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CCH Federal Taxation Comprehensive Topics Chapter 13 Tax Accounting

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CCH Federal Taxation Comprehensive Topics Chapter 13 Tax Accounting

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  1. CCH Federal TaxationComprehensive TopicsChapter 13Tax Accounting ©2006, CCH, a Wolters Kluwer business 4025 W. Peterson Ave. Chicago, IL 60646-6085 800 248 3248 www.CCHGroup.com

  2. 1. Tax Year Period 2. Short Tax Year 3. Tax Year 4. Tax YearExample 5. Tax YearIndividuals 6. Tax YearProprietorships 7. Tax YearPartnerships 8. Tax YearC Corporations 9. Tax YearPersonal Service Corporations 10. Tax YearS Corporations 11. Tax YearEstates 12. Tax YearTrusts 13. Tax YearIRS Permission to Change 14. Accounting Methods 15. Cash Method 16. Cash Method and the Economic Benefit Doctrine 17. Cash Method and the Constructive Receipts Doctrine 18. Cash Method and the Assignment of Income Doctrine 19. Cash Method and the Tax Benefit Doctrine Chapter 13 Exhibits Chapter 13, Exhibit Contents A CCH Federal Taxation Comprehensive Topics

  3. 20. Accrual Method 21. Accrual Method and the All Events Doctrine 22. Accrual Method and the Claim Of Right Doctrine 23. Prepaid Income for Services 24. Prepaid Income for Inventory 25. Prepaid Rental Income and Expense 26. Prepaid Subscription Income 27. Prepaid Membership Fees 28. Prepaid Interest Expense 29. Hybrid Method 30. Accounting MethodsIndividuals 31. Accounting MethodsCorporations 32. Accounting MethodsPartnerships 33. Accounting MethodsEstates 34. Accounting MethodsTrusts 35. Inventory—Cost Reporting 36. Inventory—Special Rules for LIFO Cost Reporting 37. Inventory—Special Rules for Purchased Merchandise 38. Inventory—Special Rules for Manufactured Products 39. Inventory—UNICAP Cost Classifications 40. Long-Term Contracts Chapter 13 Exhibits Chapter 12, Exhibit Contents B CCH Federal Taxation Comprehensive Topics

  4. Tax Year Period 12-Month Period Generally, a tax year may not exceed 12 calendar months. 52- to 53-Week Period If certain requirements are met under Code Sec. 441(f), a taxpayer may elect to use an annual period that varies from 52 to 53 weeks. In that case, the year-end must always fall on the same day of the week, such as the last Tuesday of December. A retail business may wish to have its tax years end always on Sundays so that it can conduct year-end physical inventory counts without interrupting business operations. Chapter 13, Exhibit 1 CCH Federal Taxation Comprehensive Topics

  5. Short Tax Year Definition A short tax year is a period of less than 12 calendar months. Factors Causing Short Tax Years Short tax years may arise from one of several factors, including: 1.  Initial income tax return 2.  Final income tax return 3.  Change in tax year Annualizing Income Only a change in tax year (#3 above) requires annualizing income. Chapter 13, Exhibit 2a CCH Federal Taxation Comprehensive Topics

  6. Short Tax Year Chapter 13, Exhibit 2b CCH Federal Taxation Comprehensive Topics

  7. Short Tax Year Chapter 13, Exhibit 2c CCH Federal Taxation Comprehensive Topics

  8. Alternative Annualization Method A taxpayer may enjoy some tax savings by electing an alternative annualization method.  The four-step computations are: (a) = Taxable income for the short year (b) = Taxable income for the 12 months beginning on the first day of the short period (c) = Tax on (b) (d) = Short period tax: (d) = (c) x (a) (b) Example Using the Alternative Annualization Method. FACTS:  1. ABC Corp. changes its accounting period from a calendar year to a fiscal year and must file a return for the three-month period ending March 31, 20x1 (the “short year”).  2.  ABC has $18,750 taxable income during the short year and $81,250 during the next nine months (i.e., April, 20x1 to December 31, 20x1). QUESTION: Compute ABC’s short year taxes under the alternative annualization method. Short Tax Year Chapter 13, Exhibit 2d CCH Federal Taxation Comprehensive Topics

  9. Short Tax Year Chapter 13, Exhibit 2e CCH Federal Taxation Comprehensive Topics

  10. Tax Year Definition of Calendar YearThe twelve months ended December 31. The calendar tax year is available to any type of taxpayer. Definition of Fiscal YearAny twelve-month period ending on the last day of a month other than December. Deferred Income Advantage Under Fiscal Tax Year-EndThe fiscal tax year offers an income deferral advantage to the owner of an entity such as a partnership or S corporation. The income of the entity earned between the beginning of its fiscal year and December 31 of the same year is not included in the income of a calendar-year partner or shareholder until the following calendar year. Chapter 13, Exhibit 3a CCH Federal Taxation Comprehensive Topics

  11. Tax Year Chapter 13, Exhibit 3b CCH Federal Taxation Comprehensive Topics

  12. Tax Year—Example FACTS:Amy, a calendar tax year taxpayer, is considering a fiscal year-end (“FYE”) for her partnership. QUESTION: How much income deferral would she realize if the partnership’s fiscal year ended on January 31, June 30, or November 30? Chapter 13, Exhibit 4a CCH Federal Taxation Comprehensive Topics

  13. SOLUTION: (Assuming ABC’s FYE is 1/31/x1) (Assuming ABC’s FYE is 6/30/x1) (Assuming ABC’s FYE is 11/30/x1) Number of Deferral Months 11 months (Jan. – Dec. 20x1) 6 months (Jan. – Jun. 20x1) 1 month (Nov. 20x1) Tax Year—Example Chapter 13, Exhibit 4b CCH Federal Taxation Comprehensive Topics

  14. ANALYSIS: Year That ABC’s 20x1 Income Is Taxable to Amy Month in 20x1 ABC has Income (Assuming ABC’s FYE is 1/31/x1) (Assuming ABC’s FYE is 6/30/x1) (Assuming ABC’s FYE is 11/30/x1) Jan x1 x1 x1 Feb x2 (deferred 1 yr.) x1 x1 x2 (deferred 1 yr.) x1 x1 Mar Apr x2 (deferred 1 yr.) x1 x1 May x2 (deferred 1 yr.) x1 x1 Jun x2 (deferred 1 yr.) x1 x1 Jul x2 (deferred 1 yr.) x2 (deferred 1 yr.) x1 Aug x2 (deferred 1 yr.) x2 (deferred 1 yr.) x1 Sep x2 (deferred 1 yr.) x2 (deferred 1 yr.) x1 Oct x2 (deferred 1 yr.) x2 (deferred 1 yr.) x1 Nov x2 (deferred 1 yr.) x2 (deferred 1 yr.) x1 Dec x2 (deferred 1 yr.) x2 (deferred 1 yr.) x2 (deferred 1 yr.) Tax Year—Example Chapter 13, Exhibit 4c CCH Federal Taxation Comprehensive Topics

  15. Tax Year—Individuals Calendar Tax Year-EndThe calendar tax year (i.e., 12 months ended December 31) is used by most individual for reporting taxable income/loss. Fiscal Tax Year ExceptionIndividuals are rarely able to adopt a fiscal tax year (any 12-month period ending on the last day of a month other than December). However, an individual filing as a new taxpayer (i.e., first time filer) may adopt a fiscal tax year-end, without obtaining prior approval from the IRS, if the following criteria have been met. Chapter 13, Exhibit 5a CCH Federal Taxation Comprehensive Topics

  16. Tax Year—Individuals Criteria That Must Be Met for Adopting Fiscal Year • Timely adoption. The first tax year must be adopted by the filing date of the initial return. (A filing extension does not extend the time for adoption of the fiscal year.) • Formal accounting system. A regular and continuous system of accounting must be in place during the initial and subsequent years. The IRS standard for the taxpayer’s system of accounting does not require that the records be bound. Records which are sufficient to reflect income adequate and clearly on the basis of a fiscal tax year are normally the acceptable standard of the IRS. Informal records such as check stubs, rent receipts and dividend statements are not regarded by the IRS as acceptable books of accounting. Taxpayers who do not have books (e.g., employees) must use the calendar year. [Code Sec. 441.] Chapter 13, Exhibit 5b CCH Federal Taxation Comprehensive Topics

  17. Tax Year—Proprietorships Business Follows Personal An individual taxpayer conducting a business activity generally must report the income/loss on Schedule C of the individual tax return. The tax year for the Schedule C activity must be the same period as used for personal tax reporting. Chapter 13, Exhibit 6 CCH Federal Taxation Comprehensive Topics

  18. Tax Year—Partnerships Majority Interest Tax Year Partnerships are generally required to elect the same tax year as their partners who represent a majority interest on the first day of the partnership’s first tax year. [Code Sec. 706(b).] Chapter 13, Exhibit 7a CCH Federal Taxation Comprehensive Topics

  19. Tax Year—Partnerships Five Percenters’ Common Tax Year If there is no majority interest tax year, (i.e., the majority interest use different tax years) the partnership must use the same tax year as that of the principal partners, i.e., those owning five percent or more interests in either profits or capital. Chapter 13, Exhibit 7b CCH Federal Taxation Comprehensive Topics

  20. Tax Year—Partnerships Calendar Tax Year If there is nomajority interest tax year and the principal partners do not have the same taxable year, the partnership generally must use the least aggregate deferral method. Chapter 13, Exhibit 7c CCH Federal Taxation Comprehensive Topics

  21. Tax Year—C Corporations Unrestricted Right to Select Tax Year Every newly organized corporation has the unrestricted right to select its annual tax year, regardless of the tax years employed by its shareholders. Chapter 13, Exhibit 8 CCH Federal Taxation Comprehensive Topics

  22. Tax Year—Personal Service Corporations Calendar Tax Year A personal service corporation (PSC) is a C corporation whose shareholder-employees owning over 10% of the stock provide personal services (e.g., acting, entertainment, medical, legal, consulting, or other services performed through their personal efforts). Generally, a PSC must use a calendar tax year. [Code Sec. 441(i).] PSCs are subject to a flat 35% tax rate. Chapter 13, Exhibit 9a CCH Federal Taxation Comprehensive Topics

  23. Tax Year—Personal Service Corporations Fiscal Tax Year Exception A PSC may elect a fiscal tax year under any of the following conditions:   1. The PSC’s fiscal tax year results in income deferral of not more than three months, and the shareholder-employee’s salary earned between fiscal year end and December 31 is both: (a) Paid during that period; and, (b) Proportionate to the salary paid during the preceding fiscal year.   2. A business purpose can be demonstrated. 3. The PSC retains the same fiscal tax year as was used in 1987, had it been in existence then. Chapter 13, Exhibit 9b CCH Federal Taxation Comprehensive Topics

  24. Tax Year—S Corporations Calendar Tax Year Generally, an S Corporation must use a calendar tax year. Fiscal Tax Year Exception An S Corporation may elect a fiscal tax year if it meets any one of the following conditions:   1. The S corporation’s fiscal tax year results in income deferral of not more that three months, and the shareholder-employee’s salary earned between the beginning of the fiscal year and December 31 is both:   (a) Paid during that period; and, (b) Proportionate to the salary paid during the preceding fiscal year.   2. A business purpose can be demonstrated.   3. The S corporation retains the same fiscal tax year as was used in 1987, had it been in existence then. Chapter 13, Exhibit 10 CCH Federal Taxation Comprehensive Topics

  25. Tax Year—Estates Unrestricted Right to Select Tax Year As a “new” taxpayer, an estate has the unrestricted right to select any annual tax year, without obtaining prior approval. Chapter 13, Exhibit 11 CCH Federal Taxation Comprehensive Topics

  26. Tax Year—Trusts Calendar Tax Year Trusts, other than charitable and tax-exempt trusts, must use the calendar tax year. [Code Sec. 645.] Chapter 13, Exhibit 12 CCH Federal Taxation Comprehensive Topics

  27. Tax Year—IRS Permission to Change General Rule The tax year adopted on initial year returns must generally be used in subsequent years. Changing Tax Years However, a taxpayer may change the tax year with prior IRS approval. An application for permission to change tax years must be made on Form 1128, Application for Change in Accounting Period. Filing Deadline This application must be filed by the fifteenth day of the third calendar month following the close of the short tax year that results from the change in tax year. Chapter 13, Exhibit 13a CCH Federal Taxation Comprehensive Topics

  28. Tax Year—IRS Permission to Change Chapter 13, Exhibit 13b CCH Federal Taxation Comprehensive Topics

  29. Accounting Methods General Rules Code Sec. 446 requires taxpayers to compute taxable income using the method of accounting regularly employed in keeping books, provided the method clearly reflects income. The Code recognizes the following as generally permissible accounting methods: 1. The cash method 2. The accrual method 3. A hybrid method (a combination of cash and accrual) Chapter 13, Exhibit 14 CCH Federal Taxation Comprehensive Topics

  30. Cash Method A cash-method taxpayer accounts for income when any one of three events occurs: 1. Cash is actuallyreceived. 2. Equivalent of cash is actually received (e.g., a check, property, or a promissory note that is secured and transferable). 3. Constructive receipt of cash or its equivalent occurs. Chapter 13, Exhibit 15a CCH Federal Taxation Comprehensive Topics

  31. Cash Method Definitions Value “received” indeterminable. If the value of consideration received cannot be determined, the value of consideration given in exchange for it is treated as the amount of income received. (Philadelphia Park Amusement Co. v. U.S., 54-2 USTC ¶9697 (1954).) Value “received and given” indeterminable. If consideration both received and given is impossible to value, the transaction is treated as open, and the consideration is not viewed as income until its value can be ascertained (e.g., an unsecured promise to pay from a person with unknown creditworthiness, in exchange for the renewal of a franchise with historical losses). Chapter 13, Exhibit 15b CCH Federal Taxation Comprehensive Topics

  32. Cash Method and the Economic Benefit Doctrine The economic benefit doctrine (EBD) applies to BOTH cash-basis and accrual-basis taxpayers. EBD answers the question, “what?” For example, what is the nature of the property received? Is it “economic” income or corpus? Recall the balance sheet equation: Assets = Liabilities + Owners Equity Chapter 13, Exhibit 16a CCH Federal Taxation Comprehensive Topics

  33. Cash Method and the Economic Benefit Doctrine Anything that increases Owners Equity is economic income, including the unexpected payment of one’s liabilities by an employer. However, note that economic income is NOT necessarily taxable income if:  • Specifically excluded by Congress, • Not constructively received (refer to the Constructive Receipt Doctrine), • Assigned along with the corpus (refer to the Assignment of Income Doctrine), or • Representing the recovery of expenses that were not previously deducted (refer to the Tax Benefit Doctrine). Chapter 13, Exhibit 16b CCH Federal Taxation Comprehensive Topics

  34. Cash Method and the Constructive Receipt Doctrine When There Is No Economic Benefit The constructive receipt doctrine (CRD) is relevant only when property constructively received is determined to be economic income rather than corpus under the economic benefit doctrine (EBD). Therefore, the EBD question should be asked before the CRD question. If the EBD answer is “NO,” then the CRD question is irrelevant (i.e., no need to ask “when” something received is taxable if it is not income.) Chapter 13, Exhibit 17a CCH Federal Taxation Comprehensive Topics

  35. Cash Method and the Constructive Receipt Doctrine Example. ABC, a cash-basis taxpayer, shares the top floor of an office building with the landlord. On December 31, 20x1, a tenant from another floor mistakenly leaves cash rent in ABC’s office lobby, and ABC inadvertently deposits it. ABC discovers the error on January 5, 20x2, and promptly issues a check to the landlord. The fact that ABC had dominion and control over the cash rent is irrelevant since it did not represent economic income to ABC. Chapter 13, Exhibit 17b CCH Federal Taxation Comprehensive Topics

  36. Cash Method and the Constructive Receipt Doctrine When There Is an Economic Benefit When the EBD answer is “YES,” then CRD must be applied to answer the question, “when?” (i.e., when is economic income taxable?). The answer to when is determined by the year in which the taxpayer attains dominion and control over the economic income. Chapter 13, Exhibit 17c CCH Federal Taxation Comprehensive Topics

  37. Cash Method and the Constructive Receipt Doctrine Example. XYZ stock is valued at $100 per share. After reporting record profits for the third quarter of 20x1, XYZ credits its employees with bonus stock. The bonus stock is restricted (i.e., it cannot be assigned or transferred) until 20x3. Although the stock provides an economic benefit, it is not income in 20x1 since it has not been constructively received. Chapter 13, Exhibit 17d CCH Federal Taxation Comprehensive Topics

  38. Cash Method and the Assignment of Income Doctrine The assignment of income doctrine (AID) answers the question, “who?” (i.e., who must report the taxable income?). The answer is determined by identifying the owner of the corpus producing the taxable income. Example. An uncle detaches the interest coupon from a bond and gives it to his niece. The niece promptly cashes it and deposits it into her account. If the uncle retains the bond, the interest income is taxable to him and a tax-free gift to the niece. Chapter 13, Exhibit 18 CCH Federal Taxation Comprehensive Topics

  39. Cash Method and the Tax Benefit Doctrine The tax benefit doctrine (TBD) is used to determine whether expense refunds are taxable. If an expense refund can be linked to a prior year deduction, then it is taxable income. If no linkage, then no taxable income. Example. In 20x2, a taxpayer receives a $300 state income tax refund. His employer had over-withheld state income taxes from his paychecks in 20x1. If, in 20x1, he claimed state income taxes as an itemized deduction, he must report the $300 refund as gross income in 20x2. If, on the other hand, he claimed the standard deduction in 20x1, the $300 need not be reported in 20x2. Chapter 13, Exhibit 19 CCH Federal Taxation Comprehensive Topics

  40. Accrual Method An accrual-method taxpayer accounts for income in the period in which it is actually earned, regardless of when it was collected. An item of income is deemed to be earned if: • All events have occurred to fix the taxpayer’s rights to the income (All Events Doctrine). • No legal disputes exist that would affect the taxpayer’s ownership in the property at the time the income was earned (Claim of Rights Doctrine). Chapter 13, Exhibit 20 CCH Federal Taxation Comprehensive Topics

  41. Accrual Method and the All Events Doctrine This doctrine is satisfied if all the events necessary to fix the taxpayer’s right to receive income have occurred. For example, an agreement must be firmly established and the value must be reasonably ascertainable. (Globe Corp. v. Comm., 20 TC 299, CCH Dec. 19,644 (1953).) All events are presumed to have occurred if the taxpayer has an undeniable accession to wealth, clearly realized, and over which there is complete dominion. (Glenshaw Glass Co. v. Comm., 55-1 USTC ¶9308.) Chapter 13, Exhibit 21a CCH Federal Taxation Comprehensive Topics

  42. Accrual Method and the All Events Doctrine Example. Orb Co., an accrual-basis taxpayer, provides packaged aerial target assemblies to the U.S. government in 20x1. The contract price is open-ended with respect to packaging, even though the packaging is completed in 20x1. In 20x2, the price of packaging, $500,000, becomes firmly fixed. The $500,000 packaging price is not taxable in 20x1 since Orb Co.’s right to the income is not firmly established until 20x2. Chapter 13, Exhibit 21b CCH Federal Taxation Comprehensive Topics

  43. Accrual Method and the Claim of Right Doctrine This doctrine is met if there is no legal dispute regarding the ownership of the property from which the income is earned. (North American Oil Consolidated v. Burnet, 3 USTC ¶ 943, 286 U.S. 417 (1932).)Example. In 20x1, the U.S. claims land held by Soil Inc., an accrual-basis taxpayer. The land is placed into a receivership until the dispute is settled. The land produces $5,000,000 income in 20x1. In 20x5, the dispute is settled in favor of Soil Inc. The $5,000,000 is taxable in 20x5, when the dispute is settled, not 20x1 when the income is produced. Chapter 13, Exhibit 22 CCH Federal Taxation Comprehensive Topics

  44. Prepaid Income for Services Advance payments for services to be rendered may be accrued over the period for which the services are to be performed, but only if the period does not extend beyond the end of the next tax year. If the taxpayer does not complete the performance within that period, the prepaid income is included in the year following receipt. Chapter 13, Exhibit 23a CCH Federal Taxation Comprehensive Topics

  45. Prepaid Income for Services Example. On July 1, 20x1, Fred, a calendar year, accrual-basis taxpayer, receives $1,000 in advance to provide 10 ballet lessons. Two lessons are provided in 20x1, five lessons in 20x2, and three lessons in 20x3. Fred must include $200 in 20x1 (2/10 of the $1,000); and $800 in 20x2 ([5/10 + 3/10] of the $1,000). Income for the three lessons provided in year 20x3 is included in 20x2, the year after the 20x1 advance receipt of $1,000. Chapter 13, Exhibit 23b CCH Federal Taxation Comprehensive Topics

  46. Prepaid Income for Inventory The right to income is fixed when it is earned; e.g., when goods are shipped. Accordingly, prepayments for the future shipment of goods may be deferred until shipment is made. Unlike the deferral rules for prepaid service income, there is generally no “end of year following receipt” time limitation on prepaid income received from merchandise sales.Exception to unlimited deferral rule. This exception applies to taxpayers receiving “substantial advance payments” for an inventory item that the taxpayer has on hand or that is available through normal sources of supply. In such cases, the taxpayer must include in income all advance payments received in the SECOND year following the year of receipt. Chapter 13, Exhibit 24 CCH Federal Taxation Comprehensive Topics

  47. Prepaid Rental Income and Expense Both cash- and accrual-method landlords must include rent in the year received, no matter when it is due. Advance payments of business-use rent may not be deducted by either cash- or accrual-method tenants until the year in which it is due. Chapter 13, Exhibit 25 CCH Federal Taxation Comprehensive Topics

  48. Prepaid Subscription Income Accrual basis taxpayers may elect to recognize prepaid subscription income over the subscription period. [Code Sec. 455.] If a taxpayer does not elect this deferral treatment, the income is generally includible in the tax year received. Chapter 13, Exhibit 26 CCH Federal Taxation Comprehensive Topics

  49. Prepaid Membership Fees A membership organization that receives prepaid dues in connection with the business of rendering services may elect to include income ratably over the period of time that it has a liability to render these services. [Code Sec. 456(a).] However, when the income relates to a liability that extends for more than 36 months, the income is includible in the year of receipt. [Code Sec. 456(e).] Chapter 13, Exhibit 27 CCH Federal Taxation Comprehensive Topics

  50. Prepaid Interest Expense For cash- and accrual-method taxpayers, interest paid in advance, which is properly allocable to any later tax year, is generally deemed to be paid in the later year to which it is allocable. Chapter 13, Exhibit 28 CCH Federal Taxation Comprehensive Topics