Chapter 7 Chapter 7 Accounting Periods and Accounting Periods and Methods and Depreciation Methods and Depreciation Income Tax Fundamentals 2012 Gerald E. Whittenburg & Martha Altus-Buller 2012 Cengage Learning
Chapter 7Chapter 7Accounting Periods and Accounting Periods and
Methods and DepreciationMethods and Depreciation
Income Tax Fundamentals 2012
Gerald E. Whittenburg &Martha Altus-Buller
2012 Cengage Learning
Learning ObjectivesLearning Objectives
Determine different accounting periods and methods for tax periods
Understand concept of depreciation Calculate depreciation using MACRS tables and
identify when §179 election to expense may be applied
Apply listed property and luxury automobile limitations
Understand tax treatment of intangibles Determine whether parties are considered related
and how to treat related party transactions
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Accounting PeriodsAccounting Periods
Rarely, a taxpayer’s tax year will differ from the calendar year
In a partnership The tax year must be the same tax year as 50% of partners’ If majority of partners’ tax years are different, must use tax
year of ‘principal partners’ Principal partner defined as partner with at least 5% share in
profits or capital
If principal partners have different tax years, partnership generally required to use least aggregate deferral method
Note: Partnerships don’t pay tax as an entity
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Accounting PeriodsAccounting Periods
Partnerships/S-Corporations may elect to adopt a different fiscal tax year from the one prescribed on previous slide, but onlyo If entity can demonstrate that natural
business cycle easily conforms to fiscal year other than calendar year
• Such as a golf course in Denver, CO (natural business cycle ends in October)
Note: S-Corporations don’t pay tax as an entity
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Required Tax PaymentRequired Tax Payment Even though S-Corporations and partnerships
don’t pay tax, the entity must make an estimated payment if choosing to use a fiscal year-end different from calendar year-end◦ Estimated taxes are calculated as
Estimated deferral period taxable income x
(Highest individual tax rate + 1%)
◦ Estimate deferral period taxable income by using average monthly income from preceding fiscal year
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Required Tax Payment ExampleRequired Tax Payment Example
ExampleSan Juan River Expeditions Inc., an S-Corp, has
taxable income of $360,000 for the year ended 9/30/11 with a three-month deferral period. The company made a $15,000 payment last year. What’s their current required tax payment?
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SolutionSolutionExampleSan Juan River Expeditions Inc., an S-Corp, has taxable income of
$360,000 for the year ended 9/30/11 with a three-month deferral period. The company made a $15,000 payment last year. What’s their current required tax payment?
SolutionThe required tax payment = (Estimated taxable income in deferral period x 36%) - prior year’s tax payment
Deferral period is 3 months (October – December)[($360,000/12) x 3 months] = $90,000 ($90,000 x 36%) = $32,400
($32,400 - 15,000) = $17,400 estimated tax payment due in current year
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Tax Year for Tax Year for Personal Service CorporationPersonal Service Corporation
A Personal Service Corporation (PSC) is a corporation with shareholder-employee(s) who provide a personal service, such as architects or dentists
Generally, a PSC must adopt calendar year However, can adopt a fiscal year if
◦ Can prove business purpose or◦ Fiscal year results in a deferral period of less than 3 months
and Shareholders’ salaries for deferral period are proportionate to
salaries received during rest of the period or
Corporation limits its salaries deduction
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See next slide
PSC Limit on PSC Limit on Salaries DeductionSalaries Deduction
Purpose is to keep the PSC from deducting one year’s salary in first nine months
If salaries don’t remain constant, the PSC can only deduct pro rata amount◦ Based on a required formula
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Short Period Taxable Income (TI)Short Period Taxable Income (TI)
If taxpayer has a short year (other than first or last year of operation), tax is calculated based on following example:
° In 2011, Organic Dairy LLC changes from a calendar year to tax year ending 9/30. For the short period 1/1/11 – 9/30/11, Organic Dairy LLC’s taxable income = $20,000* Steps to calculate tax for the short period
Annualize TI $20,000 x 12/9 = 26,667Estimated tax on annualized TI $26,667 x 15% = 4,000Allocate tax to short period $ 4,000 x 9/12 = 3,000
Individual taxpayers rarely change tax years
*Note: Calculations for short year TI requires special adjustments
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must use same method for tax & books
Accounting MethodsAccounting Methods There are three acceptable accounting
methods for reporting taxable income
◦ Cash◦ Hybrid◦ Accrual
Must use one method consistently◦ Make an election on your first return by filing using a
particular method◦ Must obtain permission from IRS to change
accounting methods
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Accounting MethodsAccounting MethodsCash receipts/disbursements method
◦This method most common for individuals◦Recognize income when cash actually or
constructively received◦Recognize deduction in year of payment
• Exception - can’t deduct prepaid rent or interest
◦Can’t use cash basis if taxpayer is a • C corporation • Partnership with a corporation as a partner• Tax exempt trust with unrelated business
income◦Doesn’t apply to certain organizations
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Accounting Methods Accounting Methods (continued)(continued)
Accrual method◦Recognize income when earned and can be
reasonably estimated◦Recognize deductions when incurred and can
be reasonably estimatedHybrid method
◦An example of a hybrid taxpayer is one that utilizes cash method for receipts and disbursements, but accrual for cost of products sold
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DepreciationDepreciationDepreciation is a process of allocating and
deducting the cost of assets over their useful lives◦ Does not mean devaluation of asset
◦ Land is not depreciatedMaintenance vs. depreciation
◦ Maintenance expenses are incurred to keep asset in good operating order
◦ Depreciation refers to deducting part of the original cost of the asset
Report depreciation on Form 4562
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Depreciation MethodsDepreciation Methods
Straight-line depreciation is easiest, for accounting purposes, and is calculated as (Cost of asset – salvage value)/Years in estimated life
Modified Accelerated Cost Recovery System (MACRS), for tax purposes, allows capital assets to be written off over a period identified in tax law◦ Accelerated method used for all assets except real
estate
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Personal Property Personal Property Recovery PeriodsRecovery Periods
With MACRS, each asset is depreciated according to an IRS-specified recovery period◦ 3 year ADR* midpoint of 4 years or less ◦ 5 year Computers, cars and light
trucks, R&D equipment, certain energy property and certain equipment
◦ 7 year Mostly business furniture and equipment and property with no ADR life
*See Table 7.1 on page 7-9 for Asset Depreciation Ranges (ADR) for recovery periods for all classes of assets
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Calculating Depreciation Calculating Depreciation for Personal Propertyfor Personal Property
Depreciation is determined using IRS tables◦ MACRS rates found in Table 7.2 on page 7-10◦ Rates multiplied by cost (salvage value not used in
MACRS) ◦ Tables based on half-year convention
Means 1/2 year depreciation taken in year of acquisition and 1/2 year taken in final year
May elect to use tables based on straight-line instead (percentages in Table 7.3 on page 7-11)
Note: Must use either MACRS or straight-line for all property in a given class placed in service during that year
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Using Tables – Personal PropertyUsing Tables – Personal Property
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Example 1: On March 15, Ceramatech Co. purchased furniture for $180,000; what is the recovery period and depreciation? (assume no bonus depreciation taken)
Use Table 1 to see it’s a 7-year assetUse Table 2 to get percentages
Year 1: $180,000 x .1429 = $25,722Year 2: $180,000 x .2449 = $44,082
Example 2: On February 3, Bad Boy Bling LLC bought a computer for $12,000; what is the recovery period and depreciation? (assume no bonus depreciation taken)
Use Table 7.1 to see it’s a 5-year asset Use Table 7.2 to get percentages
Year 1: $12,000 x .20 = $2,400Year 2: $12,000 x .32 = $3,840
Mid-Quarter ConventionMid-Quarter Convention
Mid-quarter convention is required if taxpayer purchases more than 40% of total assets (except real estate) in the last quarter of tax year◦ Must apply this convention to every asset purchased in
the year◦ Excludes real property and §179 property◦ Must use special mid-quarter tables
Found at major tax service such as Commerce Clearing House (CCH) or Research Institute of America (RIA)
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100% Bonus Depreciation 100% Bonus Depreciation
For property place in service after 9/8/10 and before 1/1/12
Additional depreciation immediately available Applies only to new property for use in business Amount = 100% of adjusted basis May elect out of bonus (or chose to only use
50% bonus depreciation) if have current NOL or anticipate need for higher depreciation in future years
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Personal Property Personal Property Depreciation ExampleDepreciation Example
ExampleNicole purchases a cherry desk and executive
chair for use in her engineering firm on July 16, 2011 for $8,150. What is her depreciation for 2011 using half-year convention and MACRS tables? 2012? (Assume Nicole didn’t take bonus depreciation as she anticipates higher income in subsequent years).
How would 2011 depreciation change if she had taken 50% bonus depreciation?
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SolutionSolutionExampleNicole purchases a cherry desk and executive chair for use in her engineering firm on
July 16, 2011 for $8,150. What is her depreciation for 2011 using half-year convention and MACRS tables? 2012? (Assume Nicole didn’t take bonus depreciation as she assumes higher income in subsequent years).
How would 2011 depreciation change if she had taken 50% bonus depreciation?
SolutionUsing Table 1, we can see that business furniture has a 7-year life. Table 2 shows the
percentages to use for recovery years 1 and 2; therefore2011 depreciation = $1,165 ($8,150 x .1429)2012 depreciation = $1,996 ($8,150 x .2449)
If bonus depreciation were taken:2011 depreciation = 50% bonus depreciation + MACRS % to remaining
basis$8,150 x 50% = $4,075 bonus depreciation$4,075 x .1429 = $582 MACRS depreciation Total depreciation = $4,657 ($4,075 + $582)
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$8,150 X 50% = $4,075 remaining depreciable basis
Real EstateReal Estate Real assets depreciated based on a
recovery period – 2 types of real propertyo 27.5 years Residential real estateo 39 years Nonresidential real estateo Real assets are depreciated using the straight-line
method with a mid-month convention Mid-month convention assumes all purchases made
in middle of month Used for real estate acquired after 1986 Rates found on Table 7.4 on page 7-13
Note: Different rates apply for real property acquired before 1981 and after 1980 but before 1987
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Real Estate ExampleReal Estate Example
ExampleGwen purchased a residential tri-plex on
8/1/11 for $290,000 (including land cost of $50,000). What is her depreciation for 2011? 2012?
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SolutionSolution
ExampleGwen purchased a residential tri-plex on 8/1/11 for
$290,000 (including land cost of $50,000). What is her depreciation for 2011? 2012?
SolutionSince land is not depreciable, only $240,000 may be
multiplied by percentages from Table 7.4 on page 7-13 (27.5-year residential real property). The purchase occurred in the eighth month; therefore, depreciation equals
2011 $240,000 x 1.364% = $3,2742012 $240,000 x 3.636% = $8,726
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Election to Expense - §179Election to Expense - §179 §179 allows immediate expensing of qualifying property
◦ For 2011, the annual amount allowed is $500,000 ◦ Qualifying property is tangible personal property used in a business –
can be new or used §179 election to expense is limited by 2 things
◦ If cost of qualifying property placed in service in a year > $2,000,000, then reduce §179 expense dollar for dollar For example, if assets purchased in current year = $2.1 million, taxpayer
must reduce §179 by $100,000. Therefore, election to expense is limited to = $400,000 ($500,000 – 100,000). The remaining $1.7 million of basis is depreciated over assets’ useful lives (including bonus depreciation) if applicable.
◦ Cannot take §179 expense in excess of taxable income New law allows up to $250,000 to be taken to §179 for certain
rental and leasehold improvements and restaurant properties
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Election to Expense - Election to Expense - §§179179
When using with regular MACRS, take §179 first, then reduce basis to calculate bonus depreciation, then reduce basis to calculate MACRS
For example◦ In 2011, NanoPaint Inc.’s taxable income = $1.25 million. They
placed a 7-year piece of property into service costing $842,000 – it was their only asset purchase in 2011. What is total depreciation, including election to expense?
◦ Assuming no bonus depreciation will be claimed (a) first take $500,000 deduction under §179 (b) reduced basis of $342,000 is multiplied by .1429 from MACRS tables
Total depreciation and Section 179 = $548,872 ($500,000 + (342,000 x .1429)
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§§179 Example179 Example
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ExampleOn 7/11/11, O’Neill Machinery LLC purchases a
used tooling machine (7-year asset) for $659,000. The taxable income from the business is $1,445,500. What is the company’s total depreciation deduction for the current year, including §179 and MACRS?
SolutionSolutionExampleOn 7/11/11, O’Neill Machinery LLC purchases a used tooling machine (7-year
asset) for $659,000. The taxable income from the business is $1,445,500. What is the company’s total depreciation deduction for the current year, including §179 and MACRS?
SolutionAsset purchases didn’t exceed $2,000,000 and doesn’t exceed TI, so no
reduction in §179 required: Cost $659,000§179 expense ( 500,000)Adjusted depreciable basis $159,000x Table % .1429
MACRS $ 22,721
Note: Can’t take bonus depreciation since it’s used property; Total depreciation equivalent to $500,000 + 22,721 = $522,721
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Listed PropertyListed Property
Special rules exist to limit deductions on assets that lend themselves to personal use, called ‘listed property’◦ Cars and trucks/vans under 6000 lbs. gross vehicle weight
with specific exclusions◦ Computers (unless used exclusively at business)◦ Equipment used for entertainment, recreation or amusement
If asset used <= 50% for business (or if business use falls below 50% in subsequent years) must use straight-line and election to expense not allowed
If asset used > 50% for business, must use MACRS Separate section (Part V) on page 2 of Form 4562
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Luxury Auto LimitationsLuxury Auto Limitations IRS limits annual depreciation expense that may be
claimed on passenger auto Maximum allowed amount is luxury auto limits x
business use % Luxury auto limits are quite low
◦ Annual depreciation limit on ‘luxury’ autos placed into service in 2011 are as follows 2011 - $3,060 (or $11,060 if taking bonus depreciation*) 2012 - $4,900 2013 - $2,950 2014 and subsequent years - $1,775
*Only allowed if used more than 50% in business and purchased new during 2011
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Exception to Exception to Luxury Auto LimitationsLuxury Auto Limitations
Passenger auto includes any 4-wheeled vehicle manufactured primarily for use on public streets and weighing less than 6000 lbs. ◦Some SUVs weigh more than 6000 lbs. and so can be
expensed under §179◦Beginning 10/22/04, could ‘only’ expense $25,000 and
then depreciate remainder using five year MACRS percentages
◦In 2011, these SUVs qualify for 100% bonus depreciation
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Luxury Auto ExampleLuxury Auto Example
Example On 3/15/11, Jim purchased a new automobile for
$50,000; it is a passenger auto weighing less than 6000 lb. The automobile is used 60% for business and Jim wants to know how much depreciation to claim if he elects out of the bonus depreciation rules. What if he chooses the bonus depreciation? What if the vehicle weighed more than 6000 lbs?
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SolutionSolutionExample On 3/15/11, Jim purchased a new automobile for $50,000; it is a passenger auto weighing
less than 6000 lb. The automobile was used 60% for business and Jim wants to know how much depreciation to claim if he elects out of the bonus depreciation rules. What if he does take bonus depreciation? What if the car weighs more than 6000 lbs?
SolutionRegular depreciation ($50,000 x 20%) 10,000Times business use percentage 60% X .60Possible depreciation 6,000
“Luxury auto” limitation (60% of $3,060) $ 1,836
If Jim elects bonus depreciation, gets Bonus depreciation 11,060 Times business use percentage 60% .60 Depreciation $ 6,636
A vehicle weighing more than 6000 lbs. could be fully expensed in year of purchase under §179. Depreciation = $50,000 x 60% = $30,000
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Intangible AssetsIntangible Assets §197 intangible assets are acquired by
purchase ◦Amortized over 15-years beginning in month
acquired, includes assets such as Goodwill (value attributable to expected continuation
of customers’ patronage) Covenant not to compete Franchise or trademark
◦Many intangible assets are excluded from §197 May not amortize self created assets like patents and
copyrights
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Amortization ExampleAmortization Example
ExampleFionaWear Inc. purchased a small textile
company in May 2011 for $980,000. $54,000 of the purchase price was allocated to goodwill in the buy-sell agreement. How much goodwill may FionaWear amortize in 2011?
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SolutionSolution
ExampleFionaWear Inc. purchased a small textile company in
May 2011 for $980,000. $54,000 of the purchase price was allocated to goodwill in the buy-sell agreement. How much goodwill may FionaWear amortize in 2011?
Solution$54,000/15 years = $3,600/12 months = $300 per
month §197 amortization $300 x 8 months = $2,400
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Related Party Transactions §267Related Party Transactions §267
Restricted transaction between related parties include◦ Recognizing losses on sales between related parties ◦ One accrual basis and one cash basis taxpayer as pertains to
expensing unpaid expenses and interest Related parties are:
◦ Family members such as spouses, lineal descendants, siblings
◦ A corporation and more than 50% owner◦ Brother/sister corporations◦ Parent/subsidiary corporations◦ Complex ‘constructive ownership’ rules
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Related Party Transactions §267Related Party Transactions §267
Losses disallowed between related parties◦ When property sold later to an unrelated party, all
previously disallowed losses may be taken against gain May not avoid tax when one taxpayer uses cash
method for expenses and interest and the other taxpayer uses accrual method
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The End!The End!
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My head hurts!