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 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 sold is treated when a business sells inventory.
Under the return of capital principal, 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] Tom is an attorney who often represents individuals injured on the job (workers’
compensation claims). This year, Tom spent $50 on a book entitled Plumbing For Dummies
and paid $500 to take a course on plumbing residences and rental housing. Can you imagine
circumstances in which these expenditures would be deductible as “ordinary and necessary”
for an attorney. Explain.
“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 for
that type of business) and necessary is not interpreted as only essential expenses. Tom may
represent a plumber and incurred this expenditure so he can better understand and explain how
his client was injured on the job. In this case, the expenses would be both ordinary and
necessary to Tom’s practice as an attorney, and therefore deductible.
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 Jake’s dog food as unreasonable?
Reasonableness is an issue of fact and circumstance, and extravagance is difficult to determine
definitely. However, 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. 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. Hence, the IRS is most likely to challenge the cost of the dog food
if Jake or his family controlled the local pet food company.
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 IRC 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} Jerry is a self-employed rock star and this year he expended $1,000 on
special “flashy” clothes and outfits. Jerry would like to deduct the cost of these clothes as
work-related because the clothes are not acceptable to Jerry’s sense of fashion. Under what
circumstances can Jerry deduct the cost of these work 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
Jerry’s case, the flashy rock outfits could be 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 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] Tim employs three sales representatives who often take clients to dinner and provide
entertainment in order to increase sales. This year Tim reimbursed the representatives
$2,500 for the cost of meals and $8,250 for the cost of entertaining clients. Describe the
conditions under which Tim can claim deductions for meals and entertainment.
To deduct any portion of the cost of a meal as a business expense, the amount must be
reasonable under the circumstances, the taxpayer (or an employee) must be present when the
meal is furnished, and the meal must be directly associated with the active conduct of the
taxpayer’s business. Similar to business meals, entertainment associated with business activities
contains a significant element of enjoyment. Hence, only 50% of allowable business
entertainment may be deducted as a business expense. Further, entertainment deductions are
allowable only if “business associates” are entertained, the amounts paid are reasonable in
amount, and the entertainment is either “directly related” or “associated with” the active
conduct of business
10. [LO 2] Jenny uses her car for both business and personal purposes. She purchased the auto
this year and drove 11,000 miles on business trips and 9,000 miles for personal
transportation. Describe how Jenny 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 Jenny 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, Jenny may
simply deduct a standard amount for each business mile she drives. The standard mileage rate
represents the per-mile cost of operating an automobile (including depreciation or lease
payments).
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%), lodging, transportation on site, and incidental
expenditures for the business portion of the travel. If the taxpayer’s primary purpose for the trip
is personal, the taxpayer may not deduct transportation costs to travel to and from the location
but the taxpayer may deduct meals (50%), lodging, transportation, and incidental expenditures
for the business portion of the trip. For international travel in excess of one week, the taxpayer
must allocate the cost of the transportation between personal (nondeductible) and business
(deductible) activities. Taxpayers generally determine the nondeductible portion of the
, transportation costs by multiplying the travel costs by a ratio of personal activity days to total
days travelling. Finally, remember that travel days are considered business activity days for
both domestic and international travel.
12. [LO 2] Clyde lives and operates a sole proprietorship in Dallas, Texas. This year Clyde found
it necessary to travel to Fort Worth (about 25 miles away) for legitimate business reasons. Is
Clyde’s trip likely to qualify as “away from home,” and why would this designation matter?
Besides the cost of transportation, the deduction for travel expenses includes meals (50%),
lodging, and incidental expenses. However, travel expenses are only deductible if the taxpayer is
away from home overnight while traveling. For this purpose, a taxpayer is considered to be
away from home overnight if the trip is of sufficient duration to require sleep or rest. It’s likely
that Clyde’s trip will not satisfy this condition and that he will not be able to deduct half the cost
of meals and the entire cost of lodging.
13. [LO 2] Describe the record-keeping requirements for business deductions expenses including
mixed-motive expenditures.
Taxpayers must keep specific, written, contemporaneous records of time, amount of the
expenditure, and business purpose of the travel. No deductions are allowed absent sufficient
records to document business purpose. Records of the expenditure amount, however, may not
be necessary if the taxpayer claims per diem amounts.
14. [LO 3] Explain why the domestic production activities deduction is sometimes described as
an “artificial” expense and the apparent rationale for this deduction. How might a business
begin to determine the domestic portion of revenues and expenses for products that are
assembled in the United States from parts made overseas?
The DPAD is designed to reduce the tax burden on domestic manufacturers to make investments
in domestic manufacturing facilities more attractive. It is artificial because it does not
represent an expenditure per se, but merely serves to reduce the income taxes the business must
pay and thereby increase the after-tax profitability of domestic manufacturing. The calculation
of the income allocable to domestic production can be exceedingly complex, especially in the
case of large multinational businesses, but it generally begins with determining the amount of
domestic revenue from sales of eligible property or services.
15. [LO 3] Describe the calculation of the domestic production activities deduction.
The domestic manufacturing deduction is calculated by first allocating net income between the
income produced in the US and the income produced abroad. The amount allocated to the US is
deemed qualified production activities income (QPAI). The deduction is then calculated as 9
percent of the lesser of taxable income before the deduction (AGI is used by individual taxpayers
in lieu of taxable income) or QPAI.
16. [LO 3] Describe the limits placed on the domestic production activities deduction, and
explain the apparent reason for each limitation.
Qualified production activities income (QPAI)taxable income before the deduction (AGI is used
by individual taxpayers in lieu of taxable income). The deduction itself cannot exceed 50
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 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 sold is treated when a business sells inventory.
Under the return of capital principal, 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] Tom is an attorney who often represents individuals injured on the job (workers’
compensation claims). This year, Tom spent $50 on a book entitled Plumbing For Dummies
and paid $500 to take a course on plumbing residences and rental housing. Can you imagine
circumstances in which these expenditures would be deductible as “ordinary and necessary”
for an attorney. Explain.
“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 for
that type of business) and necessary is not interpreted as only essential expenses. Tom may
represent a plumber and incurred this expenditure so he can better understand and explain how
his client was injured on the job. In this case, the expenses would be both ordinary and
necessary to Tom’s practice as an attorney, and therefore deductible.
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 Jake’s dog food as unreasonable?
Reasonableness is an issue of fact and circumstance, and extravagance is difficult to determine
definitely. However, 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. 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. Hence, the IRS is most likely to challenge the cost of the dog food
if Jake or his family controlled the local pet food company.
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 IRC 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} Jerry is a self-employed rock star and this year he expended $1,000 on
special “flashy” clothes and outfits. Jerry would like to deduct the cost of these clothes as
work-related because the clothes are not acceptable to Jerry’s sense of fashion. Under what
circumstances can Jerry deduct the cost of these work 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
Jerry’s case, the flashy rock outfits could be 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 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] Tim employs three sales representatives who often take clients to dinner and provide
entertainment in order to increase sales. This year Tim reimbursed the representatives
$2,500 for the cost of meals and $8,250 for the cost of entertaining clients. Describe the
conditions under which Tim can claim deductions for meals and entertainment.
To deduct any portion of the cost of a meal as a business expense, the amount must be
reasonable under the circumstances, the taxpayer (or an employee) must be present when the
meal is furnished, and the meal must be directly associated with the active conduct of the
taxpayer’s business. Similar to business meals, entertainment associated with business activities
contains a significant element of enjoyment. Hence, only 50% of allowable business
entertainment may be deducted as a business expense. Further, entertainment deductions are
allowable only if “business associates” are entertained, the amounts paid are reasonable in
amount, and the entertainment is either “directly related” or “associated with” the active
conduct of business
10. [LO 2] Jenny uses her car for both business and personal purposes. She purchased the auto
this year and drove 11,000 miles on business trips and 9,000 miles for personal
transportation. Describe how Jenny 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 Jenny 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, Jenny may
simply deduct a standard amount for each business mile she drives. The standard mileage rate
represents the per-mile cost of operating an automobile (including depreciation or lease
payments).
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%), lodging, transportation on site, and incidental
expenditures for the business portion of the travel. If the taxpayer’s primary purpose for the trip
is personal, the taxpayer may not deduct transportation costs to travel to and from the location
but the taxpayer may deduct meals (50%), lodging, transportation, and incidental expenditures
for the business portion of the trip. For international travel in excess of one week, the taxpayer
must allocate the cost of the transportation between personal (nondeductible) and business
(deductible) activities. Taxpayers generally determine the nondeductible portion of the
, transportation costs by multiplying the travel costs by a ratio of personal activity days to total
days travelling. Finally, remember that travel days are considered business activity days for
both domestic and international travel.
12. [LO 2] Clyde lives and operates a sole proprietorship in Dallas, Texas. This year Clyde found
it necessary to travel to Fort Worth (about 25 miles away) for legitimate business reasons. Is
Clyde’s trip likely to qualify as “away from home,” and why would this designation matter?
Besides the cost of transportation, the deduction for travel expenses includes meals (50%),
lodging, and incidental expenses. However, travel expenses are only deductible if the taxpayer is
away from home overnight while traveling. For this purpose, a taxpayer is considered to be
away from home overnight if the trip is of sufficient duration to require sleep or rest. It’s likely
that Clyde’s trip will not satisfy this condition and that he will not be able to deduct half the cost
of meals and the entire cost of lodging.
13. [LO 2] Describe the record-keeping requirements for business deductions expenses including
mixed-motive expenditures.
Taxpayers must keep specific, written, contemporaneous records of time, amount of the
expenditure, and business purpose of the travel. No deductions are allowed absent sufficient
records to document business purpose. Records of the expenditure amount, however, may not
be necessary if the taxpayer claims per diem amounts.
14. [LO 3] Explain why the domestic production activities deduction is sometimes described as
an “artificial” expense and the apparent rationale for this deduction. How might a business
begin to determine the domestic portion of revenues and expenses for products that are
assembled in the United States from parts made overseas?
The DPAD is designed to reduce the tax burden on domestic manufacturers to make investments
in domestic manufacturing facilities more attractive. It is artificial because it does not
represent an expenditure per se, but merely serves to reduce the income taxes the business must
pay and thereby increase the after-tax profitability of domestic manufacturing. The calculation
of the income allocable to domestic production can be exceedingly complex, especially in the
case of large multinational businesses, but it generally begins with determining the amount of
domestic revenue from sales of eligible property or services.
15. [LO 3] Describe the calculation of the domestic production activities deduction.
The domestic manufacturing deduction is calculated by first allocating net income between the
income produced in the US and the income produced abroad. The amount allocated to the US is
deemed qualified production activities income (QPAI). The deduction is then calculated as 9
percent of the lesser of taxable income before the deduction (AGI is used by individual taxpayers
in lieu of taxable income) or QPAI.
16. [LO 3] Describe the limits placed on the domestic production activities deduction, and
explain the apparent reason for each limitation.
Qualified production activities income (QPAI)taxable income before the deduction (AGI is used
by individual taxpayers in lieu of taxable income). The deduction itself cannot exceed 50
