WEBVTT 00:00:00.000 --> 00:00:03.500 Okay, let's unpack this. Welcome to the deep 00:00:03.500 --> 00:00:05.750 dive. The show where we take the most complex, 00:00:05.889 --> 00:00:09.070 jargon heavy documents, you know, financial regulations, 00:00:09.470 --> 00:00:12.849 legal statutes, economic research, and we try 00:00:12.849 --> 00:00:15.189 to transform them into clear, actionable knowledge. 00:00:15.410 --> 00:00:18.410 And our deep dive today is, well, it's perhaps 00:00:18.410 --> 00:00:20.750 one of the most universally relevant topics to 00:00:20.750 --> 00:00:23.230 anyone who deals with money. And yet I think 00:00:23.230 --> 00:00:25.269 it's still one of the most misunderstood. We're 00:00:25.269 --> 00:00:27.149 talking about the tax deduction. We're moving 00:00:27.149 --> 00:00:29.769 beyond that, you know, that superficial definition 00:00:29.769 --> 00:00:33.570 and really diving into the detailed. and sometimes 00:00:33.570 --> 00:00:36.649 pretty surprising, world of tax deductions, exemptions, 00:00:36.649 --> 00:00:39.189 and credits using our source material as the 00:00:39.189 --> 00:00:41.869 guide. When you even mention the words tax deductions, 00:00:41.929 --> 00:00:44.090 I think most people's eyes just glaze over. Yeah, 00:00:44.090 --> 00:00:46.450 they do. They think of paperwork, audits, accountants. 00:00:46.810 --> 00:00:49.090 But fundamentally, what we're talking about is 00:00:49.090 --> 00:00:51.189 the core mechanism that defines the difference 00:00:51.189 --> 00:00:54.009 between the total money you make and the much 00:00:54.009 --> 00:00:56.090 smaller amount of income the government actually 00:00:56.090 --> 00:00:59.859 gets to tax. Our mission today is to understand 00:00:59.859 --> 00:01:02.759 that difference. Exactly. And to start, we really 00:01:02.759 --> 00:01:05.420 have to nail down some definitions because tax 00:01:05.420 --> 00:01:07.680 systems all over the world offer multiple ways 00:01:07.680 --> 00:01:10.799 to reduce your liability. And structurally, they 00:01:10.799 --> 00:01:13.659 are just not all created equal. OK. Our sources 00:01:13.659 --> 00:01:16.719 clearly outline three distinct types of tax incentives. 00:01:17.000 --> 00:01:19.659 You have deductions, exemptions and credits. 00:01:19.900 --> 00:01:22.540 Now, while deductions and exemptions are often 00:01:22.540 --> 00:01:25.319 sort of treated the same in common speech, they 00:01:25.319 --> 00:01:28.379 both reduce your income. A credit is an entirely 00:01:28.379 --> 00:01:30.340 separate animal. OK, here's where we get that 00:01:30.340 --> 00:01:32.480 crucial aha moment right out of the gate, I think. 00:01:32.540 --> 00:01:34.840 Can you just break down for us the difference 00:01:34.840 --> 00:01:37.500 between reducing your income versus reducing 00:01:37.500 --> 00:01:40.340 the actual tax? Absolutely. So deductions and 00:01:40.340 --> 00:01:42.480 exemptions, they both work to reduce your taxable 00:01:42.480 --> 00:01:46.000 income. Imagine you earn $100 ,000 and you qualify 00:01:46.000 --> 00:01:49.540 for, say, $15 ,000 in deductions and exemptions. 00:01:49.659 --> 00:01:52.640 That means you're only taxed on $85 ,000. Okay, 00:01:52.659 --> 00:01:55.040 so it's a proportional benefit. The value of 00:01:55.040 --> 00:01:57.640 that $15 ,000 deduction really depends on my 00:01:57.640 --> 00:02:00.680 tax bracket. It depends entirely on your marginal 00:02:00.680 --> 00:02:03.459 tax rate. So if you're in the 35 % tax bracket, 00:02:03.659 --> 00:02:07.040 a $1 ,000 deduction saves you $350 in actual 00:02:07.040 --> 00:02:09.780 tax. The benefit is indirect. It's indirect, 00:02:10.000 --> 00:02:13.699 precisely. Now, a tax credit... That operates 00:02:13.699 --> 00:02:16.699 completely differently. It is a direct subtraction 00:02:16.699 --> 00:02:19.840 from the actual amount of tax owed dollar for 00:02:19.840 --> 00:02:22.900 dollar. So if you calculate that you owe $20 00:02:22.900 --> 00:02:25.360 ,000 in tax to the government and you have a 00:02:25.360 --> 00:02:28.740 $2 ,000 tax credit, you just pay $18 ,000. Simple 00:02:28.740 --> 00:02:31.259 as that. That is a massive structural difference, 00:02:31.460 --> 00:02:33.879 isn't it? A deduction is worth a percentage of 00:02:33.879 --> 00:02:36.259 its face value, depending on my bracket. A credit 00:02:36.259 --> 00:02:38.960 is worth 100 % of its face value no matter what. 00:02:39.120 --> 00:02:41.889 It's an immediate guaranteed saving. against 00:02:41.889 --> 00:02:44.650 the final bill. It is, which is why credits are, 00:02:44.650 --> 00:02:47.150 you know, universally preferred from a taxpayer's 00:02:47.150 --> 00:02:49.530 perspective. And governments often use credits 00:02:49.530 --> 00:02:51.610 for maximum policy impact to encourage things 00:02:51.610 --> 00:02:53.909 like installing solar panels or adopting a child. 00:02:54.009 --> 00:02:57.050 But deductions, they're far more common, especially 00:02:57.050 --> 00:02:59.189 when we're dealing with the costs of making money. 00:02:59.590 --> 00:03:02.469 Deductions define your economic reality. And 00:03:02.469 --> 00:03:04.810 to really understand their complexity, we first 00:03:04.810 --> 00:03:06.889 have to talk about this fundamental concept of 00:03:06.889 --> 00:03:09.439 the line. Okay, let's unpack this foundational 00:03:09.439 --> 00:03:12.419 concept of the line. It sounds almost, I don't 00:03:12.419 --> 00:03:14.900 know, mythical, but it determines the hierarchy 00:03:14.900 --> 00:03:17.639 and the effectiveness of every single deduction 00:03:17.639 --> 00:03:19.919 we take. We're talking about the calculation 00:03:19.919 --> 00:03:24.139 of adjusted gross income, right? AGI is the hinge 00:03:24.139 --> 00:03:26.979 point of the entire individual tax system, especially 00:03:26.979 --> 00:03:29.780 in the U .S., which is heavily referenced in 00:03:29.780 --> 00:03:32.740 our source material. AGI is so critical that 00:03:32.740 --> 00:03:36.500 on the 2017 U .S. 1040 tax form, it was specifically 00:03:36.500 --> 00:03:39.979 labeled as item 37. It's the number you get to 00:03:39.979 --> 00:03:42.099 after you take your first set of deductions from 00:03:42.099 --> 00:03:44.250 your total gross income. So the line divides 00:03:44.250 --> 00:03:46.550 deductions into two very distinct camps. You've 00:03:46.550 --> 00:03:48.430 got above the line and below the line. Let's 00:03:48.430 --> 00:03:50.349 start with the gold standard. What makes a deduction 00:03:50.349 --> 00:03:53.710 fall above the line? So deductions that are taken 00:03:53.710 --> 00:03:55.889 above the line are subtracted directly from your 00:03:55.889 --> 00:03:58.349 gross income, and that reduces the AGI immediately. 00:03:58.610 --> 00:04:01.969 These are... universally available and they're 00:04:01.969 --> 00:04:03.909 automatically useful no matter how you handle 00:04:03.909 --> 00:04:06.569 the rest of your taxes. The sources cite interest 00:04:06.569 --> 00:04:09.229 paid on student loans as a classic example of 00:04:09.229 --> 00:04:11.270 an allowed deduction that usually falls into 00:04:11.270 --> 00:04:14.969 this camp. And what makes reducing AGI so powerful? 00:04:15.090 --> 00:04:17.089 Why is lowering that initial baseline number 00:04:17.089 --> 00:04:19.990 the gold standard here? Well, the reduction of 00:04:19.990 --> 00:04:23.110 AGI is so significant because AGI is used all 00:04:23.110 --> 00:04:25.550 over the tax code as the baseline, the denominator, 00:04:25.750 --> 00:04:28.839 for figuring out limitations and thresholds and 00:04:28.839 --> 00:04:31.879 phase outs on practically every other tax provision. 00:04:32.180 --> 00:04:34.459 A lower AGI can be the difference between qualifying 00:04:34.459 --> 00:04:36.920 for a tax benefit and not. Wait, can you walk 00:04:36.920 --> 00:04:39.139 us through a quick scenario where AGI is that 00:04:39.139 --> 00:04:41.379 hinge point? Certainly. Let's take medical expenses. 00:04:41.639 --> 00:04:44.480 In the U .S., medical expenses are only deductible 00:04:44.480 --> 00:04:46.860 if they exceed a certain threshold. Let's say 00:04:46.860 --> 00:04:50.519 it's 7 .5 % of your AGI. So if your AGI is $100 00:04:50.519 --> 00:04:54.459 ,000, you have to spend $7 ,500 in medical expenses 00:04:54.459 --> 00:04:56.300 before you can deduct a single penny. Right. 00:04:56.360 --> 00:04:57.740 You have to clear that hurdle first. You have 00:04:57.740 --> 00:05:01.160 to clear the hurdle. But if you had $10 ,000 00:05:01.160 --> 00:05:04.000 in above -the -line deductions, things like student 00:05:04.000 --> 00:05:07.779 loan interest, self -employment tax, IRA contributions, 00:05:08.379 --> 00:05:12.600 your AGI drops to $90 ,000. Now, your threshold 00:05:12.600 --> 00:05:16.740 is only $6750. I see. So by lowering your AGI 00:05:16.740 --> 00:05:18.620 with those initial deductions, you've made it 00:05:18.620 --> 00:05:20.800 significantly easier to clear that threshold 00:05:20.800 --> 00:05:23.500 and then claim the subsequent deduction for your 00:05:23.500 --> 00:05:25.800 medical costs. So those above line deductions 00:05:25.800 --> 00:05:27.620 are just inherently more useful because they 00:05:27.620 --> 00:05:29.839 have this ripple effect through the rest of the 00:05:29.839 --> 00:05:32.300 tax calculation. They make everything else that 00:05:32.300 --> 00:05:35.339 follows more valuable. That's a key insight for 00:05:35.339 --> 00:05:37.899 you. It really is. Now, for the deductions below 00:05:37.899 --> 00:05:39.600 the line, this is where the standard deduction 00:05:39.600 --> 00:05:41.939 comes in as a major gatekeeper. These are what 00:05:41.939 --> 00:05:45.009 we commonly call itemized deductions. And they 00:05:45.009 --> 00:05:47.589 only lessen your final taxable income if their 00:05:47.589 --> 00:05:50.790 combined total amount is more than the predetermined 00:05:50.790 --> 00:05:53.149 standard deduction. This highlights a really 00:05:53.149 --> 00:05:55.610 fascinating policy trend we've seen in recent 00:05:55.610 --> 00:05:59.149 years, right? The idea of increasing the standard 00:05:59.149 --> 00:06:02.449 deduction to simplify taxes for most people? 00:06:03.319 --> 00:06:06.060 Our sources give us some real numbers here referencing 00:06:06.060 --> 00:06:09.279 the U .S. 2018 tax year. They do. The standard 00:06:09.279 --> 00:06:11.879 deduction was $12 ,000 for a single taxpayer 00:06:11.879 --> 00:06:15.379 and $24 ,000 for a married couple filing jointly. 00:06:15.759 --> 00:06:17.980 Okay, so take that married couple with the $24 00:06:17.980 --> 00:06:20.870 ,000 hurdle. Right. So they might have paid $15 00:06:20.870 --> 00:06:23.470 ,000 in mortgage interest and maybe $5 ,000 in 00:06:23.470 --> 00:06:26.410 charitable giving. That's $20 ,000 in itemized 00:06:26.410 --> 00:06:28.649 expenses. Right. Real money out of their pocket. 00:06:28.709 --> 00:06:31.649 Real money. But those expenses are functionally 00:06:31.649 --> 00:06:35.029 useless for tax purposes because they didn't 00:06:35.029 --> 00:06:38.410 clear that $24 ,000 hurdle. They're better off 00:06:38.410 --> 00:06:40.730 just taking the fixed and pretty generous standard 00:06:40.730 --> 00:06:43.449 deduction. They only benefit from itemizing if 00:06:43.449 --> 00:06:47.019 their expenses total $24 ,001 or more. It's the 00:06:47.019 --> 00:06:49.500 ultimate either or choice. You either take the 00:06:49.500 --> 00:06:52.120 fixed amount or you gather up all your receipts 00:06:52.120 --> 00:06:54.800 and try to beat it. And the higher that standard 00:06:54.800 --> 00:06:57.879 deduction gets, which is often sold as simplification, 00:06:58.100 --> 00:07:02.720 the less relevant those specific targeted below 00:07:02.720 --> 00:07:05.740 the line incentives become for the average person. 00:07:05.839 --> 00:07:07.920 That's absolutely right. And it kind of segues 00:07:07.920 --> 00:07:10.040 into a general limitation we see across many 00:07:10.040 --> 00:07:13.060 tax systems. Deductions generally require that 00:07:13.060 --> 00:07:15.819 the expense produces a current benefit. If an 00:07:15.819 --> 00:07:17.759 expense is going to produce benefits way out 00:07:17.759 --> 00:07:19.920 into the future, like buying a new building or 00:07:19.920 --> 00:07:22.420 developing a patent, it's usually subject to 00:07:22.420 --> 00:07:24.540 capitalization rules. Spreading the cost out 00:07:24.540 --> 00:07:26.560 over time. Spreading it out, exactly. But for 00:07:26.560 --> 00:07:29.180 now, the fundamental goal is simple. Matching 00:07:29.180 --> 00:07:30.980 your current expenses to your current income 00:07:30.980 --> 00:07:33.740 to accurately figure out that profit number that's 00:07:33.740 --> 00:07:36.240 subject to tax. And that idea of matching expenses 00:07:36.240 --> 00:07:38.399 to income brings us right into the world of business. 00:07:38.720 --> 00:07:41.220 This next section focuses on the core engine 00:07:41.220 --> 00:07:44.589 of deductions. business expenses. I mean, nearly 00:07:44.589 --> 00:07:47.250 all tax systems allow deductions for expenses 00:07:47.250 --> 00:07:49.829 you incur in running a business. Taxing gross 00:07:49.829 --> 00:07:52.050 revenue would just be economically catastrophic. 00:07:52.069 --> 00:07:54.889 It would be. But what actually qualifies as a 00:07:54.889 --> 00:07:57.509 legitimate business expense. That's where the 00:07:57.509 --> 00:07:59.389 definition starts getting really scrutinized. 00:07:59.490 --> 00:08:02.790 Indeed. The criteria are strict, but they also 00:08:02.790 --> 00:08:05.329 differ, sometimes fundamentally, depending on 00:08:05.329 --> 00:08:07.689 the legal system you're operating in. What's 00:08:07.689 --> 00:08:10.310 fascinating here is the definitional split between 00:08:10.310 --> 00:08:13.629 a system like the UK and one like the US. OK, 00:08:13.709 --> 00:08:15.810 walk us through that difference in philosophy. 00:08:16.379 --> 00:08:19.379 Well, the U .K. approach tends to focus on tax 00:08:19.379 --> 00:08:23.120 levied on chargeable profits of a trade. What 00:08:23.120 --> 00:08:25.139 this means is that the calculation of what's 00:08:25.139 --> 00:08:27.779 deductible is heavily governed by local, generally 00:08:27.779 --> 00:08:30.860 accepted accounting principles, or GAAP. So if 00:08:30.860 --> 00:08:32.840 your accountant says it's a valid business expense, 00:08:33.139 --> 00:08:35.700 the tax authority generally agrees. That's the 00:08:35.700 --> 00:08:37.720 strong starting point. It relies on the commercial 00:08:37.720 --> 00:08:39.779 judgment that's reflected in the financial statements. 00:08:40.549 --> 00:08:42.889 The U .S. approach, on the other hand, is codified 00:08:42.889 --> 00:08:45.970 very specifically in the tax code itself. It 00:08:45.970 --> 00:08:48.610 allows, as a deduction, all the ordinary and 00:08:48.610 --> 00:08:51.889 necessary expenses paid or incurred in carrying 00:08:51.889 --> 00:08:54.269 on any trade or business. That language seems 00:08:54.269 --> 00:08:57.269 simple, but I'm guessing it's not. It's deceptively 00:08:57.269 --> 00:08:59.950 simple. That one phrase has required, I mean, 00:08:59.950 --> 00:09:02.710 over 100 years of judicial interpretation to 00:09:02.710 --> 00:09:05.269 define what it actually means in practice. Okay, 00:09:05.350 --> 00:09:07.450 so let's unpack that central U .S. requirement. 00:09:08.169 --> 00:09:10.570 It seems to set two separate hurdles. First, 00:09:10.730 --> 00:09:13.309 you have to qualify as a trade or business. And 00:09:13.309 --> 00:09:16.350 second, the expense has to be ordinary and necessary. 00:09:16.970 --> 00:09:20.970 So what defines a trade or business in the eyes 00:09:20.970 --> 00:09:23.570 of the tax authorities? The courts have established 00:09:23.570 --> 00:09:26.129 a few major criteria that have to be met. The 00:09:26.129 --> 00:09:28.990 activity must be regular, continuous, and substantial. 00:09:29.549 --> 00:09:32.090 And this is the big one. It has to be entered 00:09:32.090 --> 00:09:35.129 into with a genuine expectation of profit. All 00:09:35.129 --> 00:09:37.519 those elements generally have to be there. That 00:09:37.519 --> 00:09:39.720 expectation of profit part seems like the most 00:09:39.720 --> 00:09:41.700 crucial and probably the most fought over point, 00:09:41.860 --> 00:09:44.440 doesn't it? Absolutely. This is the government's 00:09:44.440 --> 00:09:46.960 main tool for preventing abuse. It's often called 00:09:46.960 --> 00:09:50.139 the hobby loss rule. If you own a luxury yacht 00:09:50.139 --> 00:09:51.919 and claim to run a charter business, but you 00:09:51.919 --> 00:09:54.720 show losses year after year after year, the IRS 00:09:54.720 --> 00:09:56.559 might come in and argue you don't have a genuine 00:09:56.559 --> 00:09:58.740 expectation of profit. And then what happens? 00:09:58.919 --> 00:10:01.879 The activity gets reclassified as a hobby and 00:10:01.879 --> 00:10:04.220 the deductions are severely limited. They're 00:10:04.220 --> 00:10:06.500 often only deductible up to the amount of income 00:10:06.500 --> 00:10:09.799 the hobby generates. So if I spend $50 ,000 running 00:10:09.799 --> 00:10:12.320 my little boutique vineyard, but I only sell 00:10:12.320 --> 00:10:15.259 $5 ,000 worth of wine, if the government calls 00:10:15.259 --> 00:10:18.700 it a hobby, I can only deduct $5 ,000, even though 00:10:18.700 --> 00:10:22.039 I genuinely spent $50 ,000. Exactly. It's an 00:10:22.039 --> 00:10:24.240 effective way to stop people from turning their 00:10:24.240 --> 00:10:27.139 personal consumption into a tax write -off. The 00:10:27.139 --> 00:10:29.220 courts look at all sorts of factors to gauge 00:10:29.220 --> 00:10:32.059 that profit motive. How you carry on the activity, 00:10:32.240 --> 00:10:34.830 your expertise. the time and effort you put in, 00:10:34.870 --> 00:10:37.769 your history of income or losses. It requires 00:10:37.769 --> 00:10:40.009 a demonstrable effort to try and make money. 00:10:40.190 --> 00:10:42.110 OK, so that's the first hurdle. What about the 00:10:42.110 --> 00:10:45.230 second one? Ordinary and necessary. The expense 00:10:45.230 --> 00:10:47.070 itself has to be appropriate to the business. 00:10:47.289 --> 00:10:50.409 Right. The phrase ordinary and necessary ensures 00:10:50.409 --> 00:10:53.590 both appropriateness and purpose. Ordinary doesn't 00:10:53.590 --> 00:10:56.169 mean it happens all the time. It means the expense 00:10:56.169 --> 00:10:58.610 is common or acceptable in that specific type 00:10:58.610 --> 00:11:01.730 of business. So if you run a fishery, buying 00:11:01.730 --> 00:11:04.639 nets is ordinary. Exactly. But if you run a software 00:11:04.639 --> 00:11:07.419 company, buying nets is definitely not ordinary. 00:11:07.679 --> 00:11:10.399 And necessary means the expense is appropriate 00:11:10.399 --> 00:11:13.799 and helpful in generating income. But... and 00:11:13.799 --> 00:11:16.220 our sources really emphasize this, the expense 00:11:16.220 --> 00:11:19.679 must not be lavish and extravagant. Ah, that's 00:11:19.679 --> 00:11:22.179 the tax authority stepping in and imposing a 00:11:22.179 --> 00:11:24.740 standard of reasonableness. So I can deduct the 00:11:24.740 --> 00:11:27.139 cost of my work truck, but I probably can't deduct 00:11:27.139 --> 00:11:30.120 the cost of a diamond -encrusted helicopter just 00:11:30.120 --> 00:11:32.419 because I occasionally use it to fly to a client 00:11:32.419 --> 00:11:34.559 meeting. It's basically the government saying, 00:11:34.720 --> 00:11:36.879 look, we'll subsidize the reasonable costs you 00:11:36.879 --> 00:11:39.440 need to generate taxable income, but we are not 00:11:39.440 --> 00:11:42.059 going to subsidize your excessive personal luxury 00:11:42.059 --> 00:11:44.840 disguised as business. And that reasonableness 00:11:44.840 --> 00:11:47.340 standard is applied to everything, salaries, 00:11:47.519 --> 00:11:49.740 travel, you name it. It's important to remember 00:11:49.740 --> 00:11:51.879 these rules apply across the board, right? We're 00:11:51.879 --> 00:11:54.200 talking about the same kinds of expenses, salaries, 00:11:54.440 --> 00:11:58.679 rent, utilities being deductible for a huge multinational 00:11:58.679 --> 00:12:01.000 corporation and for an individual just starting 00:12:01.000 --> 00:12:03.600 out. Right. And we should quickly touch on flow 00:12:03.600 --> 00:12:06.240 through entities, things like partnerships as 00:12:06.240 --> 00:12:09.940 corporations and trusts. In these structures, 00:12:10.120 --> 00:12:12.960 the entity itself doesn't pay the income tax 00:12:12.960 --> 00:12:16.419 directly. The income and expenses just flow through 00:12:16.419 --> 00:12:19.399 to the owners or the beneficiaries. So the business 00:12:19.399 --> 00:12:21.720 expenses just reduce the net profit that flows 00:12:21.720 --> 00:12:24.659 through. Generally, yes, the operating expenses 00:12:24.659 --> 00:12:27.159 retain their character as part of that profit 00:12:27.159 --> 00:12:29.779 or loss calculation. But there are exceptions 00:12:29.779 --> 00:12:32.990 where the character can change. Such as? Charitable 00:12:32.990 --> 00:12:35.309 contributions, for example. If a partnership 00:12:35.309 --> 00:12:37.509 makes a charitable gift, that's generally not 00:12:37.509 --> 00:12:39.830 deducted at the partnership level. It passes 00:12:39.830 --> 00:12:42.269 through to the individual partners, but it often 00:12:42.269 --> 00:12:44.490 converts into an itemized deduction for them. 00:12:44.690 --> 00:12:46.470 So it's subject to all those personal limitations 00:12:46.470 --> 00:12:48.909 we're going to talk about later. Exactly. It 00:12:48.909 --> 00:12:50.990 ensures that the government's policy goals for 00:12:50.990 --> 00:12:52.789 charity are still enforced at the individual 00:12:52.789 --> 00:12:55.350 level, even if the gift came from a business 00:12:55.350 --> 00:12:57.909 structure. That distinction, you know, between 00:12:57.909 --> 00:12:59.750 what's a legitimate business expense and what 00:12:59.750 --> 00:13:03.490 isn't is fundamental. But even after an expense 00:13:03.490 --> 00:13:06.610 is deemed ordinary and necessary, business owners 00:13:06.610 --> 00:13:10.669 have this immediate classification problem, distinguishing 00:13:10.669 --> 00:13:13.350 between general operating expenses and the cost 00:13:13.350 --> 00:13:17.950 of goods sold, or CAGS. It's not just one big 00:13:17.950 --> 00:13:19.850 bucket of deductions. You've hit on a really 00:13:19.850 --> 00:13:22.909 critical point. CAGS is, I mean, it might be 00:13:22.909 --> 00:13:25.129 the single most important expense deduction for 00:13:25.129 --> 00:13:27.710 any business that deals with inventory, manufacturers, 00:13:28.210 --> 00:13:31.110 retailers, wholesalers. Nearly every tax system, 00:13:31.210 --> 00:13:33.429 whether it follows JAP or specific tax codes, 00:13:33.590 --> 00:13:36.570 allows a deduction for Kajias. Conceptually, 00:13:36.570 --> 00:13:38.490 it makes perfect sense. I should only be taxed 00:13:38.490 --> 00:13:40.370 on the profit I make after I recover the cost 00:13:40.370 --> 00:13:42.850 of the actual item I sold. But what are the underlying 00:13:42.850 --> 00:13:45.429 pieces of Kajias? Kajias essentially includes 00:13:45.429 --> 00:13:47.049 all the costs that are directly attributable 00:13:47.049 --> 00:13:48.809 to the production of the goods or services you're 00:13:48.809 --> 00:13:52.009 selling. So that's raw materials, freight, storage 00:13:52.009 --> 00:13:56.009 costs, direct labor, factory overhead. And importantly... 00:13:56.429 --> 00:13:58.730 CAU -GS is sometimes treated as a reduction of 00:13:58.730 --> 00:14:00.929 gross income, not a deduction in the traditional 00:14:00.929 --> 00:14:03.610 sense, but the effect on your net taxable income 00:14:03.610 --> 00:14:06.289 is exactly the same. And the crucial rule here 00:14:06.289 --> 00:14:09.129 is no double dipping, right? If you include the 00:14:09.129 --> 00:14:11.509 rent on your factory floor as part of your product 00:14:11.509 --> 00:14:14.830 cost in CAU -GS, you cannot then deduct it again 00:14:14.830 --> 00:14:17.860 as a separate operating expense. Precisely. But 00:14:17.860 --> 00:14:19.700 our sources really highlight that the accurate 00:14:19.700 --> 00:14:22.399 determination of CodGS involves immense complexities, 00:14:22.700 --> 00:14:25.659 especially in large -scale operations. They list 00:14:25.659 --> 00:14:28.799 four big inherent difficulties. First, assigning 00:14:28.799 --> 00:14:31.039 costs when you can't specifically identify them. 00:14:31.179 --> 00:14:35.039 Second, allocating common costs. Third, the timing 00:14:35.039 --> 00:14:38.080 of when you recognize the cost. And fourth, recognizing 00:14:38.080 --> 00:14:40.659 when your inventory loses value. Okay, let's 00:14:40.659 --> 00:14:43.240 focus on that first one, assign costs. If I'm 00:14:43.240 --> 00:14:45.100 a global oil distributor and I have millions 00:14:45.100 --> 00:14:47.009 of barrels of crude oil, that I bought at different 00:14:47.009 --> 00:14:48.830 prices over the last year, all sitting in my 00:14:48.830 --> 00:14:51.289 storage tanks, how on earth do I determine the 00:14:51.289 --> 00:14:53.649 cost for the specific oil I sell today? Well, 00:14:53.750 --> 00:14:55.549 since specific identification is impossible, 00:14:56.009 --> 00:14:58.330 accountants have to rely on inventory accounting 00:14:58.330 --> 00:15:01.370 conventions. The three most common are first 00:15:01.370 --> 00:15:05.250 in, first out, or FIFO, average cost, and last 00:15:05.250 --> 00:15:08.470 in, first out, or LIFO. FIFO assumes the oldest 00:15:08.470 --> 00:15:11.340 stuff is sold first. Lyco assumes the newest 00:15:11.340 --> 00:15:13.179 stuff is sold first. Right. And this is where 00:15:13.179 --> 00:15:16.740 policy really meets profitability. LIFO is particularly 00:15:16.740 --> 00:15:19.919 beneficial during inflationary periods because 00:15:19.919 --> 00:15:21.960 you're assuming that the most expensive, most 00:15:21.960 --> 00:15:24.799 recent inventory is what you sold first. That 00:15:24.799 --> 00:15:27.899 leads to a higher COGS, which in turn leads to 00:15:27.899 --> 00:15:29.840 a lower taxable profit. So it's a way to defer 00:15:29.840 --> 00:15:32.559 taxes when your costs are rising. That is the 00:15:32.559 --> 00:15:34.840 core insight. LIFO allows for some pretty aggressive 00:15:34.840 --> 00:15:37.539 profit deferral and lower tax payments when costs 00:15:37.539 --> 00:15:39.620 are going up. And this is exactly why the source 00:15:39.620 --> 00:15:41.740 material specifically mentioned that many EU 00:15:41.740 --> 00:15:44.519 countries actually prohibit LIFO accounting entirely. 00:15:45.019 --> 00:15:47.720 Really? Yes. They mandate adherence to FIFO or 00:15:47.720 --> 00:15:50.240 average cost methods. This isn't just an accounting 00:15:50.240 --> 00:15:52.799 choice. It's a political decision designed to 00:15:52.799 --> 00:15:54.919 curb what they see as aggressive tax deferral 00:15:54.919 --> 00:15:56.919 and ensure more consistency with international 00:15:56.919 --> 00:16:00.059 reporting standards, which also don't like LIFO. 00:16:00.590 --> 00:16:03.210 Fascinating. So the tax authority is regulating 00:16:03.210 --> 00:16:05.830 the very accounting method used to calculate 00:16:05.830 --> 00:16:09.129 profit to stop what they deem to be excessive 00:16:09.129 --> 00:16:12.110 manipulation. Absolutely. The second complexity 00:16:12.110 --> 00:16:14.730 you mentioned is attributing common costs, like 00:16:14.730 --> 00:16:17.850 factory overhead. If your factory uses electricity, 00:16:18.309 --> 00:16:20.870 that cost has to be allocated across all the 00:16:20.870 --> 00:16:22.710 different products you're making. This involves 00:16:22.710 --> 00:16:25.970 methods like standard costs or more complex activity 00:16:25.970 --> 00:16:28.740 -based costing. And timing is the third complexity. 00:16:28.899 --> 00:16:32.179 When do I recognize the cost? Cash method? Accrual 00:16:32.179 --> 00:16:35.399 method? Does the tax system dictate this? It 00:16:35.399 --> 00:16:38.779 dictates it heavily. Tax methods for cost recognition 00:16:38.779 --> 00:16:41.179 can be very different from GAAP. For example, 00:16:41.320 --> 00:16:43.440 tax law might let you immediately expense certain 00:16:43.440 --> 00:16:45.679 startup costs that GAAP would require you to 00:16:45.679 --> 00:16:48.179 capitalize. The rules on cost recognition are 00:16:48.179 --> 00:16:50.019 paramount for an accurate profit calculation. 00:16:50.480 --> 00:16:52.159 And the fourth complexity you mentioned relates 00:16:52.159 --> 00:16:55.559 to declining value, so inventory that you know 00:16:55.559 --> 00:16:58.059 you won't be able to sell at its full cost. Correct. 00:16:58.500 --> 00:17:00.639 Accounting standards generally let you recognize 00:17:00.639 --> 00:17:03.519 that declining value. If the market value of 00:17:03.519 --> 00:17:05.720 your inventory falls below what you paid for 00:17:05.720 --> 00:17:09.019 it, you can sometimes use the lower of cost or 00:17:09.019 --> 00:17:11.940 market value principle. This adjusts your COGS 00:17:11.940 --> 00:17:14.759 calculation upward, giving you an immediate deduction 00:17:14.759 --> 00:17:17.279 for that anticipated loss. So you don't have 00:17:17.279 --> 00:17:19.119 to wait until you sell it for cheap years later 00:17:19.119 --> 00:17:21.900 to get the tax benefit. Exactly. It ensures a 00:17:21.900 --> 00:17:24.559 business isn't forced to wait to recognize that 00:17:24.559 --> 00:17:27.619 its inventory has diminished in value. This brings 00:17:27.619 --> 00:17:30.869 us to a really crucial point. Even if an expense 00:17:30.869 --> 00:17:33.950 is ordinary and necessary, and it's properly 00:17:33.950 --> 00:17:37.029 classified as a regular operating expense, the 00:17:37.029 --> 00:17:39.430 tax system frequently imposes its own limitations, 00:17:39.730 --> 00:17:43.190 or just outright says no. This is where tax law 00:17:43.190 --> 00:17:45.970 stops just measuring income and starts actively 00:17:45.970 --> 00:17:48.750 enforcing public policy. This catalog of restrictions 00:17:48.750 --> 00:17:50.869 is extensive, and it really proves that the tax 00:17:50.869 --> 00:17:53.109 code is an active instrument of governance. The 00:17:53.109 --> 00:17:55.089 government is effectively saying, we recognize 00:17:55.089 --> 00:17:57.049 this is a cost of doing business, but we are 00:17:57.049 --> 00:17:59.390 not going to subsidize this particular activity. 00:17:59.670 --> 00:18:01.789 So give us the highlights. What are some of these 00:18:01.789 --> 00:18:04.390 specific limitations that really reveal that 00:18:04.390 --> 00:18:06.910 policy intent? Well, the sources reference several. 00:18:07.339 --> 00:18:09.759 We see maximum deductions set for the use of 00:18:09.759 --> 00:18:11.940 automobiles, for instance, which limits the tax 00:18:11.940 --> 00:18:14.240 relief businesses can get on luxury vehicles. 00:18:14.720 --> 00:18:17.240 There are also severe limits on deducting the 00:18:17.240 --> 00:18:19.859 compensation paid to certain key employees, as 00:18:19.859 --> 00:18:22.599 laid out in the U .S. Code. Let's dig into that 00:18:22.599 --> 00:18:24.480 for a second. The executive compensation limit. 00:18:24.619 --> 00:18:27.359 What's the policy goal there? The goal is to 00:18:27.359 --> 00:18:29.880 discourage what is seen as excessive executive 00:18:29.880 --> 00:18:33.569 compensation. Traditionally, this limit capped 00:18:33.569 --> 00:18:35.950 the deductibility of compensation for the CEO 00:18:35.950 --> 00:18:38.309 and a few other top executives at $1 million 00:18:38.309 --> 00:18:42.089 per person. So if a company pays its CEO $10 00:18:42.089 --> 00:18:45.230 million, $9 million of that is just not deductible 00:18:45.230 --> 00:18:46.869 for the corporation. Generally, that's right. 00:18:46.950 --> 00:18:49.329 It's a direct government lever trying to influence 00:18:49.329 --> 00:18:51.569 corporate governance and rein in what some see 00:18:51.569 --> 00:18:54.569 as runaway C -suite pay. What about lobbying? 00:18:54.750 --> 00:18:57.329 The sources mention limits on lobbying expenditures, 00:18:57.549 --> 00:19:01.029 too. Right. Expenses for lobbying or other political 00:19:01.029 --> 00:19:03.390 influence efforts are largely non -deductible. 00:19:03.509 --> 00:19:06.349 The government essentially refuses to subsidize 00:19:06.349 --> 00:19:08.430 a business's attempt to change its own laws. 00:19:08.630 --> 00:19:11.410 And then there's a universal rule. Payments that 00:19:11.410 --> 00:19:13.769 violate public policy, like criminal fines or 00:19:13.769 --> 00:19:16.910 penalties, are absolutely non -deductible. Tax 00:19:16.910 --> 00:19:18.789 codes shouldn't reduce the sting of breaking 00:19:18.789 --> 00:19:21.630 the law. Exactly. One restriction that has seen 00:19:21.630 --> 00:19:24.190 a massive shift recently is business entertainment. 00:19:24.630 --> 00:19:27.029 Yeah. Talk about that. Historically, business 00:19:27.029 --> 00:19:29.589 meals and entertainment faced severe limits. 00:19:29.789 --> 00:19:32.769 Often only 50 percent was deductible to stop 00:19:32.769 --> 00:19:34.690 people from mixing too much personal pleasure 00:19:34.690 --> 00:19:37.809 with business. However, the sources note a specific 00:19:37.809 --> 00:19:40.829 exception that temporarily or sometimes permanently 00:19:40.829 --> 00:19:43.890 removed this limit for business meals in certain 00:19:43.890 --> 00:19:47.049 tax years like 2021 and beyond. A clear economic 00:19:47.049 --> 00:19:49.150 stimulus, right? Yeah. Trying to help the struggling 00:19:49.150 --> 00:19:51.339 restaurant industry. A perfect example of how 00:19:51.339 --> 00:19:53.579 quickly the tax code can be weaponized for economic 00:19:53.579 --> 00:19:57.200 policy. Now, beyond specific expense types, the 00:19:57.200 --> 00:19:59.599 U .S. system also limits deductions based on 00:19:59.599 --> 00:20:02.140 the type of activity, especially passive activities. 00:20:02.420 --> 00:20:04.480 Okay, can you elaborate on the passive activity 00:20:04.480 --> 00:20:07.740 limitation? This provision was specifically designed 00:20:07.740 --> 00:20:11.279 to kill tax shelters. Before the mid 80s, wealthy 00:20:11.279 --> 00:20:14.119 taxpayers could invest in ventures like equipment 00:20:14.119 --> 00:20:17.019 leasing or certain real estate deals where they 00:20:17.019 --> 00:20:20.019 had little to no participation, but which generated 00:20:20.019 --> 00:20:23.220 huge paper losses through things like accelerated 00:20:23.220 --> 00:20:26.640 depreciation. So someone could be a doctor or 00:20:26.640 --> 00:20:29.359 a lawyer making half a million dollars and they 00:20:29.359 --> 00:20:32.339 could use a massive paper loss from a rental 00:20:32.339 --> 00:20:35.200 property they rarely even visited to wipe out 00:20:35.200 --> 00:20:37.480 the tax liability on their professional income. 00:20:37.829 --> 00:20:40.230 That's the classic example. The passive activity 00:20:40.230 --> 00:20:42.650 loss rules put a stop to that. They state that 00:20:42.650 --> 00:20:44.730 deductions from these passive activities can 00:20:44.730 --> 00:20:47.650 only offset income from other passive activities. 00:20:47.930 --> 00:20:49.990 Oh, so they can't cross over. They cannot cross 00:20:49.990 --> 00:20:52.569 over to shelter your active earned income. The 00:20:52.569 --> 00:20:54.509 losses can be suspended and carried forward, 00:20:54.650 --> 00:20:56.609 but they stay in their own lane, which maintains 00:20:56.609 --> 00:20:59.069 the integrity of the tax base on earned income. 00:20:59.329 --> 00:21:01.329 That makes a lot of sense from a policy standpoint. 00:21:01.650 --> 00:21:03.990 Now let's get to that truly remarkable story 00:21:03.990 --> 00:21:06.849 that illustrates the tension between pure tax 00:21:06.849 --> 00:21:10.420 theory. and public morality, the Australian drug 00:21:10.420 --> 00:21:12.940 dealer case. The Commissioner of Taxation v. 00:21:12.980 --> 00:21:16.220 La Rosa case is legendary in tax circles. So 00:21:16.220 --> 00:21:18.799 Mr. La Rosa was a heroin dealer. During a drug 00:21:18.799 --> 00:21:21.079 deal, a large sum of money was stolen from him. 00:21:21.180 --> 00:21:23.880 He then argued that since drug dealing was his 00:21:23.880 --> 00:21:26.920 trade or business, which he entered into with 00:21:26.920 --> 00:21:29.400 an expectation of profit, the money that was 00:21:29.400 --> 00:21:31.599 stolen was a loss incurred in the course of that 00:21:31.599 --> 00:21:33.740 business, and therefore it should be a deductible 00:21:33.740 --> 00:21:36.230 expense. Wait a minute. the court actually accepted 00:21:36.230 --> 00:21:39.289 that an illegal activity, selling narcotics, 00:21:39.509 --> 00:21:42.369 could be considered a trade or business for the 00:21:42.369 --> 00:21:44.750 purpose of calculating taxable profit. Initially, 00:21:44.789 --> 00:21:46.930 yes. The Australian Federal Court recognized 00:21:46.930 --> 00:21:48.990 that the purpose of the tax law was simply to 00:21:48.990 --> 00:21:51.990 arrive at the net profit. And if an expense or 00:21:51.990 --> 00:21:54.309 a loss was incurred while generating that taxable 00:21:54.309 --> 00:21:57.269 income, even if the activity was criminal, it 00:21:57.269 --> 00:21:59.490 should, theoretically, be deducted to arrive 00:21:59.490 --> 00:22:03.359 at the true net income subject to tax. Wow. That's 00:22:03.359 --> 00:22:05.619 a purely logical application of income theory, 00:22:05.740 --> 00:22:08.220 completely divorced from morality. It is. It's 00:22:08.220 --> 00:22:11.000 the ultimate unintended consequence. So how did 00:22:11.000 --> 00:22:14.559 the government respond to the optics of subsidizing 00:22:14.559 --> 00:22:17.299 a drug dealer's operational losses? The response 00:22:17.299 --> 00:22:21.230 was swift and absolute. In 2005, the Australian 00:22:21.230 --> 00:22:24.009 government amended its legislation to explicitly 00:22:24.009 --> 00:22:27.430 remove deductions for any expenses incurred while 00:22:27.430 --> 00:22:30.410 conducting criminal business activities. This 00:22:30.410 --> 00:22:33.410 legislative override is a perfect example of 00:22:33.410 --> 00:22:36.809 tax law evolving in real time to align with public 00:22:36.809 --> 00:22:39.509 policy and morality, even when it violates that 00:22:39.509 --> 00:22:42.190 pure economic logic of how you calculate income. 00:22:42.490 --> 00:22:44.509 We mentioned earlier that if an expense provides 00:22:44.509 --> 00:22:47.150 future benefits, you can't take the deduction 00:22:47.150 --> 00:22:50.519 right away. the cost has to be capitalized. This 00:22:50.519 --> 00:22:52.579 is Section 5, where we talk about long -term 00:22:52.579 --> 00:22:54.720 investment and cost recovery. It's all about 00:22:54.720 --> 00:22:56.960 spreading that deduction out over time. This 00:22:56.960 --> 00:22:59.019 is a cornerstone of both financial reporting 00:22:59.019 --> 00:23:01.819 and tax accounting. It's the principle of matching. 00:23:02.039 --> 00:23:04.279 If an asset helps you produce revenue for 10 00:23:04.279 --> 00:23:06.460 years, its cost should be matched against the 00:23:06.460 --> 00:23:08.619 revenue it helps produce over those same 10 years. 00:23:08.799 --> 00:23:11.319 The capitalization requirement is mandated for 00:23:11.319 --> 00:23:13.700 assets like plant and equipment and also for 00:23:13.700 --> 00:23:16.079 costs related to developing intangible assets. 00:23:16.519 --> 00:23:18.920 So buying a ream of paper for the office is an 00:23:18.920 --> 00:23:21.900 immediate deduction. But if I buy a specialized 00:23:21.900 --> 00:23:25.160 $1 million milling machine for my factory that 00:23:25.160 --> 00:23:28.200 I expect to use for two decades, I have to capitalize 00:23:28.200 --> 00:23:30.690 that million dollars. Exactly. You record it 00:23:30.690 --> 00:23:33.009 as an asset on your balance sheet, not as an 00:23:33.009 --> 00:23:35.789 immediate expense on your income statement. This 00:23:35.789 --> 00:23:38.470 also applies to costs for developing things like 00:23:38.470 --> 00:23:41.759 patentable invention. Okay, so once a cost is 00:23:41.759 --> 00:23:44.400 capitalized, the tax system provides these formal 00:23:44.400 --> 00:23:47.380 mechanisms for recovering that cost over the 00:23:47.380 --> 00:23:49.880 asset's useful life. What are those mechanisms 00:23:49.880 --> 00:23:52.519 called? We use two main terms for the systematic 00:23:52.519 --> 00:23:55.259 cost recovery, depreciation for tangible assets 00:23:55.259 --> 00:23:58.599 and amortization for intangible assets. Let's 00:23:58.599 --> 00:24:00.859 dig into depreciation for a second. We're talking 00:24:00.859 --> 00:24:03.039 tangible assets here, like machinery, equipment, 00:24:03.240 --> 00:24:05.559 commercial buildings. How is that cost recovery 00:24:05.559 --> 00:24:08.349 period determined? Under systems like the one 00:24:08.349 --> 00:24:11.509 in the U .S., the cost is recovered over an estimated 00:24:11.509 --> 00:24:14.309 useful life, which is often assigned by the government. 00:24:14.609 --> 00:24:17.450 The government dictates these lives based on 00:24:17.450 --> 00:24:19.470 the asset type and the business sector using 00:24:19.470 --> 00:24:23.089 it. This removes subjectivity and ensures consistency. 00:24:23.450 --> 00:24:25.509 And there are different ways to calculate the 00:24:25.509 --> 00:24:28.410 annual deduction, which can really affect a business's 00:24:28.410 --> 00:24:30.690 reported profit, especially in the early years. 00:24:31.079 --> 00:24:33.940 Correct. The annual depreciation deduction can 00:24:33.940 --> 00:24:36.339 be computed using the straight line basis, which 00:24:36.339 --> 00:24:38.980 just spreads the cost evenly across the asset's 00:24:38.980 --> 00:24:43.019 life. Simple. predictable. Or systems like the 00:24:43.019 --> 00:24:45.460 U .S. permit using a declining balance basis 00:24:45.460 --> 00:24:48.779 like 200 percent or 150 percent declining balance. 00:24:49.079 --> 00:24:51.279 And what's the benefit of that declining balance 00:24:51.279 --> 00:24:53.920 method? It front loads the deduction. It allows 00:24:53.920 --> 00:24:56.259 businesses to claim much larger deductions in 00:24:56.259 --> 00:24:58.200 the earlier years of the asset's life, which 00:24:58.200 --> 00:25:00.920 provides immediate cash flow benefits. I see. 00:25:01.000 --> 00:25:03.529 However. The U .S. system typically requires 00:25:03.529 --> 00:25:05.809 taxpayers to switch from the declining balance 00:25:05.809 --> 00:25:08.569 method to the straight line method in a specific 00:25:08.569 --> 00:25:12.009 year. This just ensures the entire cost is precisely 00:25:12.009 --> 00:25:14.930 recovered by the end of the asset's life. It's 00:25:14.930 --> 00:25:17.250 a method designed to accelerate deductions while 00:25:17.250 --> 00:25:19.750 still maintaining that systematic recovery. How 00:25:19.750 --> 00:25:22.049 does amortization for intangible assets differ? 00:25:22.589 --> 00:25:25.089 Amortization is the same idea, but for things 00:25:25.089 --> 00:25:27.609 like patents, copyrights, or acquired goodwill. 00:25:28.109 --> 00:25:30.269 It's often computed on a simpler straight line 00:25:30.269 --> 00:25:32.829 basis over the expected life of the intangible 00:25:32.829 --> 00:25:36.029 or a government specified life, often 15 years 00:25:36.029 --> 00:25:38.390 in the U .S. for certain acquired intangibles. 00:25:38.509 --> 00:25:40.710 I see our source material references capital 00:25:40.710 --> 00:25:43.029 allowances as an alternative approach used in 00:25:43.029 --> 00:25:45.910 some systems like the U .K. and Canada. How are 00:25:45.910 --> 00:25:47.890 these different from U .S. depreciation? Capital 00:25:47.890 --> 00:25:50.309 allowances are meant to simplify the process 00:25:50.309 --> 00:25:54.059 significantly. Instead of requiring complex depreciation 00:25:54.059 --> 00:25:56.640 schedules and switchover calculations, these 00:25:56.640 --> 00:25:59.180 systems just allow a fixed percentage or dollar 00:25:59.180 --> 00:26:02.220 amount of cost recovery in specific years, determined 00:26:02.220 --> 00:26:05.940 strictly by the type of asset or business. For 00:26:05.940 --> 00:26:09.140 example, the Canadian system has over 30 classes 00:26:09.140 --> 00:26:11.819 of assets, each with a predetermined recovery 00:26:11.819 --> 00:26:13.900 percentage. So it's an effort toward administrative 00:26:13.900 --> 00:26:16.920 simplicity. It is. And finally, we should mention 00:26:16.920 --> 00:26:19.619 costs that are capitalized but often stay non 00:26:19.619 --> 00:26:22.039 -recoverable until the asset is actually disposed 00:26:22.039 --> 00:26:25.079 of. Things like cost to form a corporation or 00:26:25.079 --> 00:26:28.140 certain acquisition expenses, they might be capitalized 00:26:28.140 --> 00:26:30.759 without any potential for recovery through depreciation 00:26:30.759 --> 00:26:33.240 or amortization. So the cash goes out the door 00:26:33.240 --> 00:26:35.799 now, but the tax benefit is deferred indefinitely, 00:26:35.920 --> 00:26:37.980 maybe until the business is sold or closes down. 00:26:38.140 --> 00:26:41.359 Right. Unless, as the source notes, the tax system 00:26:41.359 --> 00:26:44.140 specifically allows for an election to amortize 00:26:44.140 --> 00:26:46.279 some of those costs, like organizational costs, 00:26:46.480 --> 00:26:49.200 over a set period, which some jurisdictions do 00:26:49.200 --> 00:26:51.619 to encourage new business formation. We've spent 00:26:51.619 --> 00:26:53.799 a lot of time focused on business and calculating 00:26:53.799 --> 00:26:56.559 profit. Now let's shift our focus to the individual 00:26:56.559 --> 00:27:00.839 taxpayer in Section 6. Tax systems also provide 00:27:00.839 --> 00:27:04.160 relief for personal circumstances and, you know, 00:27:04.180 --> 00:27:06.859 non -business income generation like investment 00:27:06.859 --> 00:27:09.380 activities. This is where the rules become a 00:27:09.380 --> 00:27:12.299 really complex hybrid. While the systems recognize 00:27:12.299 --> 00:27:15.140 the costs of managing non -business income producing 00:27:15.140 --> 00:27:18.480 assets, so paying an investment advisor or maintenance 00:27:18.480 --> 00:27:21.539 on a rental property, they impose very tight 00:27:21.539 --> 00:27:24.400 controls on any losses. So if I sell an income 00:27:24.400 --> 00:27:27.019 producing asset like a stock or a rental property 00:27:27.019 --> 00:27:30.049 for a loss. How does the system treat that deduction? 00:27:30.410 --> 00:27:33.230 Many systems will allow that loss, but they limit 00:27:33.230 --> 00:27:35.750 its deductibility. They often restrict it to 00:27:35.750 --> 00:27:37.769 offsetting gains from the same class of assets. 00:27:38.029 --> 00:27:40.789 In the U .S., a loss on the sale of a non -business 00:27:40.789 --> 00:27:42.970 income -producing asset is typically a capital 00:27:42.970 --> 00:27:45.230 loss. Okay. And you can generally only use that 00:27:45.230 --> 00:27:47.250 loss to offset capital gains you realized that 00:27:47.250 --> 00:27:49.529 year, plus maybe a very small amount of ordinary 00:27:49.529 --> 00:27:52.450 income. So I can't use a $50 ,000 loss on my 00:27:52.450 --> 00:27:54.769 rental property to shelter my $100 ,000 salary. 00:27:55.259 --> 00:27:57.660 Correct. And furthermore, the sources highlight 00:27:57.660 --> 00:28:00.730 a really critical distinction for you. A loss 00:28:00.730 --> 00:28:03.490 on the sale of a personal residence, your car, 00:28:03.690 --> 00:28:07.509 jewelry or any other purely personal asset is 00:28:07.509 --> 00:28:09.970 generally not deductible. You can't just deduct 00:28:09.970 --> 00:28:11.990 a loss because your personal investment didn't 00:28:11.990 --> 00:28:14.269 work out. Unless the loss is involuntary, like 00:28:14.269 --> 00:28:17.410 a fire or theft. Exactly. If a personal asset 00:28:17.410 --> 00:28:20.589 is destroyed in a fire or it's stolen, that involuntary 00:28:20.589 --> 00:28:23.269 loss may be deductible. But it's subject to some 00:28:23.269 --> 00:28:25.930 very specific, often restrictive rules about 00:28:25.930 --> 00:28:29.029 insurance and thresholds. This really reinforces. 00:28:29.099 --> 00:28:31.500 that separation between market risk, which you 00:28:31.500 --> 00:28:34.539 bear personally, and involuntary disaster. OK, 00:28:34.619 --> 00:28:36.700 now let's move to the fixed breaks that the government 00:28:36.700 --> 00:28:38.980 provides to every taxpayer, even if they don't 00:28:38.980 --> 00:28:41.680 have a shoebox full of receipts, personal exemptions 00:28:41.680 --> 00:28:43.900 and allowances. These are fundamental social 00:28:43.900 --> 00:28:46.079 policy tools. They're fixed amounts designed 00:28:46.079 --> 00:28:48.579 to protect a baseline level of income from being 00:28:48.579 --> 00:28:51.180 taxed, essentially representing the assumed basic 00:28:51.180 --> 00:28:53.720 cost of living. The U .S. system, for instance, 00:28:53.920 --> 00:28:56.019 historically had personal exemptions for the 00:28:56.019 --> 00:28:59.039 taxpayer and their family. The source cited £36 00:28:59.039 --> 00:29:02.660 .50 for 2009. The UK has a similarly personal 00:29:02.660 --> 00:29:06.660 allowance, which was over £6 ,000 in 2009. And 00:29:06.660 --> 00:29:09.039 these amounts are incredibly important for low 00:29:09.039 --> 00:29:11.319 and middle income families, making sure that 00:29:11.319 --> 00:29:14.200 subsistence level income isn't taxed. But they 00:29:14.200 --> 00:29:16.079 aren't available to everyone, are they? That's 00:29:16.079 --> 00:29:18.960 the targeting mechanism at play. Both the U .S. 00:29:18.980 --> 00:29:21.339 exemptions and the U .K. allowances are often 00:29:21.339 --> 00:29:24.019 phased out for individuals or couples whose income 00:29:24.019 --> 00:29:26.779 gets above certain high levels. As your income 00:29:26.779 --> 00:29:29.480 rises, the benefit of that basic living deduction 00:29:29.480 --> 00:29:32.400 is systematically withdrawn, directing the subsidy 00:29:32.400 --> 00:29:35.180 toward those who need it most. Now let's go back 00:29:35.180 --> 00:29:37.420 to those itemized deductions, the famous below 00:29:37.420 --> 00:29:39.240 -the -line list that has to beat the standard 00:29:39.240 --> 00:29:41.359 deduction. These aren't arbitrary. They are the 00:29:41.359 --> 00:29:43.259 government's catalog of behaviors it wants to 00:29:43.259 --> 00:29:45.799 encourage. What specific categories does the 00:29:45.799 --> 00:29:48.599 U .S. system detail? The list is very instructive 00:29:48.599 --> 00:29:50.480 because it really reveals the intent behind the 00:29:50.480 --> 00:29:53.960 tax policy. So you've got, first, medical expenses, 00:29:54.019 --> 00:29:57.059 but only deductible above a high threshold, 7 00:29:57.059 --> 00:30:00.940 .5 % of AGI. This is relief targeted at catastrophic. 00:30:01.519 --> 00:30:05.059 not routine medical costs. Second, state and 00:30:05.059 --> 00:30:08.039 local income and property taxes, the SALT deduction. 00:30:08.319 --> 00:30:10.640 This acknowledges that local taxes reduce your 00:30:10.640 --> 00:30:13.000 ability to pay federal tax, though in recent 00:30:13.000 --> 00:30:15.500 years this has faced caps, making it a very politically 00:30:15.500 --> 00:30:19.519 charged issue. Third, interest expense, specifically 00:30:19.519 --> 00:30:22.220 on certain home loans. This is a massive subsidy 00:30:22.220 --> 00:30:24.680 designed explicitly to incentivize homeownership. 00:30:25.069 --> 00:30:28.089 Fourth, charitable contributions, gifts of money 00:30:28.089 --> 00:30:31.049 or property to nonprofits designed to outsource 00:30:31.049 --> 00:30:33.210 some social welfare to the private sector. And 00:30:33.210 --> 00:30:35.849 there are others, too, right? Yes. Fifth, retirement 00:30:35.849 --> 00:30:39.849 or health savings contributions to 401ks, IRAs, 00:30:39.849 --> 00:30:42.890 HSAs. This is a huge policy push for individuals 00:30:42.890 --> 00:30:44.789 to fund their own retirement and health care. 00:30:45.029 --> 00:30:47.970 And sixth, certain educational expenses, again, 00:30:48.009 --> 00:30:49.970 reflecting a policy goal of increasing human 00:30:49.970 --> 00:30:52.329 capital. It's crystal clear that these are the 00:30:52.329 --> 00:30:54.799 levers the government uses to. Encourage people 00:30:54.799 --> 00:30:58.359 to save, buy a house, be charitable, and pay 00:30:58.359 --> 00:31:00.099 their local taxes. And finally, there's this 00:31:00.099 --> 00:31:02.480 unique category of payments that are deductible 00:31:02.480 --> 00:31:05.019 by the payer because they become taxable to the 00:31:05.019 --> 00:31:07.460 recipient. The prime example in the U .S. is 00:31:07.460 --> 00:31:10.200 alimony. So the deduction just shifts the tax 00:31:10.200 --> 00:31:12.619 burden. When I pay alimony, I get a deduction 00:31:12.619 --> 00:31:15.079 for it, but my former spouse has to report that 00:31:15.079 --> 00:31:17.880 as taxable income. Exactly. It's called tax symmetry. 00:31:18.880 --> 00:31:20.980 The net revenue to the government is maintained, 00:31:21.180 --> 00:31:23.940 but the tax incidence just shifts to the person 00:31:23.940 --> 00:31:27.160 receiving the funds. The system requires at a 00:31:27.160 --> 00:31:29.279 minimum reporting of those amounts and often 00:31:29.279 --> 00:31:32.059 mandates withholding tax by the payer just to 00:31:32.059 --> 00:31:34.200 make sure the recipient fulfills their tax obligation. 00:31:34.619 --> 00:31:36.859 We've covered the individual and the single business 00:31:36.859 --> 00:31:39.769 in pretty exhaustive detail. Now, for our last 00:31:39.769 --> 00:31:41.630 section, let's zoom out and look at how these 00:31:41.630 --> 00:31:44.410 rules apply across massive corporate structures 00:31:44.410 --> 00:31:47.170 and international borders. This is where deductions 00:31:47.170 --> 00:31:50.190 really start to impact global economics. Stepping 00:31:50.190 --> 00:31:52.329 back to that bigger picture, corporate groups 00:31:52.329 --> 00:31:54.930 often need ways to handle losses and expenses 00:31:54.930 --> 00:31:57.750 across their affiliated companies, especially 00:31:57.750 --> 00:32:00.529 when they don't file a single consolidated tax 00:32:00.529 --> 00:32:03.569 return. This brings us to the concept of group 00:32:03.569 --> 00:32:06.210 relief. OK, define group relief for us and explain 00:32:06.210 --> 00:32:08.690 how it's different from just consolidating all 00:32:08.690 --> 00:32:11.359 the company's books into one. So group relief 00:32:11.359 --> 00:32:14.240 is a mechanism where one company, let's call 00:32:14.240 --> 00:32:16.819 it company A, is allowed a tax deduction for 00:32:16.819 --> 00:32:19.180 the expenses or losses that were generated by 00:32:19.180 --> 00:32:21.859 an affiliated, commonly controlled company, company 00:32:21.859 --> 00:32:25.480 B. It allows the loss of a struggling subsidiary 00:32:25.480 --> 00:32:27.960 to immediately offset the profits of a successful 00:32:27.960 --> 00:32:30.900 one without requiring the complex legal step 00:32:30.900 --> 00:32:33.500 of creating a single consolidated tax entity. 00:32:33.720 --> 00:32:35.440 It gets you the same economic result through 00:32:35.440 --> 00:32:37.880 a targeted tax deduction mechanism. Why is that 00:32:37.880 --> 00:32:39.869 so important, especially across borders? Well, 00:32:39.930 --> 00:32:42.529 consolidation across international borders is 00:32:42.529 --> 00:32:45.349 an administrative and legal nightmare. Group 00:32:45.349 --> 00:32:48.450 relief simplifies the process. The source mentions 00:32:48.450 --> 00:32:51.329 a really significant example where group relief 00:32:51.329 --> 00:32:53.950 may even be available for companies in EU member 00:32:53.950 --> 00:32:57.170 countries for losses incurred by group companies 00:32:57.170 --> 00:33:00.490 in other EU countries. So a UK parent company 00:33:00.490 --> 00:33:03.390 could benefit. From the losses of its French 00:33:03.390 --> 00:33:06.170 subsidiary. Precisely. It's an effort to harmonize 00:33:06.170 --> 00:33:09.210 tax policy within a common market. However, when 00:33:09.210 --> 00:33:11.349 you're crossing international borders, the default 00:33:11.349 --> 00:33:13.869 position is usually one of high scrutiny and 00:33:13.869 --> 00:33:16.670 major limitations on deductions. And I'm assuming 00:33:16.670 --> 00:33:18.690 this is where governments are trying to stop 00:33:18.690 --> 00:33:21.210 corporations from artificially moving their profits 00:33:21.210 --> 00:33:24.150 out of a high tax country and into a low tax 00:33:24.150 --> 00:33:26.990 haven. That is the absolute driving force. Many 00:33:26.990 --> 00:33:29.009 national tax systems impose severe limitations 00:33:29.009 --> 00:33:31.890 on tax deductions paid to foreign parties. especially 00:33:31.890 --> 00:33:34.130 if those parties are related entities like sister 00:33:34.130 --> 00:33:36.390 companies or subsidiaries controlled by the same 00:33:36.390 --> 00:33:39.009 parent. This is directly tied to the concepts 00:33:39.009 --> 00:33:41.509 of international tax and transfer pricing that 00:33:41.509 --> 00:33:43.589 are mentioned in the source material. OK, so 00:33:43.589 --> 00:33:45.970 let's clarify transfer pricing. What deduction 00:33:45.970 --> 00:33:49.269 is being scrutinized here? So imagine a U .S. 00:33:49.289 --> 00:33:52.359 company develops some technology. It then sets 00:33:52.359 --> 00:33:55.839 up a subsidiary in a low tax country, say Ireland. 00:33:56.279 --> 00:33:59.200 The U .S. company then pays that Irish subsidiary 00:33:59.200 --> 00:34:02.220 billions of dollars in royalty fees for the use 00:34:02.220 --> 00:34:04.759 of its own technology. Right. The U .S. company 00:34:04.759 --> 00:34:07.259 claims that royalty payment as a massive deduction 00:34:07.259 --> 00:34:10.260 in the U .S., wiping out its U .S. profit and 00:34:10.260 --> 00:34:12.699 shifting that profit base over to Ireland, where 00:34:12.699 --> 00:34:15.610 the tax rate is much lower. So the U .S. government 00:34:15.610 --> 00:34:18.889 loses the tax revenue and the company wins by 00:34:18.889 --> 00:34:21.349 exploiting that deduction. And transfer pricing 00:34:21.349 --> 00:34:23.429 rules are designed to stop that. They require 00:34:23.429 --> 00:34:25.829 that payments between related parties, like that 00:34:25.829 --> 00:34:28.469 royalty fee or an interest payment, must reflect 00:34:28.469 --> 00:34:30.889 an arm's length market rate. It has to be what 00:34:30.889 --> 00:34:33.070 an unrelated independent third party would have 00:34:33.070 --> 00:34:35.510 paid. If the royalty fee is deemed excessive 00:34:35.510 --> 00:34:37.710 and not commercial, the government will disallow 00:34:37.710 --> 00:34:39.570 the deduction on the amount that exceeds that 00:34:39.570 --> 00:34:41.969 arm's length standard. These limitations are 00:34:41.969 --> 00:34:45.960 absolutely vital for protecting the tax. So what 00:34:45.960 --> 00:34:47.840 does this all really mean? We started this deep 00:34:47.840 --> 00:34:50.739 dive by moving past that simplistic idea of a 00:34:50.739 --> 00:34:53.159 deduction. And we realized we had to first define 00:34:53.159 --> 00:34:54.920 that critical difference between a deduction, 00:34:55.119 --> 00:34:58.360 which reduces taxable income, and a credit, which 00:34:58.360 --> 00:35:00.739 reduces the tax bill directly. We established 00:35:00.739 --> 00:35:03.079 the structural foundation of the whole system, 00:35:03.219 --> 00:35:05.679 that divide created by the adjusted gross income 00:35:05.679 --> 00:35:09.460 or AGI. We learned why above the line deductions 00:35:09.460 --> 00:35:11.739 are inherently superior because they can unlock 00:35:11.739 --> 00:35:14.280 other tax benefits and how the high standard 00:35:14.280 --> 00:35:17.900 deduction acts as this major filter for below 00:35:17.900 --> 00:35:20.519 the line itemized deductions. Our journey into 00:35:20.519 --> 00:35:22.820 the business world revealed those strict constraints 00:35:22.820 --> 00:35:26.139 on deductibility. We contrasted the U .K.'s gap 00:35:26.139 --> 00:35:29.239 based trade system with the U .S.'s highly interpreted. 00:35:29.519 --> 00:35:31.980 ordinary and necessary test. And we saw that 00:35:31.980 --> 00:35:33.719 to be a legitimate business, you have to have 00:35:33.719 --> 00:35:36.340 a genuine expectation of profit. That's the critical 00:35:36.340 --> 00:35:38.760 antidote to the hobby loss problem. We dissected 00:35:38.760 --> 00:35:40.920 the incredible complexity of calculating cost 00:35:40.920 --> 00:35:43.820 of goods sold, and we recognized the policy implications 00:35:43.820 --> 00:35:46.739 that are embedded in inventory methods like LIFO 00:35:46.739 --> 00:35:50.159 and FIFO. And we cataloged how specific government 00:35:50.159 --> 00:35:53.239 limitations, from executive pay caps to passive 00:35:53.239 --> 00:35:56.179 loss restrictions, use the tax code to enforce 00:35:56.179 --> 00:35:58.579 public policy and prevent these manufactured 00:35:58.579 --> 00:36:00.980 tax shelters. That led us through the Australian 00:36:00.980 --> 00:36:03.539 heroin dealer case where, you know, moral policy 00:36:03.539 --> 00:36:05.880 ultimately had to override pure tax theory. And 00:36:05.880 --> 00:36:08.659 we outlined that essential. concept of capitalization 00:36:08.659 --> 00:36:11.179 matching long -term expenses like plant and equipment 00:36:11.179 --> 00:36:13.920 through mechanisms like depreciation and amortization. 00:36:14.599 --> 00:36:16.800 And finally, for the individual, we saw that 00:36:16.800 --> 00:36:18.900 personal deductions are not random. They are 00:36:18.900 --> 00:36:21.860 intentional policy levers. From the use of fixed 00:36:21.860 --> 00:36:24.760 personal exemptions to the highly specific thresholds 00:36:24.760 --> 00:36:28.139 on itemized deductions, like that 7 .5 % AGI 00:36:28.139 --> 00:36:30.679 floor for medical expenses or the home mortgage 00:36:30.679 --> 00:36:33.000 interest deduction, the tax code is actively 00:36:33.000 --> 00:36:35.679 steering social and economic behavior. Which 00:36:35.679 --> 00:36:37.599 brings us back to the core insight from all of 00:36:37.599 --> 00:36:40.940 this. Tax deductions are so much more than just 00:36:40.940 --> 00:36:43.710 a calculation method. They are a deliberate mechanism 00:36:43.710 --> 00:36:47.210 of fiscal policy designed to promote, to subsidize, 00:36:47.230 --> 00:36:50.650 or to restrict specific actions. Which leaves 00:36:50.650 --> 00:36:52.730 us with a final thought for you to chew on, based 00:36:52.730 --> 00:36:55.639 on everything we explored today. Since deductions 00:36:55.639 --> 00:36:57.559 are often subject to conditions that influential 00:36:57.559 --> 00:37:00.179 parties want to encourage, like that medical 00:37:00.179 --> 00:37:03.340 relief or charitable giving we detailed, how 00:37:03.340 --> 00:37:05.599 does the modern shift toward increasingly high 00:37:05.599 --> 00:37:08.860 standard deductions affect the efficacy and maybe 00:37:08.860 --> 00:37:11.280 even the political viability of those highly 00:37:11.280 --> 00:37:14.239 targeted incentives? Right. If fewer and fewer 00:37:14.239 --> 00:37:16.679 people are itemizing, are those specific policy 00:37:16.679 --> 00:37:18.840 goals like encouraging significant charitable 00:37:18.840 --> 00:37:21.320 giving or saving for catastrophic health costs 00:37:21.320 --> 00:37:23.659 still being effectively subsidized by the government? 00:37:23.949 --> 00:37:26.530 through the tax code? Or is the benefit just 00:37:26.530 --> 00:37:29.590 becoming generalized and diluted? When tax simplification 00:37:29.590 --> 00:37:32.369 removes the need to itemize, what's the trade 00:37:32.369 --> 00:37:34.690 -off in terms of that specific behavioral encouragement 00:37:34.690 --> 00:37:36.849 that those deductions were originally created 00:37:36.849 --> 00:37:39.130 for? Something to consider as you review the 00:37:39.130 --> 00:37:41.530 interplay between policy and profit. We hope 00:37:41.530 --> 00:37:44.210 this deep dive helped clarify the complex, powerful, 00:37:44.449 --> 00:37:46.769 and often surprising world of the tax deduction. 00:37:46.949 --> 00:37:47.789 Until next time.