Take ALL Expenses

[Snaggletooth]

This is an EXCELLENT ethical question!! Invite all of you to express opinion.

The discussion has raged in the past on whether to take ALL expenses for a business when lowering the profit will decrease EIC. The general consensus is this is unethical. My approach is that I take all expenses that I would normally take, but do not take heroic measures to dig out expenses that are hidden or questionable. I NEVER try to maximize the EIC - instead, my approach is "whatever comes out comes out."

Situation: Home equity loan proceeds have been used for business. Taxpayer ALWAYS has the option of reporting this on Schedule A. For 2009, the 1098 reads $17K, and the business portion allocates appx $10K.

For 2009, business has a bad year, and reports only $15,000 in profit BEFORE deducting the interest. Although business is entitled to deduct another $10,000, if taxpayer reports all of the interest on Schedule A, business income will remain high enough to result in whopping amounts of EIC. The extra SE tax would be overwhelmed by the EIC.

Business has deducted the allocation of interest in prior years. By choosing to report ALL interest on Schedule A, are we
1) merely making an election to which the taxpayer is entitled? or
2) committing an ethical violation because of inconsistent treatment?

[Keep in mind, a very broad range of "elections" exist in the Code and Regs, particularly in choosing sec. 179 depr, depr conventions, lives, NOL rollforwards/back, etc.]

[ChEAr$]

expenses and EIC

This is not an ethical question atall, for IRS has already ruled that all ordinary and necessary
expenses MUST be taken.

[taxmandan]

This is an EXCELLENT ethical question!! Invite all of you to express opinion.

The discussion has raged in the past on whether to take ALL expenses for a business when lowering the profit will decrease EIC. The general consensus is this is unethical. My approach is that I take all expenses that I would normally take, but do not take heroic measures to dig out expenses that are hidden or questionable. I NEVER try to maximize the EIC - instead, my approach is "whatever comes out comes out."

Situation: Home equity loan proceeds have been used for business. Taxpayer ALWAYS has the option of reporting this on Schedule A. For 2009, the 1098 reads $17K, and the business portion allocates appx $10K.

For 2009, business has a bad year, and reports only $15,000 in profit BEFORE deducting the interest. Although business is entitled to deduct another $10,000, if taxpayer reports all of the interest on Schedule A, business income will remain high enough to result in whopping amounts of EIC. The extra SE tax would be overwhelmed by the EIC.

Business has deducted the allocation of interest in prior years. By choosing to report ALL interest on Schedule A, are we
1) merely making an election to which the taxpayer is entitled? or
2) committing an ethical violation because of inconsistent treatment?

[Keep in mind, a very broad range of "elections" exist in the Code and Regs, particularly in choosing sec. 179 depr, depr conventions, lives, NOL rollforwards/back, etc.]

TheIRS has made it clear that they reject any failure to claim expenses in order to increase the EITC by self-employed business owners. Your "election" to not claim interest that was claimed in prior years would certainly not be acceptable to theIRS. And they are aggressively watching for just such a situation so I would not change the election for treatment of the interest.

[Gretel]

Taxpayer ALWAYS has the option of reporting this on Schedule A.

Ron, I disagree with you. You only have the option in the first year. Election becomes irrevocable unless the use of funds changes.

No sleepless nights over EIC.

[Snaggletooth]

I expected this

outpouring of horror,..and I am aware the IRS is clear on the matter of understating expenses to maximize EIC or other phased optimizations.

But what about the taxpayer's right to make an election? Why would they even call it an "election" were it not the taxpayer's option to maximize his tax situation? Would your answer be the same if:

The business has 6 - 8 truck rigs, and buys one or two every year. 2009 is a bad year, and he buys a 2 rigs. Because it is a bad year, he sets up depreciation under the Alternate Depreciation - 4 yrs SL instead of 3 yrs DD. As a result he has a small profit and EIC instead of a loss and no EIC.

Does he not have the right to this election? I think he does. The selection of equipment lives and methods is not binding on the next year's election for new equipment. And if Sch A for home equity interest is an election as well, then what is the difference??

p.s. I intentionally have not revealed how I filed the return.
p.s.s. Gretel, if you are correct, then the election is a matter of consistency.

[snowshine]

I guess the question would be is he willing to pay extra SE tax for that interest in other years? If it isn't ordinary and necessary now...

I just had a self employed person who lost some EIC because of the home office deduction. I explained to her that consistency was more important than a few dollars when dealing with the IRS!

[thomtax]

Snag,
Not taking either side on this, just a point to consider and I am not trying to be a smart aleck. My question is where did you ever get the idea that the IRS is fair or consistent?
I have seen no indication of this from them.

LT

[Bees Knees]

TTB, page 11-9 has the following author’s comment:

Author’s Comment: All allowable expenses must be
deducted in computing SE income. Net earnings from self-employment
are defined in IRC Section 1402(a) as the gross
income for the business “less the deductions allowed by this
subtitle which are attributable to such trade or business.”
The IRS looks closely at taxpayers who claim the EIC based on net
earnings from self-employment with little or no reported expenses and
will make appropriate adjustments or disregard the self-employment
income altogether for purposes of computing EIC. The IRS cautions
taxpayers to consider the 10-year disallowance of EIC in cases of fraud.
(Ltr. Rul. 200022051)

Note the letter ruling citation (which is only binding on the taxpayer that requested the letter ruling). That letter ruling says in part:

Therefore, when a taxpayer who claims the EIC reports net earnings from
self-employment with little or no reported expenses and the Service determines that the taxpayer has additional allowable expenses, the Service must subtract these additional expenses to determine the taxpayer's correct net earnings from self-employment.

The context of that statement is in regards to a taxpayer with allowable expenses but does not claim them. Nothing in that letter ruling says the taxpayer must make all possible elections to reduce tax to its lowest amount.

A typical example would be Section 179, which is an election. If the taxpayer is claiming depreciation on an expense for a depreciable asset, but does not make a Section 179 expense election, the taxpayer is still claiming the allowable expense when claiming a depreciation deduction under the normal MACRS percentage method. The IRS did not state in the letter ruling that the taxpayer is required to make all possible elections. The IRS merely said the taxpayer must claim all allowable deductions.

There is a difference, and to make the claim otherwise is going beyond what the IRS said in that letter ruling.

[BP.]

Home equity loan proceeds have been used for business.

Maybe not so much an ethical question, but a question on treatment of the home equity debt.

Taxpayer ALWAYS has the option of reporting this on Schedule A.

Is there "ALWAYS" this option? Would the treatment of the home equity interest be subject to the rules for deducting home equity debt, Pub 936?

http://www.irs.gov/pub/irs-pdf/p936.pdf

[Gretel]

p.s.s. Gretel, if you are correct, then the election is a matter of consistency.

Ron, see TTB 4-11.

[erchess]

Observations

1. We can all see from Bees' post that the requirement to claim all expenses does not mean that every election that would affect EIC must be made to reduce EIC. However I didn't notice in his post cites of what is and is not permissible. The taxpayers asked about one specific fact pattern and received an answer restricted to that fact pattern.

2. We all know that there is under certain circumstances an available election to claim mortgage or perhaps more properly home equity interest on other forms instead of Sch A .

3. Ron seems to think that this election is made year to year. That is what I thought as well but many intelligent people have chimed in to say that whatever one decides in the first year must be followed until there is a change in the facts.

4. I don't think Snowshine's example is on point. I believe that home office expenses if incurred must be claimed if there is a tax savings from not doing so. What's being debated here is precisely whether the same may bes said of the election relating to interest.

[Bees Knees]

3. Ron seems to think that this election is made year to year. That is what I thought as well but many intelligent people have chimed in to say that whatever one decides in the first year must be followed until there is a change in the facts.

As Gretel has pointed out, once the election is made to deduct the interest as business interest rather than as mortgage interest on Schedule A, the interest must continue to be treated as business interest. TTB cites Reg. §1.163-10T(o)(5) which says:

(5) Election to treat debt as not secured by a qualified residence —(i) In general. For purposes of this section, a taxpayer may elect to treat any debt that is secured by a qualified residence as not secured by the qualified residence. An election made under this paragraph shall be effective for the taxable year for which the election is made and for all subsequent taxable years unless revoked with the consent of the Commissioner.

Unless the taxpayer can get IRS to revoke the election, the taxpayer must continue to deduct the allowable interest as business interest.

That, however, is entirely different than requiring the taxpayer to make the election in the first year. If it is an election, it is not required to be made for EIC purposes. As I stated before, the IRS letter ruling is talking about claiming all allowable deductions. Not making all allowable elections.

[erchess]

TY Bees

I get it now.

[Edsel]

First Year Election

as in TTB4-11 means once the election is made in the first year, the treatment of mortgage interest as to business versus personal is incumbent upon all succeeding years.

The problem is mixed use, and churning of mortgages. People such as those described refinance their operation every 2-3 years, and with home equity being used, a new loan is made from time to time when new equipment is bought.

I believe TTB4-11 applies to the mortgage at hand, and with each new mortgage, the opportunity arises for the election to be made anew. And I can't believe anyone would go through the agony of procuring a mortgage just to optimize EIC. Most of these mortgages are "churned" for purposes of survival.

This approach has parallels in the purchase of equipment. In one year, the buyer has a choice for s.179, MACRS, alternate MACRS, conventions, bonus depr. etc. In the second year, the elections made in Year 1 must be honored in computing the depreciation for that equipment. However, NEW purchases in Year 2 may be subjected to entirely different elections.

[Snaggletooth]

Outcome

Just to close this rather lively discussion, I will now reveal how I filed the return, with the perceived (right or wrong) option of electing Schedule A treatment of mixed use loan.

The loan is three years old. It consolidated a number of smaller loans, including mortgage on the farm, personal loans, and business loans. The use of the loan funds was thus split into $X for this payoff, $Y for that payoff, and $Z for purchase of business equipment. Some 61% of this consolidation loan was for purchase of business equipment. Every year since the loan was made, I have been reporting 61% of the interest on Sch C and the remainder on Sch A -- subject to standard deduction.

For the year in question, I continued consistently, reporting 61% of the interest as business expense. Thus foregoing the treatment of 100% Sch A reporting to maximize business profits. I did this prior to beginning this thread with the question, but may have considered changing if there had been broad support for Sch A position. From the posts above, I think most of you would have done the same.