Business Income, Deductions, and Accounting Methods

1. Chapter 8 Business Income, Deductions, and Accounting Methods

2. Business income and deductions All income from whatever source derived.” Includes revenue from services and lease activities. Gross profit from sales - cost of goods is 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 conducive to profit generation. Reasonable in amount means not extravagant. 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.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.

3. Reasonableness example Rick owns a business that employs his brother, Ben. Ben is paid $45,000 per year by Rick’s business. In comparison, other employees with Ben’s responsibilities are only paid $30,000 per year. What can Rick’s business deduct for employing Ben?

4. Reasonableness solution A reasonable amount for compensating Ben is $30,000 rather than $45,000. Rick can only deduct $30,000 What is the tax status of the extra $15,000 paid to Ben? The extra $15,000 ($45,000 paid minus $30,000 deduction) is a gift from Rick to Ben.

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

6. 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 rent and interest.

7. Specifically authorized business deductions Start-up expenditures Capitalize and can elect to expense/amortize Bad debts Accrual taxpayers can use direct write off only Losses on disposition of business assets Sales or exchanges where loss is recognized 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 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.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.

8. Domestic manufacturing deduction (DMD) An “artificial” deduction that subsidizes domestic manufacturing. Domestic production of tangible products qualifies for subsidy. Subsidy is percentage (6 percent in 2007) 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.

9. 12-month rule example Ben 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 over next 24 months Pays $ 9,600 for next 8 months of rent What amounts are deductible this year?

10. 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 does not apply because period > 12 months Ben paid $ 9,600 for next 8 months of rent Deduct $7,200 ($1,200 per month x 6 months) – 12 month rule does not apply to rent or interest

11. 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 eg auto

12. Travel example Ben paid the following to attend a business meeting in Chicago: 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)

13. Travel solution Ben can deduct the following amounts: 2 days 1 day business personal 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 Note that the time spent on an activity may not be conclusive for the primary purpose – a question of fact and circumstanceNote that the time spent on an activity may not be conclusive for the primary purpose – a question of fact and circumstance

14. 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.

15. Accounting periods Annual period Full tax year is 12 months long. Short tax year is < 12 months. Year ends Calendar year is 12/31. Fiscal year 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. Note that the 52/53 week can facilitate closing of books.Note that the 52/53 week can facilitate closing of books.

16. Choosing an accounting period Proprietorships – same as proprietor. Prevents mismatch of income. “C” corporations – choice made on first tax return. 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). 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 endNote 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

17. 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.

18. Accounting methods Permissible “overall” methods: Cash – recognize income when received. Accrual – recognize income when earned or received (whichever is first generally). Hybrid – use accrual for some accounts. 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.

19. 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 (C corporations typically).

20. 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

21. 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)

22. 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.

23. Advance payment example Ben 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?

24. 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 September 30 (3/24 x $2,400). Next year Ben would recognize $2,100 - the remaining income which can only be deferred one year.

25. 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.

26. 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 We skip a discussion of inventory flows here, but a slide may be added if students are confused.We skip a discussion of inventory flows here, but a slide may be added if students are confused.

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

28. Economic performance Taxpayer liable for providing goods or services? Performance as taxpayer provides goods or services. Taxpayer liable for using property or goods? Performance 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. These rules only apply to accrual basis taxpayers.These rules only apply to accrual basis taxpayers.

29. Economic performance example Ben has signed a binding contract for Peter to provide repair services. Ben paid $1,500 and owes an additional $6,000 on the contract. The repairs will commence in the fall of 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. Include a few of the key examples from the book.Include a few of the key examples from the book.

30. 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.