Solutions Manual—Taxation of Business Entities 2025 by Spilker et al.
Chapter 1
Business Income, Deductions, and Accounting Methods
SOLUTIONS MANUAL
Discussion Questions
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 unusual 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] Explain how cost of goods is treated when a business sells inventory.
Under the return of capital principle, cost of goods sold represents a reduction in gross
income rather than a business expense. For example, if a taxpayer sells inventory for
$100,000 and reports a cost of goods sold of $40,000, the business’s gross income is
$60,000 ($100,000 – 40,000) not $100,000.
3. [LO 1] Whether a business expense is “reasonable in amount” is often a difficult question.
Explain why determining reasonableness is difficult, and describe a circumstance where
reasonableness is likely to be questioned by the IRS.
Reasonableness is an issue of fact and circumstance, and extravagance is difficult to
determine because of the subjectivity and multitude of factors involved in determining
price. 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.
4. [LO 1] Jake is a professional dog trainer who purchases and trains dogs for use by law
enforcement agencies. Last year Jake purchased 500 bags of dog food from a large pet
food company at an average cost of $30 per bag. This year, however, Jake purchased 500
bags of dog food from a local pet food company at an average cost of $45 per bag. Under
what circumstances would the IRS likely challenge the cost of Jake’s dog food as
unreasonable?
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. Hence, the IRS is most likely to challenge the cost of the
dog food if Jake’s relatives control or own the local pet food company and was benefiting
from the increased price.
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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 that are against public
policy?
The Code lists bribes, kickbacks, and “other” illegal payments as nondeductible. Congress
didn’t want the tax benefits associated with deductions to benefit or subsidize wrongdoing.
Of course, this rationale doesn’t really explain the prohibition against deducting political
contributions which is probably better explained by the potential perception that political
efforts are being subsidized by taxpayers.
6. [LO 2] Provide an example of an expense associated with the production of tax-exempt
income and explain what might happen if Congress repealed the prohibition against
deducting expenses incurred to produce tax-exempt income.
Two common examples are interest expense associated with debt used to purchase
municipal bonds and life insurance premiums paid on key employee insurance. If this
prohibition were repealed, then taxpayers would have an incentive to borrow to invest in
municipal bonds or borrow to invest in employee life insurance. This former practice
would lead to higher demand for municipal bonds (less yield) and less revenue for the
government. The latter practice would lead to higher demand for insurance (higher
premiums?) and less revenue for the government. Both practices could lead to a
perception of inequity between those taxpayers able to utilize the tax arbitrage to reduce
taxes and those who could not use the practice.
7. [LO 2] {Research} Peggy is a rodeo clown, and this year she expended $1,000 on special
“funny” clothes and outfits. Peggy would like to deduct the cost of these clothes as work-
related because she refuses to wear the clothes unless she is working. Under what
circumstances can Peggy deduct the cost of her clown clothes?
Taxpayers may deduct the cost of uniforms or special clothing they use in their business
when the clothing is not appropriate to wear as ordinary clothing outside the place of
business. In Peggy’s case, the clown clothes are analogous to special uniforms or
protective garments and could be deductible. See D. Techner, TC Memo 1997-498. Erhard
Seminar Training, TC Memo 1986-526 provides an example of clothes that were not
deductible because they were appropriate for normal wear. However, the cost of clothing
would not likely be deductible if the clothes were unacceptable solely because of the
taxpayer’s sense of fashion.
8. [LO 2] Jimmy is a sole proprietor of a small dry-cleaning business. This month Jimmy
paid for his groceries by writing checks from the checking account dedicated to the dry-
cleaning business. Why do you suppose Jimmy is using his business checking account
rather than his personal checking account to pay for personal expenditures?
Jimmy might be trying to reduce his bank charges by using one account for both personal
and business expenditures, but he could also be trying to disguise personal expenditures as
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business expenses. By commingling business and personal expenditures, Jimmy will need
to separate personal and business expenditures before claiming any business deductions.
9. [LO 2] Troy operates an editorial service that often entertains prospective authors to
encourage them to use Troy's service. This year Troy paid $3,000 for the cost of meals and
$6,200 for the cost of entertaining authors. Describe the conditions under which Troy can
deduct a portion of the cost of the meals as a business expense.
To deduct 50 percent of the cost of meals as a business expense, the meals must be
ordinary and necessary to Troy’s business, and the amount must be reasonable under the
circumstances. In addition, Troy or an employee must be present when the meal is
furnished, and the meal must be furnished to an actual or potential business associate.
Finally, the cost of the meals must be separately stated (by invoice) from the cost of the
entertainment (the cost of the entertainment is not deductible).
10. [LO 2] Susmita purchased a car this year and uses it for both business and personal
purposes. Susmita drove the car 11,000 miles on business trips and 9,000 miles for
personal transportation. Describe how Susmita will determine the amount of deductible
expenses associated with the auto.
Because only the expense relating to business use is deductible, the taxpayer must allocate
the expenses between the business and personal use portions. A common method of
allocation is relative use. In this instance, Susmita would calculate the business portion
based upon the ratio of business miles to total miles (11/20 or 55 percent). She would then
deduct the costs of operating the vehicle for business purposes plus depreciation on the
business portion (55 percent) of the vehicle’s tax basis. Alternatively, in lieu of deducting
these costs, Susmita may elect to deduct a standard amount for each business mile she
drives. The standard mileage rate (67 cents per mile for 2024) represents the per-mile cost
of operating an automobile (including depreciation or lease payments). Once Susmita has
made this election, she must continue to use it throughout the life of the auto.
11. [LO 1, LO 2] What expenses are deductible when a taxpayer combines both business and
personal activities on a trip? How do the rules for international travel differ from the rules
for domestic travel?
If the taxpayer has both business and personal motives for a trip, but the primary or
dominant motive is business, the taxpayer may deduct the transportation costs to get to the
place of business, but they may deduct only meals (50%), lodging, transportation on site,
and incidental expenditures for the business portion of the travel. If the taxpayer’s primary
purpose for the trip is personal, the taxpayer may not deduct transportation costs to travel
to and from the location, but the taxpayer may deduct meals (50%), lodging,
transportation, and incidental expenditures for the business portion of the trip. For
international travel taking more than one week, the taxpayer must allocate the cost of the
transportation between personal (nondeductible) and business (deductible) activities.
Taxpayers generally determine the nondeductible portion of the transportation costs by
multiplying the travel costs by a ratio of personal activity days to total days travelling.
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Finally, remember that travel days are considered business activity days for both domestic
and international travel.
12. [LO 2] Clyde lives and operates a sole proprietorship in Dallas, Texas. This year Clyde
found it necessary to travel to Fort Worth (about 25 miles away) for legitimate business
reasons. Is Clyde’s trip likely to qualify as “away from home”? Why would this
designation matter?
Besides the cost of transportation, the deduction for travel expenses includes meals (50%),
lodging, and incidental expenses. However, travel expenses are only deductible if the
taxpayer is away from home overnight while traveling. For this purpose, a taxpayer is
“away from home overnight” if the trip is of sufficient duration to require sleep or rest. It
is likely that Clyde’s trip will not satisfy this condition and that he will not be able to
deduct costs for meals and lodging.
13. [LO 2] Describe the record-keeping requirements for deducting business expenses,
including mixed-motive expenditures.
Taxpayers must keep specific, written, contemporaneous records of time, amount of the
expenditure, and business purpose of the travel. No deductions are allowed absent
sufficient records to document business purpose. Records of the expenditure amount,
however, may not be necessary if the taxpayer claims per diem amounts.
14. [LO 2] Describe the computation of the limit placed on the business interest deduction. Is
the disallowed business interest ever deductible?
The deduction of business interest expense is limited to the sum of business interest income
plus 30 percent of the business's adjusted taxable income. Business interest is defined as
any interest paid on debt allocable to a trade or business activity, and adjusted taxable
income is taxable income allocable to the business activity computed before deductions for
interest expense and net operating loss carryovers. Disallowed business interest can be
carried forward indefinitely.
15. [LO 2] Describe the gross receipts test and identify how this test relates to the business
interest deduction.
The gross receipts test is an annual test designed to identify small businesses that
Congress intended to exempt from some of the more complex and onerous provisions of the
law, such as the business interest deduction. As the name implies, size is measured by
whether average gross receipts exceeds a threshold amount, and businesses whose gross
receipts do not exceed the threshold in any tax year are not subject to this limitation in that
year. This amount was originally set at $25 million, but since it is indexed for inflation, the
amount in 2024 is set at $30 million. The average gross receipts is determined using the
previous three years of receipts (after subtracting sales returns and allowances). When the
business has not been in existence for three prior tax years, the test is conducted using the
years that it was in existence. Also, in the case of a taxable year of less than 12 months (a
short year), the amount of gross receipts must be annualized by multiplying the gross
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