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out, will be forced to depreciate at least part of their newly acquired assets
and will be allowed to take a tax deduction for only part of their expenditure
in the year in which the assets were acquired.
Using Business Pr ofits to Buy Out Other Owners
It is not uncommon for business owners to buy out the interests of fellow
owners and pay them with future earnings of the businesses. When this is done,
the buyers often pay the sellers directly from the earnings of the business and
treat the payments as salary even though the sellers no longer work for the
company. They then take a tax deduction for salary expense, thereby reducing
the earnings of the business by the amount of the deduction. This is an
improper treatment of the payments. The payments made from company
profits should be treated as if they were profit earned by the company and
that profit should then be attributed to the owners of the business in propor-
tion to their ownership interests. This will result in taxable income to the
owners even though the payments went directly from the company to the
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74 Tax Power for Individuals
party who sold his or her share of the business. The seller will report the
money received from the sale of the business as proceeds received from the
sale of a capital asset, but not as salary.
Paying Debts with Business Ear nings
In an effort to reduce their taxable earnings from business activities, some
taxpayers use their profits to pay off existing debts. To the degree that
those payments constitute interest payments, they will be fully
deductible. However, to the degree that those payments are repayments of
principal indebtedness, they will not give rise to a tax deduction. If a
taxpayer acquires assets used in his or her trade or business, he or she will
be eligible to take the appropriate deduction for the expenditure, whether
it was bought on credit or fully paid for at the time of acquisition.
Therefore, taxpayers who acquired business assets on credit are not
allowed to take a tax deduction for repayment of the debt incurred to
make the acquisitions in order to prevent them from taking two deduc-
tions for the same expenditure.
Using the Pr ofits of One Business to Acquir e Another
Taxpayers who use their business profits to acquire another business face a
situation that is similar to that of business owners who buy out fellow owners
in the same business. If payments that are made to the former owner who no
longer works in the business that was sold are reported as salary payments to
the seller, this would be improper and any deduction taken for salary expense
for the money paid to the seller would be inappropriate and would be disal-
lowed by the IRS in the event of an audit. Even though payments are being
made directly by a business to a seller in order to acquire another business
and are never actually paid over to the owner of the business that earned the
money, the IRS would consider the earnings to have been constructively
received by the parties who were entitled to receive the earnings and then
invested in a new venture. Whether the taxpayer would be entitled to any tax
deductions in connection with the new acquisition will depend on what was
acquired. To the extent that the funds were used to acquire a business entity,
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Deductions For Adjusted Gr oss Income 7 5
such as when the stock of a corporation is purchased, the purchase price will
merely represent the purchaser s basis in the new investment and no tax
deduction will result from the expenditure. On the other hand, if the assets
of the business are what were purchased, the buyer will probably be entitled
to take tax deductions in connection with the purchase but those deductions
may take the form of depreciation or amortization that will spread them out
over a number of years.
Leaving Profits in the Business
Some individuals mistakenly believe that as long as they leave earnings in the
business rather than distributing them to the owners, the earnings will not
be taxed. Some proprietors think that as long as they leave earnings in their
business account they can postpone taxation until such time as they are trans-
ferred out or spent for personal expenses. In fact, whether or not earnings are
distributed in some fashion is of absolutely no consequence when it comes to
determining the taxability of those earnings. This tax treatment of earnings
can actually be used by majority owners of S corporations, partnerships, and
limited liability companies to pressure minority owners into selling their
ownership interests in the company. This is accomplished by the majority
owners simply refusing to vote in favor of distributions of earnings that will
result in the owners realizing taxable income in proportion to their owner-
ship shares but not receiving any of that income with which to pay taxes on
it. All of the owners will face that situation, but majority owners often have
other income sources and are in a better financial position to cover the tax
liability on the undistributed earnings than the minority owners are.
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Chapter 5
In-home Office Expense
Deduction
Some individuals conduct business activities as a supplement to their full-
time jobs and have limited money and other assets to devote to their busi-
nesses. It is usually imperative that they hold their expenses to a minimum.
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