Chapter 7

Deductions and Losses:

Certain Business Expenses
and Losses
Comprehensive Volume
2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The Big Picture (slide 1 of 3)

Martha is nearing the end of a year that she would like to
forget.
Several years ago she loaned a friend $25,000 to enable him to
start a business.
The friend had made scheduled payments of $7,000 ($1,000 of this was
interest) when he unexpectedly died in January.
At the time of his death, he was insolvent.

Marthas attempts to collect on the debt were fruitless.

Last October Martha invested $50,000 in the stock of a

pharmaceutical company that previously had been profitable.
The company lost a patent infringement suit and declared bankruptcy
in May of this year.
Martha is notified by the bankruptcy trustee that she can expect to
receive nothing from the company.

The Big Picture (slide 2 of 3)

Martha has owned and operated a bookstore as a sole
proprietorship for the past 10 years.
The bookstore previously has produced annual profits of
about $75,000.
Due to a chain bookstore opening down the street, Marthas
bookstore sustained a net loss of $180,000 this year.

In September, a hurricane caused a large oak tree to

blow over onto Marthas house.
The cost of removing the tree and making repairs was
$32,000.
Martha received a check for $25,000 from her insurance
company in final settlement of the claim.
Her adjusted basis for the house was $280,000.
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The Big Picture (slide 3 of 3)

Finally, Martha purchased what she believes to be
1244 stock.
Unfortunately, the stocks value began to decline
significantly soon after its purchase.

Can you help to relieve Marthas feeling of

hopelessness by making her aware of beneficial loss
provisions in the tax law?
Read the chapter and formulate your response.

Bad Debts
If an account receivable arising from credit
sale of goods or services becomes worthless
A bad debt deduction is permitted only if income
arising from creation of the receivable was
previously included in income
No deduction is allowed if taxpayer is on the cash
basis since no income is reported until the cash has
been collected

The Big Picture - Example 2

Bad Debts - Cash Basis Taxpayer
Return to the facts of The Big Picture on p. 7-1.

Martha is a cash basis taxpayer

She cannot take a bad debt deduction for unpaid
accrued interest on the loan to her friend because it
was never recognized as income.

Business Bad Debts

(slide 1 of 4)

Specific charge-off method must be used

Exception: Reserve method is allowed for some
financial institutions

Deduct as ordinary loss in the year when debt

is partially or wholly worthless

Business Bad Debts

(slide 2 of 4)

If a business bad debt previously deducted as

partially worthless becomes totally worthless
in a future year
Only the remainder not previously deducted can be
deducted in the future year

Business Bad Debts

(slide 3 of 4)

In the case of total worthlessness, deduction is

allowed for entire amount in the year the debt
becomes worthless
Deductible amount depends on basis in bad debt
If debt arose from sale of services or products and the face
amount was previously included in income
That amount is deductible

If the taxpayer purchased the debt

Deduction is equal to amount paid for debt instrument

Business Bad Debts

(slide 4 of 4)

If a receivable has been written off

The collection of the receivable in a later tax year
may result in income being recognized
Income will result if the deduction yielded a tax
benefit in the year it was taken

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Nonbusiness Bad Debts

(slide 1 of 2)

Nonbusiness bad debt

Debt unrelated to the taxpayers trade or business

Deduct as short-term capital loss in year

amount of worthlessness is known with
certainty
No deduction is allowed for partial worthlessness
of a nonbusiness bad debt

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Nonbusiness Bad Debts

(slide 2 of 2)

Related party (individuals) bad debts are

generally suspect and may be treated as gifts
Regulations state that a bona fide debt arises from
a debtor-creditor relationship based on a valid and
enforceable obligation to pay a fixed or
determinable sum of money
Thus, individual circumstances must be examined
to determine whether advances between related
parties are gifts or loans
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Classification of Bad Debts

Individuals will generally have nonbusiness
bad debts unless:
In the business of loaning money, or
Bad debt is associated with the individuals trade
or business

Determination is made either at the time the

debt was created or when it became worthless

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The Big Picture - Example 5

Nonbusiness Bad Debts

Return to the facts of The Big Picture on p. 7-1.

Martha loaned her friend, Jamil, $25,000.

Jamil used the money to start a business, which
subsequently failed.
When Jamil died after having made payments of
$7,000 on the loan, he was insolvent.

Even though the proceeds of the loan were

used in a business, the loan is a nonbusiness
bad debt
The business was Jamils, not Marthas.
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Worthless Securities
Loss on worthless securities is deductible in
the year they become completely worthless
These losses are capital losses deemed to have
occurred on the last day of the year in which the
securities became worthless
Capital losses may be of limited benefit due to the
$3,000 capital loss limitation

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The Big Picture - Example 8

Worthless Securities
Return to the facts of The Big Picture on p. 7-1.

Martha, a calendar year taxpayer, owned stock

in Owl Corporation (a publicly held company).
She acquired the stock on October 1, 2013
Cost was $50,000.

On May 31, 2014, the stock became worthless as

the company declared bankruptcy.

The stock is deemed to have become worthless

as of December 31, 2014
Martha has a long-term capital loss
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Bad Debt Deductions Summary

Concept Summary 7.2

17

Section 1244 Stock

(slide 1 of 3)

Sale or worthlessness of 1244 stock results

in ordinary loss rather than capital loss for
individuals
Ordinary loss treatment (per year) is limited to
$50,000 ($100,000 for MFJ taxpayers)
Loss in excess of per year limit is treated as capital loss

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Section 1244 Stock

(slide 2 of 3)

Section 1244 loss treatment is limited to stock

owned by original purchaser who acquired the
stock from the corporation
Corporation must meet certain requirements
for stock to qualify
Major requirement is limit of $1 million of capital
contributions

Section 1244 does not apply to gains

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Section 1244 Stock

(slide 3 of 3)

Example of 1244 loss

In 2009, Sam purchases from XYZ Corp. stock
costing $150,000. (Total XYZ stock outstanding is
$800,000.) In 2014, Sam sells the stock for
$65,000.
Sam, a single taxpayer, has the following tax
consequences:
$50,000 ordinary loss
$35,000 long-term capital loss

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The Big Picture - Example 10

Section 1244 Stock

Return to the facts of The Big Picture on p. 7-1.

On March 8, 2014, Martha purchases what she

believes is 1244 stock from her friend Janice for
$20,000.
On November 2, 2014, she sells the stock in the
marketplace for $12,000.

Because Martha purchases the stock from Janice and

not the corporation, the stock is not 1244 stock to
Martha.
Hence, Martha has an $8,000 short-term capital loss.
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Losses of Individuals
Only the following losses are deductible by
individuals:
Losses incurred in a trade or business,
Losses incurred in a transaction entered into for
profit,
Losses caused by fire, storm, shipwreck, or other
casualty or by theft

22

Definition of Casualty
& Theft (C & T)
Losses or damages to the taxpayers property
that arise from fire, storm, shipwreck, or other
casualty or theft
Loss is from event that is identifiable, damaging to
taxpayers property, and sudden, unexpected, and
unusual in nature
Events not treated as casualties include losses from
disease and insect damage

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Definition of Theft
Theft includes robbery, burglary,
embezzlement, etc.
Does not include misplaced items

24

When Casualty & Theft Is Deductible

Casualties: year in which loss is sustained
Exception: If declared disaster area by President,
can elect to deduct loss in year prior to year of
occurrence

Thefts: year in which loss is discovered

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Effect of Claim for Reimbursement

If reasonable prospect of full recovery:
No casualty loss is permitted
Deduct in year of settlement any amount not
reimbursed

If only partial recovery is expected, deduct in

year of loss any amount not covered
Remainder is deducted in year claim is settled

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The Big Picture - Example 15

Disaster Area Losses

Return to the facts of The Big Picture on p. 7-1.

On September 28, 2014, Marthas personal residence was

damaged when a hurricane caused an oak tree to fall onto the
house.
The amount of her uninsured loss was $7,000.
Because of the extent of the damage in the area, the President of the
United States designated the area a disaster area.

Because Marthas loss is a disaster area loss, Martha has 2

options.
She may elect to file an amended return for 2013 and take the loss in
that year.
The amount of the loss will be reduced first by $100 and then by 10% of
her 2013 AGI.

Alternatively, she may take the loss on her 2014 income tax return.
The amount of the loss will be reduced first by $100 and then by 10% of
her 2014 AGI.
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Amount of C&T Deduction

Amount of loss and its deductibility depends
on whether:
Loss is from nonpersonal (business or production
of income) or personal property
Loss is partial or complete

28

Amount of Nonpersonal
C&T Losses
Theft or complete casualty (FMV after = 0)
Adjusted basis in property less insurance proceeds

Partial casualty
Lesser of decline in value or adjusted basis in
property, less insurance proceeds

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C&T Examples
Business and production of income losses
(no insurance proceeds received)
Adjusted
Item Basis
A
6,000
B
6,000
C
6,000

FMV
Before
8,000
8,000
4,000

FMV
After
5,000
1,000
0

Loss
3,000
6,000
6,000

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Nonpersonal C&T Losses

Losses on business, rental, and royalty properties
Deduction will be for AGI
Not subject to the $100 per event and the 10% of AGI
limitation

Losses not connected with business, rental, and

royalty properties
Deduction will be from AGI
Example - theft of a security
Theft losses of investment property are not subject to the 2% of
AGI floor on certain miscellaneous itemized deductions

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Nonpersonal C&T Gains

Depending on the property, gain can be
ordinary or capital
Amount of nonpersonal gains
Insurance proceeds less adjusted basis in property

32

Personal C&T Gains and Losses

(slide 1 of 4)

Casualty and theft losses attributable to personal use

property are subject to the $100 per event and the
10% of AGI limitations
These losses are itemized deductions, but they are not
subject to the 2% of AGI floor

Amount of personal C&T losses

Lesser of decline in value or adjusted basis in property, less
insurance proceeds

Insurance proceeds may result in gain recognition on

certain casualty and thefts
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Personal C&T Gains and Losses

(slide 2 of 4)

If a taxpayer has both personal casualty and theft

gains as well as losses, a special set of rules applies
A personal casualty gain is the recognized gain from a
casualty or theft of personal use property
A personal casualty loss for this purpose is a casualty or
theft loss of personal use property after the application of
the $100 floor

Taxpayer must first net (offset) the personal casualty

gains and personal casualty losses
Tax treatment depends on the results of this netting process
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Personal C&T Gains and Losses

(slide 3 of 4)

If netting personal casualty gains and losses

results in a net gain
Treat as gains and losses from the sale of capital
assets
Short term or long term, depending on holding period

Personal casualty and theft gains and losses

are not netted with the gains and losses on
business and income-producing property
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Personal C&T Gains and Losses

(slide 4 of 4)

If netting personal casualty gains and losses

results in a net loss
All gains and losses are treated as ordinary items
The gainsand the losses to the extent of gainsare
treated as ordinary income and ordinary loss in
computing AGI
Losses in excess of gains are deducted as itemized
deductions to the extent the losses exceed 10% of AGI

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Example of C&T Limitation

(slide 1 of 2)

Karen (AGI = $40,000) has the following

C&T in 2014 (amounts are lesser of decline in
value or adjusted basis):
1. Car stolen ($6,000) with camera inside ($500)
2. Earthquake damage: house ($2,000), furniture ($1,000)

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Example of C&T Limitation

(slide 2 of 2)

Example of C&T limitation (contd)

Karen has no insurance coverage for either
loss:
1. $6,000 + $500 = $6,500 $100 = $6,400
2. $2,000 + $1,000 = $3,000 $100 = $2,900

Karens deductible C&T loss is $5,300

[$6,400 + $2,900 (10% $40,000)]

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Research and Experimental

Expenditures (slide 1 of 2)
Definition of research and experimental (R&E)
expenditures
Costs for the development of an experimental
model, plant process, product, formula, invention,
or similar property and improvement of such
existing property

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Research and Experimental

Expenditures (slide 2 of 2)
Three alternatives are available for R&E
expenditures
Expense in year paid or incurred,
Defer and amortize over period of 60 months or
more, or
Capitalize (deductible when project abandoned or
worthless)

Tax credit of 20% of certain R&E expenditures

is available
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Domestic Production Activities

Deduction (slide 1 of 4)
The American Jobs Creation Act of 2004
created a new deduction based on the income
from manufacturing activities
The Domestic Production Activities deduction is
based on the following formula:
9% Lesser of
Qualified production activities income
Taxable (or modified adjusted gross) income or AMTI

The deduction cannot exceed 50% of an employers

W2 wages paid to employees engaged in qualified
production activities
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Domestic Production Activities

Deduction (slide 2 of 4)
Qualified production activities income is the
excess of domestic production gross receipts
over the sum of:
Cost of goods sold attributable to such receipts
Other deductions, expenses, or losses that are
directly allocable to such receipts
A share of other deductions, expenses, and losses
that are not directly allocable to such receipts or
another class of income
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Domestic Production Activities

Deduction (slide 3 of 4)
Domestic production gross receipts include the following five
specific categories:
The lease, license, sale, exchange, or other disposition of qualified
production property manufactured, produced, grown, or extracted in
the U.S.
Qualified films largely created in the U.S.
The production of electricity, natural gas, or potable water
Construction (but not self-construction) performed in the U.S.
Engineering and architectural services for domestic construction

Items specifically excluded from this definition include:

The sale of food and beverages prepared by a taxpayer at a retail
establishment and
The transmission or distribution of electricity, natural gas, or potable
water

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Domestic Production Activities

Deduction (slide 4 of 4)
Eligible taxpayers include:
Individuals, partnerships, S corporations, C
corporations, cooperatives, estates, and trusts
For a pass-through entity (e.g., partnerships, S
corporations), the deduction flows through to the
individual owners
For sole proprietors, a deduction for AGI results and is
claimed on Form 1040, line 35 on page 1

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Net Operating Losses

(slide 1 of 7)

NOLs from any one year can be offset against

taxable income of other years
The NOL provision is intended as a form of relief
for business income and losses
Only losses from trade or business operations,
casualty and theft losses, or losses from foreign
government confiscations can create a NOL

45

Net Operating Losses

(slide 2 of 7)

No nonbusiness (personal) losses or

deductions may be used in computing NOL
Exception: personal casualty and theft losses

46

Net Operating Losses

(slide 3 of 7)

Carryover period
Must carryback to 2 prior years, then carryforward to 20
future years
May make an irrevocable election to just carryforward
When there are NOLs from two or more years, use on a FIFO basis

3 year carryback is available for:

Individuals with NOL from casualty or thefts
Small businesses with NOLs from Presidentially declared disasters

5-year carryback period and a 20-year carryover period are

allowed for a farming loss

47

Net Operating Losses

(slide 4 of 7)

Example of NOL carryovers

Ken has a NOL for 2014
Ken must carryover his NOL in the following
order:
Carryback to 2012 then 2013, then carryforward to
2015, 2016, ..., 2034

Ken can elect to just carryforward his NOL

Carryover would be to 2015, 2016, ..., 2034

48

Net Operating Losses

(slide 5 of 7)

Computing NOL amount

Individual must start with taxable income and add
back:
1.
2.
3.
4.
5.

Personal and dependency exemptions

NOLs from other years
Excess nonbusiness capital losses
Excess nonbusiness deductions
Excess business capital losses

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Net Operating Losses

(slide 6 of 7)

Effect of NOL in carryback year

Taxpayer must recompute taxable income and the
income tax
All limitations and deductions based on AGI must
be recomputed
Exception - charitable contribution deduction
Determined without regard to any NOL carryback but with
regard to any other modification affecting AGI

All credits limited by or based on the tax liability

must be recomputed
50

Net Operating Losses

(slide 7 of 7)

Calculating remaining NOL after carryovers

After using the NOL in the initial carryover year,
the taxpayer must determine how much NOL
remains to carry to other years

51

Refocus On The Big Picture (slide 1 of 2)

Martha can receive tax benefits associated with her
unfortunate occurrences during the current tax year.
Bad Debt
It appears that Marthas loan to her friend was a bona fide debt.
The amount of the deduction is the unpaid principal balance of $19,000
($25,000 - $6,000).
Since the bad debt is a nonbusiness bad debt, it is classified as a short-term
capital loss.

Loss from Investment

The $50,000 loss is deductible as a long-term capital loss.
Although the actual holding period was not greater than one year
(October through May), the disposal date for the stock (a worthless
security) is deemed to be the last day of the tax year.
The loss does not appear to qualify for ordinary loss treatment under 1244.
52

Refocus On The Big Picture (slide 2 of 2)

Loss from Bookstore

The $180,000 loss from the bookstore is reported on Schedule C of Form 1040.
It is an ordinary loss, and it qualifies for NOL treatment.
Martha can carry the $180,000 net loss back and offset it against the net income of
the bookstore for the past two years.
Any amount not offset (probably about $30,000) can be carried forward for the next 20
years.
The carryback will produce a claim for a tax refund.

Casualty Loss
The loss on the damage to Marthas personal residence is a personal casualty
loss.
Using the cost of repairs method, the amount of the casualty loss is $7,000 ($32,000
- $25,000).
This amount must be reduced by $100 and 10% of AGI.

If Marthas house is located in an area declared a disaster area by the President,

Martha has the option of deducting the casualty loss on the prior years tax
return.

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If you have any comments or suggestions concerning this

PowerPoint Presentation for South-Western Federal
Taxation, please contact:
Dr. Donald R. Trippeer, CPA
trippedr@oneonta.edu
SUNY Oneonta

2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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