Chapter 5 Taxable Income from Business Operations

TAXABLE INCOME FROM BUSINESS OPERATIONS Business profit as taxable income The taxable year Methods of accounting Book-tax income differences Accounting method issues in computing taxable income NOLs

Business Profit as Taxable Income Taxable income = gross income less allowable deductions Gross income means “all income from whatever source derived.” §61 Includes discharge of debt income. Expenses are only deductible if specifically allowed by the Code (§61). Includes all ordinary and necessary expenses … in carrying on any trade or business.” (§162).

Discharge of Indebtedness Income (not in book) A taxpayer must report income when A creditor cancels the taxpayer’s debt The amount of income recognized is generally the amount of the debt forgiven Reduction of debt not income for: Discharges under Federal bankruptcy law, or Discharges that occur when the debtor is insolvent.

The Taxable Year (1 of 2) 12-month period Generally same as its financial year. Individuals use a calendar year. Business FYE generally the same for financial and tax. Need IRS permission to change tax year. Most common reason is merger of firms with different year-ends.

The Taxable Year (2 of 2) Short-year return Only occurs when tax year changed and reporting period is < 12 months. Short-year tax liability Compute short-year taxable income Annualize income Multiply by (12 mo)/(# of mo in short yr) Compute tax on annualized income Compute tax for short year Multiply annualized tax liability by (# of mo in short yr)/(12 mo)

Methods of Accounting Overall method must clearly reflect income. Establish a method by using it in the first tax return. Requires IRS permission to change. Realization and matching principles Cash and accrual methods

Realization and Matching Principles REALIZATION principle Earnings process complete. MATCHING principle Match expenses with revenues. Exceptions due to risks of tax evasion, convenience for gov’t or taxpayer, ability to pay, economic incentives.

Cash & Accrual Accounting (1 of 2) CASH method mandatory where taxpayer's records reflect only cash transactions and no inventories. ACCRUAL method mandatory for: Purchases and sales where inventories must be used. C corps and ptrshps w/ C corp partner. Small corps (avg. annual gross receipts < $5M) may use cash basis.

Cash & Accrual Accounting (2 of 2) HYBRID method Use accrual for inventories (CGS), but cash for everything else.

Book-Tax Income Differences (1 of 2) GAAP vs. tax conservatism GAAP - protect s/hs and creditors: don’t overstate book income. Tax - protect gov’t revenues: don’t understate taxable income. Contrary result may arise due to economic incentives - e.g. accelerated. depreciation.) Tax policy effect on measuring inc. e.g., fines, penalties, lobbying exp.

Book-Tax Income Differences (2 of 2) Temporary vs. permanent differences Permanent differences do not reverse; Temporary differences reverse over the life of the entity. GAAP current tax expense is based on book income. GAAP deferred tax expense is the tax effect of temporary differences (not permanent) reversing in the future.

Permanent Differences (1 of 2) Examples of permanent non-deductible expenses (deductible for fin stmts) 50% meals and entertainment Political contributions & lobby expenses Fines and penalties Interest expense to generate tax-exempt municipal bond income Premiums on key employee life insurance paid by corporation. Goodwill.

Permanent Differences (2 of 2) Examples of permanent tax preferences that make taxable income less than book income: Tax-exempt municipal bond income Life insurance proceeds on key employee policies.

Meals and Entertainment Expenses Qualified M&E expenses only 50% deductible. Must be directly related to (business discussion takes place) or associated with (directly preceding or proceeding a business meeting) a business activity. Taxpayer must be present at meals. Expense must not be lavish or extravagant.

Temporary Differences Examples of temporary differences: Depreciation Timing of accruals Capital losses Corps: only deductible against cap gains Individuals: up to $3,000/yr deductible against ordinary income Bad debts (allowance vs. write-off) Cash versus accrual accounting

Tax Expense & Deferred Taxes GAAP total tax expense (SFAS109) = current + deferred tax expense In simple situations, this approximates tax rate on book income + or - permanent differences.

Acctg Method Issues in Computing Taxable Income Cash method issues Accrual method issues Summary of cash vs. accrual Section 482

Cash Method Issues (1 of 2) Constructive receipt of income. Report when a person has unrestricted access to and control of the income. NO constructive receipt if the amount is available only on surrender of a valuable right, or if there are substantial limits on the right to receive it.

Cash Method Issues (2 of 2) Prepaid expenses Use accrual recognition when expense covers more than the following tax year. Exception: prepaid interest must be capitalized and deducted over the period for which interest is actually charged.

Accrual Method Issues Prepaid income Advanced payments received for merchandise Advances and deposits Related party accruals Bad debts Accrued expenses

Prepaid Income Prepaid income taxed when received under the Claim of Right Doctrine, not when the services are performed. Government has the right to tax income when the taxpayer has unrestricted right to use such income amounts. Examples: Rent, bonuses, services Use accrual method for service inc. if completed by end of following tax year.

Advanced Payments Received for Merchandise Advance payments received for merchandise or construction Delay tax until earned (goods delivered). OK to use accrual method if used for all tax reporting and financial reporting. Small contractors may use completed contract method instead of % of completion for accounting for long-term contracts.

Long-Term Contracts (not in book) (1 of 2) Completed contract method Real estate construction contract or home construction contract (≤ 4 units) if < 2 yrs to complete & gross receipts < $10M. Deduct expenses when incurred, and recognize income when completed.

Long-Term Contracts (not in book) (2 of 2) Percentage of completion method Income recognized = (C/T) x P C = Contract costs incurred during the period T = Estimated total cost of the contract P = Contract price

Advances and Deposits A deposit that guarantees the customer's payment of amounts owed to the creditor is an advance payment includible in income. (E.g., apartment last months’ rent?). True security deposits are not an advance payment and not includable in income. (e.g., apt security damage deposit).

Related Party Accruals The paying party cannot deduct an expense until the receiving party includes the receipt in income. Prevents accrual basis taxpayers from deducting an expense before related cash basis taxpayer recognizes the income.

Bad Debts GAAP - allowance method Tax - direct write-off method. Record income if account repaid later. Cash basis taxpayer cannot deduct bad debt unless there was an actual cash loss or if amount was previously included in income.

Accrued Expenses All Events Test requires Liability is fixed. Amount determined with reasonable accuracy. Economic Performance test for nonrecurring expenses also requires that all activities to satisfy the liability have occurred - often requires payment.

Summary of Cash & Accrual Tax Issues Income When received When earned EXCEPT Constructive receipt Inventory sale Ppd. Income Ppd. Services > next year Expense When paid When accrued Asset purchase Ppd. Expense > next year Ppd. Interest Related party accrual Write-off bad debts All events & economic performance

Section 482 IRS has authority to “distribute, apportion, or allocate gross income, deduction, credits or allowances” among businesses to CLEARLY REFLECT income of each. Transfer pricing Critical for multi-jurisdictional taxation

Net Operating Losses When NOLs can be used: Carryback 2 yrs, carryforward 20 yrs. Carryback to oldest year first. Election available to forgo carryback. NPV tax benefit if taxpayer expects sufficiently higher tax rate in future. GAAP allows recording tax benefit for EV of future NOL deductions. New rules only apply temporarily.

End of Chapter 5