Chapter 8 Business Income, Deductions, and Accounting

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Chapter 8

• Business Income, Deductions, and Accounting
  Methods

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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.

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Reasonableness example

• Rick owns a business that employs his brother,
  Ben.
• Ben is paid 45,000 per year by Ricks business.
  
• In comparison, other employees with Bens
  responsibilities are only paid 30,000 per year.
  
• What can Ricks business deduct for employing
  Ben?

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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.

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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

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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 lt 12 months and
• Benefits do not extend beyond end of next tax
  year.
• Does not apply to rent and interest.

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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

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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.

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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?

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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 lt 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 gt 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

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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.
• 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

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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)

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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

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Accounting for taxable income

• Weve 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 lt 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.

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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).

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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.

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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.

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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).

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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

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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 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.

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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?

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

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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.

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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

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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!

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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.

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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.

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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.