Federal Taxation

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accounting method

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The method under which income and expenses are determined for tax purposes. Important accounting methods include the cash basis and the accrual basis. Special methods are available for the reporting of gain on installment sales, recognition of income on construction projects (the completed contract and percentage of completion methods), and the valuation of inventories (last-in, first-out and first-in, first-out). §§ 446–474.

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deductions for adjusted gross income

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The Federal income tax is not imposed upon gross income. Rather, it is imposed upon taxable income. Congressionally identified deductions for individual taxpayers are subtracted either from gross income to arrive at adjusted gross income or from adjusted gross income to arrive at the tax base, taxable income.

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hobby losses

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Losses from an activity not engaged in for profit. The Code restricts the amount of losses that an individual can deduct for hobby activities so that these transactions cannot be used to offset income from other sources. § 183.

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ordinary and necessary

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An ordinary expense is one that is common and accepted in the general industry or type of activity in which the taxpayer is engaged. It comprises one of the tests for the deductibility of expenses incurred or paid in connection with a trade or business; for the production or collection of income; for the management, conservation, or maintenance of property held for the production of income; or in connection with the determination, collection, or refund of any tax. §§ 162(a) and 212. A necessary expense is one that is appropriate and helpful in furthering the taxpayer’s business or income-producing activity. §§ 162(a) and 212.

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reasonableness

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The Code includes a reasonableness requirement with respect to the deduction of salaries and other compensation for services. What constitutes reasonableness is a question of fact. If an expense is unreasonable, the amount that is classified as unreasonable is not allowed as a deduction. The question of reasonableness generally arises with respect to closely held corporations where there is no separation of ownership and management. § 162(a)(1).

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related-party transactions

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The tax law places restrictions upon the recognition of gains and losses between related parties because of the potential for abuse. For example, restrictions are placed on the deduction of losses from the sale or exchange of property between related parties. In addition, under certain circumstances, related-party gains that would otherwise be classified as capital gain are classified as ordinary income. §§ 267, 707(b), and 1239.

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vacation home

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The Code places restrictions upon taxpayers who rent their residences or vacation homes for part of the tax year. The restrictions may result in a scaling down of expense deductions for the taxpayers. § 280A.