Chapter 9 Tax Notes
Chapter 9 Tax Notes ACCT 404
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This 7 page Class Notes was uploaded by Victoria Andreski on Sunday March 27, 2016. The Class Notes belongs to ACCT 404 at Clemson University taught by Sarah Martin in Spring 2016. Since its upload, it has received 12 views. For similar materials see Individual Taxation in Accounting at Clemson University.
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Date Created: 03/27/16
CHAPTER 9—Business Income, Deductions, & Accounting Methods Business Income & Deductions • Schedule C—trade or business income o Includes revenue from services & sales activities o Gross profit from sales—cost of goods is a return of capital o Business income does not include extended & deferred income • Gross Income includes: o All income from whatever source derived o Gross profit from inventory sales o Income from services provided to customers o Income from renting property to customers • Business are allowed to deduct expenses for “trade or business” activities o Business expense must be made in pursuit of profits rather than the pursuit of personal motives • Hobbies are NOT businesses o Personal activity that may generate revenue o Taxpayer generally has burden of proving their intent to make a profit o Specific factors listed in Regulations such as: § History of income or loss § Elements of personal pleasure or recreation o Deductions only allowed to extent of revenue • Deductions must be directly connected to business activity o Ordinary & necessary means conducive to profit generation § Ordinary—normal or appropriate for the business under the circumstances from court case Welch v. Helvering (1993), 290 US111 • Does not have to be typical or repetitive in nature § Necessary—is helpful or conducive to the business activity • Does not need to be essential or indispensable § Ordinary & necessary applied on a case by case basis—IRS is reluctant to second-guess business decisions o Reasonable in amountà not extravagant § Reasonable—cannot be extravagant or exorbitant • If extravagant, deemed to be spent for personal rather than business reasons & is not deductible • Compare expense to market price or an arm’s length amount to determine if amount is extravagant • Usually an issue when amount is paid to a related party to the taxpayer Statutory Limits on Business Expense Deductions 1. Expenses against public privacy a. No deduction for fines, bribes, lobby expenditures, illegal bribes, illegal kickback, or political contributions i. Allowing a deduction would subsidize illegal activity & frustrate public policy ii. Businesses conducting illegal activities are allowed to deduct COGS & ordinary & necessary business expenses in conducting business activities iii. Political contributions & most lobbying expenses—no deduction to avoid the perception that the federal gov’t subsidizes taxpayer efforts to influence politics 1. Costs to submit statements to local council w/ respect to proposed legislation of direct interest to the taxpayer are allowed 2. Expenses relating to tax-exempt income a. Interest on loan where proceeds invested in municipal bonds b. Key man insurance premiums—no deduction if business is beneficiary of life insurance c. If the expense does not help generate taxable income, it is not allowed to offset taxable income i. Interest on money borrowed to buy municipal bonds ii. Life insurance premiums on lives of officers or key employees—life insurance proceeds are tax-exempt 3. Capital Expenditures a. Tangible assets—capitalize if useful like > 1 year i. Recover cost of tangible asset through depreciation ii. Buildings, machinery & equipment, furniture & fixtures, etc. b. Intangible assets—capitalize & recover through amortization or upon disposition of the asset i. Goodwill, startup costs, organizational expenditures c. Special rule 12-month rule for prepaid expenses i. Deduct if benefits ≤ 12 months AND ii. Benefits do not extend beyond end of next tax year iii. Does not apply to interest deductions 4. Personal expenses—not deductible unless expressly authorized by law a. Exceptions: i. Uniforms not suitable for street wear ii. Education if it: 1. Maintains/improves skills required by the individual in his employment or other trade/business 2. Meets the express requirements of the individual’s employer, or the requirements of applicable law or regulations for the individual to maintain employment 3. If the education is necessary to meet the minimum requirements for an occupation, it is not deductible Special Business Deductions • Losses on disposition of business assets o Recognized losses are deductible o Casualty losses are limited to lessor of decline in value (repair cost) or basis § Deduct losses in the year they occur or in the year the theft of an asset is discovered § Amount of loss depends on whether the asset is: • Completely destroyed or stolen OR o Calculated as if the asset was sold for the insurance proceeds (if any) • Partially destroyed o Amount of loss—amount of insurance proceeds minus the lessor of: § Asset’s tax basis OR § Decline in value due to the casualty o Basis is amount of loss if business asset is completely destroyed Domestic Production Activities Deduction (DPAD) • An “artificial” deduction that subsidizes domestic manufacturing o Domestic production of tangible products qualifies for subsidy but income must be allocated between qualifying & nonqualifying activities o Subsidy is percentage (9%) of the lessor of qualified production activities income (QPAI) or modified AGI § 1) Qualified Production Activities Income (QPAI)—net income from selling or leasing property that was manufactured in the US § 2) Modified AGI § Deduction cannot be greater than 50% wages paid to employees for working in qualified production activities (US) during the year • Formula o QPAI= domestic production gross receipts less expenses attributed to domestic production o Deduction is ultimately limited to 50% of wages allocated to qualified activities • Designed to reduce the tax burden of domestic manufacturers to make investments in domestic (US) manufacturing facilities more attractive • ***For large & small businesses that “manufacture, grow, or extract” tangible products entirely or in significant part within the US o Intended to entice companies to come back to the US o Doesn’t represent an actual expenditure but reduces income taxes which increases after-tax profitability • Does not represent an expenditure, but reduces the income taxes the business has to pay, so in turn increases the after-tax profitability of US manufacturing Business Expenses w/ Personal Benefits • No deduction for purely personal expenditures o Unless otherwise allowable—charitable contributions, medical, etc. • Mixed motive—motivated by both business & personal concerns o Primary motive for some expenditures (all or nothing deduction) § Business travel (away from home overnight) o Otherwise allocate deduction to business portion § Arbitrary percentage (50% meals & entertainment) • Meals: to qualify as a business expense: o 1) Amount must be reasonable under the circumstances, o 2) The taxpayer (or employer) must be present when the meal is finished, o 3) The mean must be directly associated w/ the active conduct of the taxpayer’s business • Entertainment: o 1) Only if “business associates” are entertained, o 2) The amounts paid are reasonable, & o 3) The entertainment is either “directly related to” or “associated w/” the active conduct of business § Basis for allocation (mileage or time) • Travel & Transportation: o Commuting between home & regular place of work is NEVER deductible o Operating a vehicle for business purposes can use standard mileage rate o Travel is deductible if away from home overnight for business purpose (50% of meals, lodging, transportation, & incidentals) § Travel inside US vs. travel abroad • Property use—taxpayer may only deduct the portion used for business use • Recordkeeping—document business purpose Accounting for Taxable Income • Accounting periods affect when taxpayers determine their income & deductions o Annual period § Full tax year is 12 months long § Short tax year is less than 12 months • Can occur in the first or last year of operation, but short years are treated the same as full years o Year ends § Calendar year ends 12/31 § Fiscal year end depends upon choice: • Last day of a month (not December) • 52/53 week year end is the same day of a specific month o Choosing an accounting period § Proprietorships—same as proprietor • Must have the same tax year (a calendar year end) § “C” corporations & individuals—choice made on first tax return & is consistent w/ book accounting period • Can adopt any tax year they choose § Flow-thru entities—a “required” tax year • Match to owners’ period § Tax year us adopted by filing initial tax return if calendar or fiscal year end • Businesses must report their income & deductions over a fixed accounting period or tax year Accounting Methods • Comparison of financial & tax methods o Financial accounting is “conservative” § GAAP is slow to recognize income, but quick to recognize losses/expenses § Objective is to avoid misleading investors & creditors o Tax accounting is much less conservative § Quick to recognize income but likely to defer deductions § Objective of Congress is to maximize tax revenues • Permissible “overall” methods: o Cash—recognize income when received o Accrual—recognize income when earned or received (whichever is first generally) o Hybrid—mix of accrual & cash depending upon accounts (e.g. sales on accrual) • Methods are adopted w/ 1 tax return • Large corporations must use accrual • Overall method elected must “clearly reflect income” & be applied consistently • 12-month rule—when a business prepays business expenses, it may immediately deduct the prepayment if: o 1) The contract period does not last more than a year AND o 2) The contract period does not extend beyond the end of the taxable year following the tax year in which the taxpayer makes the payment • Otherwise, the business must capitalize the prepaid amount & amortize it over the length of the contract whether the business uses the cash or accrual method Cash Method • Income recognized when actually or constructively received • Expenses recognized when paid • Pros & cons: o Flexible o Simple & relatively inexpensive o Not GAAP—poor matching of income & expense o Not available for some business organizations (large C corporations typically) Accrual Income • Income is recognized when earned OR received o All-events test—recognize income when all the events have occurred which fix the right to receive such income AND o The amount can be determined w/ reasonable accuracy • Earliest of these dates: o Complete service or sale o Payment is due o Payment is received • Better matches revenues & expenses Accrual—Prepaid Income • Advance payments for services: o Allowed to defer recognition for one year unless income is earned or recognized for financial reports o Not applicable to payments relating to rent or interest income • Advance payments for goods: o Elect one of 2 methods of recognition o Full inclusion method—recognize prepayments as income o Deferral method—include in period earned for tax or financial purposes o Unearned rent & interest must be recognized as income immediately upon receipt (unless a security deposit) o Unearned service revenue—GAAP says to recognize income as the business performs services to EARN the income § All events test for tax purposes would generally treat an advance payment as recognizable income when received o May defer recognition of prepayment as income until the tax year following the year they receive the payment o DOES NOT APPLY if: § The extent to which the income us actually earned by the end of the year of receipt § The prepayment was included in financial reporting income § The prepayment was for interest or rent • Final payment for goods—full inclusion now o Deferral recognizes income by the earlier of: § When the business would have recognized the income for tax purposes had it not received the advance payment OR § When it recognizes the income for financial reporting purposes Inventories • Must be accounted for under accrual method if sales of goods constitute a “material” income producing factor o Purchases accrued w/ AP o Sales accrued w/ AR • Cash method taxpayers may use cash method for other (non-inventory) accounts o Technique called “hybrid” method UNICAP • Inventory (purchased or produced) must be accounted for using tax version of “full absorption” rules • Indirect costs are allocated to inventories (not expenses) • Costs of selling, advertising, & research need not be capitalized • Exception for “small” businesses (average annual gross receipts less than $10 million) o Businesses that sell inventory have to determine inventory costs to accurately determine taxable income o Must maintain records of raw materials, WIP, & finished goods inventories o Tax laws require businesses to capitalize certain direct & indirect costs associated w/ inventories § It accelerates tax revenue b/c it defers deductions for the capitalized costs until the business sells the inventory § Reduces variations in the costs businesses include in inventory • Applies to manufacturers & large resellers § Typically must capitalize more costs to inventory for tax purposes (costs that support production or inventory acquisition) than they would for GAAP (typically only production facility costs) • Applies to manufacturers (Walmart) Inventory Flow Assumptions • First-in, First-out (FIFO) • Last-in, First-out (LIFO) o Same method for financial & tax records o “Book-tax conformity” requirement o Generates lowest taxable income in time of inflation o Can only use if they use it for book purposes as well • Specific identification • Businesses usually tend to use FIFO or LIFO when they sell similar, relatively low-cost high-volume products b/c business does not need to track the individual cost of each item it sells • Businesses that sell distinct, relatively high-cost low-volume products might adopt specific identification so they can track the cost of each item • When costs are increasing, a business using FIFO will have higher gross margin than if it used LIFO • When costs are decreasing, a business using LIFO will have lower gross margin than if it used FIFO • Tax laws required that a business can only use LIFO for tax purposes if it also uses LIFO for financial purposes Accruing Business Expenses 1. All-event test a. All events have occurred to establish the liability to pay b. The amount is determinable w/ reasonable accuracy c. Reserves for future liabilities NOT allowed 2. Economic performance has occurred a. Why have economic performance requirement? i. Taxpayers claimed current deduction & delayed paying cash expenditure for years (the delayed payment reduced the real cost of the deduction) ii. Businesses may not recognize a deduction for an expense until the activity generating the associated liability has occurred Economic Performance • Applies to accrual method taxpayers only • Taxpayer provides goods or services: o Performance occurs as taxpayer provides goods or services • Taxpayer using property or goods: o Performance occurs as goods are provided or o Economic performance is otherwise expected within 3.5 months of payment • Payment liabilities are performed only when paid o Essentially on the cash method for deducting expenses for payment of liabilities so deduct when paid • Interest & rent occurs ratably • Receiving goods or services from another party—deduct expenses as the other party provides the goods or services (unless it reasonably expects the other party to provide the goods or all the services within 3.5 months after the payment) • Renting or leasing property from another party—deduct rental expense over the term of the lease • Providing goods & services to another party—deduct as goods & services are provided to the other party • Recurring items exception—accrual method taxpayers can deduct certain accrued expenses even if economic performance has not occurred by year end if the recurring item is expected to persist in future years & is either not material in amount or deducting the amount matches w/ revenue Bad Debt Expense • Accrual Method o For tax purposes, deduction is only allowed when debt actually becomes worthless within the taxable year • Cash Method o No tax deduction for bad debt expense b/c no receivables in taxable income • Must use “specific write-off” method, not allowance for doubtful accounts like GAAP • Businesses must specifically identify which accounts have become worthless & directly credit the actual AR account that is uncollectible Accruals to Related Parties • Accrual method taxpayers cannot accrue & deduct expenses for liabilities owed to a related party using cash method until the related part recognizes the income • Related parties are: o Family members (parents, siblings, & spouses) o Shareholders & C corporations (shareholder owns more than 50% of corporation stock) o Owners of partnerships & S-corporations no matter what the ownership % • Situation usually happens when the owner also works in the business or a relative of the owner is employed in the business • Business is NOT allowed to deduct compensation owed to the related party until the year the related party includes the compensation in income • Extends to ANY accrued expense owed to a related cash-method taxpayer Choosing or Changing an Accounting Method • Accounting methods are generally adopted by use o A permissible method is adopted by using & reporting the method for 1 year o An impermissible method is adopted by using & reporting the method for 2 years • Generally method changes require IRS permission o Some changes are automatic o Permission is necessary to correct the use of an impermissible method • Business can unknowingly adopt an incorrect method of accounting by using it on its tax return for 2 consecutive years • Once an accounting method (right or wrong) has been adopted, it must ask for permission to change it o Permission is asked for on Form 3115—automatic for certain method changes, but there must be a valid business purpose for others & pay a fee o Tax consequences of changing methods—determine taxable income for the year of change using the new method o Add the CUMULATIVE difference in income as of the beginning of the tax year between the old method & the new method that would have been recognized for all prior years (section 481 adjustment) § If section 481 adjustment increases taxable income, taxpayer recognizes it over 4 years beginning w/ the year of change § If it decreases taxable income, taxpayer recognizes it all in the year of change
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