ACC 548: Chapter 8- Business Income, Deductions, and Accounting Methods


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Note Hobbies are not businesses. Personal activity that may generate revenue. Taxpayer generally has burden of proving their intent to make a profit. Specific factors listed in Regulations such as: History of income or loss Elements of personal pleasure or recreation Deductions only allowed to extent of revenue.

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Bad debts are discussed in two places – once in front and more details near the end of the chapter. It is important to note that cash basis taxpayers have NO accounts receivable so there is no bad debt deduction. It might also be noted that in contrast to bad debts, cash basis taxpayers can deduct bad loans – they have basis in these assets. However, this brings up whether a lone is a business loan (ordinary) or nonbusiness (short term capital). Best to save this discussion for capital assets. Business losses are also rather complex (e.g. section 1231 treatment) – this chapter merely serves to introduce the notion that business losses are deductible rather than discuss the nature of the deduction.

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Note that the time spent on an activity may not be conclusive for the primary purpose – a question of fact and circumstance

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Note that the 52/53 week can facilitate closing of books.

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Note that the first year for most fiscal year entities are typically short years Note that some exceptions are skipped – the “natural” business year end and the deferral year end

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These rules only apply to accrual basis taxpayers.

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Include a few of the key examples from the book.

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Chapter 08 Business Income, Deductions, and Accounting Methods

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Learning Objectives Describe the general requirements for deducting business expenses and identify common business deductions. Apply the limitations that apply to business deductions and distinguish between deductible and nondeductible business expenses. Identify and explain special business deductions specifically permitted under the tax laws. Explain the concept of an accounting period and describe the tax accounting periods available. Identify and describe accounting 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 = sales - cost of goods (COGS not a business deduction but rather a return of capital). Business income does not include excluded and deferred income. Deductions must be directly connected to business activity. Ordinary and necessary means that the expenditures are appropriate and conducive to profit business activities. Reasonable in amount means not extravagant.

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Statutory limits on business expense deductions Expenses against public policy are not deductible No deduction for fines, bribes, lobbying expenditures, or political contributions Expenses relating to tax-exempt income are not deductible Interest on loan where proceeds invested in municipal bonds. Key man insurance premiums – no deduction if business is beneficiary of life insurance. Capital expenditures Personal expenses

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Expenses of Producing Exempt Income 66. Ram Corp.’s operating income for the year ended December 31, 2011, amounted to $100,000. Included in Ram’s 2011 operating expenses is a $6,000 insurance premium on a policy insuring the life of Ram’s president. Ram is beneficiary of this policy. In Ram’s 2011 tax return, what amount can be deducted for the $6,000 life insurance premium? a. $6,000 b. $5,000 c. $1,000 d. $0

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Deduction of Prepaid Items Answer the accounting question – does the expenditure provide future benefits (beyond this year)? If so, generally 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. 12-month rule does not apply to prepaid interest.

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12-month rule example Ben, a cash basis calendar-year taxpayer, makes the following payments on June 30 of this year: Pays $10,000 for the next 10 months of utilities Pays $12,000 for insurance covering the next 24 months Pays $ 9,600 for next 8 months of interest on a business loan What amounts are deductible this year?

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12-month rule solution On June 30: Ben paid $10,000 for the next 10 months of utilities. Deduct all $10,000 because benefit < 12 months and ends prior to end of next year. Ben paid $12,000 for insurance over next 24 months Deduct $3,000 ($500/month x 6 months). 12-month rule does not apply because period > 12 months Ben paid $ 9,600 for next 8 months of interest Deduct $7,200 ($1,200 per month x 6 months). 12-month rule does not apply to prepaid interest

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Specifically authorized business deductions Bad debts Accrual taxpayers must use direct write off method; cannot use the reserve or allowable method Cash basis taxpayers generally have no deduction because the receivable was never included in gross income Losses on disposition of business assets Generally a sale or exchange is required to recognize losses Partial destruction casualty loss is limited to lesser of decline in value due to the casualty, or basis for property partially destroyed Complete destruction casualty loss generally is the property’s unrecovered basis

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Bad Debts – Accrual Method 65. In the case of a corporation that is not a financial institution, which of the following statements is correct with regard to the deduction for bad debts? a. Either the reserve method or the direct charge-off method may be used, if the election is made in the corporation’s first taxable year. b. On approval from the IRS, a corporation may change its method from direct charge-off to reserve. c. If the reserve method was consistently used in prior years, the corporation may take a deduction for a reasonable addition to the reserve for bad debts. d. A corporation is required to use the direct charge-off method rather than the reserve method.

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Bad Debts – Cash Method 67. Jason Budd, CPA, reports on the cash method. In April 2011, Budd billed a client $3,500 for the following professional services: Personal estate planning $2,000 Personal tax return preparation 1,000 Compilation of business financial statements 500 No part of the $3,500 was ever paid. In April 2012, the client declared bankruptcy, and the $3,500 obligation became totally uncollectible. What loss can Budd deduct on his 2012 tax return for this bad debt? a. $0 b. $ 500 c. $1,500 d. $3,500

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Domestic production activities deduction (DPAD) An “artificial” deduction that subsidizes domestic manufacturing. Domestic production of tangible products qualifies for subsidy, but income must allocated between qualifying and non-qualifying 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 further limited to 50% of wages allocated to qualified activities.

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DMD example John recorded $100,000 of receipts from a qualified domestic production activity (QDPA). John allocated $55,000 of expenses to DPGR including $12,000 of wages. John had modified AGI of $47,000. What is John’s DPAD?

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DMD solution Calculate QPAI: QDPR (receipts) $100,000 Expenses - 55,000 QPAI (qualifying income) $ 45,000 QPAI cannot exceed modified AGI: Modified AGI is $47,000, so no limit Calculate DPAD QPAI $ 45,000 2011 percent x 9% DPAD $ 4,050 Limit DPAD to 50% of wages 50% of wages is $6,000 DPAD=$4,050

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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. Specified percentage (50% for business meals and entertainment). Basis for allocation (time spent at destination, or business mileage). Recordkeeping Document business purpose. Travel, meals and entertainment, mixed use assets

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Travel example Ben paid the following to attend a business meeting in Florida: Air fare (first class) - $ 1,200 Hotel (three nights) - 750 Meals (three days) - 270 What amounts are deductible if Ben spent two days in meetings (primarily business)? What amounts are deductible if Ben spent one day in a meeting (primarily personal)

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Travel solution Ben can deduct the following amounts: 2 days 1 day business business Air fare (all or none) $ 1,200 $ 0 Hotel ($250 per day) 500 250 Meals ($90 per day x 50%) 90 45 Total Travel Deduction $ 1,790 $ 295

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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 Saturday 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 (prevents deferral of income).

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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, as compared with GAAP accounting.

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Accounting methods Permissible “overall” methods: Cash – recognize income when received. Accrual – recognize income when earned or received (generally whichever is first). Hybrid – mix of accrual and cash (e.g. accrual for sales and COGS; cash for everything else). 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, easy to defer income. Simple and relatively inexpensive. Not available for some business organizations (typically large C corporations).

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Cash Method 50. A cash-basis taxpayer should report gross income a. Only for the year in which income is actually received in cash. b. Only for the year in which income is actually received whether in cash or in property. c. For the year in which income is either actually or constructively received in cash only. d. For the year in which income is either actually or constructively received, whether in cash or in property

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Cash Method 58. Dr. Berger, a physician, reports on the cash basis. The following items pertain to Dr. Berger’s medical practice in 2011: Cash received from patients in 2011 $200,000 Cash received in 2011 from third-party reimbursers for services provided by Dr. Berger in 2010 30,000 Salaries paid to employees in 2011 20,000 Year-end 2011 bonuses paid to employees in 2012 1,000 Other expenses paid in 2011 24,000 What is Dr. Berger’s net income for 2011 from his medical practice? a. $155,000 b. $156,000 c. $185,000 d. $186,000

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Accrual income Income is generally recognized when earned 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 question Ben provides consulting services and bills Ace for $12,000. Ace disputes the amount claiming that $8,000 is the proper amount. How much income should Ben recognize under the accrual method this year? $ ________? ($8,000 - the undisputed amount satisfies the all events test)

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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 received as advance rental income 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 income by earlier of period earned for tax purposes, or when recorded for financial purposes.

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Advance payment example Ben (a calendar-year taxpayer) provides dancing lessons. On September 30th of this year he received $2,400 full payment for a 2-year service contract. What amount of income must Ben recognize: (1) if he is on the cash method? (2) if he is on the accrual method?

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Advance payment solution If Ben uses the cash method, he must recognize income as received - $2,400 this year. If Ben uses the accrual method, then he can elect to defer advances for services for a year. This year Ben would recognize $300, the income earned from October 1 (3/24 x $2,400). Next year Ben would recognize the remaining $2,100, because income can only be deferred one year.

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Accrual Method Income 52. In 2010, Stewart Corp. properly accrued $5,000 for an income item on the basis of a reasonable estimate. In 2011, after filing its 2010 federal income tax return, Stewart determined that the exact amount was $6,000. Which of the following statements is correct? a. No further inclusion of income is required as the difference is less than 25% of the original amount reported and the estimate had been made in good faith. b. The $1,000 difference is includible in Stewart’s 2011 income tax return. c. Stewart is required to notify the IRS within 30 days of the determination of the exact amount of the item. d. Stewart is required to file an amended return to report the additional $1,000 of income.

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Inventories Inventories must be accounted for under the accrual method if sales of inventory constitute a “material” income producing factor. Accrual method is used for sales of inventory, purchases, and cost of goods sold. Small taxpayers whose gross receipts do not exceed $1 million are excepted from the requirements to account for inventory 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, which may result in capitalizing more costs than for financial purposes. Indirect costs are allocated to inventories (not expensed). Costs of selling, marketing, and research need not be capitalized. Small retailers and wholesalers (average annual gross receipts < $10 million) are not required to use UNICAP.

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UNICAP 63. Which of the following costs is not included in inventory under the Uniform Capitalization rules for goods manufactured by the taxpayer? a. Research. b. Warehousing costs. c. Quality control. d. Taxes, excluding income taxes.

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UNICAP 64. Under the uniform capitalization rules applicable to property acquired for resale, which of the following costs should be capitalized with respect to inventory if no exceptions are met? Marketing costs Off-site storage costs a. Yes Yes b. Yes No c. No No d. No Yes

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Accruing business expenses All events test All events have occurred to establish the liability to pay. The amount is determinable with reasonable accuracy. and Economic performance has occurred. Mere liability is NOT ENOUGH!

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Economic performance Taxpayer is liable for providing goods or services: Performance occurs as taxpayer provides goods or services. Taxpayer is receiving goods or services from another: Performance occurs as goods or services are received, or with payment if actual performance is expected within 3 ½ months after payment. Payment liabilities (rebates, warranty costs, tort claims, and taxes): performance occurs only when amounts are paid.

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Economic performance example Ben has signed a binding contract for Peter to provide Ben with repair services. Ben paid $1,500 to Peter and owes an additional $6,000 on the contract. The repairs will commence late next year. When can Ben claim the deduction if he uses the accrual method? Answer: Although the all events test is satisfied, Ben can only deduct $7,500 next year because that is when economic performance occurs (Peter will perform services late next year).

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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.

Summary: ACC 548- Ed Foth Last updated: 3/13/12