Business Income, Deductions, and Accounting Methods Chapter 9 Business Income, Deductions, and Accounting Methods

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 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.

Statutory Limits on Business Expense Deductions #47 Expenses against public policy No deduction for fines, bribes (beware of RICO ACT), 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 (record on B/S) Personal expenses

Capital Expenditures Does the expenditure provide future benefit (beyond this year)? If so, 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

12-Month Rule Example Ben, a cash basis taxpayer, makes the following payments on June 30 of this year: $10,000 for the next 10 months of utilities. $12,000 for insurance over the next 24 months. $9,600 for the next 8 months of interest on a business loan. What amounts are deductible this year?

12-Month Rule Solution Ben can deduct all $10,000 for the utilities because: the benefit is not more than 12 months and the benefit ends prior to the end of next year. Ben can deduct $3,000 for insurance because: the payment is more than 12 months. Hence, Ben can only deduct 6 months ($500 per month). Ben can deduct $7,200 for interest because: the 12-month rule does not apply to interest.

Special Business Deductions #57 Losses on disposition of business assets Recognized losses are deductible Casualty losses are 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.

Domestic Production Activities Deduction (DPAD) An “artificial” deduction that subsidizes domestic manufacturing (purpose is to increase after tax income) Domestic production of tangible products qualifies for subsidy but income must be 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

DPAD Example What is Brian’s domestic production activities deduction? Brian recorded $100,000 of receipts from a qualified domestic production activity. Brian allocated $55,000 of expenses to the qualified domestic production activity including $12,000 of wages. Brian had modified AGI of $47,000. What is Brian’s domestic production activities deduction?

DPAD Solution Calculate QPAI: QDGR (receipts) $100,000 expenses − 55,000 QPAI (qualifying income) $ 45,000 QPAI cannot exceed modified AGI: Modified AGI is $47,000 so no limit Calculate DPAD QPAI $ 45,000 2010 percent × 9% DPAD $ 4,050 Limit DPAD to 50% of wages 50% of wages is $6,000 DPAD = $4,050

Business Expenses with Personal Benefits #49 No deduction for purely personal expenditures unless otherwise allowable – e.g. charity, medical, etc. Mixed motive? Primary motive for some expenditures (all or nothing) 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 Example Ben paid the following to attend a business meeting in Chicago: Airfare (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)?

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 × 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 circumstance

Accounting Periods Annual period Year ends 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 Note that the 52/53 week can facilitate closing of books.

Choosing an Accounting Period Proprietorships – same as proprietor “C” corporations and individuals – choice made on first tax return and is consistent with book accounting period Flow-thru entities – a “required” tax year 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 end

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 Quick to recognize income but likely to defer deductions Objective of Congress is to maximize tax revenues

Accounting Methods #60 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 Large corporations must 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: Complete 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 to 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

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?

Advance Payment Solution 1. If Ben uses the cash method, he must recognize income as received - $2,400 this year. 2. 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 × $2,400). Next year Ben would recognize the remaining $2,100 - income can only be deferred one year.

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

Accruing Business Expenses 1. 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 2. Economic performance has occurred

Economic Performance Applies to accrual method taxpayers only Taxpayer provides goods or services: Performance occurs as taxpayer provides goods or services Taxpayer using property or goods: Performance occurs as goods are provided or economic performance is otherwise expected within 3 ½ months of payment Payment liabilities are performed only when paid Interest and rent occurs ratably These rules only apply to accrual basis taxpayers.

Economic Performance Example Ben has signed a binding contract for Peter to provide Ben with repair services. Ben paid $1,500 to Peter and owes an additional $6,000 on the contract. The repairs will commence late next year. When can Ben claim the deduction if he uses the accrual method? Include a few of the key examples from the book.

Economic Performance Solution Although the all events test is satisfied, Ben can only deduct $7,500 next year because that is when economic performance occurs (taxpayer liable for performing service).

Liability and economic performance (IRC §461) Capitalize (IRC §263(a) or §471) Deduct (IRC §162) 12-month rule Disallow Meals & Entertainment Spousal Travel Club Dues Lobbying Etc.

Choosing or Changing an Accounting Method Accounting methods are generally adopted by 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 IRS permission Some changes are automatic Permission is necessary to correct the use of an impermissible method