Chap008

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 08

Business Income, Deductions, and Accounting Methods

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Learning Objectives1) Describe the general requirements for deducting business

expenses and identify common business deductions.

2) Apply the limitations on business deductions to distinguish between deductible and nondeductible business expenses.

3) Identify and explain special business deductions specifically permitted under the tax laws.

4) Explain the concept of an accounting period and describe accounting periods available to businesses.

5) Identify and describe accounting methods available to businesses and apply tax accrual methods to determine business income and expense deductions.

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Business income and deductions

Schedule C – Trade or business income Includes revenue from services and sales activities. Gross profit from sales - cost of goods is a return of capital

– not a business deduction. Business income does not include excluded and deferred

income.

Deductions must be directly connected to business activity. Ordinary and necessary means conducive to profit

generation. Reasonable in amount means not extravagant.

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Statutory limits on business expense deductions

1. Expenses against public policy No deduction for fines, bribes, lobby

expenditures, or political contributions

2. Expenses relating to tax-exempt income Interest on loan where proceeds invested in

municipal bonds. Key man insurance premiums – no deduction if

business is beneficiary of life insurance.

3. Capital expenditures4. Personal expenses

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Capital expenditures

Answer the accounting question – does the expenditure provide future benefits (beyond this year)? If so, then capitalize rather than deduct.

12-month rule for prepaid expenses: Deduct if benefit < 12 months and Benefits do not extend beyond end of next tax

year. Does not apply to interest.

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Specifically authorized business deductions

Start-up expenditures Capitalize and elect to expense/amortize

Bad debts Accrual taxpayers can use direct write off only Cash basis taxpayers have no deduction

Losses on disposition of business assets Sales or exchanges for recognized losses Casualty loss is limited to lesser of decline in value (repair

cost) or basis Basis is amount of loss if business asset is completely

destroyed

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Domestic production activities deduction (DPAD)

An “artificial” deduction that subsidizes domestic manufacturing. Domestic production of tangible products qualifies for

subsidy for income must allocated between qualifying and nonqualifying activities.

Subsidy is percentage (9 percent) of the lesser of qualified production activities income (QPAI) or modified AGI.

Formula: QPAI = domestic production gross receipts less expenses

attributed to domestic production. Deduction is ultimately limited to 50% of wages allocated

to qualified activities.

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Business expenses with personal benefits

No deduction for purely personal expenditures unless otherwise allowable – e.g. charity, medical, etc.

Mixed motive? Primary motive for some expenditures (all or nothing).

Uniforms (not adaptable to ordinary use).Business travel (away from home overnight).

Otherwise, allocate deduction to business portion.Arbitrary percentage (50% meals and entertainment).Basis for allocation (mileage or time).

Recordkeeping Document business purpose. Travel, meals and entertainment, mixed use assets

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Accounting for taxable income

We’ve learned to identify: Business gross income and Deductible expenses

Now we need to match these flows to a specific period. Accounting periods determine beginning and end

of accounting cycle. Accounting methods match income and expense

to a specific period.

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Accounting periods

Annual period Full tax year is 12 months long. Short tax year is < 12 months.

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. Example: last Friday in June.

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Choosing an accounting period

Proprietorships – same as proprietor. Prevents mismatch of income.

“C” corporations and individuals – choice made on first tax return for those with books.

Flow-thru entities – a “required” tax year. Partnerships, “S” corporations, LLCs and other

hybrid entitles. Match to owners’ period (multiple owners for

partnerships so this can be complicated).

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Accounting methods

Comparison of financial and tax methods Financial accounting is “conservative”

GAAP is slow to recognize income, but quick to recognize losses or expenses.

Objective is to avoid misleading investors & creditors.

Tax accounting is much less conservative.Objective of Congress is to maximize tax revenues.More likely to recognize income and defer losses and

expenses.

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Accounting methods

Permissible “overall” methods: Cash – recognize income when received. Accrual – recognize income when earned or

received (whichever is first generally). Hybrid – mix of accrual and cash depending upon

accounts (e.g. sales on accrual). Methods are adopted with first tax return.

Proprietorships can use either cash or accrual. Other flow-thru entities also typically have choice. “C” corporations must typically use accrual.

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Cash method

Income recognized when actually or constructively received.

Expenses recognized when paid. Pros and cons:

Flexible. Simple and relatively inexpensive. Not GAAP – poor matching of income and expense. Not available for some business organizations (large C

corporations typically).

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Accrual income

Income is recognized when earned or received All events test – recognize income when all the events

have occurred which fix the right to receive such income and

The amount can be determined with reasonable accuracy

Earliest of these dates: Completes service or sale Payment is due Payment is received

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Accrual – prepaid income

Advance payments for services: Allowed to defer recognition for one year unless income is

earned or recognized for financial records. Not applicable to payments relating rent or interest

income.

Advance payments for goods: Elect one of two methods of recognition. Full inclusion method – recognize prepayments as income. Deferral method – include in period earned for tax or

financial purposes.

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Inventories

Inventories must be accounted for under the accrual method if sales of goods constitute a “material” income producing factor. Purchases accrued with accounts payable. Sales accrued with accounts receivable.

If sales are not material or taxpayer is “small”, then goods are expensed as “supplies.”

Cash method taxpayers may use cash method for other (non-inventory) accounts. Technique is called the “hybrid” method.

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UNICAP

Inventory (purchased or produced) must be accounted for using tax version of “full absorption” rules.

Indirect costs are allocated to inventories (not expensed).

Costs of selling, advertising, and research need not be capitalized.

Exception for “small” businesses (average annual gross receipts < $10 million).

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Inventory flow assumptions

First-in, First-out (FIFO)

Last-in, Last-out (LIFO) Same method for financial and tax records “Book-tax conformity” requirement Generates lowest taxable income in time of

inflation.

Specific identification

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Accruing business expenses

1. All events test All events have occurred to establish the liability

to pay. The amount is determinable with reasonable

accuracy. Reserves for future liabilities not allowed.

and

2. Economic performance has occurred. Mere liability is NOT ENOUGH!

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Economic performance

Taxpayer liable for providing goods or services? Performance occurs as taxpayer provides goods or

services.

Taxpayer liable for using property or goods? Performance occurs as goods are provided or economic performance is otherwise expected within 3 ½

months of payment.

Payment liabilities (rebates, warranty costs, tort claims, and taxes) are performed only when paid.

Interest and rent occurs ratably.

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Choosing or changing an accounting method

Accounting methods are generally adopted via use. A permissible method is adopted by using and reporting

the method for one year. An impermissible method is adopted by using and

reporting the method for two years.

Generally method changes require permission of the IRS. a business purpose is critical - not tax avoidance. Some changes are automatic. Permission is necessary to correct the use of an

impermissible method.