,ACCESS Test Bank for McGraw Hill's Taxation of Business Entities 2023
Edition 14th Edition Spilker
Solutions Manual—Taxation of Business Entities, by Spilker et al.
Chapter 1
Business Income, Deductions, and Accounting Methods
SOLUTIONS MANUAL
Discussion Questions
1. [LO 1] What is an “ordinary and necessary” business expenditure?
“Ordinary” and “necessary” imply that an expense must be customary and helpful,
respectively. Because these terms are subjective, the tests are ambiguous. However,
ordinary is interpreted by the courts as including expenses which may be unusual for a
specific taxpayer (but not unusual for that type of business) and necessary is not
interpreted as only essential expenses. These limits can be contrasted with the reasonable
limit on amounts and the bona fide requirement for profit motivation.
2. [LO 1] Explain how cost of goods is treated when a business sells inventory.
Under the return of capital principle, cost of goods sold represents a reduction in gross
income rather than a business expense. For example, if a taxpayer sells inventory for
$100,000 and reports a cost of goods sold of $40,000, the business’s gross income is
$60,000 ($100,000 – 40,000) not $100,000.
3. [LO 1] Whether a business expense is “reasonable in amount” is often a difficult question.
Explain why determining reasonableness is difficult and describe a circumstance where
reasonableness is likely to be questioned by the IRS.
Reasonableness is an issue of fact and circumstance, and extravagance is difficult to
determine because of the subjectivity and multitude of factors involved in determining
price. Reasonableness is most likely to be an issue when a payment is made to a related
individual or the taxpayer enjoys some personal benefit incidental to the expenditure.
4. [LO 1] Jake is a professional dog trainer who purchases and trains dogs for use by law
enforcement agencies. Last year Jake purchased 500 bags of dog food from a large pet
food company at an average cost of $30 per bag. This year, however, Jake purchased 500
bags of dog food from a local pet food company at an average cost of $45 per bag. Under
what circumstances would the IRS likely challenge the cost of Jake’s dog food as
unreasonable?
A common test for reasonableness is whether the expenditure is comparable to an arm's
length amount – a price charged by objective (unrelated) individuals who do not receive
any incidental personal benefits. Hence, the IRS is most likely to challenge the cost of the
dog food if Jake’s relatives control or own the local pet food company and was benefiting
from the increased price.
© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 1
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,ACCESS Test Bank for McGraw Hill's Taxation of Business Entities 2023
Edition 14th Edition Spilker
Solutions Manual—Taxation of Business Entities, by Spilker et al.
5. [LO 2] What kinds of deductions are prohibited as a matter of public policy? Why might
Congress deem it important to disallow deductions for expenditures that are against public
policy?
The Code lists bribes, kickbacks, and “other” illegal payments as nondeductible. Congress
didn’t want the tax benefits associated with deductions to benefit or subsidize wrongdoing.
Of course, this rationale doesn’t really explain the prohibition against deducting political
contributions which is probably better explained by the potential perception that political
efforts are being subsidized by taxpayers.
6. [LO 2] Provide an example of an expense associated with the production of tax-exempt
income, and explain what might happen if Congress repealed the prohibition against
deducting expenses incurred to produce tax-exempt income.
Two common examples are interest expense associated with debt used to purchase
municipal bonds and life insurance premiums paid on key man insurance. If this
prohibition were repealed, then taxpayers would have an incentive to borrow to invest in
municipal bonds or borrow to invest in employee life insurance. This former practice
would lead to higher demand for municipal bonds (less yield) and less revenue for the
government. The latter practice would lead to higher demand for insurance (higher
premiums?) and less revenue for the government. Both practices could lead to a
perception of inequity between those taxpayers able to utilize the tax arbitrage to reduce
taxes and those who could not use the practice.
7. [LO 2] {Research} Peggy is a rodeo clown, and this year she expended $1,000 on special
“funny” clothes and outfits. Peggy would like to deduct the cost of these clothes as work-
related because she refuses to wear the clothes unless she is working. Under what
circumstances can Peggy deduct the cost of her clown clothes?
Taxpayers may deduct the cost of uniforms or special clothing they use in their business
when the clothing is not appropriate to wear as ordinary clothing outside the place of
business. In Peggy’s case, the clown clothes are analogous to special uniforms or
protective garments and could be deductible. See D. Techner, TC Memo 1997-498. Erhard
Seminar Training, TC Memo 1986-526 provides an example of clothes that were not
deductible because they were appropriate for normal wear. However, the cost of clothing
would not likely be deductible if the clothes were unacceptable solely because of the
taxpayer’s sense of fashion.
8. [LO 2] Jimmy is a sole proprietor of a small dry-cleaning business. This month Jimmy
paid for his groceries by writing checks from the checking account dedicated to the dry-
cleaning business. Why do you suppose Jimmy is using his business checking account
rather than his personal checking account to pay for personal expenditures?
Jimmy might be trying to reduce his bank charges by using one account for both personal
and business expenditures, but he could also be trying to disguise personal expenditures as
© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 2
mynursytest.store
, ACCESS Test Bank for McGraw Hill's Taxation of Business Entities 2023
Edition 14th Edition Spilker
Solutions Manual—Taxation of Business Entities, by Spilker et al.
business expenses. By commingling business and personal expenditures, Jimmy will need
to separate personal and business expenditures before claiming any business deductions.
9. [LO 2] Troy operates an editorial service that often entertains prospective authors to
encourage them to use Troy's service. This year Troy paid $3,000 for the cost of meals and
$6,200 for the cost of entertaining authors. Describe the conditions under which Troy can
deduct a portion of the cost of the meals as a business expense.
To deduct 100 percent of the cost of meals as a business expense, the meals must be
ordinary and necessary to Troy’s business, provided by a restaurant, and the amount must
be reasonable under the circumstances. In addition, Troy or an employee must be present
when the meal is furnished, and the meal must be furnished to an actual or potential
business associate. Finally, the cost of the meals must be separately stated (by invoice)
from the cost of the entertainment (the cost of the entertainment is not deductible). If the
meals and beverages are not provided by a restaurant, then only 50 percent is deductible
(assuming all of the other requirements are met).
10. [LO 2] Susmita purchased a car this year and uses it for both business and personal
purposes. Susmita drove the car 11,000 miles on business trips and 9,000 miles for
personal transportation. Describe how Susmita will determine the amount of deductible
expenses associated with the auto.
Because only the expense relating to business use is deductible, the taxpayer must allocate
the expenses between the business and personal use portions. A common method of
allocation is relative use. In this instance, Susmita would calculate the business portion
based upon the ratio of business miles to total miles (11/20 or 55 percent). She would then
deduct the costs of operating the vehicle for business purposes plus depreciation on the
business portion (55 percent) of the vehicle’s tax basis. Alternatively, in lieu of deducting
these costs, Susmita may elect to deduct a standard amount for each business mile she
drives. The standard mileage rate (58.5 cents per mile for the first six months of 2022 and
62.6 cents for the final six months) represents the per-mile cost of operating an automobile
(including depreciation or lease payments). Once Susmita has made this election, she must
continue to use it throughout the life of the auto.
11. [LO 1, LO 2] What expenses are deductible when a taxpayer combines both business and
personal activities on a trip? How do the rules for international travel differ from the rules
for domestic travel?
If the taxpayer has both business and personal motives for a trip, but the primary or
dominant motive is business, the taxpayer may deduct the transportation costs to get to the
place of business, but she may deduct only meals (50% or 100% if provided by a
restaurant), lodging, transportation on site, and incidental expenditures for the business
portion of the travel. If the taxpayer’s primary purpose for the trip is personal, the
taxpayer may not deduct transportation costs to travel to and from the location, but the
taxpayer may deduct meals (50% or 100% if provided by a restaurant), lodging,
transportation, and incidental expenditures for the business portion of the trip. For
© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 3
mynursytest.store
Edition 14th Edition Spilker
Solutions Manual—Taxation of Business Entities, by Spilker et al.
Chapter 1
Business Income, Deductions, and Accounting Methods
SOLUTIONS MANUAL
Discussion Questions
1. [LO 1] What is an “ordinary and necessary” business expenditure?
“Ordinary” and “necessary” imply that an expense must be customary and helpful,
respectively. Because these terms are subjective, the tests are ambiguous. However,
ordinary is interpreted by the courts as including expenses which may be unusual for a
specific taxpayer (but not unusual for that type of business) and necessary is not
interpreted as only essential expenses. These limits can be contrasted with the reasonable
limit on amounts and the bona fide requirement for profit motivation.
2. [LO 1] Explain how cost of goods is treated when a business sells inventory.
Under the return of capital principle, cost of goods sold represents a reduction in gross
income rather than a business expense. For example, if a taxpayer sells inventory for
$100,000 and reports a cost of goods sold of $40,000, the business’s gross income is
$60,000 ($100,000 – 40,000) not $100,000.
3. [LO 1] Whether a business expense is “reasonable in amount” is often a difficult question.
Explain why determining reasonableness is difficult and describe a circumstance where
reasonableness is likely to be questioned by the IRS.
Reasonableness is an issue of fact and circumstance, and extravagance is difficult to
determine because of the subjectivity and multitude of factors involved in determining
price. Reasonableness is most likely to be an issue when a payment is made to a related
individual or the taxpayer enjoys some personal benefit incidental to the expenditure.
4. [LO 1] Jake is a professional dog trainer who purchases and trains dogs for use by law
enforcement agencies. Last year Jake purchased 500 bags of dog food from a large pet
food company at an average cost of $30 per bag. This year, however, Jake purchased 500
bags of dog food from a local pet food company at an average cost of $45 per bag. Under
what circumstances would the IRS likely challenge the cost of Jake’s dog food as
unreasonable?
A common test for reasonableness is whether the expenditure is comparable to an arm's
length amount – a price charged by objective (unrelated) individuals who do not receive
any incidental personal benefits. Hence, the IRS is most likely to challenge the cost of the
dog food if Jake’s relatives control or own the local pet food company and was benefiting
from the increased price.
© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 1
mynursytest.store
,ACCESS Test Bank for McGraw Hill's Taxation of Business Entities 2023
Edition 14th Edition Spilker
Solutions Manual—Taxation of Business Entities, by Spilker et al.
5. [LO 2] What kinds of deductions are prohibited as a matter of public policy? Why might
Congress deem it important to disallow deductions for expenditures that are against public
policy?
The Code lists bribes, kickbacks, and “other” illegal payments as nondeductible. Congress
didn’t want the tax benefits associated with deductions to benefit or subsidize wrongdoing.
Of course, this rationale doesn’t really explain the prohibition against deducting political
contributions which is probably better explained by the potential perception that political
efforts are being subsidized by taxpayers.
6. [LO 2] Provide an example of an expense associated with the production of tax-exempt
income, and explain what might happen if Congress repealed the prohibition against
deducting expenses incurred to produce tax-exempt income.
Two common examples are interest expense associated with debt used to purchase
municipal bonds and life insurance premiums paid on key man insurance. If this
prohibition were repealed, then taxpayers would have an incentive to borrow to invest in
municipal bonds or borrow to invest in employee life insurance. This former practice
would lead to higher demand for municipal bonds (less yield) and less revenue for the
government. The latter practice would lead to higher demand for insurance (higher
premiums?) and less revenue for the government. Both practices could lead to a
perception of inequity between those taxpayers able to utilize the tax arbitrage to reduce
taxes and those who could not use the practice.
7. [LO 2] {Research} Peggy is a rodeo clown, and this year she expended $1,000 on special
“funny” clothes and outfits. Peggy would like to deduct the cost of these clothes as work-
related because she refuses to wear the clothes unless she is working. Under what
circumstances can Peggy deduct the cost of her clown clothes?
Taxpayers may deduct the cost of uniforms or special clothing they use in their business
when the clothing is not appropriate to wear as ordinary clothing outside the place of
business. In Peggy’s case, the clown clothes are analogous to special uniforms or
protective garments and could be deductible. See D. Techner, TC Memo 1997-498. Erhard
Seminar Training, TC Memo 1986-526 provides an example of clothes that were not
deductible because they were appropriate for normal wear. However, the cost of clothing
would not likely be deductible if the clothes were unacceptable solely because of the
taxpayer’s sense of fashion.
8. [LO 2] Jimmy is a sole proprietor of a small dry-cleaning business. This month Jimmy
paid for his groceries by writing checks from the checking account dedicated to the dry-
cleaning business. Why do you suppose Jimmy is using his business checking account
rather than his personal checking account to pay for personal expenditures?
Jimmy might be trying to reduce his bank charges by using one account for both personal
and business expenditures, but he could also be trying to disguise personal expenditures as
© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 2
mynursytest.store
, ACCESS Test Bank for McGraw Hill's Taxation of Business Entities 2023
Edition 14th Edition Spilker
Solutions Manual—Taxation of Business Entities, by Spilker et al.
business expenses. By commingling business and personal expenditures, Jimmy will need
to separate personal and business expenditures before claiming any business deductions.
9. [LO 2] Troy operates an editorial service that often entertains prospective authors to
encourage them to use Troy's service. This year Troy paid $3,000 for the cost of meals and
$6,200 for the cost of entertaining authors. Describe the conditions under which Troy can
deduct a portion of the cost of the meals as a business expense.
To deduct 100 percent of the cost of meals as a business expense, the meals must be
ordinary and necessary to Troy’s business, provided by a restaurant, and the amount must
be reasonable under the circumstances. In addition, Troy or an employee must be present
when the meal is furnished, and the meal must be furnished to an actual or potential
business associate. Finally, the cost of the meals must be separately stated (by invoice)
from the cost of the entertainment (the cost of the entertainment is not deductible). If the
meals and beverages are not provided by a restaurant, then only 50 percent is deductible
(assuming all of the other requirements are met).
10. [LO 2] Susmita purchased a car this year and uses it for both business and personal
purposes. Susmita drove the car 11,000 miles on business trips and 9,000 miles for
personal transportation. Describe how Susmita will determine the amount of deductible
expenses associated with the auto.
Because only the expense relating to business use is deductible, the taxpayer must allocate
the expenses between the business and personal use portions. A common method of
allocation is relative use. In this instance, Susmita would calculate the business portion
based upon the ratio of business miles to total miles (11/20 or 55 percent). She would then
deduct the costs of operating the vehicle for business purposes plus depreciation on the
business portion (55 percent) of the vehicle’s tax basis. Alternatively, in lieu of deducting
these costs, Susmita may elect to deduct a standard amount for each business mile she
drives. The standard mileage rate (58.5 cents per mile for the first six months of 2022 and
62.6 cents for the final six months) represents the per-mile cost of operating an automobile
(including depreciation or lease payments). Once Susmita has made this election, she must
continue to use it throughout the life of the auto.
11. [LO 1, LO 2] What expenses are deductible when a taxpayer combines both business and
personal activities on a trip? How do the rules for international travel differ from the rules
for domestic travel?
If the taxpayer has both business and personal motives for a trip, but the primary or
dominant motive is business, the taxpayer may deduct the transportation costs to get to the
place of business, but she may deduct only meals (50% or 100% if provided by a
restaurant), lodging, transportation on site, and incidental expenditures for the business
portion of the travel. If the taxpayer’s primary purpose for the trip is personal, the
taxpayer may not deduct transportation costs to travel to and from the location, but the
taxpayer may deduct meals (50% or 100% if provided by a restaurant), lodging,
transportation, and incidental expenditures for the business portion of the trip. For
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