6. Taxes

Introduction

You can deduct various federal, state, local, and foreign taxes directly attributable to your trade or business as business expenses.

You cannot deduct federal income taxes, estate and gift taxes, or state inheritance, legacy, and succession taxes.

Topics

This chapter discusses:

• When to deduct taxes
• Real estate taxes
• Income taxes
• Employment taxes
• Other taxes

Useful Items You may want to see:

Publication

• 15   Circular E, Employer's Tax Guide
• 378   Fuel Tax Credits and Refunds
• 533   Self-Employment Tax
• 538   Accounting Periods and Methods
• 551   Basis of Assets

Form (and Instructions)

• Sch A (Form 1040)   Itemized Deductions
• Sch SE (Form 1040)   Self-Employment Tax
• 3115   Application for Change in Accounting Method

See chapter 14 for information about getting publications and forms.

When To Deduct Taxes

Generally, you can only deduct taxes in the year you pay them. This applies whether you use the cash method or an accrual method of accounting.

Under an accrual method, you can deduct a tax before you pay it if you meet the exception for recurring items discussed under Economic Performance in Publication 538. You can also choose to ratably accrue real estate taxes as discussed later under Real Estate Taxes.

Limit on accrual of taxes.   A taxing jurisdiction can require the use of a date for accruing taxes that is earlier than the date it originally required. However, if you use an accrual method, and can deduct the tax before you pay it, use the original accrual date for the year of change and all future years to determine when you can deduct the tax.

Example.   Your state imposes a tax on personal property used in a trade or business conducted in the state. This tax is assessed and becomes a lien as of July 1 (accrual date). In 2002, the state changed the assessment and lien dates from July 1, 2003, to December 31, 2002, for property tax year 2003. Use the original accrual date (July 1, 2003) to determine when you can deduct the tax. You must also use the July 1 accrual date for all future years to determine when you can deduct the tax.

Uniform capitalization rules.   Uniform capitalization rules apply to certain taxpayers who produce real property or tangible personal property for use in a trade or business or for sale to customers. They also apply to taxpayers who acquire property for resale. Under these rules, you may have to either include certain costs in inventory or capitalize certain expenses related to the property, such as taxes. For more information, see Publication 551.

Carrying charges.   Carrying charges include taxes you pay to carry or develop real estate or to carry, transport, or install personal property. You can choose to capitalize carrying charges not subject to the uniform capitalization rules if they are otherwise deductible. For more information, see chapter 8.

Refunds of taxes.   If you receive a refund for any taxes you deducted in an earlier year, include the refund in income to the extent the deduction reduced your federal income tax in the earlier year. For more information, see Recovery of amount deducted in chapter 1.

You must include in income any interest you receive on tax refunds.

Real Estate Taxes

Deductible real estate taxes are any state, local, or foreign taxes on real estate levied for the general public welfare. The taxing authority must base the taxes on the assessed value of the real estate and charge them uniformly against all property under its jurisdiction. Deductible real estate taxes generally do not include taxes charged for local benefits and improvements that increase the value of the property. See Taxes for local benefits, later.

If you use an accrual method, you generally cannot accrue real estate taxes until you pay them to the government authority. You can, however, choose to ratably accrue the taxes during the year. See Choosing to ratably accrue, later.

Taxes for local benefits.   Generally, you cannot deduct taxes charged for local benefits and improvements that tend to increase the value of your property. These include assessments for streets, sidewalks, water mains, sewer lines, and public parking facilities. You should increase the basis of your property by the amount of the assessment.

You can deduct taxes for these local benefits only if the taxes are for maintenance, repairs, or interest charges related to those benefits. If part of the tax is for maintenance, repairs, or interest, you must be able to show how much of the tax is for these expenses to claim a deduction for that part of the tax.

Example.   X City, to improve downtown commercial business, converted a downtown business area street into an enclosed pedestrian mall. The city assessed the full cost of construction, financed with 10-year bonds, against the affected properties. The city is paying the principal and interest with the annual payments made by the property owners.

The assessments for construction costs are not deductible as taxes or as business expenses, but are depreciable capital expenses. The part of the payments used to pay the interest charges on the bonds is deductible as taxes.

Charges for services.   Water bills, sewerage, and other service charges assessed against your business property are not real estate taxes, but are deductible as business expenses.

Purchase or sale of real estate.   If real estate is sold, the real estate taxes must be divided between the buyer and the seller.

The buyer and seller must divide the real estate taxes according to the number of days in the real property tax year (the period to which the tax imposed relates) that each owned the property. Treat the seller as paying the taxes up to but not including the date of sale. Treat the buyer as paying the taxes beginning with the date of sale. You can usually find this information on the settlement statement you received at closing.

If you (the seller) cannot deduct taxes until they are paid because you use the cash method and the buyer of your property is personally liable for the tax, you are considered to have paid your part of the tax at the time of the sale. This lets you deduct the part of the tax up to the date of sale even though you did not pay it. You must also include the amount of that tax in the selling price of the property.

If you (the seller) use an accrual method and have not chosen to ratably accrue real estate taxes, you are considered to have accrued your part of the tax on the date you sell the property.

Example.   Al Green, a calendar year accrual method taxpayer, owns real estate in X County. He has not chosen to ratably accrue property taxes. November 30 of each year is the assessment and lien date for the current real property tax year, which is the calendar year. He sold the property on June 30, 2002. Under his accounting method he would not be able to claim a deduction for the taxes because the sale occurred before November 30. He is treated as having accrued his part of the tax, 180/365  (January 1-June 29), on June 30 and he can deduct it for 2002.

Choosing to ratably accrue.   If you use an accrual method, you can choose to accrue real estate tax related to a definite period ratably over that period.

Example.   John Smith is a calendar year taxpayer who uses an accrual method. His real estate taxes for the real property tax year, July 1, 2002, to June 30, 2003, are $1,200. July 1 is the assessment and lien date.

If John chooses to ratably accrue the taxes, $600 will accrue in 2002 ($1,200 × 6/12, July 1-December 31) and the balance will accrue in 2003.

Separate choices.   You can choose to ratably accrue the taxes for each separate trade or business and for nonbusiness activities if you account for them separately. Once you choose to ratably accrue real estate taxes, you must use that method unless you get permission from the IRS to change. See Changing, later.

Making the choice.   If you choose to ratably accrue the taxes for the first year in which you incur real estate taxes, attach a statement to your income tax return for that year. The statement should show all the following items.

• The trades or businesses to which the choice applies and the accounting method or methods used.
• The period to which the taxes relate.
• The computation of the real estate tax deduction for that first year.

Generally, you must file your return by the due date (including extensions). However, if you timely filed your return for the year without choosing to ratably accrue, you can still make the choice by filing an amended return within 6 months after the due date of the return (excluding extensions). Attach the statement to the amended return and write Filed pursuant to section 301.9100-2 on the statement. File the amended return at the same address you filed the original return.

If you choose to ratably accrue for a year after the first year in which you incur real estate taxes, file Form 3115. Generally, you must file this form during the tax year for which the choice is to be effective. For more information, see the instructions for Form 3115.

Changing.   To change your choice to ratably accrue real estate taxes, file Form 3115 during the tax year for which the change is requested.

Income Taxes

This section discusses federal, state, local, and foreign income taxes.

Federal income taxes.   You cannot deduct federal income taxes.

State and local income taxes.   A corporation or partnership can deduct state income taxes imposed on the corporation or partnership as business expenses. An individual can deduct state income taxes only as an itemized deduction on Schedule A (Form 1040).

However, an individual can deduct a state tax on gross income (as distinguished from net income) directly attributable to a trade or business as a business expense.

Accrual of contested income taxes.   If you use an accrual method, can deduct taxes before you pay them, and contest a state or local income tax liability, a special rule applies. Under this special rule, you must accrue and deduct any contested amount in the tax year in which the liability is finally determined.

Filing a tax return is not considered contesting a liability. If you do not make an objective act of protest or show some affirmative evidence of denial of the liability, you can deduct any additional state or local income taxes found to be due for a prior year in the year for which they were originally imposed. You cannot deduct them in the year in which the liability is finally determined.

Foreign income taxes.   Generally, you can take either a deduction or a credit for income taxes imposed on you by a foreign country or a U.S. possession. However, an individual cannot take a deduction or credit for foreign income taxes paid on income that is exempt from U.S. tax under the foreign earned income exclusion or the foreign housing exclusion. For information on these exclusions, see Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad. For information on the foreign tax credit, see Publication 514, Foreign Tax Credit for Individuals.

Employment Taxes

If you have employees, you must withhold various taxes from your employees' pay. Most employers must withhold their employees' share of social security and Medicare taxes along with state and federal income taxes. You may also need to pay certain employment taxes from your own funds. These include your share of social security and Medicare taxes as an employer, along with unemployment taxes.

You should treat the taxes you withhold from your employees' pay as wages on your tax return. You can deduct the employment taxes you must pay from your own funds as taxes.

Example.   You pay your employee $18,000 a year. However, after you withhold various taxes, your employee receives $14,500. You also pay an additional $1,500 in employment taxes. You should deduct the full $18,000 as wages. You can deduct the $1,500 you pay from your own funds as taxes.

For more information on employment taxes, see Publication 15.

Unemployment fund taxes.   As an employer, you may have to make payments to a state unemployment compensation fund or to a state disability benefit fund. Deduct these payments as taxes.

Other Taxes

The following are other taxes you can deduct if you incur them in the ordinary course of your trade or business.

Excise taxes.   You can deduct as a business expense all excise taxes that are ordinary and necessary expenses of carrying on your trade or business. However, see Fuel taxes, later.

Franchise taxes.   You can deduct corporate franchise taxes as a business expense.

Fuel taxes.   Taxes on gasoline, diesel fuel, and other motor fuels that you use in your business are usually included as part of the cost of the fuel. Do not deduct these taxes as a separate item.

You may be entitled to a credit or refund for federal excise tax you paid on fuels used for certain purposes. For more information, see Publication 378.

Occupational taxes.   You can deduct as a business expense an occupational tax charged at a flat rate by a locality for the privilege of working or conducting a business in the locality.

Personal property tax.   You can deduct any tax imposed by a state or local government on personal property used in your trade or business.

Sales tax.   Treat any sales tax you pay on a service or on the purchase or use of property as part of the cost of the service or property. If the service or the cost or use of the property is a deductible business expense, you can deduct the tax as part of that service or cost. If the property is merchandise bought for resale, the sales tax is part of the cost of the merchandise. If the property is depreciable, add the sales tax to the basis for depreciation. For more information on basis, see Publication 551.

Do not deduct state and local sales taxes imposed on the buyer that you must collect and pay over to the state or local government. Do not include these taxes in gross receipts or sales.

Self-employment tax.   You can deduct one-half of your self-employment tax as a business expense in figuring your adjusted gross income. This deduction only affects your income tax. It does not affect your net earnings from self-employment or your self-employment tax.

To deduct the tax, enter on Form 1040, line 29, the amount shown on the Deduction for one-half of self-employment tax line of Schedule SE (Form 1040).

For more information on self-employment tax, see Publication 533.

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