Chapter 7 Accounting Periods & Methods & Depreciation

1. Chapter 7Accounting Periods & Methods & Depreciation Accounting Periods & Methods & Depreciation Income Tax Fundamentals 2009 Gerald E. Whittenburg & Martha Altus-Buller Student’s Copy 2009 Cengage Learning

2. Accounting Periods • Problem when taxpayer’s tax year differs from calendar year – quite rare • Partnerships don’t pay tax as an entity • 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 is partner with at least 5% share in profits or capital • If principal partners have different tax years, partners required to use least aggregate deferral method (see pp. 7-2 – 7-3) 2009 Cengage Learning

3. Tax Year for Personal Service Corporation • A Personal Service Corporation (PSC) is a corporation with shareholder-employees whom provide a personal service • For example, architects or dentists • Generally must adopt calendar year • 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 deduction [see next slide] 2009 Cengage Learning

4. Short Period Taxable Income • If taxpayer has a short year [other than first/last year of operation], tax calculated based on following example: • Example: In 2008, Fed-Mex changes from a calendar year to tax year ending 9/30. For the short period 1/1/07 – 9/30/07, Fed-Mex’s TI = $20,000. • Calculate tax for the short period • Annualize TI 20,000 x 12/9 = 26,667 • Tax on annualized TI 26,667 x 15% = 4,000 • Allocate tax to short period 4,000 x 9/12 = $3,000 • Individual taxpayers rarely change tax years 2009 Cengage Learning

5. Accounting Methods must use same method for tax & books • There are three acceptable accounting methods for reporting taxable income [TI] • 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 2009 Cengage Learning

6. Accounting Methods • Accrual method • Recognize income when earned and can be reasonably estimated • Recognize deduction when incurred and can be reasonably estimated • Hybrid method • An example of a hybrid taxpayer is one that utilizes cash method for receipts and disbursements, but accrual for cost of products sold 2009 Cengage Learning

7. Depreciation [Form 4562] • Depreciation is a process of allocating and deducting the cost of assets over their useful lives • Does not mean devaluation of asset • Land is not depreciated • Maintenance 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 2009 Cengage Learning

8. Personal Property Recovery 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 Computer, cars and light trucks, R&D equipment, certain energy property & certain equipment • 7 year Mostly business furniture & equipment & property with no ADR life *See book for Asset Depreciation Range [ADR] classifications 2009 Cengage Learning

9. Personal Property • Depreciation is determined using IRS tables • Table 2 on p. 7-9 • Salvage value not used in MACRS • Tables based on half-year convention • 1/2 year depreciation taken in year of acquisition • 1/2 year depreciation taken in final year • May elect to use tables based on straight-line instead • Table 3 on p. 7-10 • Must use either MACRS or straight-line for all property in a given class placed in service during that year 2009 Cengage Learning

10. Mid-Quarter Convention • Mid-quarter convention is required if taxpayer purchases 40% or more 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] 2009 Cengage Learning

11. Real Estate • Real assets depreciated based on a recovery period depending on type of property • Real assets are depreciated using the straight-line method with a mid-month convention (Table 4 on p. 7-12) • Used for real estate acquired after 1986 • Treats all acquisitions/dispositions as occurring mid-month [mid-month convention] • 27.5 years: Residential rental • 39 years: Nonresidential 2009 Cengage Learning

12. Election to Expense - §179 • §179 allows immediate expensing of qualifying property • For 2008, the annual amount allowed is $250,000 • Qualifying property is tangible personal property used in a business • But not real estate or property used in residential real estate rental business • §179 election to expense is limited by 2 things • If cost of qualifying property placed in service in a year > $800,000, then reduce §179 expense $ for $ • For example, if assets purchased in current year = $900,000, then $100,000 reduction in §179 capability so limited to $250,000 – 100,000 = $150,000 election to expense and the remaining $750,000 of basis is depreciated over assets’ useful lives. • Cannot take §179 expense in excess of taxable income 2009 Cengage Learning

13. Election to Expense - §179 • When using with regular MACRS, take §179 first, then reduce basis to calculate MACRS • For example • In 2008, NanoPaint Inc. placed a seven-year piece of property into service costing $342,000 when taxable income = $1.25 million. Total asset purchases = $417,000. What is total depreciation including election to expense? • Assuming bonus depreciation not claimed – first take $250,000 deduction under §179, reduce basis to $92,000, then multiply by 14.29% MACRS rate • [$250,000] + [$92,000 x 14.29%] = $263,147 total 2009 Cengage Learning