SOLUTIONS MANUAL
MCGRAW HILL TAXATION OF BUSINESS ENTITIES 2025
CHAPTER NO. 01: BUSINESS INCOME, DEDUCTIONS, AND ACCOUNTING METHODS
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.
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 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.
MCGRAW HILL TAXATION OF BUSINESS ENTITIES 2025
CHAPTER NO. 01: BUSINESS INCOME, DEDUCTIONS, AND ACCOUNTING METHODS
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.
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 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.
