Chapter 08 Business Income, Deductions, and Accounting Methods
Learning Objectives • Describe the general requirements for deducting business expenses and identify common business deductions. • Apply the limitations on business deductions to 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 accounting periods available to businesses. • Identify and describe accounting methods available to businesses and apply tax accrual methods to determine business income and expense deductions.
Business income and deductions • Schedule C – Trade or business income • Includes revenue from services and sales activities. • Gross profit from sales - cost of goods is a return of capital – not a business deduction. • 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.
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. • Key man insurance premiums – no deduction if business is beneficiary of life insurance. • Capital expenditures • Personal expenses
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 interest.
Specifically authorized business deductions • Start-up expenditures • Capitalize and elect to expense/amortize • Bad debts • Accrual taxpayers can use direct write off only • Cash basis taxpayers have no deduction • Losses on disposition of business assets • Sales or exchanges for recognized losses • 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
Domestic production activities deduction (DPAD) • An “artificial” deduction that subsidizes domestic manufacturing. • Domestic production of tangible products qualifies for subsidy for income must allocated between qualifying and nonqualifying 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 ultimately limited to 50% of wages allocated to qualified activities.
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
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.
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 Friday in June.
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 (multiple owners for partnerships so this can be complicated).
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.
Accounting methods • Permissible “overall” methods: • Cash – recognize income when received. • Accrual – recognize income when earned or received (whichever is first generally). • Hybrid – mix of accrual and cash depending upon accounts (e.g. sales on accrual). • 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.
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 (large C corporations typically).
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
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.
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.
UNICAP • Inventory (purchased or produced) must be accounted for using tax version of “full absorption” rules. • Indirect costs are allocated to inventories (not expensed). • Costs of selling, advertising, and research need not be capitalized. • Exception for “small” businesses (average annual gross receipts < $10 million).
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
Accruing business expenses • All events test • All events have occurred to establish the liability to pay. • The amount is determinable with reasonable accuracy. • Reserves for future liabilities not allowed. and • Economic performance has occurred. • Mere liability is NOT ENOUGH!
Economic performance • Taxpayer liable for providing goods or services? • Performance occurs as taxpayer provides goods or services. • Taxpayer liable for using property or goods? • Performance occurs 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.
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.