 and welcome to this session in which we will discuss few disallowed deductions. Now deduction and taxes are good. Why? Because deductions they reduce your taxable income and as they reduce your taxable income they reduce your tax bill. So businesses they would like to get as many deductions as possible because they would reduce their tax bill that's the idea behind it. But there are certain deductions that are considered against public policy and let's take a look at those deductions. First illegal payments, two legal fees, three illegal business, four drug dealing business, five political contribution and lobbying expenditure. Now bear in mind each one of them will need to discuss separately just to explain why and under what circumstances deduction is allowed but generally speaking those are disallowed deductions unless there is a specific exception. So let's go ahead and get started. Before we proceed any further I have a public announcement about my company farhatlectures.com. Farhat accounting lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true false questions as well as exercises. Go ahead start your free trial today starting with illegal payments. Remember when we are discussing business deductions what are the overriding aspect of it? Well it has to be ordinary and necessary and reasonable in compensation. Let's talk about illegal payments. What are illegal payments? Illegal payments is when you bribe someone when you have kickbacks. Are these ordinary? Do all businesses do that? Do that and the answer is no at least in the US we don't do that. Is it necessary to make illegal payments? No it should not be necessary, it should not be ordinary and let alone reasonable. So illegal payment are not necessary payment, are not ordinary therefore any illegal payments for example if you pay to bribe a cop, a judge, if you try to bribe another business owner. Any type of a bribery is illegal you cannot deduct it. Illegal payments are not deductible. How about legal fees? If you incur legal fees, are legal fees deductible? Simply put if you are defending yourself. Well the legal fees must be related to business slash trade activity or income producing activity. So if you are incurring legal fees for your business, for your income producer let's assume you have a rental property and you have to evict a client. Well that's legal fees. How about you had a criminal case against you for some reason or another because you committed fraud. You are accused of fraud as part of your business or trade. Well criminal cases related or associated to business activities when you pay the fees those are deductible as long as they are related to business activities. In other words it's part of your business. If you're an employee it's a different story but if you are a business owner and the case is about your business. How about illegal businesses? What are some example of illegal businesses? You could be running a gambling operation, you could be a bookie, you could have poker, the legal poker machine, etc. Those are illegal businesses. For illegal businesses you have to understand it's still a business. It's illegal but it's still a business. So you can deduct operating expenses. So when you run your business you might have to pay for supplies, you might have to pay for employees, you might have to pay for contractors, you might have to pay for utilities. Operating your illegal business is business deductible. Why? Because your business income is also includeable. However illegal payments, bribing cops, kickbacks, bribing judges, trying to pay someone to influence their decision, which is a form of bribing, those are not deductible. So illegal business itself, the operating expenses and of course the operating income is taxable. I don't have to tell you the operating income is taxable. It is taxable but the operating expenses is deductible unless it's illegal payments. That's illegal business. What about drug dealers? If you are a drug dealer what would happen? Well if you are a drug dealer operating expenses are not deductible. So if you're a drug dealer and you're paying dealers, you're paying for transportation expense, you're paying for cell phone, you're paying for whatever reason to operate your business. Drug dealers cannot deduct their operating expenses. They cannot deduct their operating expenses. However, listen to this one, they can deduct cost of goods sold. So cost of goods sold is deductible for drug dealing. Remember, your income is always taxable. So you're going to take your income minus cost of goods sold, the cost of the drug itself. But to run the business on a day-to-day operation that is not deductible. That is not deductible and it will be funny. Believe it or not, this is the most interesting lecture when I have in-class lecture. We have the most interesting funny jokes about these deductions. And something related to all of those is political contribution and lobbying activities. How about if you make a political contribution from your business? Can you deduct this? Not deductible. Whether you make that contribution directly or indirectly, that's not deductible. And what's the reason behind this? Well, because if you can make political contribution and deduct political contribution, you know what's going to happen. Businesses, they're going to do what? They're going to try to basically, in a sense, quote, buy politicians to do what? Well, to make rules that influence, that sides with them. That's why it's not deductible. So they don't want to encourage you. You can make as many political contributions as you want. Simply put, you cannot deduct it for business purposes. How about lobbying activities? Trying to influence. Money is spent on lobbying to try to affect local state or federal laws or the activities of certain senior public figures, also not deductible. Whether to elect or to influence their decision, that's not deductible. However, for lobbying activities, we have two exceptions that you need to be aware of. If you are paying money to monitor legislative activities, basically keep track of laws, because that's part of your business. Maybe the laws affect your business. And you want to keep track of what's going on. You might have to pay a lobbyist to keep track, to talk to legislative, see what's going on. That's different. So as long as you're monitoring legislative activities, just to know what's going on, that's not this allowed. So it is, I should not have put double negative, that is deductible. That is allowed. Allowed means the deductible because we like deductions. Also, in-house lobbying expense. In-house lobbying expense, it means lobbying paid by your employees. As long as it's under $2,000 annually, they are permitted. However, if you exceed the 2,000, none of it is deductible. So if your employee contributed 2,500, that's it. None of it is deductible. Not the 2,000 and the 500 is not. None of it is deductible. Let's take a look at this example. Phil S is an old high school of yours. He's serving Latte at a local cafe. One day, Phil comes to you and asks you to help him prepare his federal income tax return. Okay, that's fine. You notice that his bank balance is doing a lot better than his waitering tips should allow. Now you cannot wonder about how. Well, you ask him a few questions and you find out he's not only serving expressoes, he's also moonlighting as a bookie, a legal business. So you talk to him, you sit down, it's like, okay, show me your income. So wages and tip income from the cafe is $15,000. Gambling income from his bookie business, $65,000. He paid out to winners from his bookie business, $22,000. And in case you're wondering what is a bookie business, it's basically you take bets against, for example, sports game, and you'll take a cut. And if you chose the right side, you'll have to pay. There's a payout to winners, so you have to pay them out. So this is basically part of operating your business. You also have an employee that follow up with your gamblers, call them, let them know what's going on. Whenever they need to pay, if there's a payout, so on and so forth, you pay them $5,000. Phil paid them $5,000. And the local police one of the local police officers is aware of you. And what you did is you bribe them, you pay them $10,000 to keep their mouth shut. Now we need to complete the federal income tax return for this individual. The first thing I would say, stay away from Phil, Phil S. But if you are going to compute their income taxes, we're going to include the tip income, $15,000. We're going to include the gambling income, $65,000. So total income of $80,000. Then on schedule C, Phil can deduct the $22,000. So basically the $65,000 and the $22,000 goes on schedule C because that's his business. Although it's illegal, it's still a business. Then we can deduct the $5,000 of employee expenses. So $80,000 minus $20,000. Let's do them separately. Let's do the business separately. So I want to make sure I make the point. So first, Phil has a W2 wages. W2 wages is right here, $15,000. Then we'll have to prepare a schedule C. Schedule C, we're going to have $65,000 of income minus $22,000, basically pay out to winners, minus $5,000 the employee. Phil is allowed to deduct those. So $65,000 minus $22,000 minus $5,000. That's $38,000. We cannot deduct bribe to the police officer, the local police officer. Why? Because this is illegal. The $10,000 is illegal. Now this is the business income. Now bear in mind, bear in mind, you don't want to associate yourself with a client like this. That's not your problem in a sense that you're only preparing your taxes. However, however, if you know he's bribing a police officer, then there is no confidentiality as a CPA or as an accountant or as a bookkeeper. So you have to be aware. You have to be careful of what you do. But this is basically the amount that's included in Phil taxable income, the $38,000 plus the $15,000. Your integrity is the most important thing as a CPA or as an accountant. So make sure you keep that. What should you do now? To learn more about this, this allowed deductions. Go to Farhat Lectures, look at additional lectures, MCQs, True False, that's going to help you understand this concept better. Whether you are a CPA candidate, accounting student or enrolled agent, good luck, study hard and stay safe.