Essay on Taxation
Business Income, Deductions, and Accounting Methods
1. [LO 1] What is an “ordinary and necessary” business expenditure? “Ordinary” and “necessary” imply that an expense must be customary and helpful, respectively. Because these terms are subjective, the tests are ambiguous. However, ordinary is interpreted by the courts as including expenses which may be unusual for a specific taxpayer (but not for that type of business) and necessary is not interpreted as only essential expenses. These limits can be contrasted with the reasonable limit on amounts and the bona fide requirement for profit motivation.
2. [LO 1] Is cost of goods sold deductible as a business expense for a …show more content…
Under what circumstances would the IRS likely challenge the cost Jake’s dog food as unreasonable? Reasonableness is an issue of fact and circumstance, and extravagance is difficult to determine definitely. However, a common test for reasonableness is whether the expenditure is comparable to an arm's length amount – a price charged by objective (unrelated) individuals who do not receive any incidental personal benefits. Reasonableness is most likely to be an issue when a payment is made to a related individual or the taxpayer enjoys some personal benefit incidental to the expenditure. Hence, the IRS is most likely to challenge the cost of the dog food if Jake or his family controlled the local pet food company.
5. [LO 2] What kinds of deductions are prohibited as a matter of public policy? Why might Congress deem it important to disallow deductions for expenditures against public policy? The IRC lists bribes, kickbacks, and “other” illegal payments as nondeductible. Congress didn’t want the tax