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Deductions

  • 731. What itemized deductions may be taken by an individual taxpayer?

    • Editor’s Note: The 2017 Tax Act suspended many itemized deductions for tax years beginning after 2017.  Among those suspended were deductions for: casualty and theft losses (exceptions exist for losses occurring in a federally declared disaster area), moving expenses (with an exception for members of the armed forces), expenses related to tax preparation, and expenses relating to the trade or business of being an employee (i.e., all miscellaneous itemized deductions subject to the 2 percent of AGI floor, which were suspended for 2018-2025).  The deduction for state and local taxes was capped at $10,000 (see below) and the mortgage interest deduction was limited to $750,000 (see Q 738).  This suspension and limitations will apply for tax years beginning after December 31, 2017 and before December 31, 2025.

      Itemized deductions are subtracted from adjusted gross income in arriving at taxable income; they may be claimed in addition to deductions for adjusted gross income (see Q 715). Itemized deductions are also referred to as “below-the-line” deductions.

      Among the itemized deductions taxpayers may be able to claim are the following:

      …Interest, within limits (see Q 734 to Q 738; Q 8027 to Q 8046).

      …Prior to 2018, personal expenses for the production or collection of taxable income, within limits (see Q 8049), or in conjunction with the determination, collection or refund of any tax (but some of these expenses may be considered “miscellaneous itemized deductions” (see Q 8050)). Deduction of expenses paid in connection with tax-exempt income may be disallowed (see Q 8050). Certain business expenses and expenses for the production of rents and royalties are deductible in arriving at adjusted gross income (see Q 715).

      …Prior to 2018 (see below for a discussion of the SALT cap), personal taxes of the following types: state, local and foreign real property taxes; state and local personal property taxes; state, local and foreign income, war profits, and excess profits taxes; and the generation-skipping tax imposed on income distributions (for the sales tax deduction, see below). If taxes other than these are incurred in connection with the acquisition or disposition of property, they must be treated as part of the cost of such property or as a reduction in the amount realized on the disposition.1

      …Prior to 2018, uncompensated personal casualty and theft losses. But these are deductible only to the extent that the aggregate amount of uncompensated losses in excess of $100 (for each casualty or theft) exceeds 10 percent of adjusted gross income. The $100 amount increased to $500 for 2009 only.2 The taxpayer must file a timely insurance claim for damage to property that is not business or investment property or else the deduction is disallowed to the extent that insurance would have provided compensation.3 Uncompensated casualty and theft losses in connection with a taxpayer’s business or in connection with the production of income are deductible in full (see Q 7834). The 2017 Tax Act generally eliminated a taxpayer’s ability to deduct casualty and theft loss expenses as itemized deductions (when those losses were not related to property used in a trade or business).  However, an exception exists for losses that occur in federally declared disaster areas.4

      Stock losses. Prior to 2018, the IRS announced that it intended to disallow deductions under IRC Section 165(a) for theft losses relating to declines in value of publicly traded stock when the decline is attributable to corporate misconduct. If the stock is sold or exchanged or becomes wholly worthless, any resulting loss will be treated as a capital loss. Furthermore, the Service may also impose penalties under IRC Section 6662 in such cases.5 In Field Attorney Advice, the Service concluded that a taxpayer was not entitled to a theft loss deduction for losses related to his exercise of stock options because he had not proven the elements of a theft loss.6

      Abandoned securities. The Service has issued regulations concerning the availability and character of a loss deduction under IRC Section 165 for losses sustained from abandoned securities. IRC Section 165(g) provides that if any security that is a capital asset becomes worthless during the taxable year, the resulting loss is treated as a loss from the sale or exchange of a capital asset (i.e., a capital loss) on the last day of the taxable year (unless the exception in IRC Section 165(g)(3)—concerning worthless securities of certain affiliated corporations—applies). For purposes of applying the loss characterization rule of IRC Section 165(g), the abandonment of a security establishes its worthlessness. According to the regulations, to abandon a security, a taxpayer must permanently surrender and relinquish all rights in the security and receive no consideration in exchange for the security. All the facts and circumstances determine whether the transaction is properly characterized as abandonment or some other type of transaction (e.g., an actual sale or exchange, contribution to capital, dividend, or gift). The regulations are effective for stock or other securities abandoned after March 12, 20087 (this deduction was not addressed in the 2017 Tax Act).

      …Contributions to charitable organizations, within certain limitations (see Q 8056, Q 8111) (this deduction survived the 2017 Tax Act with minimal changes).

      …Unreimbursed medical and dental expenses and expenses for the purchase of prescribed drugs or insulin incurred by the taxpayer for himself and his spouse and dependents, to the extent that such expenses exceed 7.5 percent of adjusted gross income (tax years beginning before 2013, and for 2017 and thereafter.  The amount was temporarily raised to 10 percent for other tax years) (see Q 745). A temporary exception kept the threshold at 7.5 percent of AGI for individuals age 65 and older and their spouses for 2013-2016.

      …Prior to 2018, expenses of an employee connected with his employment. Generally, such expenses are “miscellaneous itemized deductions” (see Q 733).

      …Federal estate taxes and generation-skipping transfer taxes paid on “income in respect of a decedent” (see Q 747) (this deduction was not addressed in the 2017 Tax Act).

      Generally, prior to 2018, certain moving expenses permitted under IRC Section 217 were deductible directly from gross income (see Q 715). This deduction was suspended from 2018 through 2025.

      Many of these deductions are disallowed in calculating the alternative minimum tax (see Q 777).

      In Chief Counsel Advice, the Service determined that deductions for expenses paid or incurred in connection with the administration of an individual’s estate in bankruptcy, which would have not been incurred if the property were not held by the bankrupt estate, are treated as allowable in arriving at adjusted gross income.8

      Sales tax deduction. Under AJCA 2004, taxpayers could elect to deduct state and local general sales taxes instead of state and local income taxes when they itemized deductions.9 This option was made “permanent” by the Protecting Americans from Tax Hikes Act of 2015 (PATH), but was limited to $10,000 by the SALT cap imposed under the 2017 Tax Act (see below).

      The itemized deduction is based on actual sales taxes, or on the optional sales tax tables published by the IRS.10 In general, a taxpayer may deduct actual state and local general sales taxes paid if the tax rate is the same as the general sales tax rate. If the tax rate is more than the general sales tax rate, sales taxes on motor vehicles are deductible as general sales taxes, but the tax is deductible only up to the amount of tax that would have been imposed at the general sales tax rate. Sales taxes on food, clothing, medical supplies, and motor vehicles are deductible as a general sales tax even if the tax rate was less than the general sales tax rate.11 The Service reminds taxpayers that actual receipts showing general sales taxes paid must be kept to use the actual expense method.12

      Using the optional state sales tax tables, taxpayers may use their income level and number of exemptions to find the sales tax amount for their state.13 Taxpayers may add an amount for local sales taxes if appropriate. In addition, taxpayers may add to the table amount any sales taxes paid on: (1) a motor vehicle, but only up to the amount of tax paid at the general sales tax rate; and (2) an aircraft, boat, home, or home building materials if the tax rate is the same as the general sales tax rate.14

      The Service has commented that although the sales tax deduction mainly benefits taxpayers with a state or local sales tax but no income tax (i.e., Alaska, Florida, South Dakota, Texas, Washington, and Wyoming), it may also give a larger deduction to any taxpayer who paid more in sales taxes than income taxes. For example, an individual might have bought a new car, thus boosting the sales tax total, or claimed tax credits, and lowering the state income tax paid.15 Additional guidance on claiming the sales tax deduction is set forth in Notice 2005-31.16

      Tax Reform Impact on Deduction for State, Local and Foreign Taxes

      The 2017 Tax Act limited the ability of taxpayers to deduct state and local taxes (including sales, income and property taxes), imposing a SALT cap of $10,000 ($5,000 for married taxpayers filing separate returns) on this deduction.  Foreign real property taxes can no longer be deducted.17  The cap encompasses all state and local taxes, so taxpayers are required to aggregate their relevant state and local taxes in reaching the $10,000 limit.

       


      1. IRC Sec. 164(a).

      2. IRC Sec. 165(h), as amended by TEAMTRA 2008.

      3. IRC Sec. 165(h)(5)(E), as amended by TEAMTRA 2008.

      4. IRC Sec. 165(h)(5).

      5. Notice 2004-27, 2004-1 CB 782; Treasury Release JS-1263 (3-25-2004).

      6. FAA 20073801F (8-1-2007).

      7. Treas. Reg. §1.165-5(i).

      8. CCA 200630016.

      9. IRC Sec. 164(b)(5)(A).

      10. See IRC Sec. 164(b)(5)(H).

      11See IRC Secs. 164(b)(5)(C), 164(b)(5)(D), 164(b)(5)(F). See also Pub. 600, State and Local General Sales Taxes (2006); FS-2006-9 (Jan. 2006).

      12. Pub. 600.

      13. See Publication 600, State and Local General Sales Taxes, pp. 2 – 4 (2006).

      14. See Pub. 600, State and Local General Sales Taxes (2006); see also FS-2006-9 (Jan. 2006).

      15. FS-2006-9 (Jan. 2006).

      16. 2005-14 IRB 830.

      17. IRC Sec. 164(6).

  • 732. What is the limitation on certain high income taxpayers’ itemized deductions?

    • Editor’s Note: The limitation on itemized deductions that applied to certain high-income taxpayers was also suspended for tax years beginning after December 31, 2017 and before January 1, 2026.1

      There was no phaseout of itemized deductions based on adjusted gross income (AGI) in 2010-2012. Under the American Taxpayer Relief Act of 2012 (“ATRA”), the phaseout resumed for tax years beginning in 2013-2017, and was once again suspended for 2018-2025 and thereafter.

      Therefore, in 2017, the aggregate of most itemized deductions was reduced dollar-for-dollar by the lesser of (1) 3 percent (but see Adjustments to Limit, below, for tax years beginning before 2010) of the amount of adjusted gross income that exceeds a certain income-based threshold amount , or (2) 80 percent of the amount of such itemized deductions otherwise allowable for the taxable year.2  In 2017, the thresholds were $261,500 for individual taxpayers, $313,800 for married taxpayers filing jointly, $287,650 for heads of households and $156,900 for married taxpayers filing separately.3 In 2016, the thresholds were $259,400 for individual taxpayers, $311,300 for married taxpayers filing jointly, $285,350 for heads of households and $155,650 for married taxpayers filing separately.4 In 2015, the thresholds were $258,250 for individual taxpayers, $309,900 in the case of a married taxpayer filing jointly, $285,050 for heads of household, and $154,950 for married taxpayers filing separately) 5 The threshold income levels for determining the phaseout are adjusted annually for inflation.6

      Adjustments to limit for 2005-2009 tax years. For taxable years beginning after 2005, the limitation on itemized deductions was gradually reduced until it was completely repealed in 2010. The amended limitation amount was calculated by multiplying the otherwise applicable limitation amount by the “applicable fraction.” The “applicable fraction” for each year was as follows: 66.6 percent (2/3) in 2006 and 2007; 33.3 percent (1/3) in 2008 and 2009; and 0 percent in 2010-2012.7

      The limitation on itemized deductions is not applicable to medical expenses deductible under IRC Section 213, investment interest deductible under IRC Section 163(d), or certain casualty loss deductions.8 The limitation also is not applicable to estates and trusts.9 For purposes of certain other calculations, such as the limits on deduction of charitable contributions or the 2 percent floor on miscellaneous itemized deductions, the limitations on each separate category of deductions are applied before the overall ceiling on itemized deductions is applied.10 The deduction limitation is not taken into account in the calculation of the alternative minimum tax.11


      1. IRC Sec. 68(f).

      2.IRC Sec. 68(b); as amended by ATRA, Sec. 101(2)(b); Rev. Proc. 2008-66, 2008-45 IRB 1107.

      3. Rev. Proc. 2016-55.

      4. Rev. Proc. 2015-53.

      5. IRC Sec. 68(a).

      6. IRC Sec. 68(f) (deleted by ATRA, Sec. 101(2)(b)).

      7. IRC Sec. 68(c).

      8. IRC Sec. 68(e).

      9. IRC Sec. 68(d).

      10. IRC Sec. 56(b)(1)(F).

  • 733. What are miscellaneous itemized deductions? What limits apply?

    • Editor’s Note: The 2017 Tax Act suspended all miscellaneous itemized deductions subject ot the 2 percent floor for tax years beginning after December 31, 2017 and before December 31, 2025.

      “Miscellaneous itemized deductions” are deductions from adjusted gross income (“itemized deductions”) other than the deductions for (1) interest, (2) taxes, (3) non-business casualty losses and gambling losses, (4) charitable contributions, (5) medical and dental expenses, (6) impairment-related work expenses for handicapped employees, (7) estate taxes on income in respect of a decedent, (8) certain short sale expenses (see Q 7529, Q 7530), (9) certain adjustments under the IRC claim of right provisions, (10) unrecovered investment in an annuity contract, (11) amortizable bond premium (see Q 7654, Q 7664), and (12) certain expenses of cooperative housing corporations.1

      “Miscellaneous itemized deductions” were allowed only to the extent that the aggregate of all such deductions for the taxable year exceeded 2 percent of adjusted gross income.2 For tax years other than 2010 through 2012 (and 2018-2025 under the 2017 Tax Act), miscellaneous itemized deductions were also subject to the phaseout for certain upper income taxpayers (see Q 723).

      Miscellaneous itemized deductions generally include unreimbursed employee business expenses, such as professional society dues or job hunting expenses, and expenses for the production of income, such as investment advisory fees or the cost for storage of taxable securities in a safe deposit box.3

      Expenses that relate to both a trade or business activity and a production of income or tax preparation activity (see Q 8049, Q 8051) must be allocated between the activities on a reasonable basis.4

      Certain legal expenses from employment-related litigation may be deductible.5 In Biehl v. Comm.,6 the Ninth Circuit Court of Appeals affirmed the Tax Court’s holding that attorneys’ fees paid in connection with employment related litigation must be treated as a miscellaneous itemized deduction, and not as an above-the-line deduction. The Ninth Circuit stated that simply because a lawsuit arises out of the taxpayer’s former employment, that determination is not sufficient to qualify the taxpayer’s attorneys’ fees for an above-the-line deduction under IRC Section 62(a)(2)(A). Concurring in the Tax Court’s analysis, the Ninth Circuit reiterated that the proper inquiry in deciding whether an expense has a “business connection” is what the expenditure was “in connection with” and not simply whether the expenditure arose from, or had its origins in, the taxpayer’s trade or business. According to the appeals court, whereas IRC Section 62(a)(1) only requires that the expense be attributable to a trade or business, the language in IRC Section 62(a)(2)(A) is much more definite. The court concluded that for a reimbursable expense to qualify for an above-the-line deduction not only must it be attributable to a trade or business, it must also have been incurred during the course of “performance of services as an employee.”7

      The IRC prohibits the indirect deduction, through pass-through entities, of amounts (i.e., miscellaneous itemized deductions) that would not be directly deductible by individuals.8 However, publicly offered mutual funds are not subject to this rule, and “pass-through entity,” for this purpose, does not include estates, trusts (except for grantor trusts and certain common trust funds), cooperatives, or real estate investment trusts (REITs).9 Affected pass-through entities (including partnerships, S corporations, nonpublicly offered mutual funds, and REMICs) must generally allocate to each investor his respective share of such expenses; the investor must then take the items into account for purposes of determining his taxable income and deductible expenses, if any.10 See Q 7694, Q 7938, Q 7955, , and Q 7776 regarding REMICs, mutual funds, exchange-traded funds, publicly traded limited partnerships, and S corporations, respectively.


      1 .IRC Sec. 67(b).

      2 .IRC Sec. 67(a).

      3 .Temp. Treas. Reg. §1.67-1T(a)(1).

      4 .Temp. Treas. Reg. §1.67-1T(c).

      5 .See, e.g., Kenseth v. Comm., 259 F.3d 881( 7th Circuit 2001); Brenner v. Comm., TC Memo 2001-127; Reynolds v. Comm., 296 F.3d 607 (7th Cir. 2002); Chaplain v. Comm., TC Memo 2007-58.

      6 .351 F. 3d 982 (9th Cir. 2003).

      7 .Biehl, above, aff’g, 118 TC 467 (2002).

      8 .IRC Sec. 67(c)(1); Temp. Treas. Reg. §1.67-2T.

      9 .IRC Sec. 67(c); Temp. Treas. Reg. §1.67-2T(g)(2).

      10 .Temp. Treas. Reg. §1.67-2T(a).

  • 734. Is interest deductible?

    • Editor’s Note: The 2017 Tax Act limited the mortgage interest deduction to $750,000, so that from 2018-2025, only interest on up to $750,000 of new mortgage debt may be deducted.  This limit applies to debt incurred after December 31, 2017 and before January 1, 2026.1  After December 31, 2025, absent Congressional action to extend the current rules, the $1 million mortgage interest deduction will be reinstated and will apply regardless of when the taxpayer incurred the relevant debt (see Q 740).2  Modifications to the deductibility of business interest are discussed in Q 737Q 739.

      Editor’s Note: Late in 2015, Congress acted to extend the treatment of certain mortgage insurance premiums as qualified residence interest, as discussed below, through 2016.  This treatment was extended through 2017 by the Bipartisan Budget Act of 2018, again through 2020 by the SECURE Act and through 2021 by CAA 2021.

      The deductibility of interest depends on its classification, as described below. Furthermore, interest expense that is deductible under the rules below may be subject to the additional limitation on itemized deductions (unless it is investment interest, which is not subject to that provision). Interest must be classified and is deductible within the following limitations:

      (1) Investment interest. This includes any interest expense on indebtedness properly allocable to property held for investment.3 Generally, investment interest is deductible only to the extent of investment income; however, investment interest in excess of investment income may be carried over to succeeding tax years. For purposes of this calculation, net long-term capital gain income is included in investment income if the taxpayer foregoes the reduced tax rate (0 percent/15 percent/20 percent) that applies to such income. Under JGTRRA 2003, as extended by ATRA, certain dividends are taxable at the lower capital gains rates rather than at higher ordinary income tax rates. A dividend will be treated as investment income for purposes of determining the amount of deductible investment interest income only if the taxpayer elects to treat the dividend as not being eligible for the reduced rates.4 For the temporary regulations relating to an election that may be made by noncorporate taxpayers to treat qualified dividend income as investment income for purposes of calculating the deduction for investment interest, see Treasury Regulation Section 1.163(d)-1.5 Note that the 2017 tax reform legislation placed limitations on the deductibility of business interest, which specifically excludes investment interest.

      (2) Trade or business interest. This includes any interest incurred in the conduct of a trade or business. Generally, such interest was deductible as a business expense prior to 2018.  See Q 737 for a discussion of the treatment of corporate business interest under the 2017 Tax Act.  Q 738 and Q 737 outline the new rules as they apply to pass-through entities.6

      (3) Qualified residence (mortgage) interest. Qualified residence interest is interest paid or accrued during the taxable year on debt that is secured by the taxpayer’s qualified residence and that is either (a) “acquisition indebtedness” (that is, debt incurred to acquire, construct or substantially improve the qualified residence, or any refinancing of such debt), or (b) “home equity indebtedness” (any other indebtedness secured by the qualified residence). There is a limitation of $1,000,000 ($750,000 for 2018-2025) on the aggregate amount of debt that may be treated as acquisition indebtedness, but the amount of refinanced debt that may be treated as acquisition indebtedness is limited to the amount of debt being refinanced. Prior to 2018, a deduction was generally allowed for home equity indebtedness. The aggregate amount that may be treated as “home equity indebtedness” (that is, borrowing against the fair market value of the home less the acquisition indebtedness, or refinancing to borrow against the “equity” in the home) was $100,000.7 Indebtedness incurred on or before October 13, 1987 (and limited refinancing of it) that is secured by a qualified residence is considered acquisition indebtedness. This pre-October 14, 1987 indebtedness is not subject to the $750,000 (2018-2025) aggregate limit, but is included in the aggregate limit as it applies to indebtedness incurred after October 13, 1987.8 (For 2007 through 2021, certain mortgage insurance premiums are treated as qualified residence interest.)9


      Planning Point: Although interest on home equity indebtedness is technically no longer deductible under the terms of the 2017 Tax Act, the IRS has released guidance on situations where this interest may continue to be deducted.  Pursuant to the guidance, interest on home equity loans that are used to buy, build or substantially improve the taxpayer’s home continue to be deductible to the extent that they (when combined with other relevant loans) do not exceed the $750,000 limit.  However, home equity loan interest is not deductible to the extent that the loan proceeds are used for expenditures not related to buying, building or substantially improving a home (i.e., if the proceeds are used for personal living expenses or to purchase a new car, the related interest is not deductible).  The home equity loan must be secured by the home in order for the interest to be deductible in any case.


      A “qualified residence” is the taxpayer’s principal residence and one other residence that the taxpayer (a) used during the year for personal purposes more than 14 days or, if greater, more than 10 percent of the number of days it was rented at a fair rental value, or (b) used as a residence but did not rent during the year.10

      Subject to the above limitations, qualified residence interest is deductible. If indebtedness used to purchase a residence is secured by property other than the residence, the interest incurred on it is not residential interest but is personal interest.11 The Tax Court denied a deduction for mortgage interest to individuals renting a home under a lease with an option to purchase the property. Although the house was their principal residence, they did not have legal or equitable title to the home and the earnest money did not provide ownership status.12 An individual member of a homeowner’s association was denied a deduction for interest paid by the association on a common building because the member was not the party primarily responsible for repaying the loan and the member’s principal residence was not the specific security for the loan.13 Assuming that the loan was otherwise a bona fide debt, a taxpayer could deduct interest paid on a mortgage loan from his qualified plan, even though the amount by which the loan exceeded the $50,000 limit of IRC Section 72(p) was deemed to be a taxable distribution.14 See Q 740 for a more detailed discussion of how the mortgage interest deduction was changed by the 2017 tax reform legislation.

      (4) Interest taken into account in computing income or loss from a passive activity. A passive activity is generally an activity that involves the conduct of a trade or business but in which the taxpayer does not materially participate, or any rental activity.15

      (5) Interest on extended payments of estate tax. Generally, this interest is deductible.

      (6) Interest on education loans. An above-the-line deduction is available to certain taxpayers for interest paid on a “qualified education loan.”16 The deduction is subject to a limitation of $2,500 in 2015-2022. The deduction is phased out for 2015-2018, ratably for taxpayers with modified AGI between $65,000 and $80,000 ($135,000 and $165,000 (joint returns) in 2017-2018). In 2019-2021, the phaseout range is $70,000 and $85,000 for single filers and $140,000 and $170,000 for joint returns. In 2022, the phaseout range is $70,000 and $85,000 for single filers and $145,000 and $175,000 for joint returns.17 Certain other requirements must be met for the deduction to be available.18 

      (7) Personal interest. This is any interest expense not described in (1) through (6) above and is often referred to as “consumer” interest.19 Personal interest includes interest on indebtedness properly allocable to the purchase of consumer items and interest on tax deficiencies. Personal interest is not deductible.20

      The proper allocation of interest generally depends on the use to which the loan proceeds are put, except in the case of qualified residence interest (excluding home equity interest, where the use is relevant for 2018-2025). Detailed rules for classifying interest by tracing the use of loan proceeds are contained in temporary regulations.21 The interest allocation rules apply to interest expense that would otherwise be deductible.22

      Various provisions in the Code may prohibit or delay the deduction of certain types of interest expense. For example, no deduction is allowed for interest paid on a loan used to buy or carry tax-exempt securities or, under certain conditions, for interest on a loan used to purchase or carry a life insurance or annuity contract (see Q 3).


      1. IRC Sec. 163(h)(3)(F).

      2. IRC Sec. 163(h)(3)(F)(ii).

      3. IRC Sec. 163(d)(3).

      4. IRC Secs. 1(h)(11)(D)(i), as amended by ATRA, 163(d)(4)(B).

      5. 69 Fed. Reg. 47364 (8-5-2004). See also, 70 Fed. Reg. 13100 (3-18-2005).

      6. IRC Sec. 162.

      7. IRC Sec. 163(h)(3).

      8. IRC Sec. 163(h)(3)(D).

      9. IRC Sec. 163(h)(3)(E), as amended by ATRA.

      10. IRC Sec. 163(h)(4)(A). See, e.g., FSA 200137033.

      11. Let. Ruls. 8743063 and 8742025.

      12Blanche v. Comm., TC Memo 2001-63, aff’d without opinion, 2002 U.S. App. LEXIS 6379 (5th Cir. 2002).

      13. Let. Rul 200029018.

      14. FSA 200047022.

      15. IRC Secs. 163(d), 469(c).

      16. IRC Secs. 163(h)(2)(F), 221.

      17. IRC Sec. 221(b); Rev. Proc. 2015-53, Rev. Proc. 2016-55, Rev. Proc. 2017-58, Rev. Proc. 2019-44, Rev. Proc. 2020-45, Rev. Proc. 2021-45.

      18. See IRC Sec. 221; Treas. Reg. §1.221-1.

      19. IRC Sec. 163(h)(2).

      20. IRC Sec. 163(h)(1).

      21. See Temp. Treas. Reg. §1.163-8T.

      22. Temp. Treas. Reg. §1.163-8T(m)(2).

  • 735. Is business interest deductible when the business is a corporation?

    • Under prior law, business owners were typically permitted to deduct interest expenses incurred in carrying on a trade or business (subject to limitations).1  The 2017 Tax Act generally limits the interest expense deduction to the sum of (1) business interest income, (2) 30 percent of the business’ adjusted taxable income and (3) floor plan financing interest (see below).2  Businesses with average annual gross receipts of $25 million or less for the three-taxable year period that ends with the previous tax year are exempt from this new limitation (i.e., businesses that meet the gross receipts test of IRC Section 448(c)).3

      Generally, the limit applies at the taxpayer level, but in the case of a group of affiliated corporations that file a consolidated return, it applies at the consolidated tax return filing level.


      Planning Point: The IRS has released new guidance on how 2017’s tax reform legislation impacts the business interest deduction limitation for consolidated groups.  The limitation will apply at the consolidated group level, meaning that the group’s overall adjusted taxable income for purposes of the limitation will be its consolidated taxable income, and inter-company obligations will be disregarded.

      Further, the IRS and Treasury have released proposed regulations governing the allocation of the limitation among group members, and the treatment of disallowed interest carryforwards where a member leaves or joins the group.  When one subsidiary leaves the group, the consolidated group must determine the amount of interest carryforwards that were allocated to the subsidiary.  The regulations will treat an affiliated group as a single taxpayer only if it files a consolidated return for Section 163(j) purposes.4


      “Business interest” generally excludes investment interest.  It includes any interest paid or accrued on indebtedness properly allocable to carrying on a trade or business. Under proposed regulations released late in 2018, a new definition of “interest” applies, and includes any expenses incurred to compensate for the use of money, or the time value of money—commitment fees, debt issuance costs, guaranteed payments and other “substitute” interest costs may all be considered “interest” under the new rules. Importantly, this means that many expenses that have not commonly be considered “interest” will be subject to the new limit on deductibility of business interest expense.

      The final regulations released in 2020 specifically exclude commitment fees and debt issuance costs from the definition of interest.  While partnership guaranteed payments and hedging gains or losses are not specifically included in the definition of business interest, examples in the regulations provide guidance on when such payments may be included. The final regulations retain substitute interest payments in the definition of interest because the payments generally are economically equivalent to interest. However, the final regulations provide that a substitute interest payment is treated as an interest expense to the payor only if the payment relates to a sale-repurchase or securities lending transaction that is not entered into by the payor in the payor’s ordinary course of business.  Further, the rules provide that a substitute interest payment is treated as interest income to the recipient only if the payment relates to a sale-repurchase or securities lending transaction that is not entered into by the recipient in the recipient’s ordinary course of business.

      “Business interest income” means the amount of interest that is included in the taxpayer’s gross income for the tax year that is properly allocable to carrying on a trade or business.

      “Adjusted taxable income” means taxable income computed without regard to (1) items of income, gain, deduction or loss not allocable to carrying on a trade or business, (2) business interest or business interest income, (3) any net operating loss deduction (NOL), (4) the deduction for pass-through income under Section 199A and (5) for years before 2022, any deduction for depreciation, amortization or depletion.5  For the purpose of the business interest deduction, adjusted taxable income is computed without regard for the deductions that are allowed for depreciation, amortization or depletion for tax years beginning after December 31, 2017 and before January 1, 2022.

      “Floor plan financing interest” is interest paid or accrued on floor plan financing indebtedness, which is indebtedness incurred to finance the purchase of motor vehicles held for sale or lease to retail customers (and secured by the inventory that is acquired).6

      As a result of these rules, business interest income and floor plan financing interest are fully deductible, with the limitation applying to 30 percent of the business’ adjusted taxable income.

      Unused interest expense deductions may be carried forward indefinitely.7 The IRS has released proposed regulations stating that the disallowance and carryfoward of a business interest deduction in the C corporation context will not affect whether (or when) the business interest expense reduces the C corporation’s earnings and profits. This means that corporations need not wait until the year in which the deduction is allowed to reduce earnings and profits.8 This means that corporations need not wait until the year in which the deduction is allowed to reduce earnings and profits.


      Planning Point: The IRS has released guidance clarifying that taxpayers with disqualified business interest that was disallowed for the last tax year beginning before January 1, 2018 may carry the interest forward as business interest to the first tax year beginning after December 31, 2017.  When this interest is carried forward (i.e., to 2018 and beyond), it will be treated as any other business interest that is incurred in a year beginning after December 31, 2017.  This means that the carried forward interest will be subject to the same limitations that apply to interest expenses actually incurred after the new rules became effective in 2018.  Because the new law does not contain a provision providing for excess limitation carryforwards under previously applicable “super affiliation rules”, these amounts may not be carried forward to tax years beginning after December 31, 2017.9


       

      1. IRC Sec. 163(j).

      2. IRC Sec. 163(j)(1).

      3. IRC Secs. 163(j)(2), 448(c).

      4. Notice 2018-28.

      5. IRC Sec. 163(j)(8).

      6. IRC Sec. 163(j)(9).

      7. IRC Sec. 163(j)(2).

      8. Notice 2018-28.

      9. Notice 2018-28.

  • 736. Is business interest deductible when the business is a pass-through entity?

    • Businesses that operate as pass-through entities (partnerships, S corporations, sole proprietorships) are permitted to deduct interest expenses incurred in operating the business. The 2017 Tax Act generally limits the interest expense deduction to the sum of (1) business interest income, (2) 30 percent of the business’ adjusted taxable income and (3) floor plan financing interest.[1] Businesses with average annual gross receipts of $25 million or less for the three-taxable year period that ends with the previous tax year are exempt from this new limitation (i.e., businesses that meet the gross receipts test of IRC Section 448(c)).[2]

      These rules are applied at the partnership level, and the deduction for business interest must be taken into account in determining the non-separately stated taxable income or loss of the partnership.[3] Under the 2017 Tax Act, the limit on the amount that is allowed as a deduction for business interest is increased by a partner’s distributive share of the partnership’s excess taxable income.[4]

      “Excess taxable income” is the amount that bears the same ratio to the partnership’s adjusted taxable income as:

      (x) the excess (if any) of (1) 30 percent of the adjusted taxable income of the partnership over (2) the amount (if any) by which the business interest of the partnership, reduced by floor plan financing interest, exceeds the business interest income of the partnership bears to

      (y) 30 percent of the adjusted taxable income of the partnership.[5]

      Excess taxable income must be allocated in the same manner as non-separately stated income and loss. A partner’s adjusted basis in his or her partnership interest must be reduced (not below zero) by the excess business interest that is allocated to the partner. The new law provides that similar rules will apply to S corporations and their shareholders.[6]

      As expressed in the Senate amendment to the 2017 Tax Act, the intent of this calculation was to allow a partner to deduct additional interest expense that the partner may have paid to the extent that the partnership could have deducted more business interest.

      “Business interest” means interest paid on indebtedness that is properly allocated to a trade or business, but excluding investment interest.[7] Under proposed regulations released late in 2018, a new definition of “interest” applies, and includes any expenses incurred to compensate for the use of money, or the time value of money–commitment fees, debt issuance costs, guaranteed payments and other “substitute” interest costs may all be considered “interest” under the new rules. Importantly, this means that many expenses that have not commonly be considered “interest” will be subject to the new limit on deductibility of business interest expense.

      “Business interest income” means the amount of interest income that is included in the entity’s income and properly allocated to a trade or business, excluding investment interest income.[8]

      “Trade or business” specifically excludes the trade or business of being an employee, any electing real property trades or businesses, electing farming businesses, furnishing or selling electrical, water or sewage disposal services, and gas or steam distribution and transportation.[9]

      “Adjusted taxable income” for purposes of these rules means taxable income computed without regard to non-business items of income, gain, deduction and loss, business interest and business interest income, the net operating loss deduction under Section 172, the deduction for pass-through entities under IRC Section 199A and, for 2018-2021, any deductions for depreciation, amortization or depletion.[10]

      See Q 737 for a discussion of the rules governing carryforwards of disallowed partnership business interest. See Q 735 for a discussion of the general rules governing the corporate deduction for business interest.

      [1].          IRC Sec. 163(j)(1).

      [2].          IRC Secs. 163(j)(2), 448(c).

      [3].          IRC Sec. 163(j)(4).

      [4].          IRC Sec. 163(j)(4)(A)(ii)(II).

      [5].          IRC Sec. 163(j)(4)(C).

      [6].          IRC Sec. 163(j)(4)(D).

      [7].          IRC Sec. 163(j)(5).

      [8].         IRC Sec. 163(j)(6).

      [9].          IRC Sec. 163(j)(7).

      [10].        IRC Sec. 163(j)(8).

  • 737. Can a partnership carry forward disallowed business interest?

    • The 2017 Tax Act created a special rule to allow partnerships to carry forward certain disallowed business interest (the rule does not apply to S corporations or other pass-through entities, although the new law specifies that similar rules will apply).  The general rules governing carrying forward disallowed business interest (see Q 735) do not apply to partnerships.

      Instead, disallowed business interest is allocated to each partner in the same manner as non-separately stated taxable income or loss of the partnership.1  The partner is entitled to deduct his or her share of excess business interest in any future year, but only:

      1. against excess taxable income (see Q 736) attributed to the partner by the partnership, and
      2. when the excess taxable income is related to the activities that created the excess business interest carryforward.2

      Such a deduction also requires a corresponding reduction in excess taxable income.  Further, if excess business interest is attributed to a partner, his or her basis in the partnership interest is reduced (not below zero) by the amount of the allocation even though the carryforward does not permit a partner’s deduction in the year of the basis reduction.  The partner’s deduction in a future year for the carried forward interest will not require another basis adjustment.

      If the partner disposes of the partnership interest after a basis adjustment occurred, immediately before the disposition the partner’s basis will be increased by the amount that any basis reduction exceeds the amount of excess interest expense that has been deducted by the partner.3

      The IRS has released guidance providing that it intends to issue regulations stating that when business interest is accounted for at the partner level, a partner cannot include his or her share of the partnership’s business interest income for the year except to the extent of the partner’s share of the excess of (i) the partnership’s business interest income over (ii) the partnership’s business interest expense (excluding floor plan financing).  A partner cannot include his or her share of floor plan financing interest in determining his or her individual business interest expense deduction limitation.4

      See Q 735 for a discussion of the general rules governing the corporate deduction for business interest.

      1. IRC Sec. 163(j)(4).

      2. IRC Sec. 163(j)(4)(B).

      3. IRC Sec. 163(j)(4)(B)(iii).

      4.Notice 2018-28, 2018 CB 492.

  • 738. How did tax reform change the deduction for mortgage interest for tax years beginning after 2017 and before 2025?

    • The 2017 Tax Act limited the mortgage interest deduction to interest on new mortgages of up to $750,000.  This limit applies to debt incurred after December 31, 2017 and before January 1, 2026.1  After December 31, 2025, the $1 million mortgage interest deduction will be reinstated and will apply regardless of when the taxpayer incurred the relevant debt unless Congress takes action to extend the current rule.2

      Home equity indebtedness interest cannot be deducted for tax years beginning after December 31, 2017 and before January 1, 2026.


      Planning Point: Although interest on home equity indebtedness is technically no longer deductible under the terms of the 2017 Tax Act, the IRS has released guidance on situations where this interest may continue to be deducted. Pursuant to the guidance, interest on home equity loans that are used to buy, build or substantially improve the taxpayer’s home continue to be deductible to the extent that they (when combined with other relevant loans) do not exceed the $750,000 limit. However, home equity loan interest is not deductible to the extent that the loan proceeds are used for expenditures not related to buying, building or substantially improving a home (i.e., if the proceeds are used for personal living expenses or to purchase a new car, the related interest is not deductible). The home equity loan must be secured by the home in order for the interest to be deductible in any case.


      Example: In January 2021, Jerry takes out a $500,000 mortgage to purchase a main home. The loan is secured by the main home. In February 2021, Jerry takes out a $250,000 loan to purchase a vacation home. The loan is secured by the vacation home. Because the total amount of both mortgages does not exceed $750,000, all of the interest paid on both mortgages is deductible. However, if Jerry took out a $250,000 home equity loan on the main home to purchase the vacation home, then the interest on the home equity loan would not be deductible.

      The $750,000 limit does not apply with respect to debt incurred on or before December 15, 2017.  If the taxpayer enters a binding contract on or before December 15, 2017 to close on the purchase of the taxpayer’s personal residence before January 1, 2018, and if the taxpayer actually purchases that residence before April 1, 2018, the debt will be treated as though it was incurred before December 15, 2017.3

      Debt amounts that are related to a refinancing will be treated as though incurred on the date that the original debt was incurred, provided that any additional amounts of debt incurred as a result of the refinancing do not exceed the amount of the refinanced debt.  However, this exception does not apply if the refinancing occurs after the expiration of the term of the original debt.  Further, it does not apply if the original debt was not amortized over its term, the expiration of the term of the first refinancing of the debt or, if earlier, the date which is 30 years after the date of the first refinancing.4

      ________________

      1. IRC Sec. 163(h)(3)(F).

      2. IRC Sec. 163(h)(3)(F)(ii).

      3. IRC Sec. 163(h)(3)(F)(i).

      4. IRC Sec. 163(h)(3)(F)(iii).

  • 739. What is the maximum annual limit on the income tax deduction allowable for charitable contributions?

    • An individual who itemizes may take a deduction for certain contributions “to” or “for the use of” charitable organizations. The amount that may be deducted by an individual in any one year is subject to the income percentage limitations as explained in Q 740. The value that may be taken into account for various gifts of property depends on the type of property and the type of charity to which it is contributed. These rules are explained in Q 741 to Q 743.

      For an explanation of the deduction for charitable gifts of life insurance, see Q 120.

      In the case of a gift of S corporation stock, special rules (similar to those relating to the treatment of unrealized receivables and inventory items under IRC Section 751) apply in determining whether gain on such stock is long-term capital gain for purposes of determining the amount of a charitable contribution.1

      A contribution of a partial interest in property is deductible only if the donee receives an undivided portion of the donor’s entire interest in the property. Such a contribution was upheld even where the donee did not take possession of the property during the tax year.2 Generally, a deduction is denied for the mere use of property or for any interest which is less than the donor’s entire interest in the property, unless the deduction would have been allowable if the transfer had been in trust.


      1 .IRC Sec. 170(e)(1).

      2 .Winokur v. Comm., 90 TC 733 (1988), acq. 1989-1 CB 1.

  • 740. What are the income percentage limits that apply to charitable contributions?

    • Editor’s Note 1: The 2017 Tax Act increased the 50 percent AGI limit on contributions to public charities and certain private foundations to 60 percent for tax years beginning after 2017 and before 2026.

      Editor’s Note: The 2020 CARES Act made several changes designed to encourage charitable giving during the COVID-19 outbreak.  For the 2020 tax year, the CARES Act amended IRC Section 62(a), allowing taxpayers to reduce adjusted gross income (AGI) by $300 worth of charitable contributions made in 2020 even if they do not itemize.1 The year-end stimulus package passed in December 2020 extended this temporary relief through 2021.

      The CARES Act also lifted the 60 percent AGI limit for 2020.  Cash contributions to public charities and certain private foundations in 2020 were not subject to the AGI limit (contributions to donor advised funds, supporting organizations and private grant-making organizations remained subject to the usual AGI limits).  Individual taxpayers can offset their income for 2020 up to the full amount of their AGI, and additional charitable contributions can be carried over to offset income in a later year (the amounts are not refundable).  The corporate AGI limit was raised from 10 percent to 25 percent (excess contributions also carry over to subsequent tax years).  Taxpayers must elect this treatment.2

      Fifty percent limit (sixty percent for tax years 2018-2025). An individual is allowed a charitable deduction of up to 50 (or 60) percent of his adjusted gross income for a charitable contribution to: churches; schools; hospitals or medical research organizations; organizations that normally receive a substantial part of their support from federal, state, or local governments or from the general public and that aid any of the above organizations; federal, state, and local governments. Also included in this list is a limited category of private foundations (i.e., private operating foundations and conduit foundations3) that generally direct their support to public charities.4 The above organizations are often referred to as “50 (or 60) percent-type charitable organizations.”

      Thirty percent limit. The deduction for contributions of most long-term capital gain property to the above organizations, contributions for the use of any of the above organizations, as well as contributions (other than long-term capital gain property, see Q 741) to or for the use of any other types of charitable organizations (i.e., most private foundations, see Q 743) is limited to the lesser of (a) 30 percent of the taxpayer’s adjusted gross income, or (b) 50 percent of adjusted gross income minus the amount of charitable contributions allowed for contributions to the 50 (or 60) percent-type charities.5

      Twenty percent limit. The deduction for contributions of long-term capital gain property to most private foundations (see Q 741 and Q 743) is limited to the lesser of (a) 20 percent of the taxpayer’s adjusted gross income, or (b) 30 percent of adjusted gross income minus the amount of charitable contributions allowed for contributions to the 30 percent-type charities.6

      Deductions denied because of the 50 (or 60) percent, 30 percent or 20 percent limits may be carried over and deducted over the next five years, retaining their character as 50 (or 60) percent, 30 percent or 20 percent type deductions.7

      Gifts are “to” a charitable organization if made directly to the organization. “For the use of” applies to indirect contributions to a charitable organization (e.g., an income interest in property, but not the property itself).8 The term “for the use of” does not refer to a gift of the right to use property. Such a gift would generally be a nondeductible gift of less than the donor’s entire interest.


      1. IRC Sec. 62(A)(22), added by the CARES Act.

      2.CARES Act Sec. 2205.

      3 .See IRC Sec. 170(b)(1)(E).

      4 .IRC Sec. 170(b)(1)(A).

      5 .IRC Secs. 170(b)(1)(B), 170(b)(1)(C).

      6 .IRC Sec. 170(b)(1)(D).

      7 .IRC Secs. 170(d)(1), 170(b)(1)(D)(ii).

      8 .See Treas. Reg. §1.170A-8(a)(2).

  • 741. What value of property contributed to charity can be taken into account for the charitable deduction if the gift is long-term capital gain property?

    • Editor’s Note: The 2017 Tax Act increased the 50 percent AGI limit on contributions to public charities and certain private foundations to 60 percent for tax years beginning after 2017 and before 2026.

      If an individual makes a charitable contribution to a 50 (or 60) percent-type charity (see Q 742) of property that, if sold, would have resulted in long-term capital gain (other than certain tangible personal property, see Q 744
      ), he is generally entitled to deduct the full fair market value of the property, but the deduction will be limited to 30 percent of adjusted gross income.1

      Long-term capital gain property. “Long-term capital gain” means “gain from the sale or exchange of a capital asset held for more than 1 year, if and to the extent such gain is taken into account in computing gross income.”2

      Any portion of a gift of long-term capital gain property to a 50 (or 60) percent-type organization that is disallowed as a result of the adjusted gross income limitation may be carried over for five years, retaining its character as a 30 percent type deduction (see Q 742).3

      A taxpayer may elect in any year to have gifts of long-term capital gain property be subject to a 50 (or 60) percent of adjusted gross income limit; if he does so, the gift is valued at the donor’s adjusted basis. Once made, such an election applies to all contributions of capital gain property during the taxable year (except unrelated use gifts of appreciated tangible personal property, as explained in Q 742) and is generally irrevocable for that year.4

      The deduction for any charitable contribution of property is reduced by the amount of gain that would not be long-term capital gain if the property were sold at its fair market value at the time of the contribution.5


      1 .IRC Sec. 170(b)(1)(C).

      2 .IRC Sec. 1222(3).

      3 .IRC Sec. 170(b)(1)(C)(ii).

      4 .IRC Sec. 170(b)(1)(C)(iii); Woodbury v. Comm., TC Memo 1988-272, aff’d, 90-1 USTC ¶50,199 (10th Cir. 1990).

      5 .IRC Sec. 170(e)(1)(A).

  • 742. What value of property contributed to charity can be taken into account for purposes of the charitable deduction if the gift is comprised of tangible personal property?

    • The treatment of a contribution of appreciated tangible personal property (i.e., property which, if sold, would generate long-term capital gain) depends on whether the use of the property is related or unrelated to the purpose or function of the (public or governmental) organization. If the property is related use property (e.g., a contribution of a painting to a museum), generally the full fair market value is deductible, up to 30 percent of the individual’s adjusted gross income; however, if the property is unrelated use property, the deduction is generally limited to the donor’s adjusted basis.1


      1 .IRC Secs. 170(e)(1)(B), 170(b)(1)(C); Treas. Reg. §1.170A-4(b).

  • 743. What value of property contributed to charity can be taken into account for purposes of the charitable deduction if the gift is made to a private foundation?

    • Editor’s Note: The 2017 Tax Act increased the 50 percent AGI limit on contributions to public charities and certain private foundations to 60 percent for tax years beginning after 2017 and before 2026.

      Most private foundations are family foundations subject to restricted contribution limits. Certain other private foundations (i.e., conduit foundations and private operating foundations), which operate much like public charities, are treated as 50 (or 60) percent-type organizations (see Q 740).1 The term “private foundations” as used under this heading refers to standard private (e.g., family) foundations.

      The amount of the deduction for a contribution of appreciated property (tangible or intangible) contributed to or for the use of private foundations generally is limited to the donor’s adjusted basis; however, certain gifts of qualified appreciated stock made to a private foundation are deductible at their full fair market value.2

      Qualified appreciated stock is generally publicly traded stock which, if sold on the date of contribution at its fair market value, would result in a long-term capital gain.3 Such a contribution will not constitute qualified appreciated stock to the extent that it exceeds 10 percent of the value of all outstanding stock of the corporation; family attribution rules apply in reaching the 10 percent level.4 The Service has determined that shares in a mutual fund can constitute qualified appreciated stock.5


      1 .See IRC Secs. 170(b)(1)(E), 170(b)(1)(A)(vii).

      2 .IRC Sec. 170(e)(5).

      3 .IRC Sec. 170(e)(5).

      4 .IRC Sec. 170(e)(5)(C).

      5 .Let. Rul. 199925029. See also Let. Rul. 200322005 (ADRs are qualified appreciated stock).

  • 744. What substantiation requirements apply in order for a taxpayer to take an income tax deduction for charitable contributions?

    • No charitable deduction is allowed for a contribution of cash, check, or other monetary gift unless the donor maintains either a bank record or a written communication from the donee showing the name of the organization and the date and the amount of the contribution.1

      Charitable contributions of $250 or more (whether in cash or property) must be substantiated by a contemporaneous written acknowledgment of the contribution supplied by the charitable organization. (An organization can provide the acknowledgement electronically, such as via an e-mail addressed to the donor.)2

      In prior years, substantiation was not required if certain information was reported on a return filed by the charitable organization (this exception was repealed by the 2017 Tax Act for tax years beginning after December 31, 2016).3 Special rules apply to the substantiation and disclosure of quid pro quo contributions and contributions made by payroll deduction.4 A qualified appraisal is generally required for contributions of nonreadily valued property for which a deduction of more than $5,000 is claimed.5

      No charitable deduction is allowed for a contribution of clothing or a household item unless the property is in good or used condition. Regulations may deny a deduction for a contribution of clothing or a household item which has minimal monetary value. These rules do not apply to a contribution of a single item if a deduction of more than $500 is claimed and a qualified appraisal is included with the return. Household items include furniture, furnishings, electronics, linens, appliances, and similar items; but not food, art, jewelry, and collections.6

      Special rules apply to certain types of gifts, including charitable donations of patents and intellectual property, and for donations of used motor vehicles, boats, and airplanes.7


      1. IRC Sec. 170(f)(17).

      2. IRS Pub. 1771 (March 2016), p. 5.

      3. IRC Sec. 170(f)(8) (repealed by Pub. Law. No. 115-97).

      4. Treas. Reg. §§1.170A-13(f), 1.6115-1.

      5. IRC Sec. 170(f)(11).

      6. IRC Sec. 170(f)(16).

      7. See IRC Secs. 170(e)(1)(B), 170(f)(11), 170(f)(12), 170(m); Notice 2005-44, 2005-25 IRB 1287.

  • 745. What are the limits on the medical expense deduction?

    • Editor’s Note: The 2021 year-end Consolidated Appropriations Act permanently reduced the medical expense deduction threshold from 10 percent to 7.5 percent.

      A taxpayer who itemizes deductions can deduct unreimbursed expenses for “medical care” (the term “medical care” includes dental care) and expenses for prescribed drugs or insulin for himself, a spouse and dependents, to the extent that such expenses exceed 7.5 percent of adjusted gross income. (On a joint return, the 7.5 percent floor amount is based on the combined adjusted gross income of both spouses.) The taxpayer first determines net unreimbursed expenses by subtracting all reimbursements received during the year from total expenses for medical care paid during the year. He or she must then subtract or 7.5 percent of his adjusted gross income from net unreimbursed medical expenses; only the balance, if any, is deductible.1 The deduction for medical expenses is not subject to the phaseout in itemized deductions for certain upper income taxpayers that applied before 2018. (See Q 731.)

      Though the 7.5 percent threshold was temporarily increased to 10 percent in 2013-2016, the 7.5 percent threshold continued to apply through 2016 if the taxpayer or the taxpayer’s spouse turned age 65 before the end of the taxable year. See Q 746 for examples of the types of expenses that can be deducted under the medical expense deduction.

      _________________

      1. IRC Sec. 213.

       

  • 746. What types of expenses can be deducted as medical expenses?

    • Editor’s Note: The IRS announced that personal protective equipment (PPE), such as face masks, hand sanitizer and disinfecting cleaners/wipes now count as qualified medical expenses under IRC Section 213(d).  Taxpayers are, therefore, entitled to use funds from a health FSA, Archer MSA, HSA or HRA to purchase those supplies on a pre-tax basis, as long as the PPE is purchased primarily to prevent the spread of COVID-19.  This change is made retroactively to January 1, 2020, although many plans will not require an amendment if the plan allows for reimbursement for all qualified Section 213(d) expenses.  If an amendment with retroactive effect is necessary, it must be made by December 31, 2022.[1]

      “Medical care” is generally defined as amounts paid: (a) for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body; (b) for transportation primarily for and essential to such medical care; (c) for qualified long-term services; or (d) for insurance covering such care or for any qualified long-term care insurance contract.[2]

      The Service ruled that amounts paid by individuals for diagnostic and certain similar procedures and devices, not compensated by insurance or otherwise, are deductible medical care expenses even though the individuals had no symptoms of illness. According to the Service, this includes an annual physical examination, a full-body electronic scan, and a pregnancy test.[3]

      The term “medical care” does not include cosmetic surgery or other similar procedures unless necessary to correct a deformity resulting from a congenital abnormality, a personal injury resulting from accident or trauma, or a disfiguring disease.[4] But see Al-Murshidi v. Comm.[5] (the surgical removal of excess skin from a formerly obese individual was not “cosmetic surgery” for purposes of IRC Section 213(d)(9)(A) because the procedures meaningfully promoted the proper function of the individual’s body and treated her disease; thus, the costs of the surgical procedures were deductible despite the “cosmetic surgery” classification given to the procedures by the surgeon).

      A taxpayer can deduct the medical expenses paid for a dependent (within the specified limits) even though he or she is not entitled to a dependency exemption. The fact that the dependent’s income exceeds the exemption amount (suspended for 2018-2025, $4,050 for 2016 and 2017)[6] for the year is immaterial so long as the taxpayer has furnished over one-half of his support. A child of parents who are divorced (or in some situations, separated) and who between them provide more than one-half of the child’s support for the calendar year and have custody of the child for more than one-half of the calendar year will be treated as a dependent of both parents for purposes of this deduction.[7] But in the case of a multiple support agreement, only the person designated to take the dependency exemption may deduct the dependent’s medical expenses, and then only to the extent that he or she actually paid the expenses.[8] See Q 731.

      Deductible medical expenses include amounts paid for lodging, up to $50 per individual per night, while away from home primarily for and essential to medical care if such care is provided by a physician in a licensed hospital (or similar medical care facility) and there is no element of personal pleasure, recreation or vacation in the travel away from home. No deduction is allowed if the lodgings are “lavish or extravagant.”[9] A mother was permitted to deduct lodging expenses incurred when her child was receiving medical care away from home and her presence was essential to such care.[10] A parent’s costs of attending a medical conference (i.e., registration fee, transportation costs) to obtain information about a chronic disease affecting the parent’s child were deductible so long as the costs were primarily for and essential to the medical care of the dependent. However, the costs of meals and lodging incurred by the parent while attending the conference were not deductible.[11] The Service privately ruled that taxpayers could deduct special education tuition for their children as a medical care expense where the children attended a school primarily to receive medical care in the form of special education and in those years each child had been diagnosed as having a medical condition that handicapped the child’s ability to learn.[12]

      Generally, medical expenses are deductible only in the year they are paid, regardless of when the expenses were incurred. (But see Zipkin v. U.S.,[13] holding that expenses incurred by a taxpayer to build a home to meet his wife’s special health needs were properly deducted in the year the home became habitable, even though the costs had been paid in earlier years.) Costs paid by parents to modify a van used to transport their handicapped child were deductible in the year those costs were paid, although the court held that depreciation was not a deductible medical expense.[14] However, medical expenses of a decedent paid out of his estate within one year from date of death are considered paid by the decedent at the time the expenses were incurred.[15] A decedent’s medical expenses cannot be taken as an income tax deduction unless a statement is filed waiving the right to deduct them for estate tax purposes. Amounts not deductible under IRC Section 213 may not be treated as deductible medical expenses for estate tax purposes. Thus, expenses that do not exceed the 7.5 percent floor are not deductible.[16]

      The Social Security hospital tax that an individual pays as an employee or self-employed person cannot be deducted as a medical expense.[17] However, a 65-year-old who has signed up for the supplementary medical plan under Medicare can treat his monthly premiums as amounts paid for insurance covering medical care.[18] A voluntary prescription drug insurance program, Medicare Part D, went into effect on January 1, 2006. According to the Service, an individual taxpayer can include in medical expenses the premiums paid for Medicare Part D insurance.[19]

      The unreimbursed portion of an entrance fee for life care in a residential retirement facility that is allocable to future medical care is also deductible as a medical expense in the year paid (but, if the resident leaves the facility and receives a refund, the refund is includable in gross income to the extent it is attributable to the deduction previously allowed).[20] Either the percentage method or the actuarial method may be used to calculate the portions of monthly service fees (paid for lifetime residence in a continuing care retirement community) allocable to medical care.[21] A federal district court held that none of an entrance fee paid by married taxpayers to an assisted living facility was properly deductible as a medical expense because: (1) no portion of the entrance fee was attributable to the couple’s medical care; and (2) the entrance fee was structured as a loan, which cannot serve as the basis for a deduction (citing Comm. v. Tufts[22]).[23]

      Amounts paid by an individual for medicines and drugs, which can be purchased without a doctor’s prescription, are not deductible.[24] However, amounts paid by an individual for equipment (e.g., crutches), supplies (e.g., bandages), or diagnostic devices (e.g., blood sugar test kits) may qualify as amounts paid for medical care and may be deductible under IRC Section 213. (In this ruling, the IRS determined that the crutches were used to mitigate the effect of the taxpayer’s injured leg and the blood sugar test kits were used to monitor and assist in treating the taxpayer’s diabetes; accordingly, the costs were amounts paid for medical care and were deductible.)[25]

      The costs of nutritional supplements, vitamins, herbal supplements, and “natural medicines” cannot be included in medical expenses unless they are recommended by a doctor as treatment for a specific medical condition diagnosed by a doctor.[26] Certain expenses for smoking cessation programs and products are deductible as a medical expense.[27]

      Amounts paid by individuals for breast reconstruction surgery following a mastectomy for cancer, and for vision correction surgery are medical care expenses and are deductible. But amounts paid by individuals to whiten teeth discolored as a result of age are not medical care expenses and are not deductible.[28]

      Costs paid by individuals for participation in a weight-loss program as treatment for a specific disease or diseases (e.g., obesity, hypertension, or heart disease) diagnosed by a physician are deductible as medical expenses; however, costs of diet food are not deductible.[29] According to Publication 502, this includes fees paid by a taxpayer for membership in a weight reduction group and attendance at periodic meetings. Membership dues for a gym, health club, or spa cannot be included in medical expenses, but separate fees charged for weight loss activities can be included as medical expenses. In informational guidance, the IRS has also stated that taxpayers may deduct exercise expenses, including the cost of equipment to use in the home, if required to treat an illness (including obesity) diagnosed by a physician. For an exercise expense to be deductible, the taxpayer must establish the purpose of the expense is to treat a disease rather than to promote general health, and that the taxpayer would not have paid the expense but for this purpose.[30]

      Expenses for childbirth classes were deductible as a medical expense to the extent that the class prepared the taxpayer for an active role in the process of childbirth.[31] Egg donor fees and expenses relating to obtaining a willing egg donor count as medical care expenses that are deductible.[32]

      The Service has clarified that no deduction is allowed for the cost of drugs imported from Canada.[33]

       

      [1]      Announcement 2021-7.

      [2].     IRC Sec. 213(d)(1).

      [3].     Rev. Rul. 2007-72, 2007-50 IRB 1154.

      [4].     IRC Sec. 213(d)(9); see, e.g., Let. Rul. 200344010.

      [5].     TC Summary Opinion 2001-185.

      [6].     Rev. Proc. 2015-53, Rev. Proc. 2016-55, Rev. Proc. 2017-58.

      [7].     IRC Sec. 213(d)(5).

      [8].     Treas. Reg. §1.213-1(a)(3)(i).

      [9].     IRC Sec. 213(d)(2).

      [10].  Let. Rul. 8516025.

      [11].  Rev. Rul. 2000-24, 2000-19 IRB 963.

      [12].  See Let. Rul. 200521003. See also Let. Rul. 200729019.

      [13] . 86 AFTR 2d 7052, 2000-2 USTC ¶50,863 (D. Minn. 2000).

      [14].  Henderson v. Comm., TC Memo 2000-321.

      [15].  IRC Sec. 213(c).

      [16].  Rev. Rul. 77-357, 1977-2 CB 328.

      [17].  See IRC Sec. 213(d).

      [18].  Rev. Rul. 66-216, 1966-2 CB 100.

      [19].  See IRS Pub. 502, Medical and Dental Expenses.

      [20].  Rev. Rul. 76-481, 1976-2 CB 82, as clarified by Rev. Rul. 93-72, 1993-2 CB 77; Let. Rul. 8641037.

      [21].  Baker v. Comm., 122 TC 143 (2004).

      [22].  461 U.S. 300, 307 (1983).

      [23].  Finzer v. United States, 496 F. Supp. 2d 954 (N.D. Ill. 2007).

      [24].  Rev. Rul. 2003-58, 2003-22 IRB 959.

      [25].  Rev. Rul. 2003-58, above; see also IRS Information Letter INFO-2003-169 (6-13-2003).

      [26].  IRS Pub. 502, Medical and Dental Expenses.

      [27].  See Rev. Rul. 99-28, 1999-25 IRB 6.

      [28].  Rev. Rul. 2003-57, 2003-22 IRB 959.

      [29].  Rev. Rul. 2002-19, 2002-16 IRB 778.

      [30].  Information Letter INFO 2003-0202.

      [31].  Let. Rul. 8919009.

      [32].  Let. Rul. 200318017; see also Information Letter INFO 2005-0102 (3-29-2005).

      [33].  See Information Letter INFO 2005-0011 (3-14-2005); see also Pub. 502.

  • 747. What is income in respect of a decedent and how is it taxed?

    • “Income in respect of a decedent” (IRD) refers to those amounts to which a decedent was entitled as gross income, but that were not includable in his taxable income for the year of his death.1 It can include, for example: renewal commissions of a sales representative; payment for services rendered before death or under a deferred compensation agreement; and proceeds from sales on the installment method (see Q 667). Generally, if stock is acquired in an S corporation from a decedent, the pro rata share of any income of the corporation that would have been IRD if that item had been acquired directly from the decedent is IRD.2

      The IRS has determined that a distribution from a qualified plan of the balance as of the employee’s death is IRD.3 The Service has also privately ruled that a distribution from a 403(b) tax sheltered annuity is IRD.4 The Service has also concluded that a death benefit paid to beneficiaries from a deferred variable annuity would be IRD to the extent that the death benefit exceeded the owner’s investment in the contract.5 In addition, the Service has determined that distributions from a decedent’s individual retirement account were IRD, including those parts of the distributions used to satisfy the decedent’s estate tax obligation, since the individual retirement account was found to have automatically vested in the beneficiaries.6

      However, a rollover of funds from a decedent’s IRA to a marital trust and then to the surviving spouse’s IRA was not IRD, according to the Service, where the surviving spouse was the sole trustee and sole beneficiary of the trust.7 The Service also ruled that designation of a QTIP trust as the beneficiary of a decedent’s account balance in a qualified profit sharing plan would not result in the acceleration of IRD at the time the assets from the plan passed into the trust. Consequently, the taxpayer would include the amounts of IRD in the plan in the taxpayer’s gross income only when the taxpayer received a distribution (or distributions) from the trust.8

      Gain realized upon the cancellation at death of a note payable to a decedent has been held to be IRD to the decedent’s estate.9

      The unreported increase in value reflected in the redemption value of savings bonds as of the date of a decedent’s death constitutes income in respect of a decedent.10 See Q 7688. If savings bonds on which the increases in value have not been reported are inherited, or the subject of a bequest, the reporting of such amounts may be delayed until the bonds are redeemed or disposed of by the legatee, or reach maturity, whichever is first.11 However, to the extent savings bonds are distributed by an estate or trust to satisfy pecuniary obligations or legacies, the estate or trust is required to recognize the unreported incremental increase in the redemption price of Series E bonds as income in respect of a decedent.12

      The Service determined that in the case of a taxpayer who dies before a short sale of stock is closed, any income that may result from the closing of the short sale is not IRD, and the basis of any stock held on the date of the taxpayer’s death will be stepped up.13 The Service also privately ruled that in the case of a sales contract entered into before the decedent’s death, where an economically material contingency existed at the time of the decedent’s death that might have disrupted the sale of the real property, any gain realized from the sale of the real property after the decedent’s death did not constitute IRD.14

      The Court of Appeals for the Tenth Circuit has held that an alimony arrearage paid to the estate of a former spouse was IRD and thus, taxable to the recipient beneficiaries as ordinary income.15

      The Tax Court determined that because a signed withdrawal request from the decedent constituted an effective exercise of the decedent’s right to a lump-sum distribution during his lifetime, the lump-sum distribution from TIAA-CREF was therefore income to the decedent and properly includable in the decedent’s income. Accordingly, the court held, the lump sum payment received by the decedent’s son was not a death benefits payment and, thus, was not includable in the son’s gross income as IRD.16


      1 .IRC Sec. 691(a).

      2 .IRC Sec. 1367(b).

      3 .Rev. Rul. 69-297, 1969-1 CB 131; Rev. Rul. 75-125, 1975-1 CB 254.

      4 .Let. Rul. 9031046.

      5 .Let. Rul. 200041018.

      6 .Let. Rul. 9132021. See Rev. Rul. 92-47, 1992-1 CB 198. See also Let. Rul. 200336020.

      7 .Let. Rul. 200023030.

      8 .Let. Rul. 200702007.

      9 .Est. of Frane v. Comm., 998 F.2d 567 (8th Cir. 1993).

      10 .See Rev. Rul. 64-104, 1964-1 CB 223.

      11 .See Let. Ruls. 9845026, 9507008, 9024016.

      12 .Let. Rul. 9507008.

      13 .Let. Rul. 9436017. See IRC Sec. 1014.

      14 .Let. Rul. 200744001.

      15 .Kitch v. Comm., 103 F. 3d 104, 97-1 USTC ¶50,124 (10th Cir. 1996).

      16 .Eberly v. Comm., TC Summary Op. 2006-45.

  • 748. Is the recipient of income in respect of a decedent (IRD) entitled to an income tax deduction for estate and generation-skipping transfer taxes paid on this income?

    • Generally IRD must be included in the gross income of the recipient; however, a deduction is normally permitted for estate and generation-skipping transfer taxes paid on the income. The amount of the total deduction is determined by computing the federal estate tax (or generation-skipping transfer tax) with the net IRD included and then recomputing the tax with the net IRD excluded. The difference in the two results is the amount of the income tax deduction. However, if two or more persons receive IRD of the same decedent, each recipient is entitled to only a proportional share of the income tax deduction. Similarly, if the IRD is received over more than one taxable year, only a proportional part of the deduction is allowable each year. Where the income would have been ordinary income in the hands of the decedent, the deduction is an itemized deduction.1 The recipient does not receive a stepped up basis (see Q 692).2 A beneficiary was allowed to claim a deduction for IRD attributable to annuity payments that had been received even though the estate tax had not yet been paid.3

      In technical advice, the IRS stated that the value of a decedent’s IRA should not be discounted for estate tax purposes to reflect income taxes that will be payable by the beneficiaries upon receipt of distributions from the IRAs or for lack of marketability. The Service reasoned that the deduction is a statutory remedy for the adverse income tax impact and makes any valuation discount inappropriate if the deduction applies.4 Courts have likewise denied discounts for lack of marketability.5 The Service also determined that a deduction claimed on a decedent’s estate tax return – which represented income taxes paid by the estate on the estate’s income tax return, which in turn were triggered by the amount distributed to the estate from the decedent’s IRAs – was not allowable as a deduction under IRC Section 2053. According to the Service, even if the estate had not claimed the IRD deduction, the income taxes paid on the distributions from the IRAs would still not be deductible under IRC Section 2053 because any additional benefit beyond what Congress had intended would be unwarranted.6

      The Service has ruled that if the owner-annuitant of a deferred annuity contract dies before the annuity starting date, and the beneficiary receives a death benefit under the annuity contract, the amount received by the beneficiary in a lump sum in excess of the owner-annuitant’s investment in the contract is includible in the beneficiary’s gross income as IRD. If the death benefit is instead received in the form of a series of periodic payments, the amounts received are likewise includible in the beneficiary’s gross income in an amount determined under IRC Section 72 as IRD.7 See, e.g., Let. Rul. 200537019 (where the Service ruled that the amount equal to the excess of the contract’s value over the decedent’s basis, which would be received by the estate as the named beneficiary of the contract upon surrender of the contract, would constitute IRD includible by the estate in its gross income; however, the estate would be entitled to a deduction for the amounts of IRD paid to charities in the taxable year, or for the remaining amounts of IRD that would be set aside for charitable purposes).

      In Estate of Kahn,8 the Tax Court held that in computing the gross estate value, the value of the assets held in the IRAs is not reduced by the anticipated income tax liability following the distribution of IRAs, in part because IRC Section 691(c) addresses the potential double tax issue. The Tax Court further held that a discount for lack of marketability is not warranted because the assets in the IRAs are publicly traded securities. Payment of the tax upon distribution is not a prerequisite to making the assets in the IRA marketable; consequently there is no basis for the discount. In technical advice the Service has also determined that a discount for lack of marketability is not available to an estate where the deduction for IRD is available to mitigate the potential income tax liability triggered by the IRD assets.9


      1 .IRC Sec. 691(c); Rev. Rul. 78-203, 1978-1 CB 199.

      2 .IRC Sec. 1014(c).

      3 .FSA 200011023.

      4 .TAM 200247001; see also TAM 200303010.

      5 .See Est. of Smith v. U.S., 300 F.Supp.2d 474 (S.D. TX 2004), appeal docketed, No. 04-20194 (5th Cir. 2004); Est. of Robinson v. Comm., 69 TC 222 (1977).

      6 .Let. Rul. 200444021.

      7 .Rev. Rul. 2005-30, 2005-20 IRB 1015.

      8 .125 TC 227 (2005).

      9 .TAM 200247001; see also TAM 200303010.

  • 749. How are business expenses reported for income tax purposes?

    • A deduction is permitted for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business. Examples of deductible business expenses include: (1) expenditures for reasonable salaries, (2) traveling expenses (within limits), and (3) certain rental expenses incurred for purposes of a trade or business.1 Illegal payments made in the course of business, such as bribes to government officials or illegal rebates (see Q 658), are not deductible.2 Under the 2017 Tax Act, certain expenses paid to (or at the direction of) a government or government entity in relation to the violation of any law, or investigation into potential violations of the law, are not deductible.3 Further, amounts paid in relation to sexual harassment suits that are subject to a nondisclosure agreement are not deductible.4


      Planning Point: The IRS recently released a memorandum addressing whether a lawsuit settlement could be deducted as an expense under IRC Section 162(a).  It determined that the business itself was required to prove whether the payments were compensatory, and thus deductible, or punitive (such as a fine or penalty, and thus nondeductible).  This was the case despite the fact that the settlement specifically provided that the payments were not to be construed as fines or penalties.  A deductible payment under Section 162 is generally one meant to compensate another party or to ensure compliance with a law.  In this case, the IRS required further factual analysis to determine the nature of the payments, highlighting the fact that a settlement agreement alone will not be controlling.5


      In 2022, the business standard mileage rate is 58.5 cents per mile for the first half of the year and 62.5 cents for the second half (56 cents per mile in 2021, 57.5 cents in 2020, 58 cents in 2019, 54.5 cents in 2018 and 53.5 cents in 2017).6

      Planning Point: The IRS increased the business standard mileage rate in the second half of 2022 in response to rising gas prices.

      The amount of the deduction for expenses incurred in carrying on a trade or business depends upon whether the individual is an independent contractor or an employee. Typically, whether an insurance agent is considered an independent contractor or employee is determined on the basis of all the facts and circumstances involved; however, where an employer has the right to control the manner and the means by which services are performed, an employer-employee relationship will generally be found to exist.7 The IRS has ruled that a full-time life insurance salesperson is not an “employee” for purposes of IRC Sections 62 and 67, even though he is treated as a “statutory employee” for Social Security tax purposes.8 See Q 3928. Furthermore, according to decisions from the Sixth and Eleventh Circuit Courts of Appeals, the fact that an insurance agent received certain employee benefits did not preclude his being considered an independent contractor, based on all the other facts and circumstances of the case.9 The IRS has determined, however, that a district manager of an insurance company was an employee of the company, and not an independent contractor.10 On the other hand, the IRS has determined that individuals who were regional and senior sales vice presidents of an insurance company (but who were not officers of the company) were independent contractors and not employees of the insurance company.11


      Planning Point: The Sixth Circuit Court of Appeals confirmed in 2019 that life insurance agents were properly classified as independent contractors, rather than employees.  The case involved eligibility for benefits under ERISA, and a district court, using the traditional Darden factors for determining classification status, had ruled in 2017 that the agents were employees who were eligible for ERISA benefits.  In reversing the lower court, the Sixth Circuit gave weight to the fact that both parties had expressed their intent that an independent contractor relationship would apply.  The case also opens the possibility that the weight given to the various Darden factors should vary based upon the context of the case–for example, in this case, financial benefits were at issue, so the court gave more weight to the financial structure of the relationship.12


      Independent contractors may deduct all allowable business expenses from gross income (i.e., “above-the-line”) to arrive at adjusted gross income.13 Prior to 2018, the business expenses of an employee are deductible from adjusted gross income (i.e., “below-the-line”) if he or she itemizes instead of taking the standard deduction, but only to the extent that they exceeded 2 percent of adjusted gross income when aggregated with other “miscellaneous itemized deductions.” All miscellaneous itemized deductions subject to the 2 percent floor were suspended for 2018-2025.

      Industrial agents (or “debit agents”) are treated as employees for tax purposes.14 Thus, as in the case of any employee, a debit agent can deduct transportation and away-from-home traveling expenses from adjusted gross income if he itemizes, only to the extent that the aggregate of these and other miscellaneous itemized deductions exceed 2 percent of adjusted gross income (prior to 2018 and, presumably, after 2025).15

      Self-employed taxpayers are permitted a deduction equal to one-half of their self-employment (i.e., Social Security) taxes for the taxable year. This deduction is treated as attributable to a trade or business that does not consist of the performance of services by the taxpayer as an employee; thus it is taken “above-the line.”16

      In Allemeier v. Commissioner,17 the Tax Court held that the taxpayer could deduct his expenses ($15,745) incurred in earning a master’s degree in business administration to the extent those expenses were substantiated and education-related. The court based its decision on the fact that the taxpayer’s MBA did not satisfy a minimum education requirement of his employer, nor did the MBA qualify the taxpayer to perform a new trade or business.

      See Q 750 for a discussion of the business expense deduction for meals and entertainment, including a discussion of how the IRS has interpreted the changes imposed post-tax reform.


      1. IRC Sec. 162(a).

      2. IRC Sec. 162(c).

      3. IRC Sec. 162(f).

      4. IRC Sec. 162(q).

      5. ILM 201825027.

      6. IR 2017-204 Notice 2019-02, IR-2019-215, IR-2020-279, Notice 2022-03, A-2022-13.

      7. See Butts v. Comm., TC Memo 1993-478, aff’d, 49 F.3d 713 (11th Cir. 1995); Let. Rul. 9306029.

      8. Rev. Rul. 90-93, 1990-2 CB 33.

      9. See Ware v. U.S., 67 F.3d 574 (6th Cir. 1995); Butts v. Comm., above.

      10. TAM 9342001.

      11. TAM 9736002.

      12. Jammal v. American Family Life Insurance Co., 2019 U.S. App. LEXIS 2905.

      13. IRC Sec. 62(a)(1).

      14. Rev. Rul. 58-175, 1958-1 CB 28.

      15. IRC Sec. 67.

      16. IRC Sec. 164(f).

      17. TC Memo 2005-207.

  • 750. Can business meals and entertainment expenses continue to be deducted under the 2017 tax reform legislation? What guidance has the IRS provided on this issue?

    • Editor’s Note: The 50 percent limit discussed below was lifted for 2021 and 2020, so that business meal expenses are entirely tax deductible if they otherwise qualify for the deduction.

      Prior to 2018, expenses for business meals and entertainment were required to meet one of two tests, as defined in regulations, in order to be deductible. The meal had to be: (1) “directly related to” the active conduct of the trade or business, or (2) “associated with” the trade or business. Generally, the deduction for business meals and entertainment expenses was limited to 50 percent of allowable expenses.[1] The 50 percent otherwise allowed as a deduction was then subject to the 2 percent floor that applies to miscellaneous itemized deductions.[2]

      Under the 2017 Tax Act, the deduction for all business-related entertainment expenses was repealed.  However, the 50 percent deduction for food and beverage expenses was retained.  It seems clear that food and beverages consumed while traveling for business continue to be deductible subject to the 50 percent limit.

      Costs associated with meals and beverages provided for the convenience of the employer (i.e., meals brought to the office when employees are working late or provided through an onsite dining facility) are deductible subject to the 50 percent limit, but only through 2025.

      The IRS has released a technical advice memorandum (TAM) that sheds light on the potential tax implications when employers provide employees with free meals in the office.  Post-tax reform, meals provided “for the convenience of the employer” may receive favorable tax treatment.  In the TAM, the IRS denied exclusion of the meals’ value from employee compensation.  In the scenario presented, the employer provided free meals to all employees in snack areas, at their desks and in the cafeteria, justifying provision of these meals by citing need for a secure business environment for confidential discussions, employee protection, improvement of employee health and a shortened meal period policy.  The IRS rejected these rationales, stating that the employer was required to show that the policies existed in practice, not just in form, and that they were enforced upon specific employees.  In this case, the employer had no policies relating to employee discussion of confidential information and provided no factual support for its other claims.  General goals of improving employee health were found to be insufficient.  The IRS also considered the availability of meal delivery services a factor in denying the exclusion, but indicated that if the employees were provided meals because they had to remain on the premises to respond to emergencies, that would be a factor indicating that the exclusion should be granted.

      Post-tax reform, employees are permitted to exclude the cost of employer-provided meals furnished to employees on the premises and for the employer’s convenience.  The IRS guidance clarifies that the previously applicable standard, which requires that the meals are deemed to be provided for the employer’s convenience only if they are necessary for employees to properly perform their duties, will continue to apply even post-reform.  Employers who wish to provide meals under this “convenience of the employer” provision must be able to substantiate that they have policies in place reflecting the need, and must be able to show that those policies connect the employer’s stated needs and goals to the necessity of providing employee meals.  Sufficient substantiation will depend on the facts and circumstances of each case.[3]

      The IRS has provided further guidance on the matter of whether food or beverages with a client before or after an event that is clearly categorized as “entertainment” continue to be deductible subject to the 50 percent limit, or whether they will be categorized as pure “entertainment” expenses.  The 50 percent deduction for business meal expenses will continue in effect under the 2017 tax reform legislation under certain circumstances even if provided in connection with non-deductible entertainment expenses.  In general, business owners may continue to deduct 50 percent of business meal expenses that are ordinary and necessary expenses, so long as the meal is not lavish or extravagant under the circumstances.  The meal or beverages must also be provided to current or prospective business associates, and must be purchased separately from any entertainment activities that are taking place simultaneously.  It is also permissible that the cost of the food and beverages be separately stated from the cost of the entertainment on a receipt.[4]

      In general (both pre- and post-reform), the taxpayer or his employee generally must be present for meal expenses to be deductible, and expenses that are lavish or extravagant may be disallowed. Substantiation is required for lodging expenses and, in the case of expenditures incurred on or after October 1, 1995, for most items of $75.00 or more.[5] An employee must generally provide an “adequate accounting” of reimbursed expenses to his employer.[6]

      ______________

      [1].    IRC Sec. 274(n)(1).

      [2].    Temp. Treas. Reg. §1.67-1T(a)(2).

      [3].      IRS CCA 2018-004.

      [4].     Notice 2018-76.

      [5].    Treas. Reg. §1.274-5(c)(2)(iii).

      [6].    Treas. Reg. §1.274-5(f)(4).

  • 751. Can a self-employed taxpayer deduct his or her medical insurance costs?

    • A sole proprietor who purchases health insurance in his individual name has established a plan providing medical care coverage with respect to his trade or business, and therefore may deduct the medical care insurance costs for himself, his spouse, and dependents under IRC Section 162(l), but only to the extent the cost of the insurance does not exceed the earned income derived by the sole proprietor from the specific trade or business with respect to which the insurance was purchased.

      A self-employed individual may deduct the medical care insurance costs for himself and his spouse and dependents under a health insurance plan established for his trade or business up to the net earnings of the specific trade or business with respect to which the plan is established, but a self-employed individual may not add the net profits from all his trades and businesses for purposes of determining the deduction limit under IRC Section 162(l)(2)(A). However, if a self-employed individual has more than one trade or business, he may deduct the medical care insurance costs of the self-employed individual and his spouse and dependents under each specific health insurance plan established under each specific business up to the net earnings of that specific trade or business.1

      In a legal memorandum, the IRS ruled that a self-employed individual may not deduct the costs of health insurance on Schedule C. The deduction under IRC section 162(l) must be claimed as an adjustment to gross income on the front of Form 1040.2


      1 .CCA 200524001.

      2 .CCA 200623001.