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 that 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.

Reasonableness Example Rick owns a business that employs his brother, Ben. Ben is paid $45,000 per year by Rick’s business. In comparison, other employees with Ben’s responsibilities are only paid $30,000 per year. What is Rick’s business deduction for employing Ben?

Reasonableness Solution A reasonable amount for compensating Ben is $30,000 rather than $45,000. Hence, Rick can only deduct $30,000. The extra $15,000 ($45,000 paid minus $30,000 deduction) is a gift from Rick to Ben.

Statutory Limits on Business Expense Deductions Expenditures 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. Interest must be related to taxable income. Key employee insurance premiums—no deduction if business is beneficiary of life insurance Capital Expenditures Personal Expenditures

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 expense

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 does not exceed 12 months and The benefit ends prior to the end of next year. Ben can deduct $3,000 for insurance because: The benefit exceeds 12 months. Hence, Ben can only deduct 6 months in this year ($500 per month). Ben can deduct $7,200 for interest because: The 12-month rule does not apply to interest.

Special Business Deductions Losses on Disposition of Business Property 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 loan 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 to discuss the nature of the deduction.

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) Business travel (away from home overnight) Otherwise, allocate deduction to business portion Arbitrary percentage (50% meals and entertainment) Basis for allocation (mileage or time) Record keeping 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: Primarily Primarily business personal Airfare (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 for Taxable Income We’ve learned to identify Business gross income Deductible expenses Now we need to match income and deductions to a specific period Accounting methods match income and expense to a specific period

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-through 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 Financial and Tax Accounting Methods Financial accounting is “conservative” GAAP is slow to recognize income, but quick to recognize losses or expenses Objective is to avoid misleading investors and 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 (2) 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 30 of this year he received $2,400 full payment for a 2-year service contract. What amount of income must Ben recognize if he is on the cash method? if he is on the accrual method?

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 × $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 Indirect costs are allocated to inventories (not expensed) 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 The most famous method: SWAG We skip a discussion of inventory flows here, but a slide may be added if students are confused.