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NET INCOME Q. What is net income?
A. Net income is your total income from all sources (except the items exempt from tax under Section 213 (b) see pages 18 and 65), less the deductions allowed by the Law. In computing net income, "deductions” should not be confused with
credits.” Deductions are used in computing taxable net income; credits are used to reduce net income in computing the amount subject to normal tax. (See questions I and 3 under the heading “Personal Exemptions," page 12.)
DEDUCTIBLE ITEMS Q. What items may I deduct from gross income in ascertaining my net income?
A. You are entitled to deduct disbursements, such as ordinary and necessary expenses incurred in a business transaction; insurance premiums on business property; interest, except interest on indebtedness to buy or carry securities (other than obligations of the United States issued after September 24, 1917, and originally subscribed for by the taxpayer) the income from which is entirely exempt from tax; bad debts; business losses; a reasonable allowance for the exhaustion, wear and tear of property used in trade or business, etc. The items which may be deducted are set forth in Section 214 of the Law. (See page 67.)
Q. On April 15, 1924, I paid a New York State personal income tax of $500 on income received in 1923. Is this tax deductible from gross income in my Federal tax return for 1924?
A. Yes. Income taxes imposed by States may be deducted the same as real estate or personal property taxes.
Q. Are the annual fees for an operator's or a chauffeur's license and the registration fee on an automobile deductible?
A. Yes. These items are allowable deductions regardless of whether the car is used for business or pleasure.
Q. During the year I made a number of business trips. May expenditures incurred on these trips be deducted in my return?
A. Traveling expenses incurred in pursuit of your trade or business while away from home, including the entire amount expended for meals and lodging, are deductible.
Q. I do not maintain a reserve for bad debts, but charge off each debt as it becomes worthless. To deduct these charge-offs in my tax return must I first bring legal action to determine definitely that they are worthless?
A. No. Where surrounding circumstances indicate that a debt is worthless and that legal action to enforce payment probably would not result in the satisfaction of execution on a judgment, you are warranted in claiming the charge-off as a deduction in your return. The Commissioner, if satisfied that a debt is recoverable only in part, may permit it to be charged off in part.
Q. May a net loss incurred in one year be deducted from the profits of a succeeding year?
A. Yes. Within the limitations prescribed by Section 206 of the Law (page 59), a deficit in any taxable year resulting from the operation of a trade or business regularly carried on by a taxpayer may be deducted from the income of the next succeeding year. If the loss exceeds this income, the excess may be deducted from the income of the second succeeding taxable year. The “net loss" deductible is not necessarily the loss shown by the tax return or by the books of account; it is the excess of the deductions allowed over the gross income, with the following exceptions and limitations:
(1) Deductions otherwise allowed by law but not attributable to the operation of the trade or business are allowed only to the extent of the gross income from sources other than the trade or business.
(2) A taxpayer other than a corporation may deduct capital losses otherwise allowed by law only to the extent of the capital gains.
(3) The deduction for depletion must not exceed the amount which would be allowable if computed without reference to discovery value.
(4) The deduction granted corporations of dividends received from domestic corporations is not allowed.
(5) The gross income must be increased by the amount of interest received free from tax (i.e., State, county and municipal bond, etc., interest) less non-deductible interest (interest paid on money borrowed to purchase or carry taxexempt securities).
In addition to individual taxpayers and corporations, the benefit of this provision of the Law also is granted to members of partnerships, to estates and trusts, and to insurance companies taxable under Sections 243 or 246.
ITEMS Not DEDUCTIBLE
A. The Law expressly disallows the deduction of personal, living or family expenses, such as rent paid for a home, wages of domestic servants, cost of food, clothing, etc., for the family, education of the children, upkeep of an automobile for recreation, and similar items involved in the maintenance, well-being or pleasure of the taxpayer or his dependents.
Deductions may not include investments of a permanent nature; expenditures for the erection of buildings, grading of lawns and other permanent improvement of property; or the cost of installing machinery or buying books, tools or implements having a permanent value, or similar inconsumable property, since they constitute merely a change in form of capital, not a reduction of wealth. The test is whether a capital asset has been acquired.
Q. On November 3, 1924, I sold a bond for $950 which cost me $1,000 in 1920. On November 17, 1924, I repurchased and still hold a bond of the same issue. Is my loss deductible?
A. A loss resulting from the sale of securities outside the taxpayer's trade or business is not deductible where the same or substantially identical property is acquired within thirty days before or after the date of sale and held "for any period after such sale." (See Section 214 (a) 5, page 67.)
Q. In 1920, Fred Smith purchased 300 shares of A. & W. stock for $110 a share. He sold these shares on October 2, 1924, for $60 a share. A week later he purchased 200 shares of the same stock for $75 a share, and still holds them. What is his loss?
A. Since Mr. Smith purchased 200 shares within thirty days of his sale of 300 shares, only one-third of the loss resulting from the sale is deductible. (See Section 214, (a) 5, page 67.) The allowable loss is computed thus: 300 shares bought in 1920..
$33,000 300 shares sold October 2, 1924...
Loss on sale..
x $15,000 (loss on sale)
Q. How should inventories be valued?
A. Under the Regulations of the Commissioner inventories (1) must comply as nearly as may be to the best accounting practice in the trade or business of the taxpayer, and (2) must clearly reflect the income. The bases of valuation most commonly used by business concerns, which meet the requirements of the Revenue Act, are (a) cost or (b) cost or market, whichever is lower. To reflect income clearly, the inventory practice of a taxpayer should be consistent from year to year. A basis once established may be changed only by permission of the Commissioner.
Q. What does "cost" mean?
A. When merchandise is on hand at the beginning of the year, “cost” means the inventory price of the goods. The cost of merchandise purchased during the taxable year generally means the invoice price less trade or other discounts. To this should be added transportation and other necessary charges incurred in acquiring possession of the goods.
Strictly cash discounts, approximating a fair interest rate, may or may not be deducted at the option of the taxpayer, provided a consistent course is followed.
The cost of merchandise produced by the taxpayer during the taxable year is made up of: (a) the cost of raw materials and supplies used in making the product; (b) expenditures for direct labor; (c) indirect expenses involved in production of the particular article, including a reasonable proportion of management expenses, but no part of the cost of selling or any return on capital, whether as interest or as profit.
In an industry where the usual rules for computing production costs do not apply, the costs may be approximated upon any basis that is reasonable and in conformity with established trade practice in that industry.
Q. What is meant by “cost or market, whichever is lower" basis?
A. In using this basis each item of the inventory must be valued at cost, if the cost is lower than the market value when the inventory is taken, or at the market value if the market is lower than the cost. To illustrate:
Item 10,000 lbs. grade C wool 7,500
N cotton 50,000
8,900 7,200 18,000
$45,200 $44,650 $43,100 Q. What does “market” mean?
A. Under ordinary circumstances, and for normal goods in an inventory, “market" means the current bid price at the date of the inventory for the particular merchandise in the volume in which it usually is purchased by the taxpayer.
Q. What should the inventory include?
A. The inventory should include raw materials and supplies on hand that have been acquired for sale, consumption or use in production processes, together with all finished or partly finished goods. It should include merchandise, the title to which has passed to the taxpayer, even though it has not yet been delivered into his physical possession. It should not include goods ordered for future delivery, to which the taxpayer has not taken title.
A seller should include in his inventory goods under contract for sale but not yet segregated and applied to the contract, and goods out upon consignment. He should exclude goods sold, title to which has passed to the purchaser.
Q. How should unidentified goods be valued?
A. If goods are so intermingled that they cannot be identified with specific invoices, their value is considered to be (a) the cost of the goods most recently purchased or produced or (b) the net value as shown by the inventory if the taxpayer keeps book inventories in accordance with a sound accounting system.
NON-RESIDENT ALIENS, PARTNERSHIPS AND
A. Every non-resident alien individual who receives income from sources within the United States, as provided by Section 217 of the Law (page 70), is required to report this income in an individual income tax return, Form 1040 B. If he is a member of a foreign partnership, he must include in his return his dis