deductions

self-employed health insurance deduction is dren. Photographs of missing children selected ❏ 5213 Election To Postpone also allowed on Schedule SE. See chapter 6. by the Center may appear in this publication on Determination as To Whether the

pages that would otherwise be blank. You can Presumption Applies That an Business start-up costs. For tax years be- help bring these children home by looking at the Activity Is Engaged in for Profit ginning in 2010, you can elect to deduct up to photographs and calling 1-800-THE-LOST $10,000 of business start-up costs paid or in- (1-800-843-5678) if you recognize a child. See chapter 12 for information about getting curred after 2009. See chapter 7. publications and forms.

Environmental cleanup costs. The election

to deduct qualified environmental cleanup costs

was extended to cover costs paid or incurred in

2010 and 2011. See chapter 7. What Can I Deduct?

Marginal production of oil and gas. For tax 1. To be deductible, a business expense must be

years beginning in 2010 and 2011, the 100% both ordinary and necessary. An ordinary extaxable income limit does not apply to percent- pense is one that is common and accepted in

age depletion on the marginal production of oil your industry. A necessary expense is one that

and natural gas. See chapter 9. is helpful and appropriate for your trade or busi- Deducting ness. An expense does not have to be indispensable to be considered necessary.

Business It is important to distinguish business exWhat’s New for 2011 penses from:

• The expenses used to figure cost of goods The following items highlight some changes in Expenses sold,

the tax law for 2011. • Capital expenses, and

Standard mileage rate. For 2011, the stan- • Personal expenses. dard mileage rate for the cost of operating your Introduction

car, van, pickup, or panel truck for each mile of This chapter covers the general rules for deduct- business use is 51 cents per mile Cost of Goods Sold ing business expenses. Business expenses are

the costs of carrying on a trade or business, and If your business manufactures products or

they are usually deductible if the business is purchases them for resale, you generally must

Reminders operated to make a profit. value inventory at the beginning and end of each

tax year to determine your cost of goods sold.

Topics Some of your business expenses may be in- The following reminders and other items may cluded in figuring cost of goods sold. Cost of help you file your tax return. This chapter discusses: goods sold is deducted from your gross receipts

to figure your gross profit for the year. If you IRS e-file (Electronic Filing) • What you can deduct include an expense in the cost of goods sold,

• How much you can deduct you cannot deduct it again as a business expense. • When you can deduct The following are types of expenses that go

• Not-for-profit activities into figuring cost of goods sold.

Page 2 Chapter 1 Deducting Business Expenses
• The cost of products or raw materials, in- If you go into business. When you go into it suitable for your business. This applies even if

cluding freight. business, treat all costs you had to get your some of the work would by itself be classified as

business started as capital expenses. repairs. • Storage. Usually you recover costs for a particular

• Direct labor (including contributions to asset through depreciation. Generally, you can- Capital versus Deductible pension or annuity plans) for workers who not recover other costs until you sell the busi- Expenses produce the products. ness or otherwise go out of business. However,

you can choose to amortize certain costs for • Factory overhead. To help you distinguish between capital and setting up your business. See Starting a Busi- deductible expenses, different examples are ness in chapter 8 for more information on busi- Under the uniform capitalization rules, you given below. ness start-up costs. must capitalize the direct costs and part of the

indirect costs for certain production or resale Motor vehicles. You usually capitalize the

cost of a motor vehicle you use in your business. activities. Indirect costs include rent, interest, If you do not go into business. If you are an You can recover its cost through annual deduc- taxes, storage, purchasing, processing, repack- individual and your attempt to go into business is

aging, handling, and administrative costs. not successful, the expenses you had in trying to tions for depreciation.

establish yourself in business fall into two cate- There are dollar limits on the depreciation This rule does not apply to personal property gories. you can claim each year on passenger automo- you acquire for resale if your average annual biles used in your business. See Publication gross receipts (or those of your predecessor) for 1. The costs you had before making a deci- 463. the preceding 3 tax years are not more than $10 sion to acquire or begin a specific busi- Generally, repairs you make to your busi- million. ness. These costs are personal and ness vehicle are currently deductible. However,

For more information, see the following nondeductible. They include any costs in- amounts you pay to recondition and overhaul a

sources. curred during a general search for, or pre- business vehicle are capital expenses and are

liminary investigation of, a business or recovered through depreciation. • Cost of goods sold—chapter 6 of Publica- investment possibility. tion 334. Roads and driveways. The cost of building a 2. The costs you had in your attempt to ac- • Inventories—Publication 538. private road on your business property and the quire or begin a specific business. These cost of replacing a gravel driveway with a con- • Uniform capitalization rules—Publication costs are capital expenses and you can crete one are capital expenses you may be able 538 and section 263A of the Internal Rev- deduct them as a capital loss. to depreciate. The cost of maintaining a private enue Code and the related regulations. If you are a corporation and your attempt to road on your business property is a deductible

go into a new trade or business is not success- expense.

Capital Expenses ful, you may be able to deduct all investigatory

costs as a loss. Tools. Unless the uniform capitalization rules

The costs of any assets acquired during your apply, amounts spent for tools used in your You must capitalize, rather than deduct, some

unsuccessful attempt to go into business are a business are deductible expenses if the tools costs. These costs are a part of your investment

part of your basis in the assets. You cannot take have a life expectancy of less than 1 year or their in your business and are called “capital exa deduction for these costs. You will recover the cost is minor. penses.” Capital expenses are considered assets in your business. There are, in general, costs of these assets when you dispose of them. Machinery parts. Unless the uniform capitali- three types of costs you capitalize. zation rules apply, the cost of replacing

• Business start-up costs (See Tip below). Business Assets short-lived parts of a machine to keep it in good

working condition, but not add to its life, is a • Business assets. There are many different kinds of business as- deductible expense.

• Improvements. sets; for example, land, buildings, machinery,

furniture, trucks, patents, and franchise rights. Heating equipment. The cost of changing

You must fully capitalize the cost of these as- from one heating system to another is a capital You can elect to deduct or amortize sets, including freight and installation charges. expense. certain business start-up costs. See Certain property you produce for use in your chapters 7 and 8.

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trade or business must be capitalized under the Personal versus Business

uniform capitalization rules. See Regulations Expenses section 1.263A-2 for information on these rules. Cost recovery. Although you generally cannot take a current deduction for a capital ex- Generally, you cannot deduct personal, living, or

pense, you may be able to recover the amount family expenses. However, if you have an ex- Improvements you spend through depreciation, amortization, pense for something that is used partly for busior depletion. These recovery methods allow you ness and partly for personal purposes, divide The costs of making improvements to a busi- the total cost between the business and per- to deduct part of your cost each year. In this ness asset are capital expenses if the improve- way, you are able to recover your capital ex- sonal parts. You can deduct the business part. ments add to the value of the asset, appreciably pense. See Amortization (chapter 8) and Deple- For example, if you borrow money and use lengthen the time you can use it, or adapt it to a tion (chapter 9) in this publication. A taxpayer 70% of it for business and the other 30% for a different use. Improvements are generally major can elect to deduct a portion of the costs of family vacation, you generally can deduct 70% expenditures. Some examples are: new electric certain depreciable property as a section 179 of the interest as a business expense. The re- wiring, a new roof, a new floor, new plumbing, deduction. A greater portion of these costs can maining 30% is personal interest and generally bricking up windows to strengthen a wall, and be deducted if the property is qualified disaster is not deductible. See chapter 4 for information lighting improvements. assistance property. See Publication 946 for de- on deducting interest and the allocation rules. However, you can currently deduct repairs tails. that keep your property in a normal efficient Business use of your home. If you use part operating condition as a business expense. of your home for business, you may be able to Treat as repairs amounts paid to replace parts of Going Into Business deduct expenses for the business use of your a machine that only keep it in a normal operating home. These expenses may include mortgage condition. The costs of getting started in business, before interest, insurance, utilities, repairs, and depreyou actually begin business operations, are cap- ciation.

ital expenses. These costs may include ex- Restoration plan. Capitalize the cost of re- To qualify to claim expenses for the business

penses for advertising, travel, or wages for conditioning, improving, or altering your prop- use of your home, you must meet both of the

training employees. erty as part of a general restoration plan to make following tests.

Chapter 1 Deducting Business Expenses Page 3
1. The business part of your home must be have a “net operating loss.” You can use a net

used exclusively and regularly for your How Much Can I operating loss to lower your taxes in other years.

See Publication 536 for more information. trade or business. Deduct? See Publication 542 for information about

2. The business part of your home must be: net operating losses of corporations.

You can deduct the cost of a business expense a. Your principal place of business, or if it meets the criteria of ordinary and necessary

b. A place where you meet or deal with and it is not a capital expense.

patients, clients, or customers in the When Can I Recovery of amount deducted (tax benefit normal course of your trade or business, or rule). If you recover part of an expense in the Deduct an Expense? same tax year in which you would have claimed

c. A separate structure (not attached to a deduction, reduce your current year expense When you can deduct an expense depends on your home) used in connection with by the amount of the recovery. If you have a your accounting method. An accounting method recovery in a later year, include the recovered your trade or business. is a set of rules used to determine when and how amount in income in that year. However, if part income and expenses are reported. The two of the deduction for the expense did not reduce You generally do not have to meet the exclu- basic methods are the cash method and the your tax, you do not have to include that part of sive use test for the part of your home that you accrual method. Whichever method you choose the recovered amount in income. regularly use either for the storage of inventory must clearly reflect income. For more information on recoveries and the or product samples, or as a daycare facility. For more information on accounting meth- tax benefit rule, see Publication 525. ods, see Publication 538. Your home office qualifies as your principal Payments in kind. If you provide services to place of business if you meet the following re- Cash method. Under the cash method of ac- pay a business expense, the amount you can quirements. counting, you generally deduct business ex- deduct is limited to your out-of-pocket costs. penses in the tax year you pay them. • You use the office exclusively and regu- You cannot deduct the cost of your own labor.

larly for administrative or management ac- Similarly, if you pay a business expense in Accrual method. Under an accrual method of

goods or other property, you can deduct only tivities of your trade or business. accounting, you generally deduct business ex- what the property costs you. If these costs are penses when both of the following apply. • You have no other fixed location where included in the cost of goods sold, do not deduct

you conduct substantial administrative or them as a business expense. 1. The all-events test has been met. The test

management activities of your trade or is met when: Limits on losses. If your deductions for an business. investment or business activity are more than a. All events have occurred that fix the fact

the income it brings in, you have a loss. There If you have more than one business location, of liability, and may be limits on how much of the loss you can determine your principal place of business deduct. b. The liability can be determined with reabased on the following factors. sonable accuracy. Not-for-profit limits. If you carry on your • The relative importance of the activities business activity without the intention of making 2. Economic performance has occurred. performed at each location. a profit, you cannot use a loss from it to offset

other income. See Not-for-Profit Activities later. • If the relative importance factor does not Economic performance. You generally

determine your principal place of busi- At-risk limits. Generally, a deductible loss cannot deduct or capitalize a business expense

ness, consider the time spent at each lo- until economic performance occurs. If your ex- from a trade or business or other income-producing activity is limited to the invest- pense is for property or services provided to you, cation.

ment you have “at risk” in the activity. You are at or for your use of property, economic performFor more information, see Publication 587. risk in any activity for the following. ance occurs as the property or services are

provided, or the property is used. If your ex1. The money and adjusted basis of property pense is for property or services you provide to Business use of your car. If you use your car you contribute to the activity. others, economic performance occurs as you

exclusively in your business, you can deduct car provide the property or services. 2. Amounts you borrow for use in the activity expenses. If you use your car for both business if:

and personal purposes, you must divide your Example. Your tax year is the calendar

expenses based on actual mileage. Generally, a. You are personally liable for repayment, year. In December 2010, the Field Plumbing

or Company did some repair work at your place of commuting expenses between your home and business and sent you a bill for $600. You paid it your business location, within the area of your b. You pledge property (other than prop- by check in January 2011. If you use the accrual tax home, are not deductible. erty used in the activity) as security for method of accounting, deduct the $600 on your

You can deduct actual car expenses, which the loan. tax return for 2010 because all events have

include depreciation (or lease payments), gas occurred to “fix” the fact of liability (in this case For more information, see Publication 925. and oil, tires, repairs, tune-ups, insurance, and the work was completed), the liability can be

registration fees. Or, instead of figuring the busi- Passive activities. Generally, you are in a determined, and economic performance ocness part of these actual expenses, you may be passive activity if you have a trade or business curred in that year.

able to use the standard mileage rate to figure activity in which you do not materially partici- If you use the cash method of accounting,

pate, or a rental activity. In general, deductions deduct the expense on your 2011 return. your deduction. For 2010, the standard mileage

for losses from passive activities only offset in- rate is 50 cents a mile for all business miles Prepayment. You generally cannot deduct come from passive activities. You cannot use driven before January 1, 2011. expenses in advance, even if you pay them in any excess deductions to offset other income. In If you are self-employed, you can also de- advance. This rule applies to both the cash and addition, passive activity credits can only offset duct the business part of interest on your car accrual methods. It applies to prepaid interest, the tax on net passive income. Any excess loss prepaid insurance premiums, and any other ex- loan, state and local personal property tax on the or credits are carried over to later years. Sus- pense paid far enough in advance to, in effect, car, parking fees, and tolls, whether or not you pended passive losses are fully deductible in the create an asset with a useful life extending sub- claim the standard mileage rate. year you completely dispose of the activity. For stantially beyond the end of the current tax year. more information, see Publication 925. For more information on car expenses and

the rules for using the standard mileage rate, Net operating loss. If your deductions are Example. In 2010, you sign a 10-year lease

see Publication 463. more than your income for the year, you may and immediately pay your rent for the first 3

Page 4 Chapter 1 Deducting Business Expenses
years. Even though you paid the rent for 2010, Presumption of profit. An activity is pre- lines of Schedule A (Form 1040). For taxable

2011, and 2012, you can only deduct the rent for sumed carried on for profit if it produced a profit years beginning after Dec. 31, 2008, you can

2010 on your 2010 tax return. You can deduct in at least 3 of the last 5 tax years, including the deduct a casualty loss on property you own for

the rent for 2011 and 2012 on your tax returns current year. Activities that consist primarily of personal use only to the extent it is more than

for those years. breeding, training, showing, or racing horses are $500 and exceeds 10% of your adjusted gross

presumed carried on for profit if they produced a income. The 10% AGI limitation does not apply

Contested liability. Under the cash method, profit in at least 2 of the last 7 tax years, includ- to net disaster losses resulting from federally

you can deduct a contested liability only in the ing the current year. The activity must be sub- declared disasters in 2008 and 2009 and individstantially the same for each year within this year you pay the liability. Under the accrual uals are allowed to claim the net disaster losses

method, you can deduct contested liabilities period. You have a profit when the gross income even if they do not itemize their deductions. The from an activity exceeds the deductions. such as taxes (except foreign or U.S. posses- reduction amount returns to $100 for taxable If a taxpayer dies before the end of the sion income, war profits, and excess profits years beginning after Dec. 31, 2009. See Publi- 5-year (or 7-year) period, the “test” period ends taxes) either in the tax year you pay the liability cation 547 for more information on casualty on the date of the taxpayer’s death. (or transfer money or other property to satisfy losses. For the limits that apply to home mort- If your business or investment activity the obligation) or in the tax year you settle the gage interest, see Publication 936. passes this 3- (or 2-) years-of-profit test, the IRS contest. However, to take the deduction in the will presume it is carried on for profit. This year of payment or transfer, you must meet means the limits discussed here will not apply. Category 2. Deductions that do not result in certain conditions. See section 1.461-2 of the You can take all your business deductions from an adjustment to the basis of property are al- regulations. the activity, even for the years that you have a lowed next, but only to the extent your gross

loss. You can rely on this presumption unless income from the activity is more than your de- Related person. Under an accrual method of the IRS later shows it to be invalid. ductions under the first category. Most business accounting, you generally deduct expenses deductions, such as those for advertising, insur- when you incur them, even if you have not yet Using the presumption later. If you are start- ance premiums, interest, utilities, and wages, paid them. However, if you and the person you ing an activity and do not have 3 (or 2) years belong in this category. owe are related and that person uses the cash showing a profit, you can elect to have the premethod of accounting, you must pay the ex- sumption made after you have the 5 (or 7) years

pense before you can deduct it. Your deduction of experience allowed by the test. Category 3. Business deductions that deis allowed when the amount is includible in in- You can elect to do this by filing Form 5213. crease the basis of property are allowed last, but come by the related cash method payee. See Filing this form postpones any determination only to the extent the gross income from the Related Persons in Publication 538. that your activity is not carried on for profit until 5 activity exceeds the deductions you take under (or 7) years have passed since you started the the first two categories. Deductions for deprecia- activity. tion, amortization, and the part of a casualty loss The benefit gained by making this election is an individual could not deduct in category (1) Not-for-Profit Activities that the IRS will not immediately question belong in this category. Where more than one whether your activity is engaged in for profit. asset is involved, allocate depreciation and Accordingly, it will not restrict your deductions. If you do not carry on your business or invest- these other deductions proportionally. Rather, you will gain time to earn a profit in the ment activity to make a profit, you cannot use a required number of years. If you show 3 (or 2) Individuals must claim the amounts in loss from the activity to offset other income. years of profit at the end of this period, your categories (2) and (3) as miscellane- Activities you do as a hobby, or mainly for sport deductions are not limited under these rules. If ous deductions on Schedule A (Form

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or recreation, are often not entered into for profit. you do not have 3 (or 2) years of profit, the limit 1040). They are subject to the The limit on not-for-profit losses applies to can be applied retroactively to any year with a 2%-of-adjusted-gross-income limit. See Publi- individuals, partnerships, estates, trusts, and S loss in the 5-year (or 7-year) period. cation 529 for information on this limit. corporations. It does not apply to corporations Filing Form 5213 automatically extends the other than S corporations. period of limitations on any year in the 5-year (or Example. Ida is engaged in a not-for-profit In determining whether you are carrying on 7-year) period to 2 years after the due date of activity. The income and expenses of the activity an activity for profit, several factors are taken the return for the last year of the period. The are as follows. into account. No one factor alone is decisive. period is extended only for deductions of the

Among the factors to consider are whether: activity and any related deductions that might be Gross income ................ . $3,200

affected. • You carry on the activity in a businesslike Subtract:

manner, You must file Form 5213 within 3 years Real estate taxes ....... . $700

• The time and effort you put into the activity after the due date of your return (deter- Home mortgage interest ... . 900

mined without extensions) for the year Insurance ............ . 400

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indicate you intend to make it profitable, in which you first carried on the activity, or, if Utilities .............. . 700 • You depend on the income for your liveli- earlier, within 60 days after receiving written Maintenance .......... . 200

hood, notice from the Internal Revenue Service pro- Depreciation on an automobile 600

posing to disallow deductions attributable to the Depreciation on a machine . . 200 3,700 • Your losses are due to circumstances beactivity. yond your control (or are normal in the Loss ...................... . $(500) start-up phase of your type of business),

• You change your methods of operation in Limit on Deductions Ida must limit her deductions to $3,200, the

an attempt to improve profitability, gross income she earned from the activity. The If your activity is not carried on for profit, take limit is reached in category (3), as follows. • You (or your advisors) have the knowl- deductions in the following order and only to the

edge needed to carry on the activity as a extent stated in the three categories. If you are Limit on deduction ............ . $3,200 successful business, an individual, these deductions may be taken

only if you itemize. These deductions may be Category 1: Taxes and • You were successful in making a profit in taken on Schedule A (Form 1040). interest .............. . $1,600

similar activities in the past, Category 2: Insurance,

Category 1. Deductions you can take for per- utilities, and maintenance . . . 1,300 2,900 • The activity makes a profit in some years, sonal as well as for business activities are al- and Available for Category 3 ....... . $ 300 lowed in full. For individuals, all nonbusiness

• You can expect to make a future profit deductions, such as those for home mortgage The $800 of depreciation is allocated be- from the appreciation of the assets used in interest, taxes, and casualty losses, belong in tween the automobile and machine as follows. the activity. this category. Deduct them on the appropriate

Chapter 1 Deducting Business Expenses Page 5
You can claim employment credits like enterprises pay for the same or similar serv- $600 depreciation for the x $300 = $225 such as the following if you hire individ- ices. $800 automobile

uals who meet certain requirements.

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To determine if pay is reasonable, also con-

• Empowerment zone and renewal commu- sider the following items and any other pertinent $200 depreciation for the x $300 = $75 nity employment credit (Form 8844). facts. $800 machine

• • The duties performed by the employee. Indian employment credit (Form 8845). The basis of each asset is reduced accord- • Work opportunity credit (Form 5884). • The volume of business handled. ingly.

• The character and amount of responsibil- Ida includes the $3,200 of gross income on • Credit for employer differential wage pay- ity. line 22 (total income) of Form 1040. The $1,600 ments (Form 8932).

for category (1) is deductible in full on the appro- • The complexities of your business. priate lines for taxes and interest on Schedule A Reduce your deduction for employee wages • The amount of time required. (Form 1040). Ida deducts the remaining $1,600 by the amount of any employment credits you

($1,300 for category (2) and $300 for category claim. For more information about these credits, • The cost of living in the locality. (3)) as other miscellaneous deductions on see the form on which the credit is claimed.

Schedule A (Form 1040) subject to the • The ability and achievements of the indi2%-of-adjusted-gross-income limit. vidual employee performing the service. Topics • The pay compared with the gross and net This chapter discusses: Partnerships and S corporations. If a part- income of the business, as well as with

nership or S corporation carries on a distributions to shareholders if the busi- • Tests for deducting pay not-for-profit activity, these limits apply at the ness is a corporation. partnership or S corporation level. They are re- • Kinds of pay • Your policy regarding pay for all your em- flected in the individual shareholder’s or part- ployees. ner’s distributive shares. Useful Items • The history of pay for each employee. More than one activity. If you have several You may want to see:

undertakings, each may be a separate activity or

several undertakings may be combined. The Publication Test 2—For Services

following are the most significant facts and cir- ❏ 15 (Circular E), Employer’s Tax Guide Performed

cumstances in making this determination.

❏ 15-A Employer’s Supplemental Tax You must be able to prove the payment was • The degree of organizational and eco- Guide made for services actually performed. nomic interrelationship of various undertakings. ❏ 15-B Employer’s Tax Guide to Fringe Employee-shareholder salaries. If a corpo- Benefits • The business purpose that is (or might be) ration pays an employee who is also a shareserved by carrying on the various under- holder a salary that is unreasonably high See chapter 12 for information about getting takings separately or together in a busi- considering the services actually performed, the publications and forms. ness or investment setting. excessive part of the salary may be treated as a

constructive distribution to the em- • The similarity of the undertakings. ployee-shareholder. For more information on

corporate distributions to shareholders, see The IRS will generally accept your characteri- Tests for Publication 542, Corporations. zation if it is supported by facts and circumstances. Deducting Pay

If you are carrying on two or more different activities, keep the deductions To be deductible, your employees’ pay must be

an ordinary and necessary expense and you Kinds of Pay and income from each one separate.

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Figure separately whether each is a must pay or incur it. These and other require- Some of the ways you may provide pay to your not-for-profit activity. Then figure the limit on ments that apply to all business expenses are employees in addition to regular wages or sala- deductions and losses separately for each activ- explained in chapter 1. ries are discussed next. For specialized and ity that is not for profit. In addition, the pay must meet both of the detailed information on employees’ pay and the following tests. employment tax treatment of employees’ pay,

• Test 1. see Publications 15, 15-A, and 15-B. It must be reasonable.

• Test 2. It must be for services performed. Awards

The form or method of figuring the pay does not

affect its deductibility. For example, bonuses You can generally deduct amounts you pay to 2. and commissions based on sales or earnings, your employees as awards, whether paid in

and paid under an agreement made before the cash or property. If you give property to an

services were performed, are both deductible. employee as an employee achievement award,

your deduction may be limited. Employees’ Pay Test 1—Reasonableness Achievement awards. An achievement

You must be able to prove that the pay is rea- award is an item of tangible personal property

that meets all the following requirements. sonable. Base this determination on the circum- Introduction stances that exist when you contract for the • It is given to an employee for length of

You can generally deduct the pay you give your services, not those that exist when the reasona- service or safety achievement.

employees for the services they perform. The bleness is questioned. If the pay is excessive, • It is awarded as part of a meaningful pres- pay may be in cash, property, or services. It may the excess is disallowed for deduction.

entation. include wages, salaries, or other compensation

such as vacation allowances, bonuses, commis- Factors to consider. Determine the reasona- • It is awarded under conditions and circumsions, and fringe benefits. For information about bleness of pay by the facts and circumstances. stances that do not create a significant

deducting employment taxes see chapter 5. Generally, reasonable pay is the amount that likelihood of disguised pay.

Page 6 Chapter 2 Employees’ Pay
Length-of-service award. An award will Gifts of nominal value. If, to promote em- • Meals you furnish to your employees as

qualify as a length-of-service award only if either ployee goodwill, you distribute food or merchan- part of the expense of providing recreaof the following applies. dise of nominal value to your employees at tional or social activities, such as a comholidays, you can deduct the cost of these items pany picnic. • The employee receives the award after his as a nonwage business expense. Your deduc- or her first 5 years of employment. • Meals you are required by federal law to tion for de minimis gifts of food or drink are not furnish to crew members of certain com- • The employee did not receive another subject to the 50% deduction limit that generally mercial vessels (or would be required to length-of-service award (other than one of applies to meals. For more information on this furnish if the vessels were operated at very small value) during the same year or deduction limit, see Meals and lodging, later. sea). This does not include meals you fur- in any of the prior 4 years. nish on vessels primarily providing luxury Education Expenses water transportation. Safety achievement award. An award for

safety achievement will qualify as an achieve- If you pay or reimburse education expenses for • Meals you furnish on an oil or gas platform

ment award unless one of the following applies. an employee, you can deduct the payments if or drilling rig located offshore or in Alaska.

they are part of a qualified educational assis- This includes meals you furnish at a sup- 1. It is given to a manager, administrator, tance program. Deduct them on the “Employee port camp that is near and integral to an clerical employee, or other professional benefit programs” or other appropriate line of oil or gas drilling rig located in Alaska. employee. your tax return. For information on educational

2. During the tax year, more than 10% of assistance programs, see Educational Assis- Employee benefit programs. Employee ben- your employees, excluding those listed in tance in section 2 of Publication 15-B. efit programs include the following. (1), have already received a safety

achievement award (other than one of very Fringe Benefits • Accident and health plans.

small value). • Adoption assistance. A fringe benefit is a form of pay for the performDeduction limit. Your deduction for the ance of services. You can generally deduct the • Cafeteria plans.

cost of employee achievement awards given to cost of fringe benefits. • Dependent care assistance. any one employee during the tax year is limited You may be able to exclude all or part of the to the following. • Educational assistance. value of some fringe benefits from your employ-

• $400 for awards that are not qualified plan ees’ pay. You also may not owe employment • Life insurance coverage.

awards. taxes on the value of the fringe benefits. See • Welfare benefit funds. Table 2-1, Special Rules for Various Types of • $1,600 for all awards, whether or not qual- Fringe Benefits, in Publication 15-B for details. ified plan awards. You can generally deduct amounts you spend Your deduction for the cost of fringe benefits on employee benefit programs on the applicable for activities generally considered entertain- A qualified plan award is an achievement line of your tax return. For example, if you pro- ment, amusement, or recreation, or for a facility award given as part of an established written vide dependent care by operating a dependent used in connection with such an activity (for plan or program that does not favor highly com- care facility for your employees, deduct your example, a company aircraft) for certain officers, pensated employees as to eligibility or benefits. costs in whatever categories they fall (utilities, directors, and more-than-10% shareholders is A highly compensated employee is an em- salaries, etc.). limited. ployee who meets either of the following tests. Certain fringe benefits are discussed next. Life insurance coverage. You cannot deSee Publication 15-B for more details on these duct the cost of life insurance coverage for you, 1. The employee was a 5% owner at any

and other fringe benefits. an employee, or any person with a financial time during the year or the preceding year. interest in your business, if you are directly or 2. The employee received more than Meals and lodging. You can usually deduct indirectly the beneficiary of the policy. See Reg- $110,000 in pay for the preceding year. the cost of furnishing meals and lodging to your ulations section 1.264-1 for more information.

You can choose to ignore test (2) if the em- employees. Deduct the cost in whatever cate- Welfare benefit funds. A welfare benefit

ployee was not also in the top 20% of employees gory the expense falls. For example, if you oper- fund is a funded plan (or a funded arrangement ranked by pay for the preceding year. ate a restaurant, deduct the cost of the meals having the effect of a plan) that provides welfare An award is not a qualified plan award if the you furnish to employees as part of the cost of benefits to your employees, independent con- average cost of all the employee achievement goods sold. If you operate a nursing home, tractors, or their beneficiaries. Welfare benefits awards given during the tax year (that would be motel, or rental property, deduct the cost of are any benefits other than deferred compensa- qualified plan awards except for this limit) is furnishing lodging to an employee as expenses tion or transfers of restricted property. more than $400. To figure this average cost, for utilities, linen service, salaries, depreciation, Your deduction for contributions to a welfare etc. ignore awards of nominal value. benefit fund is limited to the fund’s qualified cost Deduct achievement awards as a nonwage Deduction limit on meals. You can gener- for the tax year. If your contributions to the fund business expense on your return or business ally deduct only 50% of the cost of furnishing are more than its qualified cost, carry the excess schedule. meals to your employees. However, you can over to the next tax year.

You may not owe employment taxes deduct the full cost of the following meals. Generally, the fund’s “qualified cost” is the on the value of some achievement • Meals whose value you include in an em- total of the following amounts, reduced by the awards you provide to an employee.

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ployee’s wages. after-tax income of the fund.

See Publication 15-B. • Meals that qualify as a de minimis fringe • The cost you would have been able to

benefit as discussed in section 2 of Publi- deduct using the cash method of account- Bonuses cation 15-B. This generally includes meals ing if you had paid for the benefits directly.

you furnish to employees at your place of You can generally deduct a bonus paid to an • The contributions added to a reserve ac- business if more than half of these em- employee if you intended the bonus as addi- count that are needed to fund claims in- ployees are provided the meals for your tional pay for services, not as a gift, and the curred but not paid as of the end of the convenience. services were performed. However, the total bo- year. These claims can be for supplemennuses, salaries, and other pay must be reasona- • Meals you furnish to your employees at tal unemployment benefits, severance

ble for the services performed. If the bonus is the work site when you operate a restau- pay, or disability, medical, or life insurance

paid in property, see Property, later. rant or catering service. benefits.

Chapter 2 Employees’ Pay Page 7
For more information, see sections 419(c) and the payment under a nonaccountable plan, de- have or will receive equity in or title to the prop419A of the Internal Revenue Code and the duct it as wages and include it in the employee’s erty, the rent is not deductible.

related regulations. W-2.

See Reimbursement of Travel, Meals, and Unreasonable rent. You cannot take a rental

Loans or Advances Entertainment in chapter 11 for more informa- deduction for unreasonable rent. Ordinarily, the

tion about deducting reimbursements and an issue of reasonableness arises only if you and

You generally can deduct as wages an advance explanation of accountable and nonaccountable the lessor are related. Rent paid to a related

you make to an employee for services per- plans. person (defined below) is reasonable if it is the

formed if you do not expect the employee to same amount you would pay to a stranger for

repay the advance. However, if the employee Sick and Vacation Pay use of the same property. Rent is not unreasonperforms no services, treat the amount you ad- able just because it is figured as a percentage of vanced as a loan. If the employee does not gross sales. Sick pay. You can deduct amounts you pay to repay the loan, treat it as income to the em- your employees for sickness and injury, includ- Related persons. For this purpose, the fol- ployee. ing lump-sum amounts, as wages. However, lowing are considered related persons. your deduction is limited to amounts not com- Below-market interest rate loans. On cer- • An individual and his or her brothers and pensated by insurance or other means. tain loans you make to an employee or share- sisters, half brothers, half sisters, spouse,

holder, you are treated as having received Vacation pay. Vacation pay is an employee ancestors (parents, grandparents, etc.),

interest income and as having paid compensa- benefit. It includes amounts paid for unused and lineal descendants (children, grandtion or dividends equal to that interest. See vacation leave. You can deduct vacation pay children, etc.).

Below-Market Loans in chapter 4. only in the tax year in which the employee actu- • An individual and a corporation if the indi- ally receives it. This rule applies regardless of vidual owns, directly or indirectly, more Property whether you use the cash or accrual method of than 50% in value of the outstanding stock accounting. of the corporation. If you transfer property (including your company’s stock) to an employee as payment for • Two corporations that are members of the

services, you can generally deduct it as wages. same controlled group as defined in sec- The amount you can deduct is the property’s fair tion 267(f) of the Internal Revenue Code. market value on the date of the transfer less any • A grantor and a fiduciary of any trust. amount the employee paid for the property.

You can claim the deduction only for the tax 3. • Fiduciaries of two separate trusts if the

year in which your employee includes the prop- same person is a grantor of both trusts.

erty’s value in income. Your employee is • A fiduciary and a beneficiary of the same deemed to have included the value in income if

trust. you report it on Form W-2 in a timely manner. Rent Expense

 You treat the deductible amount as received • A fiduciary and a beneficiary of two sepain exchange for the property, and you must rec- rate trusts if the same person is a grantor

ognize any gain or loss realized on the transfer, of both trusts.

unless it is the company’s stock transferred as Introduction • A fiduciary of a trust and a corporation if payment for services. Your gain or loss is the This chapter discusses the tax treatment of rent the trust or a grantor of the trust owns, difference between the fair market value of the or lease payments you make for property you directly or indirectly, more than 50% in property and its adjusted basis on the date of use in your business but do not own. It also value of the outstanding stock of the cor- transfer. discusses how to treat other kinds of payments poration. These rules also apply to property trans- you make that are related to your use of this

property. These include payments you make for • A person and a tax-exempt educational or ferred to an independent contractor for services,

generally reported on Form 1099-MISC. taxes on the property, improvements to the charitable organization that is controlled

property, and getting a lease. There is a discus- directly or indirectly by that person or by

Restricted property. sion about capitalizing (including in the cost of members of the family of that person. If the property you

transfer for services is subject to restrictions that property) certain rent expenses at the end of the • A corporation and a partnership if the affect its value, you generally cannot deduct it chapter. same persons own more than 50% in and do not report gain or loss until it is substan- value of the outstanding stock of the cor- tially vested in the recipient. However, if the Topics poration and more than 50% of the capital recipient pays for the property, you must report This chapter discusses: or profits interest in the partnership. any gain at the time of the transfer up to the

amount paid. • The definition of rent • Two S corporations or an S corporation

and a regular corporation if the same per- “Substantially vested” means the property is • Taxes on leased property sons own more than 50% in value of the not subject to a substantial risk of forfeiture. This

means that the recipient is not likely to have to • The cost of getting a lease outstanding stock of each corporation.

give up his or her rights in the property in the • Improvements by the lessee • An executor of an estate and a beneficiary future. of the estate except in the case of a sale • Capitalizing rent expenses or exchange in satisfaction of a pecuniary

Reimbursements bequest.

See chapter 12 for information about getting for Business Expenses publications and forms. To determine whether an individual directly or

You can generally deduct the amount you pay or indirectly owns any of the outstanding stock of a

reimburse employees for business expenses in- corporation, see Related Persons in Publication

curred for your business. However, your deduc- 542, Corporations. For rules that apply to transtion may be limited. Rent actions between partners and partnerships, see

If you make the payment under an accounta- Publication 541, Partnerships.

ble plan, deduct it in the category of the expense Rent is any amount you pay for the use of

paid. For example, if you pay an employee for property you do not own. In general, you can Rent on your home. If you rent your home

travel expenses incurred on your behalf, deduct deduct rent as an expense only if the rent is for and use part of it as your place of business, you

this payment as a travel expense. If you make property you use in your trade or business. If you may be able to deduct the rent you pay for that

Page 8 Chapter 3 Rent Expense
part. You must meet the requirements for busi- Leveraged leases. Leveraged lease trans- more than $250,000 and any of the following

ness use of your home. For more information, actions may not be considered leases. Lever- apply.

see Business use of your home in chapter 1. aged leases generally involve three parties: a • Rents increase during the lease. lessor, a lessee, and a lender to the lessor.

Rent paid in advance. Generally, rent paid in Usually the lease term covers a large part of the • Rents decrease during the lease.

your trade or business is deductible in the year useful life of the leased property, and the • Rents are deferred (rent is payable after paid or accrued. If you pay rent in advance, you lessee’s payments to the lessor are enough to the end of the calendar year following the can deduct only the amount that applies to your cover the lessor’s payments to the lender. calendar year in which the use occurs and use of the rented property during the tax year. If you plan to take part in what appears to be the rent is allocated). You can deduct the rest of your payment only a leveraged lease, you may want to get an • Rents are prepaid (rent is payable before over the period to which it applies. advance ruling. Revenue Procedure 2001-28 on the end of the calendar year preceding the page 1156 of Internal Revenue Bulletin 2001-19

Example 1. You are a calendar year tax- calendar year in which the use occurs and contains the guidelines the IRS will use to deter- the rent is allocated). payer and you leased a building for 5 years mine if a leveraged lease is a lease for federal

beginning July 1. Your rent is $12,000 per year. income tax purposes. Revenue Procedure These rules do not apply if your lease specifies You paid the first year’s rent ($12,000) on June 2001-29 on page 1160 of the same Internal equal amounts of rent for each month in the

30. You can deduct only $6,000 (6/12 × $12,000) Revenue Bulletin provides the information re- lease term and all rent payments are due in the

for the rent that applies to the first year. quired to be furnished in a request for an ad- calendar year to which the rent relates (or in the

vance ruling on a leveraged lease transaction. preceding or following calendar year).

Example 2. You are a calendar year tax- Internal Revenue Bulletin 2001-19 is available at Generally, if the special rules apply, you must payer. Last January you leased property for 3 www.irs.gov/pub/irs-irbs/irb01-19.pdf. use an accrual method of accounting (and time years for $6,000 a year. You paid the full In general, Revenue Procedure 2001-28 value of money principles) for your rental ex- $18,000 (3 × $6,000) during the first year of the provides that, for advance ruling purposes only, penses, regardless of your overall method of lease. Each year you can deduct only $6,000, the IRS will consider the lessor in a leveraged accounting. In addition, in certain cases in which the part of the lease that applies to that year. lease transaction to be the owner of the property the IRS has determined that a lease was deand the transaction to be a valid lease if all the signed to achieve tax avoidance, you must take Canceling a lease. You generally can deduct factors in the revenue procedure are met, in- rent and stated or imputed interest into account as rent an amount you pay to cancel a business cluding the following. under a constant rental accrual method in which lease. • The lessor must maintain a minimum un- the rent is treated as accruing ratably over the

conditional “at risk” equity investment in entire lease term. For details, see section 467 of Lease or purchase. There may be instances the Internal Revenue Code. the property (at least 20% of the cost of in which you must determine whether your pay- the property) during the entire lease term. ments are for rent or for the purchase of the

property. You must first determine whether your • The lessee may not have a contractual

agreement is a lease or a conditional sales con- right to buy the property from the lessor at Taxes on tract. Payments made under a conditional sales less than fair market value when the right

contract are not deductible as rent expense. is exercised. Leased Property

Conditional sales contract. Whether an • The lessee may not invest in the property, If you lease business property, you can deduct agreement is a conditional sales contract de- except as provided by Revenue Procedure as additional rent any taxes you have to pay to pends on the intent of the parties. Determine 2001-28.

or for the lessor. When you can deduct these intent based on the provisions of the agreement • The lessee may not lend any money to the taxes as additional rent depends on your ac- and the facts and circumstances that exist when lessor to buy the property or guarantee the counting method. you make the agreement. No single test, or loan used by the lessor to buy the prop- special combination of tests, always applies. erty. Cash method. If you use the cash method of However, in general, an agreement may be con- accounting, you can deduct the taxes as addi- sidered a conditional sales contract rather than • The lessor must show that it expects to tional rent only for the tax year in which you pay a lease if any of the following is true. receive a profit apart from the tax deduc- them. tions, allowances, credits, and other tax • The agreement applies part of each pay- attributes. ment toward an equity interest you will re- Accrual method. If you use an accrual

method of accounting, you can deduct taxes as ceive. The IRS may charge you a user fee for issuing additional rent for the tax year in which you can • You get title to the property after you make a tax ruling. For more information, see Revenue determine all the following. a stated amount of required payments. Procedure 2011-1 as modified by Announcement 2011-7. See Revenue Procedure 2011-1, • That you have a liability for taxes on the • The amount you must pay to use the prop- 2011-1 I.R.B. 1, available at leased property. erty for a short time is a large part of the www.irs.gov/irb/2011-01_IRB/ar06.html. See • How much the liability is. amount you would pay to get title to the Announcement 2011-7, 2011-5 I.R.B. 446, property. • That economic performance occurred. available at 

• You pay much more than the current fair www.irs.gov/irb/2011-05_IRB/ar10.html. The liability and amount of taxes are deter- rental value of the property. Leveraged leases of limited-use property. mined by state or local law and the lease agree- • You have an option to buy the property at The IRS will not issue advance rulings on lever- ment. Economic performance occurs as you use

a nominal price compared to the value of aged leases of so-called limited-use property. the property.

the property when you may exercise the Limited-use property is property not expected to

option. Determine this value when you be either useful to or usable by a lessor at the Example 1. Oak Corporation is a calendar

make the agreement. end of the lease term except for continued leas- year taxpayer that uses an accrual method of

ing or transfer to a lessee. See Revenue Proce- accounting. Oak leases land for use in its busi- • You have an option to buy the property at dure 2001-28 for examples of limited-use ness. Under state law, owners of real property a nominal price compared to the total property and property that is not limited-use become liable (incur a lien on the property) for amount you have to pay under the agree- property. real estate taxes for the year on January 1 of ment. that year. However, they do not have to pay

• The agreement designates part of the pay- Leases over $250,000. Special rules are pro- these taxes until July 1 of the next year (18

ments as interest, or that part is easy to vided for certain leases of tangible property. The months later) when tax bills are issued. Under

recognize as interest. rules apply if the lease calls for total payments of the terms of the lease, Oak becomes liable for

Chapter 3 Rent Expense Page 9
the real estate taxes in the later year when the Cost of a modification agreement. You may amortize it over the remaining term of the lease.

tax bills are issued. If the lease ends before the have to pay an additional “rent” amount over part You can depreciate the part that is for your

tax bill for a year is issued, Oak is not liable for of the lease period to change certain provisions investment in the improvements over the recovthe taxes for that year. in your lease. You must capitalize these pay- ery period of the property as discussed earlier,

Oak cannot deduct the real estate taxes as ments and amortize them over the remaining without regard to the lease term.

rent until the tax bill is issued. This is when Oak’s period of the lease. You cannot deduct the payliability under the lease becomes fixed. ments as additional rent, even if they are described as rent in the agreement.

Example 2. The facts are the same as in Capitalizing Example 1 except that, according to the terms of Example. You are a calendar year taxpayer

the lease, Oak becomes liable for the real estate and sign a 20-year lease to rent part of a building Rent Expenses taxes when the owner of the property becomes starting on January 1. However, before you ocliable for them. As a result, Oak will deduct the cupy it, you decide that you really need less Under the uniform capitalization rules, you must real estate taxes as rent on its tax return for the space. The lessor agrees to reduce your rent capitalize the direct costs and part of the indirect earlier year. This is the year in which Oak’s from $7,000 to $6,000 per year and to release costs for certain production or resale activities. liability under the lease becomes fixed. the excess space from the original lease. In Include these costs in the basis of property you exchange, you agree to pay an additional rent produce or acquire for resale, rather than claim- amount of $3,000, payable in 60 monthly install- ing them as a current deduction. You recover the ments of $50 each. costs through depreciation, amortization, or cost Cost of Getting a Lease You must capitalize the $3,000 and amortize of goods sold when you use, sell, or otherwise

it over the 20-year term of the lease. Your amor- dispose of the property. You may either enter into a new lease with the tization deduction each year will be $150 Indirect costs include amounts incurred for lessor of the property or get an existing lease ($3,000 ÷ 20). You cannot deduct the $600 (12 × renting or leasing equipment, facilities, or land. from another lessee. Very often when you get an $50) that you will pay during each of the first 5 existing lease from another lessee, you must years as rent. pay the previous lessee money to get the lease, Uniform capitalization rules. You may be besides having to pay the rent on the lease. Commissions, bonuses, and fees. Commis- subject to the uniform capitalization rules if you

If you get an existing lease on property or sions, bonuses, fees, and other amounts you do any of the following, unless the property is

equipment for your business, you generally pay to get a lease on property you use in your produced for your use other than in a business must amortize any amount you pay to get that business are capital costs. You must amortize or an activity carried on for profit. lease over the remaining term of the lease. For these costs over the term of the lease. example, if you pay $10,000 to get a lease and 1. Produce real property or tangible personal

there are 10 years remaining on the lease with property. For this purpose, tangible per- Loss on merchandise and fixtures. If you no option to renew, you can deduct $1,000 each sonal property includes a film, sound re- sell at a loss merchandise and fixtures that you year. cording, video tape, book, or similar bought solely to get a lease, the loss is a cost of The cost of getting an existing lease of tangi- property. getting the lease. You must capitalize the loss ble property is not subject to the amortization and amortize it over the remaining term of the 2. Acquire property for resale. rules for section 197 intangibles discussed in lease.

chapter 8. However, these rules do not apply to the following property.

Option to renew. The term of the lease for

1. Personal property you acquire for resale if amortization includes all renewal options plus

any other period for which you and the lessor Improvements your average annual gross receipts are

$10 million or less for the 3 prior tax years. reasonably expect the lease to be renewed.

However, this applies only if less than 75% of by Lessee 2. Property you produce if you meet either of the cost of getting the lease is for the term the following conditions. If you add buildings or make other permanent remaining on the purchase date (not including improvements to leased property, depreciate any period for which you may choose to renew, a. Your indirect costs of producing the the cost of the improvements using the modified extend, or continue the lease). Allocate the property are $200,000 or less. accelerated cost recovery system (MACRS). lease cost to the original term and any option Depreciate the property over its appropriate re- b. You use the cash method of accounting term based on the facts and circumstances. In

covery period. You cannot amortize the cost and do not account for inventories. some cases, it may be appropriate to make the

allocation using a present value computation. over the remaining term of the lease.

For more information, see Regulations section If you do not keep the improvements when Example 1. You rent construction equip- 1.178-1(b)(5). you end the lease, figure your gain or loss based ment to build a storage facility. If you are subject on your adjusted basis in the improvements at

Example 1. You paid $10,000 to get a lease to the uniform capitalization rules, you must cap- that time.

with 20 years remaining on it and two options to italize as part of the cost of the building the rent For more information, see the discussion of

renew for 5 years each. Of this cost, you paid you paid for the equipment. You recover your MACRS in Publication 946, How To Depreciate $7,000 for the original lease and $3,000 for the cost by claiming a deduction for depreciation on Property. renewal options. Because $7,000 is less than the building.

75% of the total $10,000 cost of the lease (or Assignment of a lease. If a long-term lessee $7,500), you must amortize the $10,000 over 30 Example 2. You rent space in a facility to who makes permanent improvements to land years. That is the remaining life of your present conduct your business of manufacturing tools. If later assigns all lease rights to you for money lease plus the periods for renewal. you are subject to the uniform capitalization and you pay the rent required by the lease, the rules, you must include the rent you paid to amount you pay for the assignment is a capital Example 2. The facts are the same as in occupy the facility in the cost of the tools you investment. If the rental value of the leased land Example 1, except that you paid $8,000 for the produce. increased since the lease began, part of your original lease and $2,000 for the renewal op- capital investment is for that increase in the tions. You can amortize the entire $10,000 over

the 20-year remaining life of the original lease. rental value. The rest is for your investment in More information. For more information on

The $8,000 cost of getting the original lease was the permanent improvements. these rules, see Uniform Capitalization Rules in

not less than 75% of the total cost of the lease The part that is for the increased rental value Publication 538 and the regulations under Inter-

(or $7,500). of the land is a cost of getting a lease, and you nal Revenue Code section 263A.

Page 10 Chapter 3 Rent Expense
Allocate your interest expense to the follow- for a passive activity expenditure. On Septeming categories. ber 4, Connie uses an additional $40,000 from

the account for personal purposes. 4. • Nonpassive trade or business activity in- Under the interest allocation rules, the entire terest $100,000 loan is treated as property held for

• Passive trade or business activity interest investment for the period from January 4

through April 1. From April 2 through September • Investment interest Interest 3, Connie must treat $20,000 of the loan as used

• Portfolio interest in the passive activity and $80,000 of the loan as

property held for investment. From September 4 • Personal interest through December 31, she must treat $40,000 Introduction In general, you allocate interest on a loan the of the loan as used for personal purposes,

same way you allocate the loan proceeds. You $20,000 as used in the passive activity, and This chapter discusses the tax treatment of busi- allocate loan proceeds by tracing disburse- $40,000 as property held for investment. ness interest expense. Business interest exments to specific uses. pense is an amount charged for the use of Order of funds spent. Generally, you treat money you borrowed for business activities. loan proceeds deposited in an account as used The easiest way to trace disburse- (spent) before either of the following amounts. ments to specific uses is to keep the Topics proceeds of a particular loan separate • Any unborrowed amounts held in the

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This chapter discusses: from any other funds. same account.

• Allocation of interest • Any amounts deposited after these loan Secured loan. The allocation of loan pro- proceeds. • Interest you can deduct ceeds and the related interest is not generally

affected by the use of property that secures the • Interest you cannot deduct loan. Example. On January 9, Edith opened a

• Capitalization of interest checking account, depositing $500 of the proExample. You secure a loan with property ceeds of Loan A and $1,000 of unborrowed • When to deduct interest used in your business. You use the loan pro- funds. The following table shows the transac-

• Below-market loans ceeds to buy an automobile for personal use. tions in her account during the tax year.

You must allocate interest expense on the loan Date Transaction to personal use (purchase of the automobile) Useful Items even though the loan is secured by business January 9 $500 proceeds of Loan A You may want to see: property. and $1,000 unborrowed

funds deposited Publication If the property that secures the loan is

your home, you generally do not allo- January 14 $500 proceeds of Loan B 

❏ 537 Installment Sales cate the loan proceeds or the related deposited

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interest. The interest is usually deductible as ❏ 550 Investment Income and Expenses February 19 $800 used for personal qualified home mortgage interest, regardless of purposes ❏ 936 Home Mortgage Interest Deduction how the loan proceeds are used. For more information, see Publication 936. February 27 $700 used for passive

Form (and Instructions) activity

Allocation period. The period for which a June 19 $1,000 proceeds of Loan C ❏ Sch A (Form 1040) Itemized Deductions loan is allocated to a particular use begins on the deposited

❏ Sch E (Form 1040) Supplemental date the proceeds are used and ends on the November 20 $800 used for an Income and Loss earlier of the following dates. investment

❏ Sch K-1 (Form 1065) Partner’s Share of • The date the loan is repaid. December 18 $600 used for personal Income, Deductions, Credits, etc. purposes • The date the loan is reallocated to another

❏ Sch K-1 (Form 1120S) Shareholder’s use. Edith treats the $800 used for personal pur- Share of Income, Deductions, poses as made from the $500 proceeds of Loan Credits, etc. Proceeds not disbursed to borrower. Even A and $300 of the proceeds of Loan B. She

❏ if the lender disburses the loan proceeds to a treats the $700 used for a passive activity as 1098 Mortgage Interest Statement made from the remaining $200 proceeds of third party, the allocation of the loan is still based ❏ 3115 Application for Change in on your use of the funds. This applies whether Loan B and $500 of unborrowed funds. She

Accounting Method you pay for property, services, or anything else treats the $800 used for an investment as made

❏ 4952 by incurring a loan, or you take property subject entirely from the proceeds of Loan C. She treats Investment Interest Expense

Deduction to a debt. the $600 used for personal purposes as made

from the remaining $200 proceeds of Loan C ❏ 8582 Passive Activity Loss Limitations Proceeds deposited in borrower’s account. and $400 of unborrowed funds.

Treat loan proceeds deposited in an account as For the periods during which loan proceeds See chapter 12 for information about getting property held for investment. It does not matter are held in the account, Edith treats them as publications and forms. whether the account pays interest. Any interest property held for investment.

you pay on the loan is investment interest ex- Payments from checking accounts. Gen- pense. If you withdraw the proceeds of the loan, erally, you treat a payment from a checking or you must reallocate the loan based on the use of similar account as made at the time the check is Allocation of Interest the funds. written if you mail or deliver it to the payee within

a reasonable period after you write it. You can The rules for deducting interest vary, depending Example. Connie, a calendar-year tax- treat checks written on the same day as written on whether the loan proceeds are used for busi- payer, borrows $100,000 on January 4 and im- in any order. ness, personal, or investment activities. If you mediately uses the proceeds to open a checking

use the proceeds of a loan for more than one account. No other amounts are deposited in the Amounts paid within 30 days. If you retype of expense, you must make an allocation to account during the year and no part of the loan ceive loan proceeds in cash or if the loan prodetermine the interest for each use of the loan’s principal is repaid during the year. On April 2, ceeds are deposited in an account, you can treat

proceeds. Connie uses $20,000 from the checking account any payment (up to the amount of the proceeds)

Chapter 4 Interest Page 11
made from any account you own, or from cash, account ($867) continues to be investment inter- you use the proceeds of the loan for a trade or

as made from those proceeds. This applies to est expense until you either repay it or reallocate business expense. It does not matter what type

any payment made within 30 days before or it to another use. of property secures the loan. You can deduct

after the proceeds are received in cash or de- interest on a debt only if you meet all the follow- Loan repayment. When you repay any part of posited in your account. ing requirements. a loan allocated to more than one use, treat it as If the loan proceeds are deposited in an being repaid in the following order. • You are legally liable for that debt.

account, you can apply this rule even if the rules • Both you and the lender intend that the stated earlier under Order of funds spent would 1. Personal use. debt be repaid. otherwise require you to treat the proceeds as 2. Investments and passive activities (other used for other purposes. If you apply this rule to • You and the lender have a true than those included in (3)). any payments, disregard those payments (and debtor-creditor relationship.

the proceeds from which they are made) when 3. Passive activities in connection with a

applying the rules stated under Order of funds rental real estate activity in which you ac- Partial liability. If you are liable for part of a tively participate. spent. business debt, you can deduct only your share

If you received the loan proceeds in cash, 4. Former passive activities. of the total interest paid or accrued.

you can treat the payment as made on the date 5. Trade or business use and expenses for you received the cash instead of the date you Example. You and your brother borrow certain low-income housing projects. actually made the payment. money. You are liable for 50% of the note. You

use your half of the loan in your business, and Line of credit (continuous borrowings). Example. Frank gets a loan of $1,000 on you make one-half of the loan payments. You The following rules apply if you have a line of August 4 and receives the proceeds in cash. can deduct your half of the total interest pay- credit or similar arrangement. Frank deposits $1,500 in an account on August ments as a business deduction.

18 and on August 28 writes a check on the 1. Treat all borrowed funds on which interest Mortgage. Generally, mortgage interest paid account for a passive activity expense. Also, accrues at the same fixed or variable rate or accrued on real estate you own legally or Frank deposits his paycheck, deposits other as a single loan. equitably is deductible. However, rather than loan proceeds, and pays his bills during the deducting the interest currently, you may have 2. Treat borrowed funds or parts of borrowed same period. Regardless of these other transac- to add it to the cost basis of the property as funds on which interest accrues at different tions, Frank can treat $1,000 of the deposit he explained later under Capitalization of Interest. fixed or variable rates as different loans. made on August 18 as being paid on August 4 Treat these loans as repaid in the order Statement. If you paid $600 or more of from the loan proceeds. In addition, Frank can shown on the loan agreement. mortgage interest (including certain points) dur- treat the passive activity expense he paid on ing the year on any one mortgage, you generally August 28 as made from the $1,000 loan pro- Loan refinancing. Allocate the replacement will receive a Form 1098 or a similar statement. ceeds treated as deposited in the account. loan to the same uses to which the repaid loan You will receive the statement if you pay interest

Optional method for determining date of was allocated. Make the allocation only to the to a person (including a financial institution or a

reallocation. You can use the following extent you use the proceeds of the new loan to cooperative housing corporation) in the course

method to determine the date loan proceeds are repay any part of the original loan. of that person’s trade or business. A governreallocated to another use. You can treat all mental unit is a person for purposes of furnishing Debt-financed distribution. A debt-financed payments from loan proceeds in the account the statement. distribution occurs when a partnership or S cor- during any month as taking place on the later of If you receive a refund of interest you over- poration borrows funds and allocates those paid in an earlier year, this amount will be re- the following dates. funds to distributions made to partners or share- ported in box 3 of Form 1098. You cannot • The first day of that month. holders. The manner in which you report the deduct this amount. For information on how to interest expense associated with the distributed • The date the loan proceeds are deposited report this refund, see Refunds of interest later debt proceeds depends on your use of those in this chapter. in the account. proceeds.

However, you can use this optional method only Expenses paid to obtain a mortgage. How to report. If the proceeds were used in Certain expenses you pay to obtain a mortgage if you treat all payments from the account during a nonpassive trade or business activity, report cannot be deducted as interest. These ex- the same calendar month in the same way. the interest on Schedule E (Form 1040), line 28; penses, which include mortgage commissions,

Interest on a segregated account. If you enter “interest expense” and the name of the abstract fees, and recording fees, are capital partnership or S corporation in column (a) and have an account that contains only loan pro- expenses. If the property mortgaged is business the amount in column (h). If the proceeds were ceeds and interest earned on the account, you or income-producing property, you can amortize used in a passive activity, follow the Instructions can treat any payment from that account as the costs over the life of the mortgage. for Form 8582, Passive Activity Loss Limita- being made first from the interest. When the tions, to determine the amount of interest ex- Prepayment penalty. If you pay off your interest earned is used up, any remaining pay- pense that can be reported on Schedule E mortgage early and pay the lender a penalty for ments are from loan proceeds. (Form 1040), line 28; enter “interest expense” doing this, you can deduct the penalty as interand the name of the partnership in column (a) est. Example. You borrowed $20,000 and used and the amount in column (f). If the proceeds the proceeds of this loan to open a new savings Interest on employment tax deficiency. In- were used in an investment activity, enter the account. When the account had earned interest terest charged on employment taxes assessed interest on Form 4952. If the proceeds are used of $867, you withdrew $20,000 for personal pur- on your business is deductible. for personal purposes, the interest is generally poses. You can treat the withdrawal as coming not deductible. Original issue discount (OID). OID is a form first from the interest earned on the account, of interest. A loan (mortgage or other debt) gen- $867, and then from the loan proceeds, $19,133 erally has OID when its proceeds are less than ($20,000 − $867). All the interest charged on the its principal amount. The OID is the difference loan from the time it was deposited in the ac- Interest You between the stated redemption price at maturity count until the time of the withdrawal is invest- and the issue price of the loan.

ment interest expense. The interest charged on Can Deduct A loan’s stated redemption price at maturity

the part of the proceeds used for personal pur- is the sum of all amounts (principal and interest)

poses ($19,133) from the time you withdrew it You can generally deduct as a business ex- payable on it other than qualified stated interest.

until you either repay it or reallocate it to another pense all interest you pay or accrue during the Qualified stated interest is stated interest that is

use is personal interest expense. The interest tax year on debts related to your trade or busi- unconditionally payable in cash or property

charged on the loan proceeds you left in the ness. Interest relates to your trade or business if (other than another loan of the issuer) at least

Page 12 Chapter 4 Interest
annually over the term of the loan at a single Example. The facts are the same as in the You cannot currently deduct interest that

fixed rate. previous example, except that you deduct the must be capitalized, and you generally cannot

You generally deduct OID over the term of OID on a constant yield basis over the term of deduct personal interest.

the loan. Figure the amount to deduct each year the loan. The yield to maturity on your loan is

10.2467%, compounded annually. For 2010, Interest paid with funds borrowed from origi- using the constant-yield method, unless the OID you can deduct $93 [($98,500 × .102467) − nal lender. If you use the cash method of on the loan is de minimis.

$10,000]. For 2011, you can deduct $103 accounting, you cannot deduct interest you pay De minimis OID. The OID is de minimis if it [($98,593 × .102467) − $10,000]. with funds borrowed from the original lender

is less than one-fourth of 1% (.0025) of the through a second loan, an advance, or any other Loan or mortgage ends. If your loan or stated redemption price of the loan at maturity arrangement similar to a loan. You can deduct

multiplied by the number of full years from the mortgage ends, you may be able to deduct any the interest expense once you start making pay- remaining OID in the tax year in which the loan date of original issue to maturity (the term of the ments on the new loan. or mortgage ends. A loan or mortgage may end loan). When you make a payment on the new loan, due to a refinancing, prepayment, foreclosure, If the OID is de minimis, you can choose one you first apply the payment to interest and then or similar event. of the following ways to figure the amount you to the principal. All amounts you apply to the

can deduct each year. If you refinance with the original lender, interest on the first loan are deductible, along

you generally cannot deduct the re- with any interest you pay on the second loan, • On a constant-yield basis over the term of maining OID in the year in which the subject to any limits that apply.

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the loan. refinancing occurs, but you may be able to de-

• On a straight-line basis over the term of duct it over the term of the new mortgage or Capitalized interest. You cannot currently

the loan. loan. See Interest paid with funds borrowed from deduct interest you are required to capitalize

original lender under Interest You Cannot De- under the uniform capitalization rules. See Capi- • In proportion to stated interest payments. duct, later. talization of Interest, later. In addition, if you buy

• In its entirety at maturity of the loan. property and pay interest owed by the seller (for

Points. The term “points” is used to describe example, by assuming the debt and any interest You make this choice by deducting the OID in a certain of the charges paid, or treated as paid, accrued on the property), you cannot deduct the manner consistent with the method chosen on by a borrower to obtain a loan or a mortgage. interest. Add this interest to the basis of the your timely filed tax return for the tax year in These charges are also called loan origination property. which the loan is issued. fees, maximum loan charges, discount points, or

premium charges. If any of these charges Commitment fees or standby charges. Example. On January 1, 2010, you took out (points) are solely for the use of money, they are Fees you incur to have business funds available a $100,000 discounted loan and received interest. on a standby basis, but not for the actual use of $98,500 in proceeds. The loan will mature on Because points are prepaid interest, you the funds, are not deductible as interest pay- January 1, 2020 (a 10-year term), and the generally cannot deduct the full amount in the ments. You may be able to deduct them as $100,000 principal is payable on that date. Inter- year paid. However, you can choose to fully business expenses. est of $10,000 is payable on January 1 of each deduct points in the year paid if you meet certain If the funds are for inventory or certain prop- year, beginning January 1, 2011. The $1,500 tests. For exceptions to the general rule, see erty used in your business, the fees are indirect OID on the loan is de minimis because it is less Publication 936. costs and you generally must capitalize them than $2,500 ($100,000 × .0025 × 10). You The points reduce the issue price of the loan under the uniform capitalization rules. See Capi- choose to deduct the OID on a straight-line basis and result in original issue discount, deductible talization of Interest, later. over the term of the loan. Beginning in 2010, you as explained in the preceding discussion. can deduct $150 each year for 10 years. Interest on income tax. Interest charged on

Constant-yield method. If the OID is not de Partial payments on a nontax debt. If you income tax assessed on your individual income

minimis, you must use the constant-yield make partial payments on a debt (other than a tax return is not a business deduction even

method to figure how much you can deduct each debt owed the IRS), the payments are applied, though the tax due is related to income from in general, first to interest and any remainder to year. You figure your deduction for the first year your trade or business. Treat this interest as a principal. You can deduct only the interest. This using the following steps. business deduction only in figuring a net operat- rule does not apply when it can be inferred that ing loss deduction. 1. Determine the issue price of the loan. Gen- the borrower and lender understood that a different allocation of the payments would be made. Penalties. Penalties on underpaid deficien- erally, this equals the proceeds of the loan. cies and underpaid estimated tax are not inter- If you paid points on the loan (as disInstallment purchase. If you make an install- est. You cannot deduct them. Generally, you cussed later), the issue price generally is

ment purchase of business property, the con- cannot deduct any fines or penalties. the difference between the proceeds and

the points. tract between you and the seller generally

provides for the payment of interest. If no inter- Interest on loans with respect to life insur2. Multiply the result in (1) by the yield to est or a low rate of interest is charged under the ance policies. You generally cannot deduct

maturity. contract, a portion of the stated principal amount interest on a debt incurred with respect to any

payable under the contract may be recharacter- life insurance, annuity, or endowment contract 3. Subtract any qualified stated interest pay- that covers any individual unless that individual ments from the result in (2). This is the ized as interest (unstated interest). The amount

is a key person. OID you can deduct in the first year. recharacterized as interest reduces your basis

in the property and increases your interest ex- If the policy or contract covers a key person, To figure your deduction in any subsequent pense. For more information on installment you can deduct the interest on up to $50,000 of year, follow the above steps, except determine sales and unstated interest, see Publication debt for that person. However, the deduction for the adjusted issue price in step (1). To get the 537. any month cannot be more than the interest adjusted issue price, add to the issue price any figured using Moody’s Composite Yield on Sea- OID previously deducted. Then follow steps (2) soned Corporate Bonds (formerly known as and (3) above. Moody’s Corporate Bond Yield AverThe yield to maturity is generally shown in Interest You age-Monthly Average Corporates) (Moody’s

the literature you receive from your lender. If you rate) for that month.

do not have this information, consult your lender Cannot Deduct Who is a key person? A key person is an or tax advisor. In general, the yield to maturity is officer or 20% owner. However, the number of the discount rate that, when used in computing Certain interest payments cannot be deducted. individuals you can treat as key persons is lim- the present value of all principal and interest In addition, certain other expenses that may ited to the greater of the following. payments, produces an amount equal to the seem to be interest are not, and you cannot

principal amount of the loan. deduct them as interest. • Five individuals.

Chapter 4 Interest Page 13
• The lesser of 5% of the total officers and the property is used in your trade or business, until the tax year the final determination of liabilemployees of the company or 20 individu- recover capitalized interest through an adjust- ity is made. If you do not contest the deficiency,

als. ment to basis, depreciation, amortization, or then the interest accrues in the year the tax was

other method. asserted and agreed to by you.

Exceptions for pre-June 1997 contracts. However, if you contest but pay the pro- You can generally deduct the interest if the con- Partnerships and S corporations. The inter- posed tax deficiency and interest, and you do tract was issued before June 9, 1997, and the est capitalization rules are applied first at the not designate the payment as a cash bond, then covered individual is someone other than an partnership or S corporation level. The rules are the interest is deductible in the year paid. employee, officer, or someone financially inter- then applied at the partners’ or shareholders’

ested in your business. If the contract was pur- level to the extent the partnership or S corpora- Related person. If you use an accrual

chased before June 21, 1986, you can generally tion has insufficient debt to support the produc- method, you cannot deduct interest owed to a

deduct the interest no matter who is covered by tion or construction costs. related person who uses the cash method until

the contract. If you are a partner or a shareholder, you payment is made and the interest is includible in may have to capitalize interest you incur during the gross income of that person. The relation- Interest allocated to unborrowed policy the tax year for the production costs of the part- ship is determined as of the end of the tax year cash value. Corporations and partnerships nership or S corporation. You may also have to generally cannot deduct any interest expense for which the interest would otherwise be de- capitalize interest incurred by the partnership or allocable to unborrowed cash values of life in- ductible. See section 267 of the Internal Reve- S corporation for your own production costs. To surance, annuity, or endowment contracts. This nue Code for more information. properly capitalize interest under these rules, rule applies to contracts issued after June 8, you must be given the required information in an 1997, that cover someone other than an officer, attachment to the Schedule K-1 you receive director, employee, or 20% owner. For more from the partnership or S corporation. information, see section 264(f) of the Internal Below-Market Loans

Revenue Code. Additional information. The procedures for

applying the uniform capitalization rules are be- If you receive a below-market gift or demand

yond the scope of this publication. For more loan and use the proceeds in your trade or

information, see sections 1.263A-8 through business, you may be able to deduct the forgone Capitalization 1.263A-15 of the regulations and Notice 88-99. interest. See Treatment of gift and demand

Notice 88-99 is in Cumulative Bulletin 1988-2. loans later in this discussion. of Interest A below-market loan is a loan on which no

interest is charged or on which interest is Under the uniform capitalization rules, you gen- charged at a rate below the applicable federal erally must capitalize interest on debt equal to When To rate. A gift or demand loan that is a be- your expenditures to produce real property or low-market loan generally is considered an certain tangible personal property. The property Deduct Interest

must be produced by you for use in your trade or arm’s-length transaction in which you, the borrower, are considered as having received both business or for sale to customers. You cannot If the uniform capitalization rules, discussed the following. capitalize interest related to property that you under Capitalization of Interest, earlier, do not

acquire in any other manner. apply to you, deduct interest as follows. • A loan in exchange for a note that requires Interest you paid or incurred during the pro- the payment of interest at the applicable duction period must be capitalized if the property Cash method. Under the cash method, you federal rate.

produced is designated property. Designated can generally deduct only the interest you actuproperty is any of the following. ally paid during the tax year. You cannot deduct • An additional payment in an amount equal

a promissory note you gave as payment be- to the forgone interest. • Real property. cause it is a promise to pay and not an actual The additional payment is treated as a gift, divi- • Tangible personal property with a class life payment. dend, contribution to capital, payment of com- of 20 years or more. Prepaid interest. You generally cannot de- pensation, or other payment, depending on the

• Tangible personal property with an esti- duct any interest paid before the year it is due. substance of the transaction.

mated production period of more than 2 Interest paid in advance can be deducted only in

years. the tax year in which it is due. Forgone interest.

For any period, forgone interest is: • Tangible personal property with an esti- Discounted loan. If interest or a discount is

mated production period of more than 1 subtracted from your loan proceeds, it is not a 1. The interest that would be payable for that year if the estimated cost of production is payment of interest and you cannot deduct it period if interest accrued on the loan at the more than $1 million. when you get the loan. For more information, applicable federal rate and was payable see Original issue discount (OID) under Interest annually on December 31, You Can Deduct, earlier. Property you produce. You produce property minus

if you construct, build, install, manufacture, de- Refunds of interest. If you pay interest and 2. Any interest actually payable on the loan velop, improve, create, raise, or grow it. Treat then receive a refund in the same tax year of any for the period. property produced for you under a contract as part of the interest, reduce your interest deducproduced by you up to the amount you pay or tion by the refund. If you receive the refund in a Applicable federal rates are published incur for the property. later tax year, include the refund in your income by the IRS each month in the Internal to the extent the deduction for the interest re- Carrying charges. Carrying charges include Revenue Bulletin. Internal Revenue

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duced your tax. Bulletins are available on the IRS web site at taxes you pay to carry or develop real estate or

to carry, transport, or install personal property. Accrual method. Under an accrual method, www.irs.gov/irb. You can also contact an IRS

You can choose to capitalize carrying charges office to get these rates. you can deduct only interest that has accrued

not subject to the uniform capitalization rules if during the tax year.

they are otherwise deductible. For more infor- Loans subject to the rules. The rules for be- Prepaid interest. See Prepaid interest, mation, see chapter 7. low-market loans apply to the following. above.

Capitalized interest. Treat capitalized inter- Discounted loan. See Discounted loan, 1. Gift loans (below-market loans where the est as a cost of the property produced. You above. forgone interest is in the nature of a gift). recover your interest when you sell or use the

property. If the property is inventory, recover Tax deficiency. If you contest a federal in- 2. Compensation-related loans (becapitalized interest through cost of goods sold. If come tax deficiency, interest does not accrue low-market loans between an employer

Page 14 Chapter 4 Interest
and an employee or between an indepen- Exceptions for loans without significant tax the health of the individual or individual’s

dent contractor and a person for whom the effect. The following loans are specifically ex- spouse in an:

contractor provides services). empted from the rules for below-market loans a. independent living unit (which has addi- because their interest arrangements do not 3. Corporation-shareholder loans. tional available facilities outside the unit have a significant effect on the federal tax liabil- for the provision of meals and other per- 4. Tax avoidance loans (below-market loans ity of the borrower or the lender.

where the avoidance of federal tax is one sonal care), and

1. Loans made available by lenders to the of the main purposes of the interest ar- b. assisted living or nursing facility avail- general public on the same terms and con- rangement). able in the continuing care facility. ditions that are consistent with the lender’s

5. Loans to qualified continuing care facilities customary business practices. 3. The individual or individual’s spouse will be under a continuing care contract (made af2. Loans subsidized by a federal, state, or provided with assisted living or nursing ter October 11, 1985).

municipal government that are made avail- care available in the continuing care facil- Except as noted in (5) above, these rules able under a program of general applica- ity, as required for the health of the individ- apply to demand loans (loans payable in full at tion to the public. ual or the individual’s spouse. any time upon the lender’s demand) outstanding

3. Certain employee-relocation loans. For more information, see section 7872(h) of after June 6, 1984, and to term loans (loans that the Internal Revenue Code. are not demand loans) made after that date. 4. Certain loans to or from a foreign person,

unless the interest income would be effec- Sale or exchange of property. Different rules Treatment of gift and demand loans. If you tively connected with the conduct of a U.S. generally apply to a loan connected with the sale receive a below-market gift loan or demand trade or business and not exempt from or exchange of property. If the loan does not loan, you are treated as receiving an additional U.S. tax under an income tax treaty. provide adequate stated interest, part of the payment (as a gift, dividend, etc.) equal to the

5. Any other loan if the taxpayer can show principal payment may be considered interest. forgone interest on the loan. You are then

that the interest arrangement has no signif- However, there are exceptions that may require treated as transferring this amount back to the

icant effect on the federal tax liability of the you to apply the below-market interest rate rules lender as interest. These transfers are considto these loans. See Unstated Interest and Origi- ered to occur annually, generally on December lender or the borrower. Whether an interest arrangement has a significant effect on nal Issue Discount (OID) in Publication 537. 31. If you use the loan proceeds in your trade or

business, you can deduct the forgone interest the federal tax liability of the lender or the More information. For more information on each year as a business interest expense. The borrower will be determined by all the facts below-market loans, see section 7872 of the lender must report it as interest income. and circumstances. Consider all the followInternal Revenue Code and section 1.7872-5 of ing factors. Limit on forgone interest for gift loans of the regulations. $100,000 or less. For gift loans between indi- a. Whether items of income and deduction

viduals, forgone interest treated as transferred generated by the loan offset each other. back to the lender is limited to the borrower’s net

b. The amount of the items. investment income for the year. This limit applies if the outstanding loans between the lender c. The cost of complying with the be- and borrower total $100,000 or less. If the bor- low-market loan provisions if they were rower’s net investment income is $1,000 or less, to apply. 5.

it is treated as zero. This limit does not apply to a d. Any reasons, other than taxes, for loan if the avoidance of any federal tax is one of

structuring the transaction as a be- the main purposes of the interest arrangement.

low-market loan. Taxes

Treatment of term loans. If you receive a

below-market term loan other than a gift or demand loan, you are treated as receiving an addi- Exception for loans to qualified continuing

tional cash payment (as a dividend, etc.) on the care facilities. The below-market interest Introduction

date the loan is made. This payment is equal to rules do not apply to a loan owed by a qualified You can deduct various federal, state, local, and

the loan amount minus the present value, at the continuing care facility under a continuing care foreign taxes directly attributable to your trade or

applicable federal rate, of all payments due contract if the lender or lender’s spouse is age business as business expenses.

under the loan. The same amount is treated as 62 or older by the end of the calendar year. You cannot deduct federal income original issue discount on the loan. See Original A qualified continuing care facility is one or taxes, estate and gift taxes, or state issue discount (OID) under Interest You Can more facilities (excluding nursing homes) meetCAUTION

inheritance, legacy, and succession

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Deduct, earlier. ing the requirements listed below. taxes.

Exceptions for loans of $10,000 or less. The 1. Designed to provide services under continrules for below-market loans do not apply to any uing care contracts (defined below). Topics

day on which the total outstanding loans be- This chapter discusses: 2. Includes an independent living unit, and tween the borrower and lender is $10,000 or either an assisted living or nursing facility, less. This exception applies only to the follow- • When to deduct taxes or both. ing. • Real estate taxes 3. Substantially all of the independent living

1. Gift loans between individuals if the loan is unit residents are covered by continuing • Income taxes

not directly used to buy or carry in- care contracts. • Employment taxes come-producing assets. A continuing care contract is a written con- • Other taxes 2. Compensation-related loans or corpora- tract between an individual and a qualified contion-shareholder loans if the avoidance of tinuing care facility that includes all of the any federal tax is not a principal purpose of following conditions. Useful Items

the interest arrangement. You may want to see: 1. The individual or individual’s spouse must This exception does not apply to a term loan be entitled to use the facility for the rest of described in (2) above that was previously sub- Publication

their life or lives. ject to the below-market loan rules. Those rules ❏ 15 (Circular E), Employer’s Tax Guide will continue to apply even if the outstanding 2. The individual or individual’s spouse will be

balance is reduced to $10,000 or less. provided with housing, as appropriate for ❏ 334 Tax Guide for Small Business

Chapter 5 Taxes Page 15
❏ 510 Excise Taxes deduction reduced your federal income tax in date of sale. You can usually find this informathe earlier year. For more information, see Re- tion on the settlement statement you received at ❏ 538 Accounting Periods and Methods covery of amount deducted (tax benefit rule) in closing.

❏ 551 Basis of Assets chapter 1. If you (the seller) use an accrual method and

You must include in income any inter- have not elected to ratably accrue real estate Form (and Instructions) est you receive on tax refunds. taxes, you are considered to have accrued your

part of the tax on the date you sell the property. ❏ Sch A (Form 1040) Itemized Deductions

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❏ Sch SE (Form 1040) Self-Employment Example. Al Green, a calendar year accrual

Tax method taxpayer, owns real estate in Elm

❏ County. He has not elected to ratably accrue 3115 Application for Change in property taxes. November 30 of each year is the Accounting Method Real Estate Taxes assessment and lien date for the current real

See chapter 12 for information about getting property tax year, which is the calendar year. He Deductible real estate taxes are any state, local, publications and forms. sold the property on June 30, 2010. Under his or foreign taxes on real estate levied for the accounting method he would not be able to general public welfare. The taxing authority claim a deduction for the taxes because the sale must base the taxes on the assessed value of occurred before November 30. He is treated as the real estate and charge them uniformly having accrued his part of the tax, 180 When To /365 (Janu- against all property under its jurisdiction. De- ary 1–June 29), on June 30, and he can deduct ductible real estate taxes generally do not in- Deduct Taxes it for 2010. clude taxes charged for local benefits and

improvements that increase the value of the Generally, you can only deduct taxes in the year Electing to ratably accrue. If you use an ac- property. See Taxes for local benefits, later. you pay them. This applies whether you use the crual method, you can elect to accrue real estate If you use an accrual method, you generally cash method or an accrual method of account- tax related to a definite period ratably over that cannot accrue real estate taxes until you pay ing. period. them to the government authority. However, you Under an accrual method, you can deduct a can elect to ratably accrue the taxes during the tax before you pay it if you meet the exception Example. John Smith is a calendar year year. See Electing to ratably accrue, later. for recurring items discussed under Economic taxpayer who uses an accrual method. His real

Performance in Publication 538. You can also Taxes for local benefits. Generally, you can- estate taxes for the real property tax year, July 1,

elect to ratably accrue real estate taxes as dis- not deduct taxes charged for local benefits and 2010, to June 30, 2011, are $1,200. July 1 is the cussed later under Real Estate Taxes. assessment and lien date. improvements that tend to increase the value of

Limit on accrual of taxes. A taxing jurisdic- your property. These include assessments for If John elects to ratably accrue the taxes,

streets, sidewalks, water mains, sewer lines, $600 will accrue in 2010 ($1,200 × 6 tion can require the use of a date for accruing /12, July

taxes that is earlier than the date it originally and public parking facilities. You should in- 1–December 31) and the balance will accrue in

required. However, if you use an accrual crease the basis of your property by the amount 2011.

method, and can deduct the tax before you pay of the assessment. Separate elections. You can elect to rata- it, use the original accrual date for the year of You can deduct taxes for these local benefits bly accrue the taxes for each separate trade or change and all future years to determine when only if the taxes are for maintenance, repairs, or business and for nonbusiness activities if you you can deduct the tax. interest charges related to those benefits. If part account for them separately. Once you elect to of the tax is for maintenance, repairs, or interest, ratably accrue real estate taxes, you must use Example. Your state imposes a tax on per- you must be able to show how much of the tax is that method unless you get permission from the sonal property used in a trade or business con- for these expenses to claim a deduction for that IRS to change. See Form 3115, later. ducted in the state. This tax is assessed and part of the tax.

becomes a lien as of July 1 (accrual date). In Making the election. If you elect to ratably

2010, the state changed the assessment and Example. To improve downtown commer- accrue the taxes for the first year in which you

lien dates from July 1, 2011, to December 31, cial business, Waterfront City converted a down- incur real estate taxes, attach a statement to

2010, for property tax year 2011. Use the origi- town business area street into an enclosed your income tax return for that year. The state- nal accrual date (July 1, 2011) to determine pedestrian mall. The city assessed the full cost ment should show all the following items. when you can deduct the tax. You must also use of construction, financed with 10-year bonds,

the July 1 accrual date for all future years to against the affected properties. The city is pay- • The trades or businesses to which the

determine when you can deduct the tax. ing the principal and interest with the annual election applies and the accounting

payments made by the property owners. method or methods used.

Uniform capitalization rules. Uniform capi- The assessments for construction costs are • The period to which the taxes relate. talization rules apply to certain taxpayers who not deductible as taxes or as business exproduce real property or tangible personal prop- penses, but are depreciable capital expenses. • The computation of the real estate tax de- erty for use in a trade or business or for sale to The part of the payments used to pay the inter- duction for that first year. customers. They also apply to certain taxpayers est charges on the bonds is deductible as taxes. who acquire property for resale. Under these Generally, you must file your return by the due rules, you either include certain costs in inven- Charges for services. Water bills, sewerage, date (including extensions). However, if you tory or capitalize certain expenses related to the and other service charges assessed against timely filed your return for the year without elect- property, such as taxes. For more information, your business property are not real estate taxes, ing to ratably accrue, you can still make the see chapter 1. but are deductible as business expenses. election by filing an amended return within 6

Carrying charges. Carrying charges include months after the due date of the return (exclud- Purchase or sale of real estate. If real estate taxes you pay to carry or develop real estate or ing extensions). Attach the statement to the is sold, the real estate taxes must be allocated to carry, transport, or install personal property. amended return and write “Filed pursuant to between the buyer and the seller. You can elect to capitalize carrying charges not section 301.9100-2” on the statement. File the

The buyer and seller must allocate the real subject to the uniform capitalization rules if they amended return at the same address where you estate taxes according to the number of days in are otherwise deductible. For more information, filed the original return. the real property tax year (the period to which see chapter 7. the tax imposed relates) that each owned the Form 3115. If you elect to ratably accrue

Refunds of taxes. If you receive a refund for property. Treat the seller as paying the taxes up real estate taxes for a year after the first year in

any taxes you deducted in an earlier year, in- to but not including the date of sale. Treat the which you incur real estate taxes, or if you want

clude the refund in income to the extent the buyer as paying the taxes beginning with the to revoke your election to ratably accrue real

Page 16 Chapter 5 Taxes
estate taxes, file Form 3115. For more informa- the tax as part of that service or cost. If the

tion, including applicable time frames for filing, Employment Taxes property is merchandise bought for resale, the

see the Instructions for Form 3115. sales tax is part of the cost of the merchandise. If

the property is depreciable, add the sales tax to If you have employees, you must withhold vari- Note. If you are filing an application for a the basis for depreciation. For more information ous taxes from your employees’ pay. Most em- change in accounting method filed after January on basis, see Publication 551. ployers must withhold their employees’ share of 9, 2011, for a year of change ending after April social security and Medicare taxes along with Do not deduct state and local sales 29, 2010, see Revenue Procedure 2011-14, state and federal income taxes. You may also taxes imposed on the buyer that you 2011-4 I.R.B. 330, available at need to pay certain employment taxes from your

CAUTION

must collect and pay over to the state

!

www.irs.gov/irb/2011-04IRB/ar08.html. own funds. These include your share of social or local government. Also, do not include these security and Medicare taxes as an employer, taxes in gross receipts or sales. along with unemployment taxes.

Your deduction for wages paid is not re- Income Taxes duced by the social security, medicare, and in- Self-employment tax. You can deduct

come taxes you withhold from your employees. one-half of your self-employment tax as a busi- This section discusses federal, state, local, and You can deduct the employment taxes you must ness expense in figuring your adjusted gross foreign income taxes. pay from your own funds as taxes. income. This deduction only affects your income

tax. It does not affect your net earnings from Federal income taxes. You cannot deduct Example. You pay your employee $18,000 self-employment or your self-employment tax. federal income taxes. a year. However, after you withhold various To deduct the tax, enter on Form 1040, line taxes, your employee receives $14,500. You State and local income taxes. A corporation 27, the amount shown on the Deduction for also pay an additional $1,500 in employment or partnership can deduct state and local in- one-half of self-employment tax line of Schedule taxes. You should deduct the full $18,000 as come taxes imposed on the corporation or part- SE (Form 1040). wages. You can deduct the $1,500 you pay from nership as business expenses. An individual For more information on self-employment your own funds as taxes. can deduct state and local income taxes only as tax, see Publication 334. For more information on employment taxes, an itemized deduction on Schedule A (Form see Publication 15 (Circular E). 1040).

However, an individual can deduct a state Unemployment fund taxes. As an employer, tax on gross income (as distinguished from net you may have to make payments to a state income) directly attributable to a trade or busi- unemployment compensation fund or to a state ness as a business expense. disability benefit fund. Deduct these payments

Accrual of contested income taxes. If you as taxes. 6.

use an accrual method, and you contest a state

or local income tax liability, you must accrue and

deduct any contested amount in the tax year in

which the liability is finally determined. Other Taxes Insurance

If additional state or local income taxes for a

prior year are assessed in a later year, you can The following are other taxes you can deduct if

deduct the taxes in the year in which they were you incur them in the ordinary course of your

originally imposed (the prior year) if the tax liability is not contested. You cannot deduct them in

trade or business. What’s New

the year in which the liability is finally deter- Excise taxes. You can deduct as a business

mined. Self-employed health insurance deduction. expense all excise taxes that are ordinary and Effective March 30, 2010, if you were necessary expenses of carrying on your trade or The filing of an income tax return is not self-employed and paid for health insurance, business. However, see Fuel taxes, later. considered a contest and, in the ab- you may be able to include in your deduction any sence of an overt act of protest, you

TIP

Franchise taxes. You can deduct corporate premiums you paid to cover your child who was can deduct the tax in the prior year. Also, you franchise taxes as a business expense. under age 27 at the end of 2010, even if the child can deduct any additional taxes in the prior year was not your dependent. For 2010, the if you do not show some affirmative evidence of Fuel taxes. Generally, taxes on gasoline, die- self-employed health insurance deduction is denial of the liability. sel fuel, and other motor fuels that you use in also allowed on Schedule SE. See

However, if you consistently deduct addi- your business are included as part of the cost of Self-Employed Health Insurance Deduction.

tional assessments in the year they are paid or the fuel. Do not deduct these taxes as a sepafinally determined (including those for which rate item.

there was no contest), you must continue to do You may be entitled to a credit or refund for

so. You cannot take a deduction in the earlier federal excise tax you paid on fuels used for Introduction year unless you receive permission to change certain purposes. For more information, see

your method of accounting. For more informa- Publication 510. You generally can deduct the ordinary and nection on accounting methods, see When Can I essary cost of insurance as a business expense

Deduct an Expense in chapter 1. Occupational taxes. You can deduct as a if it is for your trade, business, or profession.

business expense an occupational tax charged However, you may have to capitalize certain

Foreign income taxes. Generally, you can at a flat rate by a locality for the privilege of insurance costs under the uniform capitalization

take either a deduction or a credit for income working or conducting a business in the locality. rules. For more information, see Capitalized

taxes imposed on you by a foreign country or a Premiums, later.

U.S. possession. However, an individual cannot Personal property tax. You can deduct any

take a deduction or credit for foreign income tax imposed by a state or local government on Topics taxes paid on income that is exempt from U.S. personal property used in your trade or busi- This chapter discusses: tax under the foreign earned income exclusion ness.

or the foreign housing exclusion. For information • Deductible premiums on these exclusions, see Publication 54, Tax Sales tax. Treat any sales tax you pay on a

Guide for U.S. Citizens and Resident Aliens service or on the purchase or use of property as • Nondeductible premiums

Abroad. For information on the foreign tax credit, part of the cost of the service or property. If the • Capitalized premiums see Publication 514, Foreign Tax Credit for Indi- service or the cost or use of the property is a

viduals. deductible business expense, you can deduct • When to deduct premiums

Chapter 6 Insurance Page 17
Useful Items 8. Overhead insurance that pays for business them and report the premium amounts on

overhead expenses you have during long Schedule K-1 (Form 1065) as guaranteed You may want to see: periods of disability caused by your injury payments to be included in your gross inor sickness. come. However, if the policy is in your Publication name and you pay the premiums yourself, 9. Car and other vehicle insurance that cov-

❏ 15-B Employer’s Tax Guide to Fringe the partnership must reimburse you and ers vehicles used in your business for lia- Benefits report the premium amounts on Schedule bility, damages, and other losses. If you K-1 (Form 1065) as guaranteed payments ❏ 525 Taxable and Nontaxable Income operate a vehicle partly for personal use, to be included in your gross income. Oth- deduct only the part of the insurance pre- ❏ 538 Accounting Periods and Methods erwise, the insurance plan will not be con- mium that applies to the business use of sidered to be established under your ❏ 547 Casualties, Disasters, and Thefts the vehicle. If you use the standard mile- business.

age rate to figure your car expenses, you

Form (and Instructions) cannot deduct any car insurance premi- • For more-than-2% shareholders, a policy

ums. can be either in the name of the S corpo-

❏ 1040 U.S. Individual Income Tax Return ration or in the name of the shareholder.

10. Life insurance covering your officers and You can either pay the premiums yourself

See chapter 12 employees if you are not directly or indi- for information about getting or your S corporation can pay them and

publications and forms. rectly a beneficiary under the contract. report the premium amounts on Form W-2

11. Business interruption insurance that pays as wages to be included in your gross

income. However, if the policy is in your for lost profits if your business is shut down

due to a fire or other cause. name and you pay the premiums yourself,

Deductible Premiums the S corporation must reimburse you and

report the premium amounts on Form W-2

Self-Employed Health as wages to be included in your gross You generally can deduct premiums you pay for income. Otherwise, the insurance plan will the following kinds of insurance related to your Insurance Deduction

not be considered to be established under trade or business. 

You may be able to deduct premiums paid for your business.

1. Insurance that covers fire, storm, theft, ac- medical and dental insurance and qualified

cident, or similar losses. long-term care insurance for yourself, your Medicare premiums you voluntarily pay to obspouse, and your dependents. Effective March tain insurance that is similar to qualifying private 2. Credit insurance that covers losses from 30, 2010, the insurance can also cover your health insurance can be used to figure the de- business bad debts. child who was under age 27 at the end of 2010, duction. If you previously filed a return without

3. Group hospitalization and medical insur- even if the child was not your dependent. A child using Medicare premiums to figure the deducance for employees, including long-term includes your son, daughter, stepchild, adopted tion, you can file an amended return to refigure

care insurance. child, or foster child. A foster child is any child the deduction. For more information, see Form

placed with you by an authorized placement 1040X, Amended U.S. Individual Income Tax

a. If a partnership pays accident and agency or by judgment, decree, or other order of Return.

health insurance premiums for its part- any court of competent jurisdiction. Amounts paid for health insurance coverage

ners, it generally can deduct them as from retirement plan distributions that were non- One of the following statements must be guaranteed payments to partners. taxable because you are a retired public safety true.

officer cannot be used to figure the deduction. b. If an S corporation pays accident and • You were self-employed and had a net Take the deduction on Form 1040, line 29. health insurance premiums for its profit for the year reported on Schedule C more-than-2% shareholder-employees,

it generally can deduct them, but must (Form 1040), Profit or Loss From Busi- Qualified long-term care insurance. You

ness; Schedule C-EZ (Form 1040), Net also include them in the shareholder’s can include premiums paid on a qualified Profit From Business; or Schedule F wages subject to federal income tax long-term care insurance contract when figuring (Form 1040), Profit or Loss From Farming. withholding. See Publication 15-B. your deduction. But, for each person covered,

• You were a partner with net earnings from you can include only the smaller of the following

4. Liability insurance. amounts. self-employment for the year reported on

Schedule K-1 (Form 1065), Partner’s 5. Malpractice insurance that covers your 1. The amount paid for that person. Share of Income, Deductions, Credits, personal liability for professional negli- etc., box 14, code A. 2. The amount shown below. Use the per- gence resulting in injury or damage to pa- son’s age at the end of the tax year. tients or clients. • You used one of the optional methods to

6. Workers’ compensation insurance set by figure your net earnings from a. Age 40 or younger–$330

self-employment on Schedule SE. state law that covers any claims for bodily b. Age 41 to 50–$620 injuries or job-related diseases suffered by • You were a shareholder owning more than

employees in your business, regardless of c. Age 51 to 60–$1,230 2% of the outstanding stock of an S corpofault. ration with wages for the year from the d. Age 61 to 70–$3,290

corporation reported on Form W-2, Wage a. If a partnership pays workers’ compen- e. Age 71 or older–$4,110 and Tax Statement. sation premiums for its partners, it generally can deduct them as guaranteed The insurance plan must be established, or Qualified long-term care insurance con- payments to partners. considered to be established as discussed in the tract. A qualified long-term care insurance

b. If an S corporation pays workers’ com- following bullets, under your business. contract is an insurance contract that only propensation premiums for its vides coverage of qualified long-term care serv- • For self-employed individuals filing a more-than-2% shareholder-employees, ices. The contract must meet all the following Schedule C, C-EZ, or F, a policy can be it generally can deduct them, but must requirements. either in the name of the business or in the also include them in the shareholder’s name of the individual. • It must be guaranteed renewable. wages.

• For partners, a policy can be either in the • It must provide that refunds, other than

7. Contributions to a state unemployment in- name of the partnership or in the name of refunds on the death of the insured or

surance fund are deductible as taxes if the partner. You can either pay the premi- complete surrender or cancellation of the

they are considered taxes under state law. ums yourself or your partnership can pay contract, and dividends under the contract

Page 18 Chapter 6 Insurance
may be used only to reduce future premi- Effect on self-employment tax. For tax years you cannot get business insurance coverums or increase future benefits. beginning in 2010, you can subtract the age for certain business risks. However,

self-employed health insurance deduction when your actual losses may be deductible. See • It must not provide for a cash surrender figuring net earnings for your self-employment Publication 547. value or other money that can be paid, tax from the business under which the insurance assigned, pledged, or borrowed. 2. Loss of earnings. You cannot deduct pre- plan is established, or considered to be estab- miums for a policy that pays for lost earn- • It generally must not pay or reimburse ex- lished as discussed earlier. For more informa- ings due to sickness or disability. However, penses incurred for services or items that tion, see Schedule SE (Form 1040). see the discussion on overhead insurance, would be reimbursed under Medicare, ex- item (8), under Deductible Premiums, ear- cept where Medicare is a secondary payer How to figure the deduction. Generally, you lier. or the contract makes per diem or other can use the worksheet in the Form 1040 instrucperiodic payments without regard to ex- tions to figure your deduction. However, if any of 3. Certain life insurance and annuities.

penses. the following apply, you must use Worksheet a. For contracts issued before June 9, 6-A in this chapter. Qualified long-term care services. Quali- 1997, you cannot deduct the premiums

fied long-term care services are: • You had more than one source of income on a life insurance policy covering you,

subject to self-employment tax. an employee, or any person with a fi- • Necessary diagnostic, preventive, thera- nancial interest in your business if you peutic, curing, treating, mitigating, and re- • You file Form 2555, Foreign Earned In- are directly or indirectly a beneficiary of habilitative services, and come, or Form 2555-EZ, Foreign Earned

Income Exclusion. the policy. You are included among • Maintenance or personal care services. possible beneficiaries of the policy if the • You are using amounts paid for qualified The services must be required by a chronically ill policy owner is obligated to repay a long-term care insurance to figure the de- individual and prescribed by a licensed health loan from you using the proceeds of the duction. care practitioner. policy. A person has a financial interest

If you are claiming the health coverage tax in your business if the person is an Chronically ill individual. A chronically ill credit, complete Form 8885, Health Coverage owner or part owner of the business or individual is a person who has been certified as Tax Credit, before you figure this deduction. has lent money to the business. one of the following.

Health coverage tax credit. You may be b. For contracts issued after June 8, 1997, • An individual who has been unable, due to able to take this credit only if you were an eligible you generally cannot deduct the premi- loss of functional capacity for at least 90 trade adjustment assistance (TAA) recipient, al- ums on any life insurance policy, en- days, to perform at least two activities of ternative TAA (ATAA) recipient, reemployment dowment contract, or annuity contract if daily living without substantial assistance trade adjustment assistance (RTAA) recipient, you are directly or indirectly a benefi- from another individual. Activities of daily or Pension Benefit Guaranty Corporation pen- ciary. The disallowance applies without living are eating, toileting, transferring sion recipient. Use Form 8885 to figure the regard to whom the policy covers. (general mobility), bathing, dressing, and amount, if any, of this credit. continence. c. Partners. If, as a partner in a partner- When figuring the amount to enter on line 1 ship, you take out an insurance policy • An individual who requires substantial su- of Worksheet 6-A, do not include the following. on your own life and name your part- pervision to be protected from threats to • Any amounts you included on Form 8885, ners as beneficiaries to induce them to health and safety due to severe cognitive retain their investments in the partner- line 4. impairment. ship, you are considered a beneficiary.

The certification must have been made by a • Any qualified health insurance premiums You cannot deduct the insurance premilicensed health care practitioner within the previ- you paid to “U.S. Treasury-HCTC.” ums. ous 12 months. • Any health coverage tax credit advance

Benefits received. payments shown in box 1 of Form 1099-H, 4. Insurance to secure a loan. If you take out For information on exHealth Coverage Tax Credit (HCTC) Ad- a policy on your life or on the life of an- cluding benefits you receive from a long-term

vance Payments. other person with a financial interest in care contract from gross income, see Publica- your business to get or protect a business tion 525.

More than one health plan and business. loan, you cannot deduct the premiums as

Other coverage. You cannot take the deduc- If you have more than one health plan during the a business expense. Nor can you deduct

year and each plan is established under a differ- the premiums as interest on business tion for any month you were eligible to participate in any employer (including your spouse’s) ent business, you must use separate work- loans or as an expense of financing loans.

subsidized health plan at any time during that sheets (Worksheet 6-A) to figure each plan’s net In the event of death, the proceeds of the

month, even if you did not actually participate. In earnings limit. Include the premium you paid policy are generally not taxed as income

addition, effective March 30, 2010, if you were under each plan on line 1 or line 2 of that sepa- even if they are used to liquidate the debt.

eligible for any month or part of a month to rate worksheet and your net profit (or wages)

participate in any subsidized health plan main- from that business on line 4 (or line 11). For a

tained by the employer of either your dependent plan that provides long-term care insurance, the

or your child who was under age 27 at the end of total of the amounts entered for each person on

2010, do not use amounts paid for coverage for line 2 of all worksheets cannot be more than the Capitalized Premiums

that month to figure the deduction. These rules appropriate limit shown on line 2 for that person. Under the uniform capitalization rules, you must are applied separately to plans that provide capitalize the direct costs and part of the indirect long-term care insurance and plans that do not costs for certain production or resale activities. provide long-term care insurance. However, any

medical insurance payments not deductible on Include these costs in the basis of property you Nondeductible produce or acquire for resale, rather than claim- Form 1040, line 29, can be included as medical

ing them as a current deduction. You recover the expenses on Schedule A (Form 1040), Itemized Premiums

Deductions, if you itemize deductions. costs through depreciation, amortization, or cost

of goods sold when you use, sell, or otherwise You cannot deduct premiums on the following Effect on itemized deductions. Subtract the dispose of the property. kinds of insurance.

health insurance deduction from your medical Indirect costs include premiums for insurinsurance when figuring medical expenses on 1. Self-insurance reserve funds. You cannot ance on your plant or facility, machinery, equipSchedule A (Form 1040) if you itemize deduc- deduct amounts credited to a reserve set ment, materials, property produced, or property

tions. up for self-insurance. This applies even if acquired for resale.

Chapter 6 Insurance Page 19
Worksheet 6-A. Self-Employed Health Insurance Deduction Worksheet Keep for Your Records

Note. Use a separate worksheet for each trade or business under which an insurance plan is established.

1. Enter the total amount paid in 2010 for health insurance coverage established under your business for

2010 for you, your spouse, and your dependents. Effective March 30, 2010, your insurance can also

cover your child who was under age 27 at the end of 2010, even if the child was not your dependent.

But do not include the following.

• Amounts for any month you were eligible to participate in a health plan subsidized by your or your

spouse’s employer or, effective March 30, 2010, the employer of either your dependent or your

child who was under the age of 27 at the end of 2010.

• Any amounts paid from retirement plan distributions that were nontaxable because you are a

retired public safety officer.

• Any amounts you included on Form 8885, line 4.

• Any qualified health insurance premiums you paid to “U.S. Treasury-HCTC.”

• Any health coverage tax credit advance payments shown in box 1 of Form 1099-H.

• Any payments for qualified long-term care insurance (see line 2) ...................... . 1.

2. For coverage under a qualified long-term care insurance contract, enter for each person covered the

smaller of the following amounts.

a) Total payments made for that person during the year.

b) The amount shown below. Use the person’s age at the end of the tax year.

 $330—if that person is age 40 or younger

$620—if age 41 to 50

$1,230—if age 51 to 60

$3,290—if age 61 to 70

$4,110—if age 71 or older

Do not include payments for any month you were eligible to participate in a long-term care

insurance plan subsidized by your or your spouse’s employer or, effective March 30, 2010, the

employer of either your dependent or your child who was under the age of 27 at the end of 2010.

If more than one person is covered, figure separately the amount to enter for each person. Then

enter the total of those amounts ............................................ . 2.

3. Add lines 1 and 2 .......................................................... . 3.

4. Enter your net profit* and any other earned income** from the trade or business under which the

insurance plan is established. Do not include Conservation Reserve Program payments exempt from

self-employment tax. If the business is an S corporation, skip to line 11 .................... . 4.

5. Enter the total of all net profits* from: Schedule C (Form 1040), line 31; Schedule C-EZ (Form 1040),

line 3; Schedule F (Form 1040), line 36; or Schedule K-1 (Form 1065), box 14, code A; plus any other

income allocable to the profitable businesses. Do not include Conservation Reserve Program

payments exempt from self-employment tax. See the Instructions for Schedule SE (Form 1040). Do

not include any net losses shown on these schedules. ................................ . 5.

6. Divide line 4 by line 5 ....................................................... . 6.

7a. Complete Schedule SE (Form 1040) as a worksheet. When completing Section A, line 3, or Section B,

line 3, of the worksheet Schedule SE, treat the amount from Form 1040, line 29, as zero. Enter on this

line the amount shown on that worksheet Schedule SE, Section A, line 6, or Section B, line 13 .... . 7a.

7b. Multiply line 7a by the percentage on line 6 ........................................ . 7b.

8. Subtract line 7b from line 4 ................................................... . 8.

9. Enter the amount, if any, from Form 1040, line 28, attributable to the same trade or business in which

the insurance plan is established ............................................... . 9.

10. Subtract line 9 from line 8 .................................................... . 10.

11. Enter your Medicare wages (Form W-2, box 5) from an S corporation in which you are a

more-than-2% shareholder and in which the insurance plan is established .................. . 11.

12. Enter any amount from Form 2555, line 45, attributable to the amount entered on line 4 or 11 above,

or any amount from Form 2555-EZ, line 18, attributable to the amount entered on line 11 above. When

completing Form 2555, line 44, use the deduction figured on line 7a above (in place of the amount

from Form 1040, line 27) that is allocable to the excluded income ......................... . 12.

13. Subtract line 12 from line 10 or 11, whichever applies ................................. . 13.

14. Enter the smaller of line 3 or line 13 here and on Form 1040, line 29. Do not include this amount

when figuring any medical expense deduction on Schedule A (Form 1040). .................. . 14.

* If you used either optional method to figure your net earnings from self-employment from any business, do not enter your net profit from the business.

Instead, enter the amount attributable to that business from Schedule SE (Form 1040), Section B, line 4b.

* *Earned income includes net earnings and gains from the sale, transfer, or licensing of property you created. However, it does not include capital gain

income.

Page 20 Chapter 6 Insurance
Uniform capitalization rules. You may be can deduct in 2011 and 2012 the premium allo- • Form 4626, Alternative Minimum Tax—

subject to the uniform capitalization rules if you cable to those years. Corporations.

do any of the following, unless the property is

produced for your use other than in a business Dividends received. If you receive dividends Topics or an activity carried on for profit. from business insurance and you deducted the This chapter discusses: premiums in prior years, at least part of the

1. Produce real property or tangible personal dividends generally are income. For more infor- • Carrying charges property. For this purpose, tangible per- mation, see Recovery of amount deducted (tax

sonal property includes a film, sound re- benefit rule) in chapter 1 under How Much Can I • Research and experimental costs

cording, video tape, book, or similar Deduct? • Intangible drilling costs property.

• Exploration costs 2. Acquire property for resale.

• Development costs However, these rules do not apply to the following property. • Circulation costs

1. Personal property you acquire for resale if 7. • Environmental cleanup costs

your average annual gross receipts are • Qualified disaster expenses $10 million or less for the 3 prior tax years.

• Business start-up and organizational costs 2.

the following conditions.

Property you produce if you meet either of Costs You • Reforestation costs

• Retired asset removal costs a. Your indirect costs of producing the

property are $200,000 or less. Can Deduct • Barrier removal costs

b. You use the cash method of accounting or Capitalize • Film and television production costs

and do not account for inventories.

Useful Items

More information. For more information on What’s New You may want to see:

these rules, see Uniform Capitalization Rules in

Publication 538 and the regulations under Inter- Publication

nal Revenue Code section 263A. Business start-up costs. For tax years beginning in 2010, you can elect to deduct up to ❏ 544 Sales and Other Dispositions of

$10,000 of business start-up costs paid or in- Assets

curred after 2009. See Business Start-Up and

When To Deduct Organizational Costs for more information. Form (and Instructions)

Environmental cleanup costs. The election ❏ 3468 Investment Credit Premiums to deduct qualified environmental cleanup costs ❏ 8826 Disabled Access Credit was extended to cover costs paid or incurred in You can usually deduct insurance premiums in 2010 and 2011. See Environmental Cleanup the tax year to which they apply. See chapter 12 for information about getting Costs for more information. publications and forms.

Cash method. If you use the cash method of

accounting, you generally deduct insurance premiums in the tax year you actually paid them,

even if you incurred them in an earlier year. Introduction Carrying Charges However, see Prepayment, later. This chapter discusses costs you can elect to

deduct or capitalize. Carrying charges include the taxes and interest Accrual method. If you use an accrual

method of accounting, you cannot deduct insur- You generally deduct a cost as a current you pay to carry or develop real property or to

business expense by subtracting it from your carry, transport, or install personal property. ance premiums before the tax year in which you income in either the year you incur it or the year Certain carrying charges must be capitalized incur a liability for them. In addition, you cannot you pay it. under the uniform capitalization rules. (For infor- deduct insurance premiums before the tax year If you capitalize a cost, you may be able to mation on capitalization of interest, see chapter in which you actually pay them (unless the ex- recover it over a period of years through periodic 4.) You can elect to capitalize carrying charges ception for recurring items applies). For more deductions for amortization, depletion, or depre- not subject to the uniform capitalization rules, information about the accrual method of acciation. When you capitalize a cost, you add it to but only if they are otherwise deductible. counting, see chapter 1. For information about

the basis of property to which it relates. You can elect to capitalize carrying charges the exception for recurring items, see Publica- A partnership, corporation, estate, or trust separately for each project you have and for tion 538.

makes the election to deduct or capitalize the each type of carrying charge. For unimproved

Prepayment. You cannot deduct expenses in costs discussed in this chapter except for explo- and unproductive real property, your election is

advance, even if you pay them in advance. This ration costs for mineral deposits. Each individual good for only 1 year. You must decide whether

rule applies to any expense paid far enough in partner, shareholder, or beneficiary elects to capitalize carrying charges each year the

advance to, in effect, create an asset with a whether to deduct or capitalize exploration property remains unimproved and unproductive.

useful life extending substantially beyond the costs. For other real property, your election to capitalend of the current tax year. ize carrying charges remains in effect until con- You may be subject to the alternative Expenses such as insurance are generally struction or development is completed. For minimum tax (AMT) if you deduct re- allocable to a period of time. You can deduct personal property, your election is effective until

CAUTION

search and experimental, intangible

!

insurance expenses for the year to which they the date you install or first use it, whichever is drilling, exploration, development, circulation, or are allocable. later. business organizational costs.

For more information on the alternative mini- Example. In 2010, you signed a 3-year in- How to make the election. To make the elec- mum tax, see the instructions for one of the surance contract. Even though you paid the pre- tion to capitalize a carrying charge, write a state- following forms. miums for 2010, 2011, and 2012 when you ment saying which charges you elect to

signed the contract, you can only deduct the • Form 6251, Alternative Minimum Tax— capitalize. Attach it to your original tax return for

premium for 2010 on your 2010 tax return. You Individuals. the year the election is to be effective. However,

Chapter 7 Costs You Can Deduct or Capitalize Page 21
if you timely filed your return for the year without IF you . . . THEN . . .

making the election, you can still make the elec- Elect to deduct research and Deduct all research and experimental costs in the tion by filing an amended return within 6 months experimental costs as a current first year you pay or incur the costs and all later of the due date of the return (excluding exten- business expense years. sions). Attach the statement to the amended

return and write “Filed pursuant to section Do not deduct research and If you meet the requirements, amortize them over at

301.9100-2” on the statement. File the amended experimental costs as a current least 60 months, starting with the month you first

return at the same address you filed the original business expense receive an economic benefit from the research. See

Research and Experimental Costs in chapter 8. return.

• Quality control testing. • Amounts properly allocable to the cost of

Research and depreciable property, or • Research in connection with literary, historical, or similar projects. • Amounts paid only out of production or Experimental Costs proceeds from production if these • The acquisition of another’s patent, model, amounts are depletable income to the re- The costs of research and experimentation are production, or process. cipient. generally capital expenses. However, you can

elect to deduct these costs as a current business When and how to elect. You make the elecexpense. Your election to deduct these costs is How to make the election. You elect to de- tion to deduct research and experimental costs binding for the year it is made and for all later duct IDCs as a current business expense by by deducting them on your tax return for the year years unless you get IRS approval to make a taking the deduction on your income tax return in which you first pay or incur research and change. for the first tax year you have eligible costs. No experimental costs. If you do not make the elecIf you meet certain requirements, you may formal statement is required. If you file Schedule tion to deduct research and experimental costs

elect to defer and amortize research and experi- C (Form 1040), enter these costs under “Other in the first year in which you pay or incur the

mental costs. For information on electing to de- expenses.” costs, you can deduct the costs in a later year

fer and amortize these costs, see Research and For oil and gas wells, your election is binding only with approval from the IRS. Experimental Costs in chapter 8. for the year it is made and for all later years. For

Research credit. If you pay or incur qualified geothermal wells, your election can be revoked

Research and experimental costs defined. research expenses, you may be able to take the by the filing of an amended return on which you

Research and experimental costs are reasona- research credit. For more information about the do not take the deduction. You can file the

ble costs you incur in your trade or business for research credit, see the instructions for Form amended return for the year up to the normal

activities intended to provide information that 6765, Credit for Increasing Research Activities. time of expiration for filing a claim for credit or

would eliminate uncertainty about the develop- refund, generally, within 3 years after the date

ment or improvement of a product. Uncertainty you filed the original return or within 2 years after

exists if the information available to you does not the date you paid the tax, whichever is later.

establish how to develop or improve a product or Intangible the appropriate design of a product. Whether Energy credit for costs of geothermal wells.

costs qualify as research and experimental Drilling Costs If you capitalize the drilling and development

costs depends on the nature of the activity to costs of geothermal wells that you place in servwhich the costs relate rather than on the nature The costs of developing oil, gas, or geothermal ice during the tax year, you may be able to claim

of the product or improvement being developed wells are ordinarily capital expenditures. You a business energy credit. See the instructions

or the level of technological advancement. for Form 3468 for more information. can usually recover them through depreciation

The costs of obtaining a patent, including or depletion. However, you can elect to deduct

attorneys’ fees paid or incurred in making and Nonproductive well. If you capitalize your intangible drilling costs (IDCs) as a current busiperfecting a patent application, are research and IDCs, you have another option if the well is ness expense. These are certain drilling and

experimental costs. However, costs paid or in- nonproductive. You can deduct the IDCs of the development costs for wells in the United States

curred to obtain another’s patent are not re- nonproductive well as an ordinary loss. You in which you hold an operating or working intersearch and experimental costs. must indicate and clearly state your election on est. You can deduct only costs for drilling or your tax return for the year the well is completed. preparing a well for the production of oil, gas, or Product. The term “product” includes any of Once made, the election for oil and gas wells is geothermal steam or hot water. the following items. binding for all later years. You can revoke your You can elect to deduct only the costs of

• Formula. election for a geothermal well by filing an items with no salvage value. These include amended return that does not claim the loss. wages, fuel, repairs, hauling, and supplies re- • Invention.

lated to drilling wells and preparing them for Costs incurred outside the United States. • Patent. production. Your cost for any drilling or develop- You cannot deduct as a current business ex- • Pilot model. ment work done by contractors under any form pense all the IDCs paid or incurred for an oil, of contract is also an IDC. However, see gas, or geothermal well located outside the • Process. Amounts paid to contractor that must be capital- United States. However, you can elect to include ized, later. • Technique. the costs in the adjusted basis of the well to You can also elect to deduct the cost of figure depletion or depreciation. If you do not • Property similar to the items listed above. drilling exploratory bore holes to determine the make this election, you can deduct the costs location and delineation of offshore hydrocarbon It also includes products used by you in your over the 10-year period beginning with the tax deposits if the shaft is capable of conducting trade or business or held for sale, lease, or year in which you paid or incurred them. These hydrocarbons to the surface on completion. It license. rules do not apply to a nonproductive well. does not matter whether there is any intent to

Costs not included. Research and experi- produce hydrocarbons.

mental costs do not include expenses for any of If you do not elect to deduct your IDCs as a

the following activities. current business expense, you can elect to deduct them over the 60-month period beginning Exploration Costs • Advertising or promotions. with the month they were paid or incurred. • Consumer surveys. The costs of determining the existence, location,

Amounts paid to contractor that must be extent, or quality of any mineral deposit are • Efficiency surveys. capitalized. Amounts paid to a contractor ordinarily capital expenditures if the costs lead

• Management studies. must be capitalized if they are either: to the development of a mine. You recover these

Page 22 Chapter 7 Costs You Can Deduct or Capitalize
costs through depletion as the mineral is re- Method 2—Do not claim any depletion de- timely filed your return for the year without makmoved from the ground. However, you can elect duction for the tax year the mine reaches ing the election, you can still make the election

to deduct domestic exploration costs paid or the producing stage and any later tax years by filing an amended return within 6 months of

incurred before the beginning of the develop- until the depletion you would have deducted the due date of the return (excluding extenment stage of the mine (except those for oil, gas, equals the exploration costs you deducted. sions). Clearly indicate the election on your

and geothermal wells). amended return and write “Filed pursuant to

You also must recapture deducted explora- section 301.9100-2.” File the amended return at

How to make the election. You elect to de- tion costs if you receive a bonus or royalty from the same address you filed the original return.

duct exploration costs by taking the deduction mine property before it reaches the producing

stage. Do not claim any depletion deduction for Foreign development costs. The rules dis- on your income tax return, or on an amended

the tax year you receive the bonus or royalty and cussed earlier for foreign exploration costs apply income tax return, for the first tax year for which

any later tax years, until the depletion you would to foreign development costs. you wish to deduct the costs paid or incurred

during the tax year. Your return must adequately have deducted equals the exploration costs you Reduced corporate deductions for develop- describe and identify each property or mine, and deducted.

ment costs. The rules discussed earlier for clearly state how much is being deducted for Generally, if you dispose of the mine before reduced corporate deductions for exploration each one. The election applies to the tax year you have fully recaptured the exploration costs costs also apply to corporate deductions for de- you make this election and all later tax years. you deducted, recapture the balance by treating velopment costs. all or part of your gain as ordinary income. Partnerships and S corporations. Each Under these circumstances, you generally partner, not the partnership, elects whether to treat as ordinary income all of your gain if it is capitalize or to deduct that partner’s share of less than your adjusted exploration costs with exploration costs. Each shareholder, not the S respect to the mine. If your gain is more than Circulation Costs

corporation, elects whether to capitalize or to your adjusted exploration costs, treat as ordi- deduct that shareholder’s share of exploration A publisher can deduct as a current business nary income only a part of your gain, up to the costs. expense the costs of establishing, maintaining, amount of your adjusted exploration costs. or increasing the circulation of a newspaper,

Reduced corporate deductions for explora- magazine, or other periodical. For example, a Foreign exploration costs. If you pay or incur tion costs. A corporation (other than an S publisher can deduct the cost of hiring extra exploration costs for a mine or other natural corporation) can deduct only 70% of its domes- employees for a limited time to get new sub- deposit located outside the United States, you tic exploration costs. It must capitalize the re- scriptions through telephone calls. Circulation cannot deduct all the costs in the current year. maining 30% of costs and amortize them over costs are deductible even if they normally would You can elect to include the costs (other than for the 60-month period starting with the month the be capitalized. an oil, gas, or geothermal well) in the adjusted exploration costs are paid or incurred. A corpo- This rule does not apply to the following basis of the mineral property to figure cost de- ration may also elect to capitalize and amortize costs that must be capitalized. pletion. (Cost depletion is discussed in chapter mining exploration costs over a 10-year period. 9.) If you do not make this election, you must • The purchase of land or depreciable prop- For more information on this method of amortideduct the costs over the 10-year period begin- erty. zation, see Internal Revenue Code section ning with the tax year in which you pay or incur 59(e). • The acquisition of circulation through the them. These rules also apply to foreign develop- The 30% the corporation capitalizes cannot purchase of any part of the business of ment costs. be added to its basis in the property to figure another publisher of a newspaper, magacost depletion. However, the amount amortized zine, or other periodical, including the

is treated as additional depreciation and is sub- purchase of another publisher’s list of subject to recapture as ordinary income on a dispo- scribers.

sition of the property. See Section 1250 Development Costs

Property under Depreciation Recapture in chap- You can deduct costs paid or incurred during the Other treatment of circulation costs. If you ter 3 of Publication 544. do not want to deduct circulation costs as a tax year for developing a mine or any other These rules also apply to the deduction of current business expense, you can elect one of natural deposit (other than an oil or gas well) development costs by corporations. See Devel- the following ways to recover these costs. located in the United States. These costs must opment Costs, later. be paid or incurred after the discovery of ores or • Capitalize all circulation costs that are minerals in commercially marketable quantities. Recapture of exploration expenses. When properly chargeable to a capital account Development costs include those incurred for (see chapter 1). your mine reaches the producing stage, you you by a contractor. Also, development costs must recapture any exploration costs you • Amortize circulation costs over the 3-year include depreciation on improvements used in elected to deduct. Use either of the following period beginning with the tax year they the development of ores or minerals. They do methods. were paid or incurred. not include costs for the acquisition or improveMethod 1— ment of depreciable property. Include the deducted costs in

gross income for the tax year the mine Instead of deducting development costs in How to make the election. You elect to capireaches the producing stage. Your election the year paid or incurred, you can elect to treat talize circulation costs by attaching a statement

must be clearly indicated on the return. In- them as deferred expenses and deduct them to your return for the first tax year the election

crease your adjusted basis in the mine by ratably as the units of produced ores or minerals applies. Your election is binding for the year it is

the amount included in income. Generally, benefited by the expenses are sold. This elec- made and for all later years, unless you get IRS

you must elect this recapture method by the tion applies each tax year to expenses paid or approval to revoke it.

due date (including extensions) of your re- incurred in that year. Once made, the election is

turn. However, if you timely filed your return binding for the year and cannot be revoked for

for the year without making the election, any reason.

you can still make the election by filing an Environmental Cleanup amended return within 6 months of the due How to make the election. The election to

date of the return (excluding extensions). deduct development costs ratably as the ores or Costs

Make the election on your amended return minerals are sold must be made for each mine

and write “Filed pursuant to section or other natural deposit by a clear indication on Environmental cleanup costs are generally capi301.9100-2” on the form where you are in- your return or by a statement filed with the IRS tal expenditures. However, you can elect to decluding the income. File the amended re- office where you file your return. Generally, you duct these costs as a current business expense

turn at the same address you filed the must make the election by the due date of the if certain requirements (discussed later) are met.

original return. return (including extensions). However, if you This special tax treatment is generally available

Chapter 7 Costs You Can Deduct or Capitalize Page 23
for environmental cleanup costs you pay or incur than one environmental cleanup cost, you can section 1245 when you sell or otherwise dispose

before January 1, 2012. elect to deduct one or more of such expendi- of the property that would have received an

tures for that year. You can elect to deduct one addition to basis had you not made the election. Environmental cleanup costs. Environmen- expenditure and elect to capitalize another ex- For more information on recapturing the deduc- tal cleanup costs are generally costs you pay or penditure (whether or not they are of the same tion, see Depreciation and amortization under

incur to abate or control hazardous substances type or paid or incurred with respect to the same Gain Treated as Ordinary Income in Publication

at a qualified contaminated site. qualified contaminated site). An election to de- 544.

Hazardous substance. Hazardous sub- duct an expenditure for one year has no effect More information. For more information on other years. You must make a separate elec- stances are defined in section 101(14) of the about expensing of qualified disaster expenses, Comprehensive Environmental Response, tion for each year in which you intend to deduct see Internal Revenue Code section 198A. Compensation, and Liability Act of 1980 and environmental cleanup costs.

certain substances are designated as hazard- Recapture. This deduction may have to be ous in section 102 of the Act. Also, petroleum recaptured as ordinary income under section products are treated as hazardous substances.

However, substances are not hazardous if a 1245 when you sell or otherwise dispose of the Business Start-Up and property that would have received an addition to removal or remedial action is prohibited under basis if you had not elected to deduct the expen- Organizational Costs sections 104 and 104(a)(3) of the Act. diture. For more information on recapturing the

Qualified contaminated site. A qualified deduction, see Depreciation Recapture in Publi- Business start-up and organizational costs are

contaminated site is any area that meets both of cation 544. generally capital expenditures. However, you

the following requirements. can elect to deduct up to $5,000 of business More information. For more information start-up and $5,000 of organizational costs paid about the environmental cleanup cost deduc- 1. You hold it for use in a trade or business, or incurred after October 22, 2004. The $5,000 tion, see Internal Revenue Code section 198. for the production of income, or as inven- deduction is reduced by the amount your total tory. start-up or organizational costs exceed $50,000.

2. There has been a release, threat of re- Any remaining costs must be amortized. For

information about amortizing start-up and orga- lease, or disposal of any hazardous sub- Qualified Disaster nizational costs, see chapter 8. stance at or on the site.

Expenses Start-up costs include any amounts paid or You must get a statement from the designated incurred in connection with creating an active state environmental agency that the site meets trade or business or investigating the creation or requirement (2). You can elect to deduct rather than capitalize acquisition of an active trade or business. Orga- A site is not eligible if it is on, or proposed for, any qualified disaster expenses that you paid or nizational costs include the costs of creating a incurred after 2007. the national priorities list under section corporation. For more information on start-up 105(a)(8)(B) of the Comprehensive Environ- Qualified disaster expense. A qualified dis- and organizational costs, see chapter 8. mental Response, Compensation, and Liability aster expense is an expenditure that: Act of 1980. To find out if a site is on the national Special rule for 2010 start-up costs. For

priorities list, contact the U.S. Environmental tax years beginning in 2010, you can elect to 1. Is paid or incurred in connection with a

Protection Agency. deduct up to $10,000 of business start-up costs trade or business or with business-related paid or incurred after 2009. The $10,000 deduc- property, Expenditures for depreciable property. tion is reduced (but not below zero) by the You cannot deduct the cost of acquiring depre- 2. Is otherwise capitalized, and amount such start-up costs exceed $60,000. ciable property used in connection with the Any remaining costs must be amortized. 3. Is for one of the following purposes. abatement or control of hazardous substances

at a qualified contaminated site. However, the How to make the election. You elect to de- a. The abatement or control of hazardous part of the depreciation for such property that is duct the start-up or organizational costs by substances that were released because otherwise allocated to the qualified contami- claiming the deduction on the income tax return of a federally declared disaster occur- nated site shall be treated as an environmental (filed by the due date including extensions) for ring before January 1, 2010, cleanup cost. the tax year in which the active trade or business

b. The removal of debris from, or the dem- begins. However, if you timely filed your return When and how to elect. You elect to deduct olition of structures on, real property for the year without making the election, you can environmental cleanup costs by taking the de- that is business-related property dam- still make the election by filing an amended duction on the income tax return (filed by the due aged or destroyed as a result of a fed- return within 6 months of the due date of the

date including extensions) for the tax year in erally declared disaster occurring return (excluding extensions). Clearly indicate which the costs are paid or incurred. The costs before such date, or the election on your amended return and write are deducted differently depending on the type “Filed pursuant to section 301.9100-2.” File the c. The repair of business-related property of business entity involved. amended return at the same address you filed damaged as a result of a federally deIndividuals. Deduct the environmental the original return. The election applies when clared disaster occurring before such

cleanup costs on the “Other Expenses” line of computing taxable income for the current tax date.

Schedule C, E, or F (Form 1040). If the schedule year and all subsequent years.

requires you to separately identify each expense Federally declared disaster. A federally de- included in “Other Expenses” write “Section 198

Election” on the line next to the environmental clared disaster is a disaster that occurred in an

cleanup costs. area declared by the President to be eligible for Reforestation Costs

federal assistance under the Robert T. Stafford

All other entities. All other taxpayers (in- Relief and Emergency Assistance Act. Reforestation costs are generally capital expen- cluding S corporations, partnerships, and trusts) ditures. However, you can elect to deduct up to deduct the environmental cleanup costs on the Business-related property. Busi- $10,000 ($5,000 if married filing separately; $0 ness-related property is property you held (a) for “Other Deductions” line of the appropriate fed- for a trust) of qualifying reforestation costs paid eral income tax return. On a schedule attached use in a trade or business or for the production or incurred after October 22, 2004, for each of income or (b) that is stock in trade or other to the return that separately identifies each ex- qualified timber property. The remaining costs pense included in “Other Deductions” write property included in inventory or held mainly for can be amortized over an 84-month period. For sale to customers. “Section 198 Election” on the line next to the information about amortizing reforestation amount for environmental cleanup costs. Recapture. If you made the election to deduct costs, see chapter 8.

More than one environmental cleanup qualified disaster expenses, the deduction may Qualifying reforestation costs are the direct

cost. If, for any tax year, you pay or incur more have to be recaptured as ordinary income under costs of planting or seeding for forestation or

Page 24 Chapter 7 Costs You Can Deduct or Capitalize
reforestation. Qualified timber property is prop- his share of the partnership’s expenses because

erty that contains trees in significant commercial Retired Asset Removal of how John applied the limit, ABC can add

quantities. See chapter 8 for more information $6,000 to the basis of its property.

on qualifying reforestation costs and qualified Costs

Qualification standards. You can deduct timber property. If you retire and remove a depreciable asset in your costs as a current expense only if the bar- If you elect to deduct qualified reforestation connection with the installation or production of rier removal meets the guidelines and require- costs, create and maintain separate timber ac- a replacement asset, you can deduct the costs ments issued by the Architectural and counts for each qualified timber property and of removing the retired asset. However, if you Transportation Barriers Compliance Board include all reforestation costs and the dates replace a component (part) of a depreciable under the Americans with Disabilities Act (ADA) each was applied. Do not include this qualified asset, capitalize the removal costs if the re- of 1990. You can view the Americans with Disatimber property in any account (for example, placement is an improvement and deduct the bilities Act at www.ada.gov/pubs/ada.htm. depletion block) for which depletion is allowed. costs if the replacement is a repair. The following is a list of some architectural

barrier removal costs that can be deducted.

How to make the election. You elect to de- • Ground and floor surfaces.

duct qualifying reforestation costs by claiming Barrier Removal Costs • Walks. the deduction on your timely filed income tax

return (including extensions) for the tax year the The cost of an improvement to a business asset • Parking lots.

expenses were paid or incurred. If Form T (Tim- is normally a capital expense. However, you can • Ramps. ber), Forest Activities Schedule, is required, elect to deduct the costs of making a facility or

complete Part IV of Form T. If Form T is not public transportation vehicle more accessible to • Entrances.

required, attach a statement containing the fol- and usable by those who are disabled or elderly. • Doors and doorways. lowing information for each qualified timber You must own or lease the facility or vehicle for

use in connection with your trade or business. • Stairs. property for which an election is being made.

A facility is all or any part of buildings, struc- • Floors. • The unique stand identification numbers. tures, equipment, roads, walks, parking lots, or • Toilet rooms. • The total number of acres reforested dur- similar real or personal property. A public transportation vehicle is a vehicle, such as a bus or ing the tax year. • Water fountains.

railroad car, that provides transportation service • The nature of the reforestation treatments. • Telephones. to the public (including service for your custom-

• The total amounts of qualified reforesta- ers, even if you are not in the business of provid- • Elevators.

ing transportation services). tion expenditures eligible to be amortized You cannot deduct any costs that you paid or • Controls. or deducted.

incurred to completely renovate or build a facility • Signage. or public transportation vehicle or to replace However, if you timely filed your return for the • Alarms. depreciable property in the normal course of year without making the election, you can still

make the election by filing an amended return business. • Protruding objects.

within 6 months of the due date of the return Deduction limit. The most you can deduct as • Symbols of accessibility.

(excluding extensions). Clearly indicate the a cost of removing barriers to the disabled and You can find the ADA guidelines and require- election on your amended return and write “Filed the elderly for any tax year is $15,000. However, ments for architectural barrier removal at www. pursuant to section 301.9100-2.” File the you can add any costs over this limit to the basis usdoj.gov/crt/ada/reg3a.html. amended return at the same address you filed of the property and depreciate these excess

the original return. The election applies when costs. The following is a list of some deductible

computing taxable income for the current tax transportation barrier removal costs.

year and all subsequent years. Partners and partnerships. The $15,000 • Rail facilities. limit applies to a partnership and also to each If you elected to deduct qualified timber costs partner in the partnership. A partner can allocate • Buses.

on a federal income tax return filed before June the $15,000 limit in any manner among the part- • Rapid and light rail vehicles. 15, 2006, but did not include the above informa- ner’s individually incurred costs and the part- tion, complete Part IV of Form T or the required ner’s distributive share of partnership costs. If You can find the guidelines and requirements for

statement and attach it to the first federal income the partner cannot deduct the entire share of transportation barrier removal at www.fta.dot.

tax return you file after June 14, 2006. If you partnership costs, the partnership can add any gov.

have not elected to deduct qualified timber costs costs not deducted to the basis of the improved Also, you can access the ADA website at in a prior year you may be able to do so by filing property. www.ada.gov for additional information.

Form 3115, Application for Change in Account- A partnership must be able to show that any

amount added to basis was not deducted by the Other barrier removals. To be deductible, ing Method. For more information, see Notice partner and that it was over a partner’s $15,000 expenses of removing any barrier not covered 2006-47 on page 892 of Internal Revenue Bulle- limit (as determined by the partner). If the part- by the above standards must meet all three of tin 2006-20. Internal Revenue Bulletin 2006-20

nership cannot show this, it is presumed that the the following tests. is available at www.irs.gov/pub/irs-irbs/irb06-20. partner was able to deduct the distributive share pdf. 1. The removed barrier must be a substantial of the partnership’s costs in full.

For additional information on reforestation barrier to access or use of a facility or

costs, see chapter 8. Example. John Duke’s distributive share of public transportation vehicle by persons

ABC partnership’s deductible expenses for the who have a disability or are elderly.

removal of architectural barriers was $14,000. Recapture. This deduction may have to be 2. The removed barrier must have been a John had $12,000 of similar expenses in his sole recaptured as ordinary income under section barrier for at least one major group of per- proprietorship. He elected to deduct $7,000 of 1245 when you sell or otherwise dispose of the sons who have a disability or are elderly them. John allocated the remaining $8,000 of (such as people who are blind, deaf, or property that would have received an addition to the $15,000 limit to his share of ABC’s ex- wheelchair users). basis if you had not elected to deduct the expen- penses. John can add the excess $5,000 of his

diture. For more information on recapturing the own expenses to the basis of the property used 3. The barrier must be removed without crededuction, see Depreciation Recapture in Publi- in his business. Also, if ABC can show that John ating any new barrier that significantly imcation 544. could not deduct $6,000 ($14,000 – $8,000) of pairs access to or use of the facility or

Chapter 7 Costs You Can Deduct or Capitalize Page 25
vehicle by a major group of persons who see chapter 3 of Publication 550, Investment

have a disability or are elderly. Income and Expenses. Starting a Business

Topics When you start a business, treat all eligible costs How to make the election. If you elect to

This chapter discusses: you incur before you begin operating the busi- deduct your costs for removing barriers to the ness as capital expenditures which are part of disabled or the elderly, claim the deduction on • Deducting amortization your basis in the business. Generally, you re- your income tax return (partnership return for

partnerships) for the tax year the expenses were cover costs for particular assets through depre- • Amortizing costs of starting a business paid or incurred. Identify the deduction as a ciation deductions. However, you generally

separate item. The election applies to all the • Amortizing costs of getting a lease cannot recover other costs until you sell the

qualifying costs you have during the year, up to business or otherwise go out of business. See • Amortizing costs of section 197 intangibles the $15,000 limit. If you make this election, you Capital Expenses in chapter 1 for a discussion

must maintain adequate records to support your • Amortizing reforestation costs on how to treat these costs if you do not go into

deduction. business. • Amortizing costs of geological and geo- For your election to be valid, you generally physical costs For costs paid or incurred after September 8,

must file your return by its due date, including 2008, you can deduct a limited amount of

extensions. However, if you timely filed your • Amortizing costs of pollution control facili- start-up and organizational costs. The costs that

return for the year without making the election, ties are not deducted currently can be amortized you can still make the election by filing an • Amortizing costs of research and experi- ratably over a 180-month period. The amortiza- amended return within 6 months of the due date mentation tion period starts with the month you begin oper- of the return (excluding extensions). Clearly indi- ating your active trade or business. You are not cate the election on your amended return and • Amortizing costs of certain tax preferences required to attach a statement to make this elec- write “Filed pursuant to section 301.9100-2.” File tion. Once made, the election is irrevocable. See the amended return at the same address you Useful Items Temporary Regulations sections 1.195-1T, filed the original return. Your election is irrevoca- 1.248-1T, and 1.709-1T. ble after the due date, including extensions, of You may want to see: For costs paid after October 22, 2004, and your return. before September 9, 2008, you can elect to Publication

deduct a limited amount of business start-up Disabled access credit. If you make your ❏ 544 Sales and Other Dispositions of and organizational costs in the year your active business accessible to persons with disabilities Assets trade or business begins. Any costs not de- and your business is an eligible small business, ducted can be amortized ratably over a you may be able to claim the disabled access ❏ 550 Investment Income and Expenses 180-month period, beginning with the month you credit. If you choose to claim the credit, you must ❏ 946 How To Depreciate Property begin business. If the election is made, you must reduce the amount you deduct or capitalize by attach any statement required by Regulations the amount of the credit. Form (and Instructions) sections 1.195-1(b), 1.248-1(c), and 1.709-1(c). For more information about the disabled acHowever, you can apply the provisions of Tem- cess credit, see Form 8826. ❏ 4562 Depreciation and Amortization porary Regulations sections 1.195-1T,

❏ 4626 Alternative Minimum Tax— 1.248-1T, and 1.709-1T to all business start-up

Corporations and organizational costs paid or incurred after

Film and Television October 22, 2004, provided the period of limita- ❏ 6251 Alternative Minimum Tax— tions on assessment has not expired for the year Individuals Production Costs of the election. Otherwise the provisions under

Regulations section 1.195-1(b), 1.248-1(c), and See chapter 12 for information about getting Film and television production costs are gener- 1.709-1(c) will apply. publications and forms. ally capital expenses. However, you can elect to For costs paid or incurred before October 23,

deduct costs paid or incurred for certain produc- 2004, you can elect to amortize business

tions that begin after October 22, 2004. For start-up and organization costs over an amortimore information, see section 181 of the Internal zation period of 60 months or more. See How To

Revenue Code and Temporary Regulations How To Deduct Make the Election, later.

sections 1.181-1T through 1.181-6T. The cost must qualify as one of the following. Amortization • A business start-up cost.

To deduct amortization that begins during the • An organizational cost for a corporation. current tax year, complete Part VI of Form 4562 • An organizational cost for a partnership. and attach it to your income tax return.

To report amortization from previous years, 8. in addition to amortization that begins in the Note. For a tax year beginning in 2010, the

current year, list on Form 4562 each item sepa- maximum deduction for business start-up costs

rately. For example, in 2009, you began to amor- has increased. For more information, see Busi- Amortization tize a lease. In 2010, you began to amortize a ness Start-Up and Organizational Costs in chapsecond lease. Report amortization from the new ter 7. Also see section 195(b)(3).

lease on line 42 of your 2010 Form 4562. Report

amortization from the 2009 lease on line 43 of Business Start-Up Costs Introduction

your 2010 Form 4562.

Amortization is a method of recovering (deduct- Start-up costs are amounts paid or incurred for: If you do not have any new amortizable ex- ing) certain capital costs over a fixed period of (a) creating an active trade or business; or (b) penses for the current year, you are not required time. It is similar to the straight line method of investigating the creation or acquisition of an to complete Form 4562 (unless you are claiming depreciation. active trade or business. Start-up costs include

The various amortizable costs covered in depreciation). Report the current year’s deduc- amounts paid or incurred in connection with an

this chapter are included in the list below. How- tion for amortization that began in a prior year existing activity engaged in for profit; and for the

ever, this chapter does not discuss amortization directly on the “Other deduction” or “Other ex- production of income in anticipation of the activof bond premium. For information on that topic, pense line” of your return. ity becoming an active trade or business.

Page 26 Chapter 8 Amortization
Qualifying costs. A start-up cost is amortiz- Qualifying costs. To qualify as an organiza- • Filing fees.

able if it meets both of the following tests. tional cost, it must be:

• It is a cost you could deduct if you paid or • For the creation of the corporation, Nonqualifying costs. The following costs

incurred it to operate an existing active cannot be amortized. • Chargeable to a capital account (see trade or business (in the same field as the chapter 1), • The cost of acquiring assets for the part- one you entered into). nership or transferring assets to the part- • Amortized over the life of the corporation if • It is a cost you pay or incur before the day nership. the corporation had a fixed life, and your active trade or business begins. • The cost of admitting or removing part- • Incurred before the end of the first tax year ners, other than at the time the partnership Start-up costs include amounts paid for the in which the corporation is in business. is first organized. following:

A corporation using the cash method of ac- • The cost of making a contract concerning • An analysis or survey of potential markets, counting can amortize organizational costs in- the operation of the partnership trade or products, labor supply, transportation facil- curred within the first tax year, even if it does not business including a contract between a ities, etc. pay them in that year. partner and the partnership.

• Advertisements for the opening of the Examples of organizational costs include: • The costs for issuing and marketing inter- business. • The cost of temporary directors. ests in the partnership such as brokerage,

• Salaries and wages for employees who registration, and legal fees and printing • The cost of organizational meetings. are being trained and their instructors. costs. These “syndication fees” are capital

• State incorporation fees. expenses that cannot be depreciated or • Travel and other necessary costs for se- amortized. curing prospective distributors, suppliers, • The cost of legal services.

or customers.

Liquidation of partnership. If a partnership is • Salaries and fees for executives and con- Nonqualifying costs. The following items are liquidated before the end of the amortization sultants, or for similar professional serv- capital expenses that cannot be amortized: period, the unamortized amount of qualifying ices. • Costs for issuing and selling stock or se- organizational costs can be deducted in the

curities, such as commissions, profes- partnership’s final tax year. However, these

Nonqualifying costs. Start-up costs do not sional fees, and printing costs. costs can be deducted only to the extent they

include deductible interest, taxes, or research qualify as a loss from a business. • Costs associated with the transfer of as- and experimental costs. See Research and Exsets to the corporation. perimental Costs, later. How To Amortize

Purchasing an active trade or business. Costs of Organizing Deduct start-up and organizational costs in

Amortizable start-up costs for purchasing an ac- equal amounts over the applicable amortization

tive trade or business include only investigative a Partnership period (discussed earlier). You can choose an

costs incurred in the course of a general search amortization period for start-up costs that is dif- The costs to organize a partnership are the for or preliminary investigation of the business. ferent from the period you choose for organiza- direct costs of creating the partnership. These are costs that help you decide whether to tional costs, as long as both are not less than the

purchase a business. Costs you incur in an applicable amortization period. Once you

attempt to purchase a specific business are cap- Qualifying costs. A partnership can amortize choose an amortization period, you cannot

ital expenses that you cannot amortize. an organizational cost only if it meets all the change it. following tests. To figure your deduction, divide your total Example. On June 1st, you hired an ac- • It is for the creation of the partnership and start-up or organizational costs by the months in counting firm and a law firm to assist you in the not for starting or operating the partner- the amortization period. The result is the amount potential purchase of XYZ, Inc. They researched ship trade or business. you can deduct for each month. XYZ’s industry and analyzed the financial projections of XYZ, Inc. In September, the law firm • It is chargeable to a capital account (see Cash method partnership. A partnership us- prepared and submitted a letter of intent to XYZ, chapter 1). ing the cash method of accounting can deduct Inc. The letter stated that a binding commitment • It could be amortized over the life of the an organizational cost only if it has been paid by would result only after a purchase agreement partnership if the partnership had a fixed the end of the tax year. However, any cost the was signed. The law firm and accounting firm life. partnership could have deducted as an organi- continued to provide services including a review zational cost in an earlier tax year (if it had been of XYZ’s books and records and the preparation • It is incurred by the due date of the part- paid that year) can be deducted in the tax year of of a purchase agreement. On October 22nd, you nership return (excluding extensions) for payment. signed a purchase agreement with XYZ, Inc. the first tax year in which the partnership

All amounts paid or incurred to investigate is in business. However, if the partnership

the business before October 22nd are amortiz- uses the cash method of accounting and How To Make the Election able investigative costs. Amounts paid on or pays the cost after the end of its first tax

after that date relate to the attempt to purchase year, see Cash method partnership under To elect to amortize start-up or organizational How To Amortize, later. the business and therefore must be capitalized. costs, you must complete and attach Form 4562

• It is for a type of item normally expected to to your return for the first tax year you are in Disposition of business. If you completely benefit the partnership throughout its en- business. You may also be required to attach an dispose of your business before the end of the tire life. accompanying statement (described later) to amortization period, you can deduct any remain- your return. ing deferred start-up costs. However, you can Organizational costs include the following For start-up or organizational costs paid or deduct these deferred start-up costs only to the fees. incurred after September 8, 2008, an accompa- extent they qualify as a loss from a business. nying statement is not required. Generally, for • Legal fees for services incident to the or- start-up or organizational costs paid or incurred Costs of Organizing ganization of the partnership, such as ne- before September 9, 2008, unless you choose gotiation and preparation of the a Corporation to apply Temporary Regulations sections partnership agreement. 1.195-1T and 1.248-1T, you must also attach an

Amounts paid to organize a corporation are the • Accounting fees for services incident to accompanying statement to elect to amortize

direct costs of creating the corporation. the organization of the partnership. the costs.

Chapter 8 Amortization Page 27
If you have both start-up and organizational • The month your corporation or partnership You cannot deduct amortization for the month

costs, attach a separate statement (if required) began active business (or acquired the you dispose of the intangible.

to your return for each type of cost. See Starting business). If you pay or incur an amount that increases a Business, earlier, for more information. • The number of months in your amortiza- the basis of an amortizable section 197 intangi- Generally, you must file the return by the due tion period (which is generally 180 ble after the 15-year period begins, amortize it date (including any extensions). However, if you months). over the remainder of the 15-year period begintimely filed your return for the year without mak- ning with the month the basis increase occurs.

ing the election, you can still make the election Partnerships. The statement prepared for You are not allowed any other depreciation

by filing an amended return within 6 months of a cash basis partnership must also indicate the or amortization deduction for an amortizable

the due date of the return (excluding exten- amount paid before the end of the year for each section 197 intangible.

sions). For more information, see the instruc- cost. Tax-exempt use property subject to a lease. tions for Part VI of Form 4562. You do not need to separately list any part- The amortization period for any section 197 in- Once you make the election to amortize nership organizational cost that is less than $10. tangible leased under a lease agreement en- start-up or organizational costs, you cannot re- Instead, you can list the total amount of these tered into after March 12, 2004, to a tax-exempt voke it. costs with the dates the first and last costs were organization, governmental unit, or foreign per- incurred. If your business is organized as a corpora- son or entity (other than a partnership), shall not After a partnership makes the election to tion or partnership, only the corporation or part- be less than 125 percent of the lease term. amortize organizational costs, it can later file an nership can elect to amortize its start-up or amended return to include additional organiza- Cost attributable to other property. The organizational costs. A shareholder or partner tional costs not included in the partnership’s rules for section 197 intangibles do not apply to cannot make this election. You, as a share- original return and statement. any amount that is included in determining the holder or partner, cannot amortize any costs you cost of property that is not a section 197 intangi- incur in setting up your corporation or partner- ble. For example, if the cost of computer ship. Only the corporation or partnership can software is not separately stated from the cost of amortize these costs. Getting a Lease hardware or other tangible property and you However, you, as an individual, can elect to consistently treat it as part of the cost of the amortize costs you incur to investigate an inter- If you get a lease for business property, you hardware or other tangible property, these rules est in an existing partnership. These costs qual- recover the cost by amortizing it over the term of do not apply. Similarly, none of the cost of ac- ify as business start-up costs if you acquire the the lease. The term of the lease for amortization quiring real property held for the production of partnership interest. purposes generally includes all renewal options rental income is considered the cost of goodwill,

(and any other period for which you and the going concern value, or any other section 197

Start-up costs election statement. If you lessor reasonably expect the lease to be re- intangible.

elect to amortize your start-up costs, attach a newed). However, renewal periods are not inseparate statement (if required) that contains cluded if 75% or more of the cost of acquiring the Section 197 Intangibles the following information. lease is for the term of the lease remaining on Defined the acquisition date (not including any period for • A description of the business to which the which you may choose to renew, extend, or start-up costs relate. The following assets are section 197 intangibles continue the lease). and must be amortized over 180 months: • A description of each start-up cost in- For more information on the costs of getting

curred. a lease, see Cost of Getting a Lease in 1. Goodwill;

chapter 3. • The month your active business began (or 2. Going concern value;

was acquired). How to amortize. Enter your deduction in Part 3. Workforce in place; VI of Form 4562 if you are deducting amortiza- • The number of months in your amortiza- tion that begins during the current year, or on the 4. Business books and records, operating tion period (which is generally 180 appropriate line of your tax return if you are not systems, or any other information base, months). otherwise required to file Form 4562. including lists or other information concerning current or prospective customers; Filing the statement early. You can elect

to amortize your start-up costs by filing the state- 5. A patent, copyright, formula, process, dement with a return for any tax year before the sign, pattern, know-how, format, or similar

year your active business begins. If you file the Section 197 Intangibles item;

statement early, the election becomes effective Generally, you may amortize the capitalized 6. A customer-based intangible; in the month of the tax year your active business costs of “section 197 intangibles” (defined later) begins. 7. A supplier-based intangible; ratably over a 15-year period. You must amorRevised statement. You can file a revised 8. Any item similar to items (3) through (7); tize these costs if you hold the section 197

statement to include any start-up costs not in- intangibles in connection with your trade or busi- 9. A license, permit, or other right granted by cluded in your original statement. However, you ness or in an activity engaged in for the produc- a governmental unit or agency (including cannot include on the revised statement any tion of income. issuances and renewals); cost you previously treated on your return as a You may not be able to amortize sec- cost other than a start-up cost. You can file the 10. A covenant not to compete entered into in tion 197 intangibles acquired in a trans- connection with the acquisition of an inter- revised statement with a return filed after the

CAUTION

action that did not result in a significant

!

est in a trade or business; return on which you elected to amortize your change in ownership or use. See Anti-Churning start-up costs. Rules 11. Any franchise, trademark, or trade name; , later.

and Your amortization deduction each year is the Organizational costs election statement. If

applicable part of the intangible’s adjusted basis 12. A contract for the use of, or a term interest you elect to amortize your corporation’s or part- (for purposes of determining gain), figured by in, any item in this list. nership’s organizational costs, attach a sepa- amortizing it ratably over 15 years (180 months). rate statement (if required) that contains the The 15-year period begins with the later of: You cannot amortize any of the in- following information. tangibles listed in items (1) through (8) • The month the intangible is acquired, or • A description of each cost.

CAUTION

that you created rather than acquired

!

• The month the trade or business or activity unless you created them in acquiring assets that • The amount of each cost. engaged in for the production of income make up a trade or business or a substantial part

• The date each cost was incurred. begins. of a trade or business.

Page 28 Chapter 8 Amortization
Goodwill. This is the value of a trade or busi- services used or sold by the business because 4. Most computer software. (See Computer

ness based on expected continued customer of business relationships with suppliers. software, later.)

patronage due to its name, reputation, or any For example, you must amortize the part of 5. Any of the following assets not acquired in other factor. the purchase price of a business that is for the connection with the acquisition of a trade existence of the following intangibles. Going concern value. This is the additional or business or a substantial part of a trade

value of a trade or business that attaches to • A favorable relationship with distributors or business.

property because the property is an integral part (such as favorable shelf or display space a. An interest in a film, sound recording, of an ongoing business activity. It includes value at a retail outlet). video tape, book, or similar property. based on the ability of a business to continue to • A favorable credit rating. function and generate income even though b. A right to receive tangible property or

there is a change in ownership (but does not • A favorable supply contract. services under a contract or from a govinclude any other section 197 intangible). It also ernmental agency.

includes value based on the immediate use or Government-granted license, permit, etc. c. An interest in a patent or copyright. availability of an acquired trade or business, This is any right granted by a governmental unit such as the use of earnings during any period in d. Certain rights that have a fixed duration or an agency or instrumentality of a governmen- which the business would not otherwise be or amount. (See Rights of fixed duration tal unit. For example, you must amortize the available or operational. or amount, later.) capitalized costs of acquiring (including issuing

Workforce in place, etc. This includes the or renewing) a liquor license, a taxicab medal- 6. An interest under either of the following. composition of a workforce (for example, its ex- lion or license, or a television or radio broadcastperience, education, or training). It also includes ing license. a. An existing lease or sublease of tangi- the terms and conditions of employment, ble property. whether contractual or otherwise, and any other Covenant not to compete. Section 197 invalue placed on employees or any of their attrib- tangibles include a covenant not to compete (or b. A debt that was in existence when the

utes. similar arrangement) entered into in connection interest was acquired.

For example, you must amortize the part of with the acquisition of an interest in a trade or

business, or a substantial portion of a trade or 7. A right to service residential mortgages un- the purchase price of a business that is for the

existence of a highly skilled workforce. Also, you business. An interest in a trade or business less the right is acquired in connection with

must amortize the cost of acquiring an existing includes an interest in a partnership or a corpo- the acquisition of a trade or business or a

employment contract or relationship with em- ration engaged in a trade or business. substantial part of a trade or business.

ployees or consultants. An arrangement that requires the former 8. Certain transaction costs incurred by par- owner to perform services (or to provide prop- Business books and records, etc. This in- ties to a corporate organization or reorgan- erty or the use of property) is not similar to a cludes the intangible value of technical manuals, ization in which any part of a gain or loss is covenant not to compete to the extent the not recognized. training manuals or programs, data files, and amount paid under the arrangement represents accounting or inventory control systems. It also reasonable compensation for those services or Intangible property that is not amortizable includes the cost of customer lists, subscription for that property or its use. under the rules for section 197 intangibles can lists, insurance expirations, patient or client files, be depreciated if it meets certain requirements. and lists of newspaper, magazine, radio, and You generally must use the straight line method Franchise, trademark, or trade name. A television advertisers. over its useful life. For certain intangibles, the franchise, trademark, or trade name is a section

Patents, copyrights, etc. This includes pack- depreciation period is specified in the law and 197 intangible. You must amortize its purchase regulations. For example, the depreciation pe- age design, computer software, and any interest or renewal costs, other than certain contingent

in a film, sound recording, videotape, book, or riod for computer software that is not a section payments that you can deduct currently. For

other similar property, except as discussed later 197 intangible is generally 36 months. information on currently deductible contingent

under Assets That Are Not Section 197 In- payments, see chapter 11. For more information on depreciating intantangibles. gible property, see Intangible Property under Professional sports franchise. A What Method Can You Use To Depreciate Your Customer-based intangible. This is the com- franchise engaged in professional sports and Property? in chapter 1 of Publication 946. position of market, market share, and any other any intangible assets acquired in connection

value resulting from the future provision of with acquiring the franchise (including player Computer software. Section 197 intangibles goods or services because of relationships with contracts) is a section 197 intangible amortiz- do not include the following types of computer customers in the ordinary course of business. able over a 15-year period. software. For example, you must amortize the part of the

purchase price of a business that is for the Contract for the use of, or a term interest in, a 1. Software that meets all the following re- existence of the following intangibles. section 197 intangible. Section 197 in- quirements. tangibles include any right under a license, con- • A customer base. tract, or other arrangement providing for the use a. It is, or has been, readily available for

• A circulation base. of any section 197 intangible. It also includes purchase by the general public.

any term interest in any section 197 intangible, • An undeveloped market or market growth. b. It is subject to a nonexclusive license. whether the interest is outright or in trust.

• Insurance in force. c. It has not been substantially modified.

Assets That Are Not This requirement is considered met if • A mortgage servicing contract. the cost of all modifications is not more Section 197 Intangibles • An investment management contract. than the greater of 25% of the price of

the publicly available unmodified • Any other relationship with customers in- The following assets are not section 197 in- software or $2,000. volving the future provision of goods or tangibles.

services. 1. Any interest in a corporation, partnership, 2. Software that is not acquired in connection

trust, or estate. with the acquisition of a trade or business Accounts receivable or other similar rights to or a substantial part of a trade or business. income for goods or services provided to cus- 2. Any interest under an existing futures contomers before the acquisition of a trade or busi- tract, foreign currency contract, notional Computer software defined. Computer ness are not section 197 intangibles. principal contract, interest rate swap, or software includes all programs designed to similar financial contract. Supplier-based intangible. This is the value cause a computer to perform a desired function.

resulting from the future acquisition of goods or 3. Any interest in land. It also includes any database or similar item that

Chapter 8 Amortization Page 29
is in the public domain and is incidental to the 1. You or a related person (defined later) held indirectly controls the organization (or

operation of qualifying software. or used the intangible at any time from July whose family members control it).

25, 1991, through August 10, 1993. • A corporation and a partnership if the Rights of fixed duration or amount. Section 2. You acquired the intangible from a person same persons own more than 20% of the 197 intangibles do not include any right under a who held it at any time during the period in value of the outstanding stock of the cor- contract or from a governmental agency if the (1) and, as part of the transaction, the user poration and more than 20% of the capital right is acquired in the ordinary course of a trade did not change. or profits interest in the partnership. or business (or in an activity engaged in for the 3. You granted the right to use the intangible • Two S corporations, and an S corporation production of income) but not as part of a to a person (or a person related to that and a regular corporation, if the same per- purchase of a trade or business and either: person) who held or used it at any time sons own more than 20% of the value of • Has a fixed life of less than 15 years, or during the period in (1). This applies only if the outstanding stock of each corporation.

the transaction in which you granted the • Is of a fixed amount that, except for the • Two partnerships if the same persons right and the transaction in which you ac- rules for section 197 intangibles, would be own, directly or indirectly, more than 20% quired the intangible are part of a series of recovered under a method similar to the of the capital or profits interests in both related transactions. See Related person, unit-of-production method of cost recov- partnerships. later, for more information. ery. • A partnership and a person who owns,

However, this does not apply to the following Exceptions. The anti-churning rules do not directly or indirectly, more than 20% of the

intangibles. apply in the following situations. capital or profits interests in the partnership. • Goodwill. • You acquired the intangible from a decedent and its basis was stepped up to its • Two persons who are engaged in trades • Going concern value. fair market value. or businesses under common control (as

• A covenant not to compete. described in section 41(f)(1) of the Internal • The intangible was amortizable as a sec- Revenue Code). • A franchise, trademark, or trade name. tion 197 intangible by the seller or transferor you acquired it from. This exception • A customer-related information base, cus- When to determine relationship. Persons does not apply if the transaction in which tomer-based intangible, or similar item. are treated as related if the relationship existed you acquired the intangible and the trans- at the following time. action in which the seller or transferor acSafe Harbor for Creative quired it are part of a series of related • In the case of a single transaction, immetransactions. diately before or immediately after the Property Costs transaction in which the intangible was ac- • The gain-recognition exception, discussed quired. If you are engaged in the trade or business of later, applies.

film production, you may be able to amortize the • In the case of a series of related transaccreative property costs for properties not set for tions (or a series of transactions that com- Related person. For purposes of the production within 3 years of the first capitalized prise a qualified stock purchase under anti-churning rules, the following are related per- transaction. You may amortize these costs rata- section 338(d)(3) of the Internal Revenue sons. bly over a 15-year period beginning on the first Code), immediately before the earliest

day of the second half of the tax year in which • An individual and his or her brothers, sis- transaction or immediately after the last

ters, half-brothers, half-sisters, spouse, you properly write off the costs for financial ac- transaction.

ancestors (parents, grandparents, etc.), counting purposes. If, during the 15-year period,

you dispose of the creative property rights, you and lineal descendants (children, grand- Ownership of stock. In determining

must continue to amortize the costs over the children, etc.). whether an individual directly or indirectly owns

remainder of the 15-year period. any of the outstanding stock of a corporation, the • A corporation and an individual who owns, following rules apply. Creative property costs include costs paid or directly or indirectly, more than 20% of the

incurred to acquire and develop screenplays, value of the corporation’s outstanding Rule 1. Stock directly or indirectly owned by

scripts, story outlines, motion picture production stock. or for a corporation, partnership, estate, or trust

rights to books and plays, and other similar is considered owned proportionately by or for its • Two corporations that are members of the properties for purposes of potential future film shareholders, partners, or beneficiaries. same controlled group as defined in sec- development, production, and exploitation. tion 1563(a) of the Internal Revenue Rule 2. An individual is considered to own

Amortize these costs using the rules of Rev- Code, except that “more than 20%” is sub- the stock directly or indirectly owned by or for his enue Procedure 2004-36. For more information, stituted for “at least 80%” in that definition or her family. Family includes only brothers and see Revenue Procedure 2004-36, 2004-24 and the determination is made without re- sisters, half-brothers and half-sisters, spouse, I.R.B. 1063, available at gard to subsections (a)(4) and (e)(3)(C) of ancestors, and lineal descendants. www.irs.gov/irb/2004-24_IRB/ar16.html. section 1563. (For an exception, see sec- Rule 3. An individual owning (other than by tion 1.197-2(h)(6)(iv) of the regulations.) A change in the treatment of creative applying Rule 2) any stock in a corporation is property costs is a change in method of • A trust fiduciary and a corporation if more considered to own the stock directly or indirectly

CAUTION

accounting. than 20% of the value of the corporation’s

!

owned by or for his or her partner. outstanding stock is owned, directly or indirectly, by or for the trust or grantor of the Rule 4. For purposes of applying Rule 1, 2,

Anti-Churning Rules or 3, treat stock constructively owned by a per- trust.

son under Rule 1 as actually owned by that Anti-churning rules prevent you from amortizing • The grantor and fiduciary, and the fiduci- person. Do not treat stock constructively owned most section 197 intangibles if the transaction in ary and beneficiary, of any trust. by an individual under Rule 2 or 3 as owned by

which you acquired them did not result in a • The fiduciaries of two different trusts, and the individual for reapplying Rule 2 or 3 to make

significant change in ownership or use. These the fiduciaries and beneficiaries of two dif- another person the constructive owner of the

rules apply to goodwill and going concern value, stock. ferent trusts, if the same person is the and to any other section 197 intangible that is grantor of both trusts. not otherwise depreciable or amortizable. Gain-recognition exception. This exception • The executor and beneficiary of an estate. Under the anti-churning rules, you cannot to the anti-churning rules applies if the person

use 15-year amortization for the intangible if any • A tax-exempt educational or charitable or- you acquired the intangible from (the transferor)

of the following conditions apply. ganization and a person who directly or meets both of the following requirements.

Page 30 Chapter 8 Amortization
• That person would not be related to you Changing Your Disposition of (as described under Related person, ear- Accounting Method Section 197 Intangibles lier) if the 20% test for ownership of stock Generally, you must get IRS approval to change and partnership interests were replaced by A section 197 intangible is treated as deprecia- your method of accounting. File Form 3115, a 50% test. ble property used in your trade or business. If Application for Change in Accounting Method, to you held the intangible for more than 1 year, any • That person chose to recognize gain on request a change to a permissible method of gain on its disposition, up to the amount of allow- the disposition of the intangible and pay accounting for amortization. able amortization, is ordinary income (section income tax on the gain at the highest tax The following are examples of a change in 1245 gain). If multiple section 197 intangibles rate. See chapter 2 in Publication 544 for method of accounting for amortization. are disposed of in a single transaction or a information on making this choice. series of related transactions, treat all of the • A change in the amortization method, pe- section 197 intangibles as if they were a single riod of recovery, or convention of an amor- If this exception applies, the anti-churning asset for purposes of determining the amount of tizable asset. rules apply only to the amount of your adjusted gain that is ordinary income. Any remaining basis in the intangible that is more than the gain • A change in the accounting for amortiz- gain, or any loss, is a section 1231 gain or loss. If recognized by the transferor. able assets from a single asset account to you held the intangible 1 year or less, any gain

Notification. a multiple asset account (pooling), or vice or loss on its disposition is an ordinary gain or If the person you acquired the versa. loss. For more information on ordinary or capital intangible from chooses to recognize gain under gain or loss on business property, see chapter 3 the rules for this exception, that person must • A change in the accounting for amortiz- in Publication 544. notify you in writing by the due date of the return able assets from one type of multiple ason which the choice is made. set account to a different type of multiple Nondeductible loss. You cannot deduct any asset account. loss on the disposition or worthlessness of a

section 197 intangible that you acquired in the Anti-abuse rule. You cannot amortize any Changes in amortization that are not a change same transaction (or series of related transac- section 197 intangible acquired in a transaction in method of accounting include the following: tions) as other section 197 intangibles you still for which the principal purpose was either of the • A change in computing amortization in the have. Instead, increase the adjusted basis of following. each remaining amortizable section 197 intangi- tax year in which your use of the asset • To avoid the requirement that the intangi- changes. ble by a proportionate part of the nondeductible

ble be acquired after August 10, 1993. loss. Figure the increase by multiplying the non- • An adjustment in the useful life of an am- deductible loss on the disposition of the intangi- • To avoid any of the anti-churning rules. ortizable asset. ble by the following fraction.

• Generally, the making of a late amortiza- • The numerator is the adjusted basis of More information. For more information tion election or the revocation of a timely each remaining intangible on the date of about the anti-churning rules, including addi- valid amortization election. the disposition. tional rules for partnerships, see Regulations • Any change in the placed-in-service date section 1.197-2(h). • The denominator is the total adjusted ba- of an amortizable asset. ses of all remaining amortizable section

197 intangibles on the date of the disposi- Incorrect Amount of See Regulations section 1.446-1(e)(2)(ii)(a) tion. Amortization Deducted for more information and examples.

If you later discover that you deducted an incor- Covenant not to compete. A covenant not to Automatic approval. In some instances, you rect amount for amortization for a section 197 compete, or similar arrangement, is not consid- may be able to get automatic approval from the ered disposed of or worthless before you dis- intangible in any year, you may be able to make IRS to change your method of accounting for pose of your entire interest in the trade or a correction for that year by filing an amended amortization. For a list of automatic accounting business for which you entered into the cove- return. See Amended Return, next. If you are not method changes, see the Instructions for Form nant. allowed to make the correction on an amended 3115. Also see the Instructions for Form 3115

return, you can change your accounting method for more information on getting approval, auto- Nonrecognition transfers. If you acquire a to claim the correct amortization. See Changing matic approval procedures, and a list of excep- section 197 intangible in a nonrecognition transYour Accounting Method, later. tions to the automatic approval process. fer, you are treated as the transferor with respect

For more information, see Revenue Proce- to the part of your adjusted basis in the intangidure 2006-12, as modified by Revenue Proce- ble that is not more than the transferor’s adAmended Return dure 2006-37, and Revenue Procedure justed basis. You amortize this part of the

2008-52, as amplified, clarified, and modified by adjusted basis over the intangible’s remaining If you deducted an incorrect amount for amorti- Revenue Procedure 2009-39. See Revenue amortization period in the hands of the trans- zation, you can file an amended return to correct Procedure 2006-12, 2006-3 I.R.B. 310, avail- feror. Nonrecognition transfers include transfers the following. able at to a corporation, partnership contributions and

• A mathematical error made in any year. www.irs.gov/irb/2006-03_IRB/ar14.html. distributions, like-kind exchanges, and involunSee Revenue Procedure 2006-37, 2006-38 tary conversions. • A posting error made in any year. I.R.B. 499, available at In a like-kind exchange or involuntary con-

• An amortization deduction for a section www.irs.gov/irb/2006-38_IRB/ar10.html. version of a section 197 intangible, you must

197 intangible for which you have not See Revenue Procedure 2008-52, 2008-36 continue to amortize the part of your adjusted

I.R.B. 587, available at basis in the acquired intangible that is not more adopted a method of accounting. www.irs.gov/irb/2008-36_IRB/ar09.html. than your adjusted basis in the exchanged or

See Revenue Procedure 2009-39, 2009-38 converted intangible over the remaining amorti- When to file. If an amended return is allowed, I.R.B. 371, available at zation period of the exchanged or converted you must file it by the later of the following dates. www.irs.gov/irb/2009-38_IRB/ar08.html. intangible. Amortize over a new 15-year period

• 3 years from the date you filed your origi- the part of your adjusted basis in the acquired

Note. If you are filing an application for a intangible that is more than your adjusted basis nal return for the year in which you did not change in accounting method filed on or after in the exchanged or converted intangible. deduct the correct amount. (A return filed January 10, 2011, for a year of change ending early is considered filed on the due date.) on or after April 30, 2010, see Revenue Proce- Example. You own a section 197 intangible

• 2 years from the time you paid your tax for dure 2011-14, 2011-4 I.R.B. 330, available at you have amortized for 4 full years. It has a

that year. www.irs.gov/irb/2011-04_IRB/ar08.html. remaining unamortized basis of $30,000. You

Chapter 8 Amortization Page 31
exchange the asset plus $10,000 for a like-kind Amortization period. The 84-month amortisection 197 intangible. The nonrecognition pro- zation period starts on the first day of the first Geological and visions of like-kind exchanges apply. You amor- month of the second half of the tax year you

tize $30,000 of the $40,000 adjusted basis of the incur the costs (July 1 for a calendar year tax- Geophysical Costs acquired intangible over the 11 years remaining payer), regardless of the month you actually

in the original 15-year amortization period for the incur the costs. You can claim amortization de- You can amortize the cost of geological and transferred asset. You amortize the other ductions for no more than 6 months of the first geophysical expenses paid or incurred in con- $10,000 of adjusted basis over a new 15-year and last (eighth) tax years of the period. nection with oil and gas exploration or develop- period. ment within the United States. These costs can

Life tenant and remainderman. If one per- be amortized ratably over a 24-month period

son holds the property for life with the remainder beginning on the mid-point of the tax year in

going to another person, the life tenant is entitled which the expenses were paid or incurred. For Reforestation Costs to the full amortization for qualifying reforesta- major integrated oil companies (as defined in

section 167(h)(5)), these costs must be amor- tion costs incurred by the life tenant. Any re- You can elect to deduct a limited amount of mainder interest in the property is ignored for tized ratably over a 5-year period for costs paid

reforestation costs paid or incurred during the or incurred after May 17, 2006 (a 7-year period amortization purposes. tax year. See Reforestation Costs in chapter 7. for costs paid or incurred after December 19, You can elect to amortize the qualifying costs 2007). Recapture. If you dispose of qualified timber that are not deducted currently over an property within 10 years after the tax year you If you retire or abandon the property during 84-month period. There is no limit on the amount the amortization period, no amortization deduc- incur qualifying reforestation expenses, report of your amortization deduction for reforestation tion is allowed in the year of retirement or aban- any gain as ordinary income up to the amortiza- costs paid or incurred during the tax year. donment. tion you took. See chapter 3 of Publication 544 The election to amortize reforestation costs

for more information. incurred by a partnership, S corporation, or estate must be made by the partnership, corporaHow to make the election. To elect to amor- tion, or estate. A partner, shareholder, or

tize qualifying reforestation costs, complete Part Pollution Control beneficiary cannot make that election.

A partner’s or shareholder’s share of amor- VI of Form 4562 and attach a statement that

contains the following information. Facilities tizable costs is figured under the general rules

for allocating items of income, loss, deduction, • A description of the costs and the dates You can elect to amortize the cost of a certified etc., of a partnership or S corporation. The am- you incurred them. pollution control facility over 60 months. How- ortizable costs of an estate are divided between

ever, see Atmospheric pollution control facilities the estate and the income beneficiary based on • A description of the type of timber being for an exception. The cost of a pollution control the income of the estate allocable to each. grown and the purpose for which it is facility that is not eligible for amortization can be grown. depreciated under the regular rules for deprecia- Qualifying costs. Reforestation costs are the Attach a separate statement for each property tion. Also, you can claim a special depreciation direct costs of planting or seeding for forestation for which you amortize reforestation costs. allowance on a certified pollution control facility or reforestation. Qualifying costs include only that is qualified property even if you elect to those costs you must capitalize and include in Generally, you must make the election on a amortize its cost. You must reduce its cost (am- the adjusted basis of the property. They include timely filed return (including extensions) for the ortizable basis) by the amount of any special costs for the following items. tax year in which you incurred the costs. How- allowance you claim. See chapter 3 of Publica- ever, if you timely filed your return for the year • Site preparation. tion 946. without making the election, you can still make • Seeds or seedlings. A certified pollution control facility is a new the election by filing an amended return within 6 identifiable treatment facility used in connection • Labor. months of the due date of the return (excluding with a plant or other property in operation before extensions). Attach Form 4562 and the state- • Tools. 1976, to reduce or control water or atmospheric ment to the amended return and write “Filed pollution or contamination. The facility must do • Depreciation on equipment used in plant- pursuant to section 301.9100-2” on Form 4562. so by removing, changing, disposing, storing, or ing and seeding. File the amended return at the same address preventing the creation or emission of pollu- you filed the original return. tants, contaminants, wastes, or heat. The facility Qualifying costs do not include costs for which must be certified by state and federal certifying the government reimburses you under a Revoking the election. You must get IRS ap- authorities. cost-sharing program, unless you include the proval to revoke your election to amortize quali- The facility must not significantly increase reimbursement in your income. fying reforestation costs. Your application to the output or capacity, extend the useful life, or revoke the election must include your name, Qualified timber property. Qualified timber reduce the total operating costs of the plant or address, the years for which your election was in property is property that contains trees in signifi- other property. Also, it must not significantly effect, and your reason for revoking it. Please change the nature of the manufacturing or pro- cant commercial quantities. It can be a woodlot provide your daytime telephone number (op- or other site that you own or lease. The property duction process or facility. tional), in case we need to contact you. You, or qualifies only if it meets all of the following re- The federal certifying authority will not certify your duly authorized representative, must sign quirements. your property to the extent it appears you will the application and file it at least 90 days before recover (over the property’s useful life) all or part • It is located in the United States. the due date (without extensions) for filing your of its cost from the profit based on its operation income tax return for the first tax year for which • It is held for the growing and cutting of (such as through sales of recovered wastes). your election is to end. timber you will either use in, or sell for use The federal certifying authority will describe the

in, the commercial production of timber nature of the potential cost recovery. You must

products. then reduce the amortizable basis of the facility

Send the application to: by this potential recovery. • It consists of at least one acre planted with Internal Revenue Service tree seedlings in the manner normally New identifiable treatment facility. A new Associate Chief Counsel used in forestation or reforestation. identifiable treatment facility is tangible depre- Passthroughs and Special Industries ciable property that is identifiable as a treatment CC:PSI:6 Qualified timber property does not include facility. It does not include a building and its 1111 Constitution Ave., NW, IR-5300 property on which you have planted shelter belts structural components unless the building is ex- Washington, DC 20224 or ornamental trees, such as Christmas trees. clusively a treatment facility.

Page 32 Chapter 8 Amortization
Atmospheric pollution control facilities. (excluding extensions). Attach Form 4562 to the

Certain atmospheric pollution control facilities amended return and write “Filed pursuant to

can be amortized over 84 months. To qualify,

the following must apply.

section 301.9100-2” on Form 4562. File the 9. amended return at the same address you filed

• The facility must be acquired and placed the original return.

in service after April 11, 2005. If acquired, Your election is binding for the year it is

the original use must begin with you after made and for all later years unless you obtain Depletion April 11, 2005. approval from the IRS to change to a different

• The facility must be used in connection method.

with an electric generation plant or other What’s New

property placed in operation after December 31, 1975, that is primarily coal fired. Marginal production of oil and gas. The

• If you construct, reconstruct, or erect the Optional Write-off temporary suspension of the 100% taxable infacility, only the basis attributable to the come limitation on percentage depletion on the

construction, reconstruction, or erection of Certain Tax marginal production of oil and natural gas also

completed after April 11, 2005, qualifies. applies to tax years beginning in 2010 and 2011. Preferences

Basis reduction for corporations. A corpo- You can elect to amortize certain tax preference ration must reduce the amortizable basis of a items over an optional period beginning in the pollution control facility by 20% before figuring Introduction

tax year in which you incurred the costs. If you the amortization deduction. make this election, there is no AMT adjustment. Depletion is the using up of natural resources by

mining, quarrying, drilling, or felling. The deple- More information. For more information on The applicable costs and the optional recovery tion deduction allows an owner or operator to the amortization of pollution control facilities, periods are as follows: account for the reduction of a product’s see Code sections 169 and 291(c) and the re- • Circulation costs — 3 years, reserves. lated regulations. There are two ways of figuring depletion: • Intangible drilling and development costs

— cost depletion and percentage depletion. For 60 months, mineral property, you generally must use the

Research and • Mining exploration and development costs method that gives you the larger deduction. For

— 10 years, and standing timber, you must use cost depletion.

Experimental Costs • Research and experimental costs — 10 Topics years.

You can elect to amortize your research and This chapter discusses:

experimental costs, deduct them as current How to make the election. To elect to amor- business expenses, or write them off over a • Who can claim depletion

tize qualifying costs over the optional recovery 10-year period (see Optional write-off method • Mineral property period, complete Part VI of Form 4562 and at- below). tach a statement containing the following infor- • Timber If you elect to amortize these costs, deduct mation to your return for the tax year in which the them in equal amounts over 60 months or more.

The amortization period begins the month you election begins:

first receive an economic benefit from the costs. • Your name, address, and taxpayer identifi- For a definition of “research and experimental costs” and information on deducting them as cation number; and Who Can

current business expenses, see chapter 7 • The type of cost and the specific amount .

of the cost for which you are making the Claim Depletion? Optional write-off method. Rather than election.

amortize these costs or deduct them as a cur- If you have an economic interest in mineral prop- rent expense, you have the option of deducting Generally, the election must be made on a erty or standing timber, you can take a deduction (writing off) research and experimental costs timely filed return (including extensions) for the for depletion. More than one person can have an ratably over a 10-year period beginning with the economic interest in the same mineral deposit or tax year in which you incurred the costs. How- tax year in which you incurred the costs. For timber. ever, if you timely filed your return for the year more information, see Optional Write-off of Cer- without making the election, you can still make You have an economic interest if both the

tain Tax Preferences, later, and section 59(e) of following apply. the election by filing an amended return within 6 the Internal Revenue Code.

months of the due date of the return (excluding • You have acquired by investment any in- Costs you can amortize. You can amortize extensions). Attach Form 4562 to the amended terest in mineral deposits or standing tim- costs chargeable to a capital account (see chap- return and write “Filed pursuant to section ber.

ter 1) if you meet both of the following require- 301.9100-2” on Form 4562. File the amended

ments. • You have a legal right to income from the return at the same address you filed the original extraction of the mineral or cutting of the • You paid or incurred the costs in your return. timber to which you must look for a return

trade or business. of your capital investment.

• You are not deducting the costs currently. Revoking the election. You must obtain con- A contractual relationship that allows you an sent from the IRS to revoke your election. Your economic or monetary advantage from products

How to make the election. To elect to amor- request to revoke the election must be submit- of the mineral deposit or standing timber is not,

ted to the IRS in the form of a letter ruling before in itself, an economic interest. A production pay- tize research and experimental costs, complete

Part VI of Form 4562 and attach it to your in- the end of the tax year in which the optional ment carved out of, or retained on the sale of,

recovery period ends. The request must contain mineral property is not an economic interest. come tax return. Generally, you must file the all of the information necessary to demonstrate return by the due date (including extensions).

However, if you timely filed your return for the the rare and unusual circumstances that would Individuals, corporations, estates, and

justify granting revocation. If the request for rev- trusts who claim depletion deductions year without making the election, you can still

make the election by filing an amended return ocation is approved, any unamortized costs are

CAUTION

may be liable for alternative minimum

!

within 6 months of the due date of the return deductible in the year the revocation is effective. tax.

Chapter 9 Depletion Page 33
You must estimate or determine recoverable by your gross income from the property during

Mineral Property units (tons, pounds, ounces, barrels, thousands the tax year.

of cubic feet, or other measure) of mineral prod- The rates to be used and other conditions

ucts using the current industry method and the and qualifications for oil and gas wells are dis- Mineral property includes oil and gas wells, most accurate and reliable information you can cussed later under Independent Producers and mines, and other natural deposits (including ge- obtain. Royalty Owners and under Natural Gas Wells. othermal deposits). For this purpose, the term Rates and other rules for percentage depletion “property” means each separate interest you Number of units sold. You determine the of other specific minerals are found later in own in each mineral deposit in each separate number of units sold during the tax year based Mines and Geothermal Deposits. tract or parcel of land. You can treat two or more on your method of accounting. Use the following separate interests as one property or as sepa- table to make this determination. Gross income. When figuring your percentrate properties. See section 614 of the Internal age depletion, subtract from your gross income

Revenue Code and the related regulations for IF you THEN the units sold from the property the following amounts.

rules on how to treat separate mineral interests. use ... during the year are ... • Any rents or royalties you paid or incurred There are two ways of figuring depletion on The cash The units sold for which for the property. mineral property. method of you receive payment • The part of any bonus you paid for a lease • Cost depletion. accounting during the tax year on the property allocable to the product (regardless of the year of • Percentage depletion. sold (or that otherwise gives rise to gross sale). income) for the tax year. Generally, you must use the method that gives An accrual The units sold based on A bonus payment includes amounts you paid as you the larger deduction. However, unless you method of your inventories and a lessee to satisfy a production payment re- are an independent producer or royalty owner, accounting method of accounting for tained by the lessor. you generally cannot use percentage depletion inventory.

for oil and gas wells. See Oil and Gas Wells, Use the following fraction to figure the part of

later. The number of units sold during the tax year the bonus you must subtract.

does not include any for which depletion deducCost Depletion tions were allowed or allowable in earlier years. No. of units sold in the tax year Bonus Recoverable units from the × Payments To figure cost depletion you must first determine Figuring the cost depletion deduction. property

Once you have figured your property’s basis for the following. For oil and gas wells and geothermal depos- depletion, the total recoverable units, and the • The property’s basis for depletion. its, gross income from the property is defined number of units sold during the tax year, you can later under Oil and Gas Wells. For property other figure your cost depletion deduction by taking • The total recoverable units of mineral in than a geothermal deposit or an oil and gas well, the following steps. the property’s natural deposit. gross income from the property is defined later

• The number of units of mineral sold during under Mines and Geothermal Deposits. Step Action Result

the tax year. Taxable income limit. The percentage deple- 1 Divide your property’s Rate per

basis for depletion by unit. tion deduction generally cannot be more than

Basis for depletion. To figure the property’s total recoverable units. 50% (100% for oil and gas property) of your

basis for depletion, subtract all the following taxable income from the property figured without 2 Multiply the rate per Cost from the property’s adjusted basis. the depletion deduction and the domestic pro- unit by units sold depletion duction activities deduction.

1. Amounts recoverable through: during the tax year. deduction. Taxable income from the property means

gross income from the property minus all allowa- a. Depreciation deductions, ble deductions (excluding any deduction for de- Note. You must keep accounts for the de- b. Deferred expenses (including deferred pletion or qualified domestic production pletion of each property and adjust these ac- exploration and development costs), activities) attributable to mining processes, in- counts each year for units sold and depletion and cluding mining transportation. These deductible claimed. items include, but are not limited to, the follow- c. Deductions other than depletion. ing. Elective safe harbor for owners of oil and gas

2. The residual value of land and improve- property. Owners of oil and gas property may • Operating expenses.

ments at the end of operations. use an elective safe harbor in determining the • Certain selling expenses. property’s recoverable reserves for purposes of 3. The cost or value of land acquired for pur- computing cost depletion. If this election is • Administrative and financial overhead. poses other than mineral production. made, special rules apply. See Revenue Proce- • Depreciation. dure 2004-19 on page 563 of Internal Revenue Adjusted basis. The adjusted basis of your Bulletin 2004-10, available at www.irs.gov/pub/ • Intangible drilling and development costs. property is your original cost or other basis, plus irs-irbs/irb04-10.pdf. certain additions and improvements, and minus • Exploration and development expendi- To make the election, attach a statement to

certain deductions such as depletion allowed or tures. your timely filed (including extensions) original allowable and casualty losses. Your adjusted return for the first tax year for which the safe basis can never be less than zero. See Publica- The following rules apply when figuring your harbor is elected. The statement must indicate taxable income from the property for purposes tion 551, Basis of Assets, for more information that you are electing the safe harbor provided by of the taxable income limit. on adjusted basis. Revenue Procedure 2004-19. The election, if

made, is effective for the tax year in which it is • Do not deduct any net operating loss deTotal recoverable units. The total recover- made and all subsequent years. It cannot be duction from the gross income from the

able units is the sum of the following. revoked for the tax year in which it is elected, but property.

may be revoked in a later year. Once revoked, it • The number of units of mineral remaining • Corporations do not deduct charitable con- cannot be re-elected for the next 5 years. at the end of the year (including units re- tributions from the gross income from the

covered but not sold). property. Percentage Depletion • The number of units of mineral sold during • If, during the year, you dispose of an item

the tax year (determined under your To figure percentage depletion, you multiply a of section 1245 property that was used in

method of accounting, as explained next). certain percentage, specified for each mineral, connection with mineral property, reduce

Page 34 Chapter 9 Depletion
any allowable deduction for mining ex- • The interest in the profits or capital of a • The retailer does not buy oil or natural gas

penses by the part of any gain you must partnership. from your customers or persons related to

report as ordinary income that is allocable your customers. • The beneficial interests in an estate or to the mineral property. See section trust. • There are no arrangements for the retailer 1.613-5(b)(1) of the regulations for infor- to acquire oil or natural gas you produced mation on how to figure the ordinary gain Any interest owned by or for a corporation, for resale or made available for purchase allocable to the property. partnership, trust, or estate is considered to be by the retailer.

owned directly both by itself and proportionately • Neither you nor the retailer knows of or Oil and Gas Wells by its shareholders, partners, or beneficiaries. controls the final disposition of the oil or

natural gas you sold or the original source You cannot claim percentage depletion for an oil Retailers who cannot claim percentage de- of the petroleum products the retailer ac- or gas well unless at least one of the following pletion. You cannot claim percentage deple- quired for resale. applies. tion if both the following apply. • You are either an independent producer or Transferees who cannot claim percentage a royalty owner. 1. You sell oil or natural gas or their depletion. You cannot claim percentage de- by-products directly or through a related • The well produces natural gas that is ei- pletion if you received your interest in a proven person in any of the following situations. ther sold under a fixed contract or pro- oil or gas property by transfer after 1974 and

duced from geopressured brine. before October 12, 1990. For a definition of the a. Through a retail outlet operated by you term “transfer,” see section 1.613A-7(n) of the or a related person. regulations. For a definition of the term “interest If you are an independent producer or royalty

owner, see Independent Producers and Royalty b. To any person who is required under an in proven oil or gas property,” see section

Owners agreement with you or a related person 1.613A-7(p) of the regulations. , next.

to use a trademark, trade name, or For information on the depletion deduction service mark or name owned by you or Figuring percentage depletion. Generally, for wells that produce natural gas that is either a related person in marketing or distrib- as an independent producer or royalty owner, sold under a fixed contract or produced from uting oil, natural gas, or their you figure your percentage depletion by comput- geopressured brine, see Natural Gas Wells, by-products. ing your average daily production of domestic oil later. or gas and comparing it to your depletable oil or c. To any person given authority under an gas quantity. If your average daily production agreement with you or a related person does not exceed your depletable oil or gas quan- Independent Producers and to occupy any retail outlet owned, tity, you figure your percentage depletion by Royalty Owners leased, or controlled by you or a related multiplying the gross income from the oil or gas

If you are an independent producer or royalty person. property (defined later) by 15%. If your average

owner, you figure percentage depletion using a daily production of domestic oil or gas exceeds

2. The combined gross receipts from sales your depletable oil or gas quantity, you must rate of 15% of the gross income from the property based on your average daily production of (not counting resales) of oil, natural gas, or make an allocation as explained later under Avdomestic crude oil or domestic natural gas up to their by-products by all retail outlets taken erage daily production exceeds depletable

your depletable oil or natural gas quantity. How- into account in (1) are more than $5 million quantities.

ever, certain refiners, as explained next, and for the tax year. In addition, there is a limit on the percentage

certain retailers and transferees of proven oil depletion deduction. See Taxable income limit, For the purpose of determining if this rule and gas properties, as explained later, cannot later. applies, do not count the following. claim percentage depletion. For information on

figuring the deduction, see Figuring percentage • Bulk sales (sales in very large quantities) Average daily production. Figure your averdepletion, later. of oil or natural gas to commercial or in- age daily production by dividing your total dodustrial users. mestic production of oil or gas for the tax year by

Refiners who cannot claim percentage de- the number of days in your tax year. • Bulk sales of aviation fuels to the Depart- pletion. You cannot claim percentage deple- ment of Defense. Partial interest. If you have a partial inter- tion if you or a related person refine crude oil and est in the production from a property, figure your you and the related person refined more than • Sales of oil or natural gas or their share of the production by multiplying total pro- 75,000 barrels on any day during the tax year by-products outside the United States if duction from the property by your percentage of based on average (rather than actual) daily re- none of your domestic production or that interest in the revenues from the property. finery runs for the tax year. The average daily of a related person is exported during the You have a partial interest in the production refinery run is computed by dividing total refinery tax year or the prior tax year. from a property if you have a net profits interest runs for the tax year by the total number of days in the property. To figure the share of production in the tax year. Related person. To determine if you and for your net profits interest, you must first deterRelated person. You and another person another person are related persons, see Re- mine your percentage participation (as meaare related persons if either of you holds a signif- lated person under Refiners who cannot claim sured by the net profits) in the gross revenue percentage depletion, earlier. icant ownership interest in the other person or if from the property. To figure this percentage, you

a third person holds a significant ownership in- Sales through a related person. You are divide the income you receive for your net profits

terest in both of you. interest by the gross revenue from the property. considered to be selling through a related perFor example, a corporation, partnership, es- Then multiply the total production from the prop- son if any sale by the related person produces

tate, or trust and anyone who holds a significant erty by your percentage participation to figure gross income from which you may benefit beownership interest in it are related persons. A your share of the production. cause of your direct or indirect ownership inter- partnership and a trust are related persons if one est in the person. Example. John Oak owns oil property in person holds a significant ownership interest in You are not considered to be selling through which Paul Elm owns a 20% net profits interest. each of them.

a related person who is a retailer if all the follow- During the year, the property produced 10,000 For purposes of the related person rules, ing apply. barrels of oil, which John sold for $200,000. significant ownership interest means direct or John had expenses of $90,000 attributable to indirect ownership of 5% or more in any one of • You do not have a significant ownership the property. The property generated a net profit the following. interest in the retailer. of $110,000 ($200,000 − $90,000). Paul re-

• The value of the outstanding stock of a • You sell your production to persons who ceived income of $22,000 ($110,000 × .20) for

corporation. are not related to either you or the retailer. his net profits interest.

Chapter 9 Depletion Page 35
Paul determined his percentage participation percentage depletion purposes without regard Partner’s or shareholder’s adjusted basis.

to be 11% by dividing $22,000 (the income he to the RMFP. The partnership or S corporation must allocate

received) by $200,000 (the gross revenue from Gross income from the property does not to each partner or shareholder his or her share

the property). Paul determined his share of the of the adjusted basis of each oil or gas property include lease bonuses, advance royalties, or

oil production to be 1,100 barrels (10,000 bar- held by the partnership or S corporation. The other amounts payable without regard to prorels × 11%). partnership or S corporation makes the alloca- duction from the property. tion as of the date it acquires the oil or gas

Depletable oil or natural gas quantity. Gen- property. Average daily production exceeds depleterally, your depletable oil quantity is 1,000 bar- Each partner’s share of the adjusted basis of able quantities. If your average daily produc- the oil or gas property generally is figured ac- rels. Your depletable natural gas quantity is tion for the year is more than your depletable oil

6,000 cubic feet multiplied by the number of cording to that partner’s interest in partnership or natural gas quantity, figure your allowance for

barrels of your depletable oil quantity that you capital. However, in some cases, it is figured depletion for each domestic oil or natural gas

choose to apply. If you claim depletion on both according to the partner’s interest in partnership property as follows. income. oil and natural gas, you must reduce your depletable oil quantity (1,000 barrels) by the num- 1. Figure your average daily production of oil The partnership or S corporation adjusts the

ber of barrels you use to figure your depletable or natural gas for the year. partner’s or shareholder’s share of the adjusted

natural gas quantity. basis of the oil and gas property for any capital 2. Figure your depletable oil or natural gas expenditures made for the property and for any quantity for the year. Example. You have both oil and natural gas change in partnership or S corporation interests.

production. To figure your depletable natural 3. Figure depletion for all oil or natural gas Each partner or shareholder must sep- gas quantity, you choose to apply 360 barrels of produced from the property using a per- arately keep records of his or her share your 1000-barrel depletable oil quantity. Your centage depletion rate of 15%.

RECORDS

of the adjusted basis in each oil and depletable natural gas quantity is 2.16 million 4. Multiply the result figured in (3) by a frac- gas property of the partnership or S corporation. cubic feet of gas (360 × 6000). You must reduce tion, the numerator of which is the result The partner or shareholder must reduce his or your depletable oil quantity to 640 barrels (1000 figured in (2) and the denominator of which her adjusted basis by the depletion allowed or − 360). is the result figured in (1). This is your allowable on the property each year. The part-

 If you have production from marginal wells, depletion allowance for that property for ner or shareholder must use that reduced adsee section 613A(c)(6) of the Internal Revenue the year. justed basis to figure cost depletion or his or her

Code to figure your depletable oil or natural gas gain or loss if the partnership or S corporation

quantity. disposes of the property. Taxable income limit. If you are an indepen- Business entities and family members. dent producer or royalty owner of oil and gas, You must allocate the depletable oil or gas Reporting the deduction. Information that your deduction for percentage depletion is lim- quantity among the following related persons in you, as a partner or shareholder, use to figure ited to the smaller of the following. proportion to each entity’s or family member’s your depletion deduction on oil and gas properproduction of domestic oil or gas for the year. • 100% of your taxable income from the ties is reported by the partnership or S corporaproperty figured without the deduction for tion on Schedule K-1 (Form 1065) or on • Corporations, trusts, and estates if 50% or depletion and the deduction for domestic Schedule K-1 (Form 1120S). Deduct oil and gas more of the beneficial interest is owned by production activities under section 199 of depletion for your partnership or S corporation the same or related persons (considering the Internal Revenue Code. For a defini- interest on Schedule E (Form 1040). The deple- only persons that own at least 5% of the tion deducted on Schedule E is included in figur- tion of taxable income from the property, beneficial interest). see Taxable income limit ing income or loss from rental real estate or , earlier, under

• You and your spouse and minor children. Mineral Property. royalty properties. The instructions for Schedule

E explain where to report this income or loss and A related person is anyone mentioned in the • 65% of your taxable income from all whether you need to file either of the following related persons discussion under Nondeduct- sources, figured without the depletion al- forms. ible loss in chapter 2 of Publication 544, except lowance, the deduction for domestic prothat for purposes of this allocation, item (1) in duction activities, any net operating loss • Form 6198, At-Risk Limitations.

that discussion includes only an individual, his or carryback, and any capital loss carryback. • Form 8582, Passive Activity Loss Limita- her spouse, and minor children. You can carry over to the following year any tions.

Controlled group of corporations. Mem- amount you cannot deduct because of the

bers of the same controlled group of corpora- 65%-of-taxable-income limit. Add it to your de- Electing large partnerships must figure de- tions are treated as one taxpayer when figuring pletion allowance (before applying any limits) for pletion allowance. An electing large partner- the depletable oil or natural gas quantity. They the following year. ship, rather than each partner, generally must share the depletable quantity. Under this rule, a figure the depletion allowance. The partnership controlled group of corporations is defined in Note. figures the depletion allowance without taking For tax years beginning after 2009 section 1563(a) of the Internal Revenue Code, into account the 65-percent-of-taxable-income and before 2012, the 100% taxable income limit except that the stock ownership requirement in limit and the depletable oil or natural gas quan- does not apply to percentage depletion on mar- that definition is “more than 50%” rather than “at tity. Also, the adjusted basis of a partner’s inter- ginal production of oil and natural gas. For infor- least 80%.” mation on marginal production, see section est in the partnership is not affected by the

depletion allowance. 613A(c)(6) of the Internal Revenue Code. Gross income from the property. For pur- An electing large partnership is one that

poses of percentage depletion, gross income meets both the following requirements.

from the property (in the case of oil and gas Partnerships and S Corporations • The partnership had 100 or more partners wells) is the amount you receive from the sale of in the preceding year. the oil or gas in the immediate vicinity of the well. Generally, each partner or shareholder, and not

If you do not sell the oil or gas on the property, the partnership or S corporation, figures the de- • The partnership chooses to be an electing

but manufacture or convert it into a refined prod- pletion allowance separately. (However, see large partnership.

uct before sale or transport it before sale, the Electing large partnerships must figure deplegross income from the property is the represen- tion allowance, later.) Each partner or share- Disqualified persons. An electing large

tative market or field price (RMFP) of the oil or holder must decide whether to use cost or partnership does not figure the depletion allowgas, before conversion or transportation. percentage depletion. If a partner or shareholder ance of its partners that are disqualified perIf you sold gas after you removed it from the uses percentage depletion, he or she must ap- sons. Disqualified persons must figure it

premises for a price that is lower than the RMFP, ply the 65%-of-taxable-income limit using his or themselves, as explained earlier.

determine gross income from the property for her taxable income from all sources. All the following are disqualified persons.

Page 36 Chapter 9 Depletion
• Refiners who cannot claim percentage de- requirements, the additional authorized trans- Clay and shale used or sold for pletion (discussed under Independent Pro- portation is considered mining and included in use in making sewer pipe or bricks ducers and Royalty Owners, earlier). the computation of gross income from mining. or used or sold for use as sintered

or burned lightweight aggregates 71 • Retailers who cannot claim percentage /2% If you wish to include transportation of

depletion (discussed under Independent Clay used or sold for use in more than 50 miles in the computation

Producers and Royalty Owners, earlier). making drainage and roofing tile, of gross income from mining, file an

flower pots, and kindred products, application in duplicate with the IRS. Include on • Any partner whose average daily produc- and gravel, sand, and stone (other the application the facts concerning the physical tion of domestic crude oil and natural gas than stone used or sold for use by and other requirements which prevented the is more than 500 barrels during the tax a mine owner or operator as construction and operation of the plant within 50 year in which the partnership tax year dimension or ornamental stone) 5% miles of the point of extraction. Send this appli- ends. Average daily production is dis- cation to: cussed earlier. You can find a complete list of minerals and Internal Revenue Service their percentage depletion rates in section Associate Chief Counsel 613(b) of the Internal Revenue Code. Natural Gas Wells Passthroughs and Special Industries Corporate deduction for iron ore and coal. CC:PSI:FO

You can use percentage depletion for a well that The percentage depletion deduction of a corpo- 1111 Constitution Ave., N.W., IR-5300

produces natural gas either sold under a fixed ration for iron ore and coal (including lignite) is Washington, DC 20224 contract or produced from geopressured brine. reduced by 20% of:

• The percentage depletion deduction for Disposal of coal or iron ore. You cannot take

Natural gas sold under a fixed contract. a depletion deduction for coal (including lignite) the tax year (figured without regard to this Natural gas sold under a fixed contract qualifies reduction), minus or iron ore mined in the United States if both the

for a percentage depletion rate of 22%. This is following apply. domestic natural gas sold by the producer under • The adjusted basis of the property at the

a contract that does not provide for a price in- close of the tax year (figured without the • You disposed of it after holding it for more

crease to reflect any increase in the seller’s tax depletion deduction for the tax year). than 1 year.

liability because of the repeal of percentage de- • You disposed of it under a contract under pletion for gas. The contract must have been in Gross income from the property. For prop- which you retain an economic interest in effect from February 1, 1975, until the date of erty other than a geothermal deposit or an oil or the coal or iron ore.

sale of the gas. Price increases after February 1, gas well, gross income from the property means 1975, are presumed to take the increase in tax Treat any gain on the disposition as a capital the gross income from mining. Mining includes gain. liability into account unless demonstrated other- all the following. wise by clear and convincing evidence. Disposal to related person. This rule does • Extracting ores or minerals from the not apply if you dispose of the coal or iron ore to

Natural gas from geopressured brine. Qual- ground. one of the following persons.

ified natural gas from geopressured brine is eli- • Applying certain treatment processes. • A related person (as listed in chapter 2 of gible for a percentage depletion rate of 10%. • Transporting ores or minerals (generally, Publication 544). This is natural gas that is both the following. not more than 50 miles) from the point of • A person owned or controlled by the same • Produced from a well you began to drill extraction to the plants or mills in which interests that own or control you. after September 1978 and before 1984. the treatment processes are applied.

• Determined in accordance with section

Excise tax. Gross income from mining in- Geothermal deposits. Geothermal deposits 503 of the Natural Gas Policy Act of 1978

cludes the separately stated excise tax received located in the United States or its possessions to be produced from geopressured brine. by a mine operator from the sale of coal to qualify for a percentage depletion rate of 15%. A

compensate the operator for the excise tax the geothermal deposit is a geothermal reservoir of

Mines and mine operator must pay to finance black lung natural heat stored in rocks or in a watery liquid

Geothermal Deposits benefits. or vapor. For percentage depletion purposes, a

geothermal deposit is not considered a gas well. Extraction. Extracting ores or minerals Certain mines, wells, and other natural deposits, Figure gross income from the property for a from the ground includes extraction by mine geothermal steam well in the same way as for oil including geothermal deposits, qualify for per- owners or operators of ores or minerals from the centage depletion. and gas wells. See Gross income from the prop- waste or residue of prior mining. This does not erty earlier, under Oil and Gas Wells. Percentapply to extraction from waste or residue of prior Mines and other natural deposits. age depletion on a geothermal deposit cannot For a nat- mining by the purchaser of the waste or residue ural deposit, the percentage of your gross in- be more than 50% of your taxable income from or the purchaser of the rights to extract ores or the property. come from the property that you can deduct as minerals from the waste or residue.

depletion depends on the type of deposit.

The following is a list of the percentage de- Treatment processes. The processes in- Lessor’s Gross Income

pletion rates for the more common minerals. cluded as mining depend on the ore or mineral

mined. To qualify as mining, the treatment A lessor’s gross income from the property that

DEPOSITS RATE processes must be applied by the mine owner or qualifies for percentage depletion usually is the

operator. For a listing of treatment processes total of the royalties received from the lease.

Sulphur, uranium, and, if from considered as mining, see section 613(c)(4) of However, for oil, gas, or geothermal property,

deposits in the United States, the Internal Revenue Code and the related regu- gross income does not include lease bonuses,

asbestos, lead ore, zinc ore, nickel lations. advanced royalties, or other amounts payable

ore, and mica ............ . 22% without regard to production from the property. Transportation of more than 50 miles. If

Gold, silver, copper, iron ore, and the IRS finds that the ore or mineral must be Bonuses and advanced royalties. Bonuses certain oil shale, if from deposits in transported more than 50 miles to plants or mills and advanced royalties are payments a lessee the United States .......... . 15% to be treated because of physical and other makes before production to a lessor for the grant Borax, granite, limestone, marble, of rights in a lease or for minerals, gas, or oil to mollusk shells, potash, slate, be extracted from leased property. If you are the soapstone, and carbon dioxide lessor, your income from bonuses and ad- produced from a well ....... . 14% vanced royalties received is subject to an allowCoal, lignite, and sodium chloride 10% ance for depletion.

Chapter 9 Depletion Page 37
Figuring cost depletion. To figure cost de- The term “timber property” means your eco- IRS’s consent. The prior election (and revocapletion on a bonus, multiply your adjusted basis nomic interest in standing timber in each tract or tion) is disregarded for purposes of making a

in the property by a fraction, the numerator of block representing a separate timber account. subsequent election. See Form T (Timber), Forwhich is the bonus and the denominator of which Depletion unit. You figure your depletion est Activities Schedule, for more information.

is the total bonus and royalties expected to be unit each year by taking the following steps. received. To figure cost depletion on advanced Form T. Complete and attach Form T (Timber) royalties, use the computation explained earlier 1. Determine your cost or adjusted basis of to your income tax return if you claim a deduc- under Cost Depletion, treating the number of the timber on hand at the beginning of the tion for timber depletion, choose to treat the units for which the advanced royalty is received year. Adjusted basis is defined under Cost

as the number of units sold. Depletion cutting of timber as a sale or exchange, or make in the discussion on Mineral

Property. an outright sale of timber. Figuring percentage depletion. In the

case of mines, wells, and other natural deposits 2. Add to the amount determined in (1) the

other than gas, oil, or geothermal property, you cost of any timber units acquired during

may use the percentage rates discussed earlier the year and any additions to capital.

under Mines and Geothermal Deposits. Any bo- 3. Figure the number of timber units to take nus or advanced royalty payments are generally into account by adding the number of tim- part of the gross income from the property to ber units acquired during the year to the 10. which the rates are applied in making the calcu- number of timber units on hand in the ac- lation. However, in the case of independent pro- count at the beginning of the year and then ducers and royalty owners of oil and gas adding (or subtracting) any correction to property, bonuses and advance royalty payments are not a part of gross income. the estimate of the number of timber units

remaining in the account. Business

Terminating the lease. If you receive a bo- 4. Divide the result of (2) by the result of (3). nus on a lease that expires, terminates, or is This is your depletion unit. Bad Debts

abandoned before you derive any income from

the extraction of mineral, include in income for

Example. You bought a timber tract for the year of expiration, termination, or abandonment, the depletion deduction you took. Also $160,000 and the land was worth as much as Introduction

the timber. Your basis for the timber is $80,000. increase your adjusted basis in the property to If someone owes you money that you are not Based on an estimated one million board feet restore the depletion deduction you previously going to be able to collect, you have a bad debt. (1,000 MBF) of standing timber, you figure your subtracted.

depletion unit to be $80 per MBF ($80,000 ÷ There are two kinds of bad debts—business For advanced royalties, include in income for 1,000). If you cut 500 MBF of timber, your deple- and nonbusiness. This chapter discusses only the year of lease termination, the depletion tion allowance would be $40,000 (500 MBF × business bad debts. claimed on minerals for which the advanced $80). Generally, a business bad debt is one that royalties were paid if the minerals were not produced before termination. Increase your ad- When to claim depletion. Claim your deple- comes from operating your trade or business.

justed basis in the property by the amount you tion allowance as a deduction in the year of sale You can deduct business bad debts on your

include in income. or other disposition of the products cut from the business income tax return.

timber, unless you choose to treat the cutting of All other bad debts are nonbusiness bad

Delay rentals. These are payments for defer- timber as a sale or exchange (explained below). debts and are deductible only as short-term cap- ring development of the property. Since delay Include allowable depletion for timber products ital losses on Schedule D (Form 1040). For more rentals are ordinary rent, they are ordinary in- not sold during the tax year the timber is cut as a information on nonbusiness bad debts, see Pub- come that is not subject to depletion. These cost item in the closing inventory of timber prod- lication 550. rentals can be avoided by either abandoning the ucts for the year. The inventory is your basis for

determining gain or loss in the tax year you sell lease, beginning development operations, or Topics obtaining production. the timber products.

This chapter discusses:

Example. Assume the same facts as in the

previous example except that you sold only half • Definition of business bad debt

of the timber products in the cutting year. You Timber • When a debt becomes worthless would deduct $20,000 of the $40,000 depletion

that year. You would add the remaining $20,000 • How to claim a business bad debt You can figure timber depletion only by the cost depletion to your closing inventory of timber method. Percentage depletion does not apply to • Recovery of a bad debt products. timber. Base your depletion on your cost or other

basis in the timber. Your cost does not include Electing to treat the cutting of timber as a Useful Items the cost of land or any amounts recoverable sale or exchange. You can elect, under certhrough depreciation. tain circumstances, to treat the cutting of timber You may want to see:

Depletion takes place when you cut standing held for more than 1 year as a sale or exchange.

You must make the election on your income tax Publication timber. You can figure your depletion deduction

when the quantity of cut timber is first accurately return for the tax year to which it applies. If you

make this election, subtract the adjusted basis ❏ 525 Taxable and Nontaxable Income measured in the process of exploitation. for depletion from the fair market value of the ❏ 536 Net Operating Losses (NOLs) for timber on the first day of the tax year in which Figuring cost depletion. To figure your cost Individuals, Estates, and Trusts you cut it to figure the gain or loss on the cutting. depletion allowance, you multiply the number of You generally report the gain as long-term capi- ❏ 544 Sales and Other Dispositions of timber units cut by your depletion unit. tal gain. The fair market value then becomes Assets

Timber units. When you acquire timber your basis for figuring your ordinary gain or loss ❏ 550 Investment Income and Expenses property, you must make an estimate of the on the sale or other disposition of the products

quantity of marketable timber that exists on the cut from the timber. For more information, see ❏ 556 Examination of Returns, Appeal

property. You measure the timber using board Timber in chapter 2 of Publication 544, Sales Rights, and Claims for Refund

feet, log scale, cords, or other units. If you later and Other Dispositions of Assets.

determine that you have more or less units of You may revoke an election to treat the cut- See chapter 12 for information about getting

timber, you must adjust the original estimate. ting of timber as a sale or exchange without publications and forms.

Page 38 Chapter 10 Business Bad Debts
as debts sold by a business. The executor of the Example. Jane Zayne owns the Zayne

Definition of Business decedent’s estate treats any loss from the debts Dress Company. She guaranteed payment of a

as a business bad debt if the debts were closely $20,000 note for Elegant Fashions, a dress outBad Debt related to the decedent’s trade or business let that is not a “related person.” Elegant Fashwhen they became worthless. Otherwise, a loss ions is one of Zayne’s largest clients. Elegant

A business bad debt is a loss from the worth- from these debts becomes a nonbusiness bad Fashions later defaulted on the loan. As a result,

lessness of a debt that was either: debt for the decedent’s estate. Ms. Zayne paid the remaining balance of the

loan in full to the bank. • Created or acquired in your trade or busi- Liquidation. If you liquidate your business She can claim a business bad debt deducness, or and some of your accounts receivable become tion only for the amount she paid, since her worthless, they become business bad debts. • Closely related to your trade or business guarantee was made in the course of her trade

when it became partly or totally worthless. or business for a good faith business purpose. Types of Business Bad She was motivated by the desire to retain one of

A debt is closely related to your trade or busi- Debts her better clients and keep a sales outlet.

ness if your primary motive for incurring the debt Deductible in the year paid. If you make a The following are situations that may result in a is business related. Bad debts of a corporation payment on a loan you guaranteed, you can business bad debt. (other than an S corporation) are always busi- deduct it in the year paid, unless you have rights ness bad debts. Loans to clients and suppliers. If you loan against the borrower.

money to a client, supplier, employee, or distrib- Credit sales. Business bad debts are mainly Rights against a borrower. When you utor for a business reason and subsequently, the result of credit sales to customers. Goods make payment on a loan you guaranteed, you after making attempts to collect, the loan receiv- that have been sold, but not yet paid for, and may have the right to take the place of the able becomes worthless, you have a business services that have been performed, but not yet lender. The debt is then owed to you. If you have bad debt. paid for, are recorded in your books as either this right, or some other right to demand payaccounts receivable or notes receivable. After a Debts of political parties. If a political party ment from the borrower, you cannot claim a bad

reasonable period of time, if you have tried to (or other organization that accepts contributions debt deduction until these rights become partly

collect the amount due, but are unable to do so, or spends money to influence elections) owes or totally worthless.

the uncollectible part becomes a business bad you money and the debt becomes worthless,

debt. Joint debtor. If two or more debtors jointly you can claim a bad debt deduction only if you

 Accounts or notes receivable valued at fair use an accrual method of accounting and meet owe you money, your inability to collect from one

market value (FMV) when received are deducti- all the following tests. does not enable you to deduct a proportionate

ble only at that value, even though the FMV may amount as a bad debt.

be less than the face value. If you purchased an 1. The debt arose from the sale of goods or

services in the ordinary course of your Sale of mortgaged property. If mortgaged or account receivable for less than its face value,

trade or business. pledged property is sold for less than the debt, and the receivable subsequently becomes

worthless, the most you are allowed to deduct is the unpaid, uncollectible balance of the debt is a 2. More than 30% of your receivables ac- bad debt. the amount you paid to acquire it. crued in the year of the sale were from

You can claim a bad debt deduction sales to political parties.

only if the amount owed to you was 3. You made substantial and continuing efCAUTION

previously included in gross income.

!

forts to collect on the debt. When a Debt Becomes This applies to amounts owed to you from all

sources of taxable income, including sales, Loan or capital contribution. You cannot Worthless

services, rents, and interest. claim a bad debt deduction for a loan you made

to a corporation if, based on the facts and cir- You do not have to wait until a debt is due to Accrual method. If you use the accrual cumstances, the loan is actually a contribution to determine whether it is worthless. A debt be- method of accounting, generally, you report in- capital. comes worthless when there is no longer any come as you earn it. You can only claim a bad chance the amount owed will be paid. debt deduction for an uncollectible receivable if Debts of an insolvent partner. If your busi- It is not necessary to go to court if you can you have previously included the uncollectible ness partnership breaks up and one of your show that a judgment from the court would be amount in income. former partners becomes insolvent, you may uncollectible. You must only show that you have If you qualify, you can use the nonac- have to pay more than your pro rata share. If you taken reasonable steps to collect the debt. crual-experience method of accounting dis- pay any part of the insolvent partner’s share of Bankruptcy of your debtor is generally good evi- cussed later. Under this method, you do not the debts, you can claim a bad debt deduction dence of the worthlessness of at least a part of have to accrue income that, based on your ex- for the amount you paid that is attributable to the an unsecured and unpreferred debt. perience, you do not expect to collect. insolvent partner’s share.

Cash method. If you use the cash method Property received for debt. If you receive Business loan guarantee. If you guarantee a of accounting, generally, you report income property in partial settlement of a debt, reduce debt that subsequently becomes worthless, the when you receive payment. You cannot claim a the debt by the FMV of the property received. debt can qualify as a business bad debt if all the bad debt deduction for amounts owed to you You can deduct the remaining debt as a bad following requirements are met. because you never included those amounts in debt if and when it becomes worthless.

income. For example, a cash basis architect • You made the guarantee in the course of If you later sell the property, any gain on the

cannot claim a bad debt deduction if a client fails your trade or business. sale is due to the appreciation of the property. It

to pay the bill because the architect’s fee was is not a recovery of a bad debt. For information • You have a legal duty to pay the debt. never included in income. on the sale of an asset, see Publication 544.

• You made the guarantee before the debt

Debts from a former business. If you sell became worthless. You meet this requireyour business but retain its receivables, these ment if you reasonably expected you

debts are business debts because they arose would not have to pay the debt without full How To Claim a

out of your trade or business. If any of these reimbursement from the issuer.

receivables subsequently become worthless, Business Bad Debt • You receive reasonable consideration for the loss is still a business bad debt. making the guarantee. You meet this re- There are two methods to claim a business bad Debt acquired from a decedent. The char- quirement if you made the guarantee in debt. acter of a loss from debts of a business acquired accord with normal business practice or

from a decedent is determined in the same way for a good faith business purpose. • The specific charge-off method.

Chapter 10 Business Bad Debts Page 39
• The nonaccrual-experience method. You may have longer to file the claim if you were Change in accounting method. See Form

unable to manage your financial affairs due to a 3115, Application for Change in Accounting Generally, you must use the specific charge-off physical or mental impairment. Such an impair- Method, and the Instructions for Form 3115 for method. However, you may use the nonac- ment requires proof of existence. information on obtaining consent to change to a crual-experience method if you meet the re- nonaccrual-experience method (other than one quirements discussed later under For details and more information about filing a of the safe harbor methods) or to change from Nonaccrual-Experience Method. claim, see Publication 556. Use one of the fol- one method to another.

lowing forms to file a claim. For more informaSpecific Charge-Off Method tion, see the instructions for the applicable form.

If you use the specific charge-off method, you

can deduct specific business bad debts that

Table 10-1. Forms Used To File a Recovery of a Bad Claim

become either partly or totally worthless during Debt the tax year. IF you filed as THEN file...

a... If you claim a deduction for a bad debt on your Partly worthless debts. You can deduct spe- Sole proprietor or income tax return and later recover (collect) all cific bad debts that become partly uncollectible Form 1040X farmer or part of it, you may have to include all or part of during the tax year. Your tax deduction is limited the recovery in gross income. The amount you to the amount you charge off on your books Corporation Form 1120X include is limited to the amount you actually during the year. You do not have to charge off S corporation Form 1120S deducted. However, you can exclude the and deduct your partly worthless debts annually. (check box H(4)) amount deducted that did not reduce your tax. You can delay the charge off until a later year. Report the recovery as “Other income” on the However, you cannot deduct any part of a debt Partnership Form 1065 appropriate business form or schedule. after the year it becomes totally worthless. (check box G(5)) See Recoveries in Publication 525 for more

Significantly modified debt. An exception information.

to the charge-off rule exists for debt which has Net operating loss (NOL) carryover. If a been significantly modified and on which the Nonaccrual-Experience bad debt deduction increases an NOL carryover holder recognized gain. For more information, Method that has not expired before the beginning of the see Regulations section 1.166-3(a)(3). tax year in which the recovery takes place, you If you use an accrual method of accounting and Deduction disallowed. Generally, you can treat the deduction as having reduced your tax. qualify under the rules explained in this section, claim a partial bad debt deduction only in the A bad debt deduction that contributes to a NOL

you can use the nonaccrual-experience method year you make the charge-off on your books. If, helps lower taxes in the year to which you carry

under audit, the IRS does not allow your deduc- for bad debts. Under this method, you do not the NOL. See Publication 536 for more information and the debt becomes partly worthless in a accrue service related income you expect to be tion about NOLs.

uncollectible. later tax year, you can deduct the amount you

charged off in that year plus the disallowed Generally, you can use the nonacamount charged off in the earlier year. The crual-experience method for accounts receivacharge-off in the earlier year, unless reversed on ble for services you performed only if:

your books, fulfills the charge-off requirement for • The services are provided in the fields of the later year. accounting, actuarial science, architecture, 11. consulting, engineering, health, law, or the Totally worthless debts. If a debt becomes performing arts, or totally worthless in the current tax year, you can

deduct the entire amount, less any amount de- • You meet the $5 million gross receipts test

ducted in an earlier tax year when the debt was for all prior years. Other Expenses

only partly worthless.

You do not have to make an actual Service related income. You can use the

charge-off on your books to claim a bad debt

deduction for a totally worthless debt. However, nonaccrual-experience method only for What’s New

amounts earned by performing services. You you may want to do so. If you do not and the IRS cannot use this method for amounts owed to you Standard mileage rate. The standard mile- later rules the debt is only partly worthless, you

will not be allowed a deduction for the debt in from activities such as lending money, selling age rate for the cost of operating your car, van,

goods, or acquiring receivables or other rights to pickup, or panel truck in 2010 is 50 cents a mile that tax year. A deduction of a partly worthless receive payment. for all business miles. For more information, see bad debt is limited to the amount actually Car and truck expenses, under Miscellaneous charged off. Gross receipts test. You meet the gross re- Expenses.

ceipts test if your average annual gross receipts Filing a claim for refund. If you did not deduct for any prior 3-tax-year period does not exceed a bad debt on your original return for the year it $5,000,000. became worthless, you can file a claim for a

credit or refund. If the bad debt was totally worth- Introduction

Interest or penalty charged. Generally, you less, you must file the claim by the later of the This chapter covers business expenses that following dates. cannot use the nonaccrual-experience method may not have been explained to you, as a busi- for amounts due on which you charge interest or • 7 years from the date your original return ness owner, in previous chapters of this publica- a late payment penalty. However, do not treat a was due (not including extensions). tion. discount offered for early payment as the charg-

• 2 years from the date you paid the tax. ing of interest or a penalty if both the following Topics apply. This chapter discusses: If the claim is for a partly worthless bad debt, • You otherwise accrue the full amount due you must file the claim by the later of the follow- as gross income at the time you provide • Travel, meals, and entertainment ing dates. the services. • Bribes and kickbacks • 3 years from the date you filed your origi- • You treat the discount allowed for early nal return. • Charitable contributions payment as an adjustment to gross in-

• 2 years from the date you paid the tax. come in the year of payment. • Education expenses

Page 40 Chapter 11 Other Expenses
• Lobbying expenses Table 11-1. Reporting Reimbursements

• Penalties and fines IF the type of reimbursement (or other

• Repayments (claim of right) expense allowance) arrangement is under THEN the employer reports on Form W-2

• Other miscellaneous expenses An accountable plan with:

Actual expense reimbursement: No amount.

Useful Items Adequate accounting made and excess

You may want to see: returned

Actual expense reimbursement: The excess amount as wages in box 1. Publication Adequate accounting and return of excess

both required but excess not returned ❏ 15-B Employer’s Tax Guide to Fringe

Benefits Per diem or mileage allowance up to the No amount.

federal rate: ❏ 463 Travel, Entertainment, Gift, and Car Adequate accounting made and excess Expenses returned

❏ 526 Charitable Contributions Per diem or mileage allowance up to the The excess amount as wages in box 1. The

❏ 529 Miscellaneous Deductions federal rate: amount up to the federal rate is reported only

Adequate accounting and return of excess in box 12—it is not reported in box 1. ❏ 544 Sales and Other Dispositions of both required but excess not returned Assets

Per diem or mileage allowance exceeds the The excess amount as wages in box 1. The ❏ 970 Tax Benefits for Education federal rate: amount up to the federal rate is reported only

❏ 1542 Per Diem Rates Adequate accounting made up to the federal in box 12—it is not reported in box 1.

rate only and excess not returned

See chapter 12 for information about getting A nonaccountable plan with: publications and forms.

Either adequate accounting or return of The entire amount as wages in box 1.

excess, or both, not required by plan

No reimbursement plan The entire amount as wages in box 1. Reimbursement of

Travel, Meals, and reimburse these expenses under an accounta- • You make the advance within a reasonaEntertainment ble plan, then you can deduct the amount allow- ble period of time.

able to the extent of the tax law as travel, meal,

and entertainment expenses on your tax return. If any expenses reimbursed under this ar- The following discussion explains how to handle rangement are not substantiated, or an excess any reimbursements or allowances you may If you reimburse these expenses under a reimbursement is not returned within a reasona- provide for travel, meals, and entertainment ex- nonaccountable plan, then you must report the ble period of time by an employee, you are not penses when incurred by your employees. If you reimbursements as wages on Form W-2, Wage allowed to deduct these expenses as reim- are self-employed and report your income and and Tax Statement, and deduct them as wages bursed under an accountable plan. Instead, expenses on Schedule C or C-EZ (Form 1040), on the appropriate line of your tax return. If you treat the reimbursed expenses as paid under a see Publication 463. make a single payment to your employees and it nonaccountable plan, discussed later. To be deductible for tax purposes, expenses includes both wages and an expense reim- incurred for travel, meals, and entertainment Adequate accounting. Your employees must bursement, you must specify the amount attribu- must be ordinary and necessary expenses in- adequately account to you for their travel, table to reimbursement and report it accordingly. curred while carrying on your trade or business. meals, and entertainment expenses. They must

Generally, you also must show that entertain- See Table 11-1, Reporting Reimbursements. give you documentary evidence of their travel,

ment expenses (including meals) are directly mileage, and other employee business exrelated to, or associated with, the conduct of penses. This evidence should include items

your trade or business. For more information on Accountable Plans such as receipts, along with either a statement

travel, meals, and entertainment, including de- of expenses, an account book, a day-planner, or An accountable plan requires your employees to ductibility, see Publication 463. similar record in which the employee entered meet all of the following requirements. They each expense at or near the time the expense must: Reimbursements was incurred.

1. Have paid or incurred deductible expenses Excess reimbursement or allowance. An A “reimbursement or allowance arrangement” while performing services as your employ- excess reimbursement or allowance is any provides for payment of advances, reimburse- ees, ments, and charges for travel, meals, and enter- amount you pay to an employee that is more

2. Adequately account to you for these ex- than the business-related expenses for which tainment expenses incurred by your employees the employee adequately accounted. The em- during the ordinary course of business. Upon penses within a reasonable period of time, ployee must return any excess reimbursement satisfying your established substantiation re- and

or other expense allowance to you within a rea- quirements, you can deduct the allowable 3. Return any excess reimbursement or al- sonable period of time. amount on your tax return. Because of differ- lowance within a reasonable period of ences between accounting methods and tax Reasonable period of time. A reasonable time. law, these amounts may not be the same. For period of time depends on the facts and circum- example, you can deduct 100% of the cost of An arrangement under which you advance stances. Generally, actions that take place meals on your business books and records. money to employees is treated as meeting (3) within the times specified in the following list will However, for tax purposes, only 50% of these above only if the following requirements are also be treated as taking place within a reasonable costs are allowed by law as a tax deduction. met. period of time. A reimbursement or allowance arrangement

(including per diem allowances, discussed later) • The advance is reasonably calculated not 1. You give an advance within 30 days of the

depends on whether you have: (1) an accounta- to exceed the amount of anticipated ex- time the employee has incurred the exble plan or (2) a nonaccountable plan. If you penses. pense.

Chapter 11 Other Expenses Page 41
2. Your employees adequately account for combination of payments covering fixed and va- allowance compares to the federal rate. See

their expenses within 60 days after the ex- riable costs, such as a cents-per-mile rate to Table 11-1.

penses were paid or incurred. cover your employees’ variable operating costs Allowance less than or equal to the federal (such as gas, oil, etc.) plus a flat amount to cover 3. Your employees return any excess reim- rate. If your allowance for the employee is less your employees’ fixed costs (such as deprecia- bursement within 120 days after the ex- than or equal to the appropriate federal rate, that tion, insurance, etc.). For information on using a penses were paid or incurred. allowance is not included as part of the em- FAVR allowance, see Revenue Procedure ployee’s pay in box 1 of the employee’s Form 4. You give a periodic statement (at least 2010-39 in Internal Revenue Bulletin 2010-42. W-2. Deduct the allowance as travel expenses quarterly) to your employees that asks You can read Revenue Procedure 2010-39 at (including meals that may be subject to the 50% them to either return or adequately ac- www.irs.gov/pub/irs-irbs/irb10-42.pdf. limit, discussed later). See How to deduct under count for outstanding advances and they Per diem allowance. Accountable Plans, earlier. If your employee actu- comply within 120 days of the date of the ally substantiates to you the other elements (dis- statement. Allowance more than the federal rate. If

cussed earlier) of the expenses reimbursed your employee’s allowance is more than the using the per diem allowance, how you report appropriate federal rate, you must report the How to deduct. You can claim a deduction for and deduct the allowance depends on whether allowance as two separate items. travel, meals, and entertainment expenses if the allowance is for lodging and meal expenses you reimburse your employees for these ex- Include the allowance amount up to the fed- or for meal expenses only and whether the al- penses under an accountable plan. Generally, eral rate in box 12 (code L) of the employee’s lowance is more than the federal rate.

the amount you can deduct for meals and enter- Form W-2. Deduct it as travel expenses (as

tainment, is subject to a 50% limit, discussed Regular federal per diem rate. The regular explained above). This part of the allowance is

later. If you are a sole proprietor, or are filing as a federal per diem rate is the highest amount the treated as reimbursed under an accountable

single member limited liability company, deduct federal government will pay to its employees plan.

the travel reimbursement on line 24a and the while away from home on travel. It has two Include the amount that is more than the

deductible part of the meals and entertainment components: federal rate in box 1 (and in boxes 3 and 5 if they

reimbursement on line 24b, Schedule C (Form apply) of the employee’s Form W-2. Deduct it as 1. Lodging expense, and 1040) or line 2, Schedule C-EZ (Form 1040). wages subject to income tax withholding, social

If you are filing an income tax return for a 2. Meal and incidental expense (M & IE). security, Medicare, and federal unemployment

corporation, the reimbursement should be in- taxes. This part of the allowance is treated as The rates are different for different locations. cluded with the amount claimed on the Other reimbursed under a nonaccountable plan as ex- Publication 1542 lists the rates in the continental deductions line of Form 1120, U.S. Corporation plained later under Nonaccountable Plans. United States. Income Tax Return. If you are filing any other

business income tax return, such as a partner- Standard meal allowance. The federal rate

ship or S corporation return, deduct the reim- for meal and incidental expenses (M & IE) is the Meals and Entertainment

bursement on the appropriate line of the return standard meal allowance. You can pay only an

M & IE allowance to employees who travel away Under an accountable plan, you can generally as provided in the instructions for that return.

from home if: deduct only 50% of any otherwise deductible

business-related meal and entertainment ex- • You pay the employee for actual expenses penses you reimburse your employees. The de- Per Diem and Car Allowances for lodging based on receipts submitted to duction limit applies even if you reimburse them

you, You can reimburse your employees under an for 100% of the expenses.

accountable plan based on travel days, miles, or • You provide for the lodging,

some other fixed allowance. In these cases, Application of the 50% limit. The 50% de- • You pay for the actual expense of the your employee is considered to have accounted duction limit applies to reimbursements you lodging directly to the provider, to you for the amount of the expense that does make to your employees for expenses they incur

not exceed the rates established by the federal • You do not have reasonable belief that for meals while traveling away from home on

government. Your employee must actually sub- lodging expenses were incurred by the business and for entertaining business customstantiate to you the other elements of the ex- employee, or ers at your place of business, a restaurant, or

pense, such as time, place, and business another location. It applies to expenses incurred • The allowance is computed on a basis purpose. at a business convention or reception, business similar to that used in computing the em- meeting, or business luncheon at a club. The ployee’s wages (that is, number of hours Federal rate. The federal rate can be figured deduction limit may also apply to meals you worked or miles traveled). using any one of the following methods. furnish on your premises to your employees.

1. For per diem amounts: Internet access. Per diem rates are avail- Related expenses. Taxes and tips relating

able on the Internet. You can access per diem to a meal or entertainment activity you reima. The regular federal per diem rate. rates at www.gsa.gov. burse to your employee under an accountable

plan are included in the amount subject to the b. The standard meal allowance. High-low method. This is a simplified 50% limit. Reimbursements you make for ex- method of computing the federal per diem rate c. The high-low rate. penses, such as cover charges for admission to for lodging and meal expenses for traveling a nightclub, rent paid for a room to hold a dinner within the continental United States. It elimi- 2. For car expenses: or cocktail party, or the amount you pay for nates the need to keep a current list of the per parking at a sports arena, are all subject to the a. The standard mileage rate. diem rate in effect for each city in the continental 50% limit. However, the cost of transportation to United States. b. A fixed and variable rate (FAVR). and from an otherwise allowable business meal Under the high-low method, the per diem or a business-related entertainment activity is amount for travel during 2010 is $233 ($65 for M not subject to the 50% limit. & IE) for certain high-cost locations. All other Car allowance. Your employee is considered areas have a per diem amount of $160 ($52 for to have accounted to you for car expenses that Amount subject to 50% limit. If you provide M & IE). The high-cost locations eligible for the do not exceed the standard mileage rate. For your employees with a per diem allowance only $233 per diem amount under the high-low 2010, the standard mileage rate for each busi- for meal and incidental expenses, the amount method are listed in Publication 1542. ness mile is 50 cents per mile for all business treated as an expense for food and beverages is

miles. Reporting per diem and car allowances. the lesser of the following.

You can choose to reimburse your employ- The following discussion explains how to report • The per diem allowance. ees using a fixed and variable rate (FAVR) al- per diem and car allowances. The manner in

lowance. This is an allowance that includes a which you report them depends on how the • The federal rate for M & IE.

Page 42 Chapter 11 Other Expenses
If you provide your employees with a per diem deduct the reimbursement as compensation or reasonably expect to gain in the future. For exallowance that covers lodging, meals, and inci- wages only to the extent it meets the deductibil- ample, the cost of advertising that encourages

dental expenses, you must treat an amount ity tests for employees’ pay in chapter 2. Deduct people to contribute to the Red Cross, to buy

equal to the federal M & IE rate for the area of the allowable amount as compensation or U.S. Savings Bonds, or to participate in similar

travel as an expense for food and beverages. If wages on the appropriate line of your income tax causes is usually deductible.

the per diem allowance you provide is less than return, as provided in its instructions.

the federal per diem rate for the area of travel, Generally, amounts paid for meals, enter- Anticipated liabilities. Anticipated liabilities

you can treat 40% of the per diem allowance as or reserves for anticipated liabilities are not de- tainment, and amusement provided to individu- the amount for food and beverages. ductible. For example, assume you sold 1-year als who are not your employees are not subject TV service contracts this year totaling $50,000. Meal expenses when subject to “hours of to the 50% limit. Such activities must be directly From experience, you know you will have ex- related to the active conduct of your trade or service” limits. You can deduct 80% of the penses of about $15,000 in the coming year for business. Examples include: reimbursed meals your employees consume these contracts. You cannot deduct any of the while away from their tax home on business • Amounts paid for meals, goods, services, $15,000 this year by charging expenses to a during, or incident to, any period subject to the or the use of a facility. You are allowed a reserve or liability account. You can deduct your Department of Transportation’s “hours of serv- deduction only to the extent it is included expenses only when you actually pay or accrue ice” limits. in the gross income of the recipient as them, depending on your accounting method. See Publication 463 for a detailed discussion compensation for services or as a prize or

of individuals subject to the Department of award. Bribes and kickbacks. Engaging in the pay- Transportation’s “hours of service” limits. ment of bribes or kickbacks is a serious criminal • Expenses that exceed $600 and are re- matter. Such activity could result in criminal De minimis (minimal) fringe benefit. The quired to be reported on an information prosecution. Any payments that appear to have 50% limit does not apply to an expense for food return, for example, Form 1099-MISC. been made, either directly or indirectly, to an or beverage that is excluded from the gross See the General Instructions for Certain

official or employee of any government or an income of an employee because it is a de Information Returns, for more information

agency or instrumentality of any government are minimis fringe benefit. See Publication 15-B for about reporting requirements. not deductible for tax purposes and are in viola- additional information on de minimis fringe ben- • The cost of providing meals, entertain- tion of the law. efits. ment, goods and services, or use of facili- Payments paid directly or indirectly to a per- Company cafeteria or executive dining ties you sell to the public. For example, if son in violation of any federal or state law (but room. The cost of food and beverages you you operate a nightclub, your expense for only if that state law is generally enforced, de- provide primarily to your employees on your the entertainment you furnish to your cus- fined below) that provides for a criminal penalty business premises is deductible. This includes tomers, such as a floor show, is a busi- or for the loss of a license or privilege to engage ness expense that is fully deductible. the cost of maintaining the facilities for providing in a trade or business are also not allowed as a

the food and beverages. These expenses are • The cost of providing meals, entertain- deduction for tax purposes. subject to the 50% limit unless they qualify as a ment, or recreational facilities to the gen- de minimis fringe benefit, discussed in Publica- Meaning of “generally enforced.” A state eral public as a means of advertising or tion 15-B, or unless they are compensation to law is considered generally enforced unless it is promoting goodwill in the community is your employees and you treat them as provided never enforced or enforced only for infamous fully deductible. under a nonaccountable plan. persons or persons whose violations are extraordinarily flagrant. For example, a state law is

Employee activities. The expense of provid- generally enforced unless proper reporting of a

ing recreational, social, or similar activities (in- violation of the law results in enforcement only

cluding the use of a facility) for your employees Miscellaneous under unusual circumstances.

is deductible. The benefit must be primarily for Kickbacks. A kickback is a payment for re- your employees who are not highly compen- Expenses ferring a client, patient, or customer. The com- sated.

mon kickback situation occurs when money or For this purpose, a highly compensated em- In addition to travel, meal, and entertainment property is given to someone as payment for ployee is an employee who meets either of the expenses, other miscellaneous expenses that influencing a third party to purchase from, use following requirements. are deductible, subject to limitations, include: the services of, or otherwise deal with the per1. Owned a 10% or more interest in the busi- son who pays the kickback. In many cases, the • Amounts paid for the reasonable cost of ness during the year or the preceding year. person whose business is being sought or en- advertising that are directly related to your An employee is treated as owning any in- joyed by the person who pays the kickback is not business activities. Generally, amounts terest owned by his or her brother, sister, aware of the payment. paid to influence legislation (i.e., lobbying) spouse, ancestors, and lineal descend- are not deductible for tax purposes. See For example, the Yard Corporation is in the

ants. Lobbying expenses, later. business of repairing ships. It engages in the

practice of returning 10% of the repair bills as 2. Received more than $110,000 in pay for • Amounts paid that are directly related to kickbacks to the captains and chief officers of the preceding year. You can choose to in- the conduct of business meetings of your the vessels it repairs. Although this practice is clude only employees who were also in the employees, partners, stockholders, considered an ordinary and necessary expense top 20% of employees when ranked by agents, or directors. Some minor social of getting business, it is clearly a violation of a pay for the preceding year. activities may be allowed, however, these state law that is generally enforced. These ex- expenses are subject to the 50% limit. For example, the expenses for food, bever- penditures are not deductible for tax purposes,

ages, and entertainment for a company-wide • Amounts paid that are directly related to whether or not the owners of the shipyard are

picnic are not subject to the 50% limit. and necessary for attending business subsequently prosecuted.

meetings or conventions of certain Form 1099-MISC. It does not matter tax-exempt organizations. These organi- Nonaccountable Plans whether any kickbacks paid during the tax year zations include business leagues, cham- are deductible on your income tax return in re- bers of commerce, real estates boards, A nonaccountable plan is an arrangement that gards to information reporting. See Form and trade and professional associations. does not meet the requirements for an account- 1099-MISC for more information.

able plan. All amounts paid, or treated as paid,

under a nonaccountable plan are reported as Advertising expenses. You can usually de- Car and truck expenses. The costs of operatwages on Form W-2. The payments are subject duct as a business expense the cost of institu- ing a car, truck, or other vehicle in your business

to income tax withholding, social security, Medi- tional or goodwill advertising to keep your name are deductible. For more information on how to

care, and federal unemployment taxes. You can before the public if it relates to business you figure your deduction, see Publication 463.

Chapter 11 Other Expenses Page 43
Charitable contributions. Cash payments to of contract or fiduciary duty, or antitrust viola- you to be able to work (impairment-related exan organization, charitable or otherwise, may be tions. You must include this compensation in penses) as a business expense, rather than as a

deductible as business expenses if the pay- your income. However, you may be able to take medical expense.

ments are not charitable contributions or gifts. If a special deduction. The deduction applies only You are disabled if you have either of the

the payments are charitable contributions or to amounts recovered for actual injury, not any following.

gifts, you cannot deduct them as business ex- additional amount. The deduction is the smaller • A physical or mental disability (for exam- penses. However, corporations (other than S of the following. ple, blindness or deafness) that function- corporations) can deduct charitable contribu- • The amount you received or accrued for ally limits your being employed. tions on their income tax returns, subject to damages in the tax year reduced by the limitations. See the Instructions for Form 1120 • A physical or mental impairment that sub- amount you paid or incurred in the year to for more information. Sole proprietors, partners stantially limits one or more of your major recover that amount. in a partnership, or shareholders in an S corpo- life activities.

ration may be able to deduct charitable contribu- • Your losses from the injury you have not

tions made by their business on Schedule A deducted. The expense qualifies as a business expense

(Form 1040). if all the following apply.

Demolition expenses or losses. Amounts • Your work clearly requires the expense for Example. You paid $15 to a local church for paid or incurred to demolish a structure are not you to satisfactorily perform that work. a half-page ad in a program for a concert it is deductible. These amounts are added to the sponsoring. The purpose of the ad was to en- • The goods or services purchased are basis of the land where the demolished structure courage readers to buy your products. Your pay- clearly not needed or used, other than in- was located. Any loss for the remaining un- ment is not a charitable contribution. However, cidentally, in your personal activities. depreciated basis of a demolished structure you can deduct it as an advertising expense. would not be recognized until the property is • Their treatment is not specifically provided

disposed. for under other tax law provisions. Example. You made a $100,000 donation

to a committee organized by the local Chamber Education expenses. Ordinary and neces- of Commerce to bring a convention to your city, Example. You are blind. You must use a

sary expenses paid for the cost of the education intended to increase business activity, including reader to do your work, both at and away from and training of your employees are deductible. yours. Your payment is not a charitable contribu- your place of work. The reader’s services are See Education Expenses in chapter 2. tion. However, you can deduct it as a business only for your work. You can deduct your ex- You can also deduct the cost of your own expense. penses for the reader as a business expense. education (including certain related travel) re- See Publication 526 for a discussion of lated to your trade or business. You must be Internet-related expenses. Generally, you donated inventory, including capital gain prop- able to show the education maintains or im- can deduct internet-related expenses including erty. proves skills required in your trade or business, domain registrations fees and webmaster con- or that it is required by law or regulations, for sulting costs. If you are starting a business you Club dues and membership fees. Generally, keeping your license to practice, status, or job. may have to amortize these expenses as amounts paid or incurred for membership in any For example, an attorney can deduct the cost of start-up costs. For more information about am- club organized for business, pleasure, recrea- attending Continuing Legal Education (CLE) ortizing start-up and organizational costs, see tion, or any other social purpose are not deducti- classes that are required by the state bar associ- chapter 8. ble. Clubs organized for business, pleasure, ation to maintain his or her license to practice

recreation, or other social purpose include, but law. Interview expense allowances. Reimburse- are not limited to country clubs, golf and athletic Education expenses you incur to meet the ments you make to job candidates for transpor- clubs, hotel clubs, sporting clubs, airline clubs, minimum requirements of your present trade or tation or other expenses related to interviews for and clubs operated to provide meals under cir- business, or those that qualify you for a new possible employment are not wages. You can cumstances generally considered to be condu- trade or business, are not deductible. This is true deduct the reimbursements as a business ex- cive to business discussions. even if the education maintains or improves pense. However, expenses for food, beverages, skills presently required in your business. For Exception. The following organizations are and entertainment are subject to the 50% limit more information on education expenses, see not treated as clubs organized for business, discussed earlier under Meals and Entertain- Publication 970. pleasure, recreation, or other social purpose un- ment.

less one of the main purposes is to conduct

entertainment activities for members or their Franchise, trademark, trade name. If you Legal and professional fees. Fees charged

guests or to provide members or their guests buy a franchise, trademark, or trade name, you by accountants and attorneys that are ordinary

with access to entertainment facilities. can deduct the amount you pay or incur as a and necessary expenses directly related to op- business expense only if your payments are part erating your business are deductible as busi- • Boards of trade. of a series of payments that are: ness expenses. However, usually legal fees you

• Business leagues. pay to acquire business assets are not deducti- 1. Contingent on productivity, use, or disposi- ble. These costs are added to the basis of the • Chambers of commerce. tion of the item, property.

• Civic or public service organizations. 2. Payable at least annually for the entire Fees that include payments for work of a

term of the transfer agreement, and personal nature (such as drafting a will, or dam- • Professional organizations such as bar as- ages arising from a personal injury), are not sociations and medical associations. 3. Substantially equal in amount (or payable allowed as a business deduction on Schedule C under a fixed formula). • Real estate boards. or C-EZ. If the invoice includes both business

When determining the term of the transfer and personal charges, compute the business • Trade associations. agreement, include all renewal options and any portion as follows: multiply the total amount of

other period for which you and the transferrer the bill by a fraction, the numerator of which is Credit card convenience fees. Credit card reasonably expect the agreement to be re- the amount attributable to business matters, the

companies charge a fee to businesses who ac- newed. denominator of which is the total amount paid.

cept their cards. This fee when paid or incurred A franchise includes an agreement that gives The result is the portion of the invoice attributaby the business can be deducted as a business one of the parties to the agreement the right to ble to business expenses. The portion attributaexpense. distribute, sell, or provide goods, services, or ble to personal matters is the difference

facilities within a specified area. between the total amount and the business porDamages recovered. Special rules apply to tion (computed above).

compensation you receive for damages sus- Impairment-related expenses. If you are dis- Legal fees relating to personal tax advice

tained as a result of patent infringement, breach abled, you can deduct expenses necessary for may be deductible on Line 22, Schedule A

Page 44 Chapter 11 Other Expenses
(Form 1040), if you itemize deductions. How- 3. Any officer or employee of the White each day that completion is delayed beyond the

ever, the deduction is subject to the 2% limita- House Office of the Executive Office of the completion date stipulated in the contract.

tion on miscellaneous itemized deductions. See President and the two most senior level These additional costs are deductible business

Publication 529, Miscellaneous Deductions. officers of each of the other agencies in expenses.

Tax preparation fees. The cost of hiring a the Executive Office. On the other hand, penalties or fines paid to

4. Any individual who: any government agency or instrumentality be- tax professional, such as a C.P.A., to prepare

cause of a violation of any law are not deducti- that part of your tax return relating to your business as a sole proprietor is deductible on Sched- a. Is serving in a position in Level I of the ble. These fines or penalties include the

ule C or Schedule C-EZ. Any remaining cost Executive Schedule under section 5312 following amounts.

may be deductible on Schedule A (Form 1040) if of title 5, United States Code, • Paid because of a conviction for a crime or

you itemize deductions. b. Has been designated by the President after a plea of guilty or no contest in a You can also claim a business deduction for as having Cabinet-level status, or criminal proceeding. amounts paid or incurred in resolving asserted c. Is an immediate deputy of an individual • Paid as a penalty imposed by federal, tax deficiencies for your business operated as a listed in item (a) or (b). sole proprietor. state, or local law in a civil action, including certain additions to tax and additional

Licenses and regulatory fees. Licenses and Exceptions to denial of deduction. The amounts and assessable penalties imregulatory fees for your trade or business paid general denial of the deduction does not apply to posed by the Internal Revenue Code.

annually to state or local governments generally the following. • Paid in settlement of actual or possible are deductible. Some licenses and fees may • Expenses of appearing before, or commu- liability for a fine or penalty, whether civil have to be amortized. See chapter 8 for more nicating with, any local council or similar or criminal. information. governing body concerning its legislation • Forfeited as collateral posted for a pro- (local legislation) if the legislation is of di- Lobbying expenses. Generally, lobbying ex- ceeding that could result in a fine or pen- rect interest to you or to you and an organ- penses are not deductible. Lobbying expenses alty. ization of which you are a member. An include amounts paid or incurred for any of the Indian tribal government is treated as a following activities. Examples of nondeductible penalties and local council or similar governing body. fines include the following. • Influencing legislation. • Any in-house expenses for influencing leg- • Fines for violating city housing codes. • Participating in or intervening in any politi- islation and communicating directly with a

cal campaign for, or against, any candi- covered executive branch official if those • Fines paid by truckers for violating state date for public office. expenses for the tax year do not exceed maximum highway weight laws. $2,000 (excluding overhead expenses). • Attempting to influence the general public, • Fines for violating air quality laws. or segments of the public, about elections, • Expenses incurred by taxpayers engaged • Civil penalties for violating federal laws re- legislative matters, or referendums. in the trade or business of lobbying (pro- garding mining safety standards and dis- fessional lobbyists) on behalf of another • Communicating directly with covered ex- charges into navigable waters. person (but does apply to payments by the ecutive branch officials (defined later) in other person to the lobbyist for lobbying any attempt to influence the official actions A fine or penalty does not include any of the activities). or positions of those officials. following.

• Researching, preparing, planning, or coor- Moving machinery. Generally, the cost of • Legal fees and related expenses to defend dinating any of the preceding activities. moving machinery from one city to another is a yourself in a prosecution or civil action for

deductible expense. So is the cost of moving a violation of the law imposing the fine or Your expenses for influencing legislation and machinery from one plant to another, or from civil penalty. communicating directly with a covered execu- one part of your plant to another. You can de- tive branch official include a portion of your labor • Court costs or stenographic and printing duct the cost of installing the machinery in the costs and general and administrative costs of charges. new location. However, you must capitalize the your business. For information on making this costs of installing or moving newly purchased • Compensatory damages paid to a govern- allocation, see section 1.162-28 of the regula- machinery. ment.

tions.

You cannot claim a charitable or business Outplacement services. The costs of outPolitical contributions. Contributions or gifts expense deduction for amounts paid to an or- placement services you provide to your employ- paid to political parties or candidates are not ganization if both of the following apply. ees to help them find new employment, such as deductible. In addition, expenses paid or in- career counseling, resum  ́ e assistance, skills as-  ́ • The organization conducts lobbying activi- sessment, etc. are deductible. curred to take part in any political campaign of a ties on matters of direct financial interest The costs of outplacement services may candidate for public office are not deductible. to your business. cover more than one deduction category. For Indirect political contributions. You can- • A principal purpose of your contribution is example, deduct as a utilities expense the cost not deduct indirect political contributions and to avoid the rules discussed earlier that of telephone calls made under this service and costs of taking part in political activities as busi- prohibit a business deduction for lobbying deduct as rental expense the cost of renting ness expenses. Examples of nondeductible ex- expenses. machinery and equipment for this service. penses include the following. For information on whether the value of outIf a tax-exempt organization, other than a sec- placement services is includable in your employ- • Advertising in a convention program of a

tion 501(c)(3) organization, provides you with a ees’ income, see Publication 15-B. political party, or in any other publication if

notice on the part of dues that is allocable to any of the proceeds from the publication Penalties and fines. Penalties paid for late nondeductible lobbying and political expenses, are for, or intended for, the use of a politi- performance or nonperformance of a contract you cannot deduct that part of the dues. cal party or candidate. are generally deductible. For instance, you own Covered executive branch official. For and operate a construction company. You have • Admission to a dinner or program (includpurposes of this discussion, a covered executive been contracted to construct a building by a ing, but not limited to, galas, dances, film

branch official is any of the following. certain date. Due to construction delays, the presentations, parties, and sporting

building is not completed and ready for occu- events) if any of the proceeds from the 1. The President. pancy on the date stipulated in the contract. You function are for, or intended for, the use of

2. The Vice President. are now required to pay an additional amount for a political party or candidate.

Chapter 11 Other Expenses Page 45
• Admission to an inaugural ball, gala, Method 1. Figure your tax for 2010 claiming for the tax year in which it is a proper deduction

parade, concert, or similar event if identi- a deduction for the repaid amount. under your accounting method. For example, if

fied with a political party or candidate. you use the accrual method, you are entitled to Method 2. Figure your tax for 2010 claiming the deduction or credit in the tax year in which a credit for the prepaid amount. Follow these the obligation for the repayment accrues. Repairs. The cost of repairing or improving steps.

property used in your trade or business is either Subscriptions. Subscriptions to professional, 1. Figure your tax for 2010 without deducting a deductible or capital expense. Routine mainte- technical, and trade journals that deal with your the repaid amount. nance that keeps your property in a normal effi- business field are deductible.

cient operating condition, but that does not 2. Refigure your tax from the earlier year

materially increase the value or substantially without including in income the amount Supplies and materials. Unless you have deprolong the useful life of the property is deducti- you repaid in 2010. ducted the cost in any earlier year, you generally

ble in the year that it is incurred. Otherwise, the can deduct the cost of materials and supplies 3. Subtract the tax in (2) from the tax shown cost must be depreciated over the useful life of actually consumed and used during the tax year. on your return for the earlier year. This is the property. See Form 4562 and its instructions If you keep incidental materials and supplies the amount of your credit. for how to compute and claim the depreciation on hand, you can deduct the cost of the incidendeduction. 4. Subtract the answer in (3) from the tax for tal materials and supplies you bought during the

2010 figured without the deduction (step tax year if all the following requirements are met. The cost of repairs includes the costs of 1). labor, supplies, and certain other items. The • You do not keep a record of when they are

value of your own labor is not deductible. Exam- If Method 1 results in less tax, deduct the used.

ples of repairs include: amount repaid as discussed earlier under Type • You do not take an inventory of the of deduction. • Reconditioning floors (but not replace- amount on hand at the beginning and end

ment), If Method 2 results in less tax, claim the of the tax year. credit on line 72 of Form 1040, and write “I.R.C. • Repainting the interior and exterior walls 1341” next to line 72. • This method does not distort your income.

of a building,

Example. For 2009, you filed a return and You can also deduct the cost of books, profes- • Cleaning and repairing roofs and gutters, sional instruments, equipment, etc., if you nor- reported your income on the cash method. In and 2010, you repaid $5,000 included in your 2009 mally use them within a year. However, if the

• Fixing plumbing leaks (but not replace- gross income under a claim of right. Your filing usefulness of these items extends substantially

ment of fixtures). status in 2010 and 2009 is single. Your income beyond the year they are placed in service, you

and tax for both years are as follows: generally must recover their costs through depreciation. For more information regarding de- Repayments. If you had to repay an amount 2009 2009 preciation see Publication 946, How To you included in your income in an earlier year, With Income Without Income Depreciate Property. you may be able to deduct the amount repaid for Taxable the year in which you repaid it. Or, if the amount Income $15,000 $10,000 Utilities. Business expenses for heat, lights, you repaid is more than $3,000, you may be able power, telephone service, and water and sewer- to take a credit against your tax for the year in Tax $ 1,836 $ 1,086 age are deductible. However, any part attributa- which you repaid it. ble to personal use is not deductible. 2010 2010 

Type of deduction. The type of deduction Without Deduction With Deduction Telephone. The cost of basic local teleyou are allowed in the year of repayment de- Taxable phone service (including any taxes) for the first pends on the type of income you included in the Income $49,950 $44,950 telephone line you have in your home, even

earlier year. For instance, if you repay an Tax though you have an office in your home is not $8,675 $7,425 amount you previously reported as a capital deductible. However, charges for business

gain, deduct the repayment as a capital loss on Your tax under Method 1 is $7,425. Your tax long-distance phone calls on that line, as well as

Schedule D (Form 1040). If you reported it as under Method 2 is $7,925, figured as follows: the cost of a second line into your home used

self-employment income, deduct it as a busi- exclusively for business, are deductible business deduction on Schedule C or Schedule Tax previously determined for 2009 $ 1,836 ness expenses.

C-EZ (Form 1040) or Schedule F (Form 1040). Less: Tax as refigured ......... . − 1,086

Decrease in 2009 tax $ 750 If you reported the amount as wages, unem- Regular tax liability for 2010 ...... . $8,675 ployment compensation, or other nonbusiness Less: Decrease in 2009 tax ...... . − 750 ordinary income, enter it on Schedule A (Form Refigured tax for 2010 $ 7,925 1040) as a miscellaneous itemized deduction

that is subject to the 2% limitation. However, if

the repayment is over $3,000 and Method 1 Because you pay less tax under Method 1, you 12. should take a deduction for the repayment in (discussed later) applies, deduct it on Schedule 2010.

A (Form 1040) as a miscellaneous itemized deduction that is not subject to the 2% limitation. sion does not apply to the following.

Repayment does not apply. This discus- How To Get Tax

Repayment — $3,000 or less. If the • Deductions for bad debts. amount you repaid was $3,000 or less, deduct it

from your income in the year you repaid it. • Deductions from sales to customers, such Help

Repayment— as returns and allowances, and similar over $3,000. If the amount You can get help with unresolved tax issues, items. you repaid was more than $3,000, you can de- order free publications and forms, ask tax ques- duct the repayment, as described earlier. How- • Deductions for legal and other expenses tions, and get information from the IRS in sev- ever, you can instead choose to take a tax credit of contesting the repayment. eral ways. By selecting the method that is best for the year of repayment if you included the for you, you will have quick and easy access to income under a “claim of right.” This means that Year of deduction (or credit). If you use tax help. at the time you included the income, it appeared the cash method of accounting, you can take the

that you had an unrestricted right to it. If you deduction (or credit, if applicable) for the tax Contacting your Taxpayer Advocate. The

qualify for this choice, figure your tax under both year in which you actually make the repayment. Taxpayer Advocate Service (TAS) is an indemethods and use the method that results in less If you use any other accounting method, you can pendent organization within the IRS. We help

tax. deduct the repayment or claim a credit for it only taxpayers who are experiencing economic

Page 46 Chapter 12 How To Get Tax Help
harm, such as not being able to provide necessi- you can listen to on the telephone. The majority Phone. Many services are available by

ties like housing, transportation, or food; taxpay- of the information and services listed in this phone. 

ers who are seeking help in resolving tax publication are available to you free of charge. If

problems with the IRS; and those who believe there is a fee associated with a resource or • Ordering forms, instructions, and publica- that an IRS system or procedure is not working service, it is listed in the publication. tions. Call 1-800-TAX-FORM as it should. Here are seven things every tax- Accessible versions of IRS published prod- (1-800-829-3676) to order current-year payer should know about TAS: ucts are available on request in a variety of forms, instructions, and publications, and

• The Taxpayer Advocate Service is your alternative formats for people with disabilities. prior-year forms and instructions. You

voice at the IRS. should receive your order within 10 days.

Free help with your return. Free help in pre- • Our service is free, confidential, and tai- • Asking tax questions. Call the IRS with paring your return is available nationwide from lored to meet your needs. your tax questions at 1-800-829-4933. IRS-trained volunteers. The Volunteer Income

• You may be eligible for our help if you Tax Assistance (VITA) program is designed to • Solving problems. You can get

have tried to resolve your tax problem help low-income taxpayers and the Tax Coun- face-to-face help solving tax problems

through normal IRS channels and have seling for the Elderly (TCE) program is designed every business day in IRS Taxpayer Asgotten nowhere, or you believe an IRS to assist taxpayers age 60 and older with their sistance Centers. An employee can exprocedure just isn’t working as it should. tax returns. Many VITA sites offer free electronic plain IRS letters, request adjustments to

filing and all volunteers will let you know about your account, or help you set up a pay- • We help taxpayers whose problems are credits and deductions you may be entitled to ment plan. Call your local Taxpayer Assis- causing financial difficulty or significant claim. To find the nearest VITA or TCE site, call tance Center for an appointment. To find cost, including the cost of professional 1-800-829-1040. the number, go to representation. This includes businesses

As part of the TCE program, AARP offers the www.irs.gov/localcontacts or look in the as well as individuals.

Tax-Aide counseling program. To find the near- phone book under United States Govern- • Our employees know the IRS and how to est AARP Tax-Aide site, call 1-888-227-7669 or ment, Internal Revenue Service. navigate it. If you qualify for our help, we’ll visit AARP’s website at • TTY/TDD equipment. If you have access assign your case to an advocate who will www.aarp.org/money/taxaide. to TTY/TDD equipment, call listen to your problem, help you under- For more information on these programs, go 1-800-829-4059 to ask tax questions or to stand what needs to be done to resolve it, to IRS.gov and enter keyword “VITA” in the order forms and publications. and stay with you every step of the way upper right-hand corner. until your problem is resolved. • TeleTax topics. Call 1-800-829-4477 to lisInternet. You can access the IRS web- ten to pre-recorded messages covering • We have at least one local taxpayer advo- site at IRS.gov 24 hours a day, 7 days various tax topics. cate in every state, the District of Colum- a week to: bia, and Puerto Rico. You can call your • Refund information. To check the status of

local advocate, whose number is in your • E-file your return. Find out about commer- your 2010 refund, call 1-800-829-1954 or phone book, in Pub. 1546, Taxpayer Ad- cial tax preparation and e-file services 1-800-829-4477 (automated refund infor- vocate Service—Your Voice at the IRS, available free to eligible taxpayers. mation 24 hours a day, 7 days a week). and on our website at www.irs.gov/advo- Wait at least 72 hours after the IRS ac- • Check the status of your 2010 refund. Go cate. You can also call our toll-free line at knowledges receipt of your e-filed return, to IRS.gov and click on Where’s My Re- 1-877-777-4778 or TTY/TDD or 3 to 4 weeks after mailing a paper re- 1-800-829-4059. fund. Wait at least 72 hours after the IRS turn. If you filed Form 8379 with your re- acknowledges receipt of your e-filed re- • You can learn about your rights and re- turn, wait 14 weeks (11 weeks if you filed turn, or 3 to 4 weeks after mailing a paper sponsibilities as a taxpayer by visiting our electronically). Have your 2010 tax return return. If you filed Form 8379 with your online tax toolkit at www.taxtoolkit.irs.gov available so you can provide your social . return, wait 14 weeks (11 weeks if you You can get updates on hot tax topics by security number, your filing status, and the filed electronically). Have your 2010 tax visiting our YouTube channel at www.you- exact whole dollar amount of your refund. return available so you can provide your tube.com/tasnta and our Facebook page If you check the status of your refund and social security number, your filing status, at www.facebook.com/YourVoiceAtIRS are not given the date it will be issued, , or and the exact whole dollar amount of your by following our tweets at www.twitter. please wait until the next week before refund. com/YourVoiceAtIRS checking back. .

• Download forms, including talking tax • Other refund information. To check the Low Income Taxpayer Clinics (LITCs). forms, instructions, and publications. status of a prior–year refund or amended The Low Income Taxpayer Clinic program • Order IRS products online. return refund, call 1-800-829-1040. serves individuals who have a problem with the

IRS and whose income is below a certain level. • Research your tax questions online. Evaluating the quality of our telephone LITCs are independent from the IRS. Most • Search publications online by topic or services. To ensure IRS representatives give LITCs can provide representation before the keyword. accurate, courteous, and professional answers, IRS or in court on audits, tax collection disputes, we use several methods to evaluate the quality and other issues for free or a small fee. If an • Use the online Internal Revenue Code, of our telephone services. One method is for a individual’s native language is not English, some regulations, or other official guidance. second IRS representative to listen in on or clinics can provide multilingual information • View Internal Revenue Bulletins (IRBs) record random telephone calls. Another is to ask about taxpayer rights and responsibilities. For published in the last few years. some callers to complete a short survey at the more information, see Publication 4134, Low end of the call. Income Taxpayer Clinic List. This publication is • Figure your withholding allowances using

available at IRS.gov, by calling the withholding calculator online at Walk-in. Many products and services

1-800-TAX-FORM (1-800-829-3676), or at your www.irs.gov/individuals. are available on a walk-in basis.

local IRS office. • Determine if Form 6251 must be filed by

Free tax services. Publication 910, IRS using our Alternative Minimum Tax (AMT) • Products. You can walk in to many post

Guide to Free Tax Services, is your guide to IRS Assistant. offices, libraries, and IRS offices to pick up

services and resources. Learn about free tax certain forms, instructions, and publica- • Sign up to receive local and national tax information from the IRS, including publications, tions. Some IRS offices, libraries, grocery news by email. services, and education and assistance pro- stores, copy centers, city and county govgrams. The publication also has an index of over • Get information on starting and operating ernment offices, credit unions, and office

100 TeleTax topics (recorded tax information) a small business. supply stores have a collection of products

Chapter 12 How To Get Tax Help Page 47
available to print from a CD or photocopy a special need, such as a disability, an • Tax Map: an electronic research tool and

from reproducible proofs. Also, some IRS appointment can be requested. All other finding aid.

offices and libraries have the Internal Rev- issues will be handled without an appoint- • Tax law frequently asked questions. enue Code, regulations, Internal Revenue ment. To find the number of your local Bulletins, and Cumulative Bulletins avail- • Tax Topics from the IRS telephone re- office, go to www.irs.gov/localcontacts or able for research purposes. sponse system. look in the phone book under United

• Services. You can walk in to your local States Government, Internal Revenue • Internal Revenue Code—Title 26 of the

Taxpayer Assistance Center every busi- Service U.S. Code. . ness day for personal, face-to-face tax • Fill-in, print, and save features for most tax help. An employee can explain IRS letters, Mail. You can send your order for forms. request adjustments to your tax account, forms, instructions, and publications to or help you set up a payment plan. If you • Internal Revenue Bulletins. the address below. You should receive need to resolve a tax problem, have ques- a response within 10 days after your request is • Toll-free and email technical support. tions about how the tax law applies to your received. individual tax return, or you are more com- • Two releases during the year.

fortable talking with someone in person, – The first release will ship the beginning

visit your local Taxpayer Assistance Internal Revenue Service of January 2011.

Center where you can spread out your 1201 N. Mitsubishi Motorway – The final release will ship the beginning

records and talk with an IRS representa- Bloomington, IL 61705-6613 of March 2011.

tive face-to-face. No appointment is necessary—just walk in. If you prefer, you DVD for tax products. You can order Purchase the DVD from National Technical

can call your local Center and leave a Publication 1796, IRS Tax Products Information Service (NTIS) at 

message requesting an appointment to re- DVD, and obtain: www.irs.gov/cdorders for $30 (no handling fee)

solve a tax account issue. A representa- or call 1-877-233-6767 toll-free to buy the DVD • Current-year forms, instructions, and pub- tive will call you back within 2 business for $30 (plus a $6 handling fee). lications. days to schedule an in-person appointment at your convenience. If you have an • Prior-year forms, instructions, and publicaongoing, complex tax account problem or tions.

Page 48 Chapter 12 How To Get Tax Help
To help us develop a more useful index, please let us know if you have ideas for index entries. Index See “Comments and Suggestions” in the “Introduction” for the ways you can reach us.

A Circulation costs, newspapers Experimentation costs .... . 22, Below-market ............. . 14

Advertising ................. . 43 and periodicals .......... . 23 33 Business expense for ...... . 11

Amortization: Cleanup costs, Exploration costs .......... . 22 Capitalized ............ . 13, 14

environmental ............ . 23 Carrying charge ........... . 21 Anti-abuse rule ............ . 31

Club dues .................. . 44 Deductible ................ . 12 Anti-churning rules ........ . 30 F Forgone .................. . 14 Atmospheric pollution control Comments on publication ... . 1

Fees: Life insurance policies ..... . 13 facilities ................ . 32 Commitment fees .......... . 13 Commitment .............. . 13 Not deductible ............ . 13 Corporate organization Computer software ......... . 29 Legal and professional ..... . 44 Refunds of ................ . 14 costs ................... . 27 Constant-yield method, Regulatory ................ . 45 When to deduct ........... . 14 Dispositions of section 197 OID ...................... . 13 Tax return preparation ..... . 45 Internet-related intangibles .............. . 31 Contested liability ........... . 5 Fines ....................... . 45 expenses ................ . 44 Experimental costs ........ . 33 Contributions:

Geological and geophysical Forgone interest ........... . 14 Interview expenses ......... . 44

Charitable ................ . 44 Form: costs ................... . 32 Political ................... . 45 How to deduct 3115 ................. . 16, 31 ............ . 26 Copyrights ................. . 29 K 4562 ..................... . 26 Incorrect amount Cost depletion Key person ................. . 13 ............. . 34 5213 ...................... . 5 deducted ............... . 31

Cost of getting lease Kickbacks .................. . 43 ... . 10, 28 8826 ..................... . 26 Partnership organization Cost of goods sold .......... . 2 8885 ..................... . 19 costs ................... . 27

Pollution control facilities ... . 32 Cost recovery ............... . 3 T ......................... . 38 L

Covenant not to Franchise .............. . 29, 44 Reforestation costs ........ . 32 Leases:

Reforestation expenses .... . 24 compete ................. . 29 Franchise taxes ............ . 17 Canceling .................. . 9

Related person ............ . 30 Credit card convenience Free tax services ........... . 46 Cost of getting ........ . 10, 28

Research costs ........... . 33 fees ...................... . 44 Fringe benefits .............. . 7 Improvements by lessee ... . 10

Section 197 intangibles Fuel taxes .................. . 17 Leveraged ................. . 9

defined ................. . 28 Mineral ................... . 37

Starting a business D Oil and gas ............... . 37

costs ................... . 26 De minimis OID ............ . 13 G Sales distinguished ......... . 9

Start-up costs ............. . 26 Debt-financed Gas wells .................. . 37 Taxes on .................. . 9

Anticipated liabilities distributions ............. . 12 Geological and geophysical Legal and professional ....... . 43

Definitions: costs: fees ...................... . 44 Assessments, local ........ . 16

Business bad debt ......... . 39 Development, oil and Licenses ............... . 29, 45 Assistance (See Tax help)

Necessary expense ........ . 2 gas ..................... . 32 Life insurance coverage ..... . 7 At-risk limits ................ . 4

Ordinary expense .......... . 2 Exploration, oil and gas .... . 32 Limit on deductions ......... . 5 Attorney fees ............... . 44

Section 197 intangibles .... . 28 Geothermal wells ....... . 22, 37 Line of credit ............... . 12 Awards .................... . 6, 7

Demolition expenses ....... . 44 Gifts, nominal value ......... . 7 Loans:

Depletion: Going into business ...... . 3, 26 Below-market interest

B Mineral property ........... . 34 Goodwill ................... . 29 rate .................... . 14

Bad debts: Oil and gas wells .......... . 35 Discounted ............... . 14

Defined ................... . 39 Percentage table .......... . 37 Loans or Advances .......... . 8 H How to treat ............... . 39 Timber .................... . 38 Lobbying expenses ........ . 45 Health insurance, deduction for Recovery ................. . 40 Who can claim ............ . 33 Long-term care self-employed ............ . 18 Types of .................. . 39 Depreciation (See Cost insurance ................ . 18 Heating equipment .......... . 3 When worthless ........... . 39 recovery) Losses .................... . 4, 5 Help (See Tax help) Bonuses: Development costs, At-risk limits ................ . 4

Employee .................. . 7 miners ................... . 23 Net operating .............. . 4

Royalties ................. . 37 Disabled, improvements Passive activities ........... . 4 I

Bribes ...................... . 43 for ....................... . 25 Impairment-related

Brownfields (See Environmental Drilling and development expenses ................ . 44 M

cleanup costs) costs ..................... . 22 Improvements ............... . 3 Machinery parts ............. . 3

Business: Dues, membership ......... . 44 By lessee ................. . 10 Meals ...................... . 41

Assets ..................... . 3 For disabled and elderly ... . 25 Meals and entertainment ... . 42 Books and records ........ . 29 E Income taxes ............... . 17 Meals and lodging ........... . 7 Meal expenses ............ . 42

Economic interest Incorrect amount of Methods of accounting ...... . 4 Use of car .............. . 4, 43 .......... . 33 amortization deducted ... . 31

Economic performance Mining: Use of home ............... . 3 ..... . 4 Insurance: Depletion ................. . 37 Education expenses ...... . 7, 44 Capitalized premiums ...... . 19 Development costs ........ . 23 Elderly, improvements Deductible premiums ...... . 18 C Exploration costs .......... . 22 for ....................... . 25 Nondeductible

Campaign contribution More information (See Tax help) ..... . 45 Employee benefit premiums ............... . 19

Capital expenses Mortgage ................... . 12 ............ . 3 programs ................. . 7 Self-employed

Capitalization of interest Moving expenses, ... . 14 Employment taxes ......... . 17 individuals .............. . 18

machinery ............... . 45 Car allowance .............. . 42 Entertainment .............. . 41 Intangible drilling costs .... . 22

Car and truck expenses .... . 43 Environmental cleanup Intangibles, amortization ... . 28

Carrying charges ........... . 21 (remediation) costs ...... . 23 Interest: N

Charitable contributions .... . 44 Excise taxes ............... . 17 Allocation of ............... . 11 Natural gas ................. . 37

Publication 535 (2010) Page 49
Nonqualifying Percentage depletion ....... . 34 Removal ................... . 25 Fuel ...................... . 17

intangibles ............... . 29 Personal property tax ...... . 17 Rent expense, Income ................... . 17

Not-for-profit activities ...... . 5 Political contributions ...... . 45 capitalizing ............... . 10 Leased property ............ . 9

Repairs .................... . 46 Personal property ......... . 17 Pollution control

Real estate ............... . 16 O facilities .................. . 32 Repayments (claim of Sales ..................... . 17 Prepaid expense ............ . 4 right) ..................... . 46 Office in home .............. . 3 Unemployment fund ....... . 17 Extends useful life ......... . 21 Research costs ........ . 22, 33 Oil and gas wells: Taxpayer Advocate ......... . 46 Interest ................... . 14 Depletion ................. . 35

Rent ....................... . 9 Telephone .................. . 46 Drilling costs .............. . 22 S

Prepayment penalty ........ . 12 Timber ................. . 32, 38 Partnerships .............. . 36 Sales taxes ................. . 17

Presumption of profit........ . 5 Tools ........................ . 3 S corporations ............ . 36 Section 179 expense deduction Publications Trademark, trade name .... . 29, Optional write-off method: (See Tax help) (See Cost recovery) 44 Circulation costs .......... . 33 Self-employed health insurance Experimental costs ........ . 33 Travel ...................... . 41 R deduction ................ . 18

Intangible drilling and TTY/TDD information ....... . 46 Real estate taxes ........... . 16 Self-employment tax ....... . 17 development costs ...... . 33 Recapture: Self-insurance, reserve Mining exploration and Exploration expenses ...... . 23 for ....................... . 19 U

development costs ...... . 33 Timber property ........... . 32 Sick pay ..................... . 8 Unemployment fund Research costs ........... . 33

Recovery of amount taxes ..................... . 17 Standard meal allowance ... . 42 Organization costs: deducted .................. . 4 Unpaid expenses, related Corporate Standard mileage rate ...... . 42 ................. . 27

Refiners who cannot claim person ................... . 14 Partnership ............... . 27 Standby charges ........... . 13

percentage depletion ..... . 35 Utilities ..................... . 46 Organizational costs ....... . 24 Start-up costs .......... . 24, 26

Reforestation costs .... . 24, 32 Original issue discount ..... . 12 Subscriptions .............. . 46

Outplacement services ..... . 45 Regulatory fees ............ . 45 Suggestions for V

Reimbursements ........... . 41 publication ................ . 1 Vacation pay ................ . 8

Business expenses ......... . 8 Supplies and materials ..... . 46 P Mileage ................... . 42

Passive activities ............ . 4 Nonaccountable plan ...... . 43 W

T Wages: Payments in kind ............ . 4 Per diem .................. . 42

Tax help .................... . 46 Property ................... . 8 Penalties ................... . 12 Related persons: Tests for deducting pay ..... . 6 Deductible ................ . 45 Anti-churning rules ........ . 30 Tax preparation fees ....... . 45

Welfare benefit funds ........ . 7 Nondeductible ............ . 45 Coal or iron ore ........... . 37 Taxes ....................... . 9

Prepayment ............... . 12 Payments to ............ . 5, 14 Carrying charge ........... . 21 ■

Per diem and car Refiners .................. . 35 Employment .............. . 17

allowances ............... . 42 Rent expense .............. . 8 Excise .................... . 17

Unreasonable rent .......... . 8 Franchise ................. . 17

Page 50 Publication 535 (2010)