Welcome back. In the next series of videos, we'll examine deductions more closely. First, recall that deductions are essentially the tax word for expense that can reduce the tax base. Recall that Section 61 defines income as broadly conceived. That is the taxpayer should assume everything is income unless Congress says it's not. But with deductions, on the other hand, we should always assume deductions are disallowed. That is, we cannot reduce income by them unless a specific provision permits the deduction. The courts have generally held that whether and to what extent deductions are allowed depends on legislative grace. That is what Congress has decided to legislatively decree what is an allowable expense that can reduce the tax base. As a result, deductions are defined quite narrowly and have many rules associated with them. This is for a good reason since the risk is that taxpayers might abuse deductions and reduce their tax base by too much, leaving less money to the government to fund its operations and investments. Another important aspect of deductions is substantiation. This means that the taxpayer has the burden of proof for supporting whether all deductions claimed on the tax return are legitimate. To do so taxpayers must maintain adequate records. For example, if you're a small business owner and have legitimate business expenses associated with travel, hotel, maybe advertising, it's incredibly important that you keep receipts and the invoices to prove that these expenses are legitimate in case the IRS decides to audit you or your tax return. This is the proverbial behavior of sticking all my receipts in a shoebox. We need these receipts to the extent we want to claim certain deductions and must substantiate the legitimacy for those deductions. So let's look back at the income tax formula. We've already discussed gross income and so the first set of deductions we'll look at is called Deductions for Adjusted Gross Income or deductions for AGI. These deductions are subtracted from gross income to then yield Adjusted Gross Income. Recall that this subtotal, AGI, is very important because it determines floors and ceilings in terms of the amount of many other deductions that we'll see later that can be claimed on a taxpayer's tax return. AGI also affects the size of tax credits that can be claimed as well. As a result, we need to make sure we can identify the right expenses as deductions for AGI. Broadly speaking, what are deductions for AGI? Because they're subtracted from gross income to determine Adjusted Gross Income, they're also called above the line deductions or above AGI. These expenses can be deducted even if a taxpayer does not itemize. That is, even if a taxpayer takes the simple standard deduction and does not keep track of itemized deductions like medical expenses or donations to charity. If a taxpayer does itemize, then the for AGI deductions will determine the size of some of those itemized deductions. For example, medical expenses are deductible only to the extent they exceed 7.5 percent of AGI. So specific to the actual deductions for AGI, they can essentially be placed into two broad categories. The first is expenses related to business activities whether they're direct or indirect expenses. This includes business expenses related to running a business as a sole proprietor or a partner in a partnership. For example, sole proprietor expenses are reported on a Form 1040 Schedule C. Expenses related to partnership business activities or rental activities are reported on Schedule E. The second category is expenses that subsidize specific activities. For example, paying alimony, paying for education-related tuition and fees, paying interest on a student loan, or contributing funds into a Traditional Individual Retirement Account or IRA. These are all activities that Congress has deemed to deserve a deduction that offsets gross income. Thus they lower the individual's tax base. So after subtracting for AGI deductions from gross income in yielding Adjusted Gross Income, the taxpayer has the choice to deduct the greater of either itemized deductions, also known as from AGI deductions or the standard deduction. We've already discussed the standard deduction in a previous video. So let's focus on from AGI deductions here. If the taxpayer selects to deduct itemized deductions, he or she has to report them on Schedule A of the Form 1040. From AGI deductions here include medical expenses to the extent they exceed 7.5 percent of AGI. State and local taxes up to a $10,000 cap, for example, the income taxes I pay to the state of Illinois are a deduction on my federal tax return up to the cap. Contributions to qualify charities, for example, the American Red Cross or American Cancer Society. Gambling losses, some types of personal interest expense such as home mortgage interest and investment interests, and personal casualty losses but only if they are attributable to a federally declared disaster area. Again note that some AGI thresholds apply in calculating these deductions. So they may not be necessarily be fully deductible after all is said and done. It's also important to mention Section 212 here. Section 212 allows deductible treatment for expenses that are what's known as ordinary and necessary. That is, related to the production or collection of income, the management, conservation, or maintenance of property held for the production of income, and expenses paid in connection with the determination, collection, or refund of any tax. So what does this actually mean? What are some examples here? Well, IRC Section 212 allows some expenses to be deductible. In particular, deductible for AGI if their expenses related to producing rent or royalty income. For example, you own an office building that you rent out, but you have some expenses associated with the office building like utilities, maintenance, and insurance, these expenses will be deductible for AGI. Other examples could be expenses paid to determine the taxpayer's tax liability related to their business, rent, royalty, or farming operations. For example, if the sole proprietor hires an accountant to calculate the income tax and file a tax return, the payment made by the sole proprietor for the accountant will be a for AGI deduction. So where do trade or business-related expenses show up on the tax return? First, their details are reported on Schedule C, E, or F. Schedule C details the profit or loss from a business of a sole proprietor, or a one-owner business. It could be a taxpayer's main source of income, for example, a business selling goods or services, or it could be a business activity on the side. For example, if you're a freelance artist, or author on the side, or a part-time consultant. In any of those cases, you would report the income generated and related expenses on Schedule C. The key here, however, is that the deductions must be directly connected to generating the income in that business activity. Schedule E details the income and losses from other activities such as from rental properties or royalty activities or for partnerships or being a shareholder in what's known as an S-Corporation. These types of businesses, as well as a sole proprietorship, are broadly known as pass-through entities. Here the income and expenses are not taxed at the business entity level, but rather are passed through to the individual owner or investor to be taxed only at the individual's level. Therefore, there's only one layer of tax. Contrast this with a typical C-Corporation - think Microsoft or Ford Motor Company - where the corporation pays an entity-level tax, but then when it distributes dividends to their shareholders, the shareholders pay tax on the dividend income as well. People refer to this structure as the double taxation of corporate income. But what gets reported on Schedule C and E is income and losses from pass-through businesses. In fact, profit and losses from farming reported on Schedule F also represent pass-through activities. Here, the farmer reports the various income and expenses related to farming, then reports the net amount on the individual tax return. For all these activities, the net amount appears on the face of the Form 1040. In particular, these are the exact spots where the individual's business income is reported on the individual tax return whether it be from Schedule C, E, or F. These net profits or losses are summarized on the face of the Form 1040 to be combined with other income items. Because expenses associated with these business activities are deducted before arriving at AGI, they are all considered for AGI deductions. So in all, in this video, we've gone through, at a very high level, the distinction between for and from AGI deductions as most touched on business-related and investment-related expenses.
