©2013, College for Financial Planning, all rights reserved. Module 2 Tax Accounting & Forms of Business CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAM Income Tax Planning

Learning Objectives 2–1: Identify characteristics, advantages and disadvantages of the cash or accrual method of accounting. 2–2: Evaluate a situation to select the most appropriate method of tax accounting to use. 2–3: Identify an advantage or disadvantage of a particular method of inventory valuation. 2–4: Explain characteristics, advantages, or disadvantages of a business form. 2–5: Identify requirements for a valid S corporation election. 2–6: Evaluate a situation to recommend the most appropriate business form. 2–7: Analyze a situation to calculate the allowable home- office deduction. 2-2

Questions to Get Us Warmed Up 2-3

Learning Objectives 2–1: Identify characteristics, advantages and disadvantages of the cash or accrual method of accounting. 2–2: Evaluate a situation to select the most appropriate method of tax accounting to use. 2–3: Identify an advantage or disadvantage of a particular method of inventory valuation. 2–4: Explain characteristics, advantages, or disadvantages of a business form. 2–5: Identify requirements for a valid S corporation election. 2–6: Evaluate a situation to recommend the most appropriate business form. 2–7: Analyze a situation to calculate the allowable home- office deduction. 2-4

Cash Method of Accounting Income recognized when actually received (generally) Constructive receipt doctrine Expenses deducted when actually paid Allows for greater flexibility in timing income and expenses May be allowed when inventories are used if taxpayer meets “small business exception” 2-5

Accrual Method of Accounting Generally must be used if inventory is a material income-producing factor. Income is recognized when earned—all-events test must be met. Expenses deducted when liability is established—all-events test must be met and, generally, economic performance must have occurred. 2-6

All-Events Test for Accrual Method Income recognition All events must have occurred to fix the right to the income Must be able to estimate with reasonable accuracy Deduction of expenses All events must have occurred to fix the obligation to pay Must be able to estimate with reasonable accuracy Economic performance generally must have occurred 2-7

Other Methods of Accounting Hybrid method of accounting Combines cash and accrual methods of accounting to reflect the nature of the business (e.g., inventory and service) Long-term contract method of accounting Contract for manufacture of a unique item Not normally carried in ending inventory Not completed in tax year contract entered into Item usually takes more than 12 months to complete 2-8

Inventory Valuation Last-In, First-Out (LIFO) 2-9 Advantages Defers income taxes when prices are rising Improves cash flow when prices are rising More current costs matched against current revenues gives more realistic financial picture Disadvantages Reduces earning figure when prices are rising Understates ending inventory when prices are rising

Inventory Valuation First-In, First-Out (FIFO) 2-10 Advantages Higher earnings figure in time of inflation In times of declining prices, matches higher-priced inventory items against revenues Ending inventory figure represents current cost (replacement) figure Disadvantages Higher earnings figure in inflationary times results in greater tax liability

Learning Objectives 2–1: Identify characteristics, advantages and disadvantages of the cash or accrual method of accounting. 2–2: Evaluate a situation to select the most appropriate method of tax accounting to use. 2–3: Identify an advantage or disadvantage of a particular method of inventory valuation. 2–4: Explain characteristics, advantages, or disadvantages of a business form. 2–5: Identify requirements for a valid S corporation election. 2–6: Evaluate a situation to recommend the most appropriate business form. 2–7: Analyze a situation to calculate the allowable home- office deduction. 2-11

Sole Proprietorship 2-12 Advantages Availability of certain retirement plans Applicable tax credits or losses reported on individual 1040 No tax consequences on formation or liquidation Conduit entity (no double taxation) Self-employed health insurance deduction Disadvantages Unlimited personal liability Lack of continuity of life Capital structure limited Liable for self-employment tax

Partnerships Conduit entity Joint and several liability Lack of continuity of life Limited capital structure Income recognition on disproportionate distribution of Section 751 “hot” assets Occasional income recognition on formation Ability to use special allocations Basis issues—cash plus adjusted basis of property contributed plus share of debt, increased by flow- through of income and reduced by flow-through of losses and distributions Partners liable for self-employment tax 2-13

Limited Partnerships 2-14 Advantages Limited personal liability for limited partners Special allocations may allow certain tax items to flow through to specific partners Disadvantages Service limited partners not allowed Limited partners cannot have day-to-day control Must have a general partner

C Corporation 2-15 Advantages Limited liability Transferability of interest Easy to raise additional business capital Continuity of business life Centralized management Separate taxable entity Graduated corporate tax rates Employee benefit plans Corporate dividend exclusion Section 1244 stock treatment

C Corporation 2-16 Disadvantages Corporate formalities required Large amounts of paperwork Generally more expensive to run Excess compensation rules No preferential LTCG rates Possible oppression of minority shareholders Possible accumulated earnings tax Double taxation Possible classification as a personal service corporation (PSC)

Personal Service Corporation C corporation ONLY Substantially all of the stock held by employees, retired employees, or their estates Substantially all of the services performed in listed fields Benefit of graduated corporate tax rates denied Mnemonic: CALL AAA for HELP 2-17

S Corporation 2-18 Advantages Conduit taxation passes through losses and income Section 1244 treatment of stock Potential reduction in Social Security taxes Disadvantages Profits taxed to shareholders even if not distributed Losses deductible only to extent of basis in stock and debt Required to maintain S status Potential of “sting tax,” LIFO recapture, built- in gains tax

S Corporation Election Must be a domestic corporation No more than 100 shareholders allowed Only one class of stock Shareholders must be U.S. citizens or residents All shareholders must be individuals or a certain type of trust All shareholders must elect S status (Form 2553) Majority of outstanding stock to revoke S status 2-19

LLCs & LLPs Limited Liability Company Partnership taxation Limited liability Statutory entity Limited liability for members Dissolution upon death, retirement, or resignation Management structure determined by LLC’s operating agreement Single member LLC is treated as a disregarded entity Limited Liability Partnership Joint and several liability for contractual liabilities (maybe) May have personal liability for own malpractice or torts No personal liability for malpractice or torts of partners 2-20

Self-Employed Health Insurance Above the line deduction Sole prop, partner, >2% shareholder in S corp. No effect on SE income Health Insurance & Qualified LTC premiums Taxpayer, Spouse & Dependents Limitations o No participation in subsidized plan o Limited to business earned income o Plan must be in business name (unless sole proprietorship) 2-21

Check-the-Box Regulations One owner—default taxation as sole proprietorship 2 or more owners— default taxation as partnership May elect to be treated as a corporation under the Regulations 2-22

Learning Objectives 2–1: Identify characteristics, advantages and disadvantages of the cash or accrual method of accounting. 2–2: Evaluate a situation to select the most appropriate method of tax accounting to use. 2–3: Identify an advantage or disadvantage of a particular method of inventory valuation. 2–4: Explain characteristics, advantages, or disadvantages of a business form. 2–5: Identify requirements for a valid S corporation election. 2–6: Evaluate a situation to recommend the most appropriate business form. 2–7: Analyze a situation to calculate the allowable home- office deduction. 2-23

Home Office Expense Deduction Requirements Must be used regularly and exclusively as principal place of business o Meet with patients, clients or customers, OR o Connected to trade or business if separate structure Administrative or management activities if no other fixed location Limitation Tentative net income limit Only items deductible without regard to home office may generate a loss Simplified (Safe Harbor) Method $5/square foot; maximum of 300 square feet All other requirements must be met 2-24

Review Question 1 Which one of the following is not an advantage of the cash basis method of accounting? a.Taxes are not paid until income is received. b.Taxpayers can keep simple records. c.Taxpayers can control each year’s receipts and payouts. d.Constructive receipt serves to defer income. 2-25

Review Question 2 Under which one of the following circumstances may the long-term contract method of accounting be used? a.The manufacture of an item of inventory, which consistently takes longer than one year to complete. b.The manufacture of a unique item for which the contract is not completed in the year into which it is entered. c.The construction of property for which payments will be received over more than one taxable year. 2-26

Review Question 3 Which of the following is a correct statement regarding the FIFO method of accounting for inventory? a.During periods of declining inventory prices, lower taxable income will result. b.During periods of increasing inventory prices, the cost of goods sold (COGS) will be higher. c.During periods of increasing inventory prices, lower taxable income will result. 2-27

Review Question 4 Which one of the following is a correct statement regarding the LIFO method of accounting for inventory? a.During periods of declining inventory prices, lower taxable income will result. b.During periods of declining inventory prices, the cost of goods sold (COGS) will be higher. c.During periods of increasing inventory prices, lower taxable income will result. 2-28

Review Question 5 Which one of the following is a non-tax disadvantage of operating as a sole proprietorship? I.inability to raise capital II.unlimited liability III. lack of continuity of life a.I and II only b.II and III only c.I, II, and III 2-29

Review Question 6 The partner’s tax basis in his or her interest in a partnership a.remains unchanged unless additional capital is contributed or distributions are made. b.is increased by his or her share of income reported by the partnership. c.remains unchanged until the interest is sold or otherwise disposed. 2-30

Review Question 7 One tax advantage of a C corporation is a.the ability to have income taxed at lower rates. b.the ability to distribute income to shareholders tax free. c.the ability to contribute, tax free, appreciated securities in exchange for stock of an investment company. 2-31

Review Question 8 S corporation shareholders have the ability to deduct losses to the extent of a.their original contribution of capital to the business. b.their adjusted basis in the stock, adjusted for corporate loans personally guaranteed. c.their adjusted basis in the stock, adjusted for money they have directly loaned to the corporation. 2-32

Review Question 9 Which one of the following forms of business is generally recognized as having the most readily available access to additional capital? a.sole proprietorship b.general partnership c.C corporation d.S corporation 2-33

Review Question 10 Which of the following are characteristics of a C corporation? I.The number of shareholders is limited. II.The bankruptcy of shareholders has no effect on the business form. III.Shareholder liability is limited. IV.Capital structure is dependent upon the resources of the shareholders. a.I and II only b.I and IV only c.II and III only d.II and IV only e.III and IV only 2-34

Review Question 11 Bill Giles, an engineer, is contemplating forming a C corporation for his practice. He will be the sole employee of the corporation. Which of the following statements accurately describe the income tax consequences of such an arrangement? I.The corporation would be considered a Personal Service Corporation. II.The corporation would not be considered a Personal Service Corporation. III.The net income of the corporation will be subject to graduated tax rates. IV.The net income of the corporation will be taxed at Bill’s individual tax rates. V.The net income of the corporation will be subject to a flat 35% tax rate. a.I and IV only b.I and V only c.II and III only d.II and IV only e.II and V only 2-35

Review Question 12 Which of the following statements are true regarding an S corporation? a.Shareholders have limited liability. b.The number of shareholders is limited to 100. c.The death of an owner requires reorganization of the corporation. d.The corporation is a conduit for items of income, deductions, and tax credits. a.III only b.I and IV only c.II and III only d.I, II, and IV only e.II, III, and IV only 2-36

Review Question 13 John Matthews, a married taxpayer filing a joint return, sold Section 1244 stock during the current year. Which of the following correctly identify the tax treatment of the sale? I.Up to $50,000 of loss is treated as an ordinary loss. II.Up to $100,000 of loss is treated as an ordinary loss. III.Any loss in excess of the maximum annual ordinary loss is treated as a capital loss. IV.A gain on a sale is considered ordinary income. a.I and III only b.II and III only c.II and IV only d.I, III, and IV only e.II, III, and IV only 2-37

Review Question 14 Randy Jackson operates a sole proprietorship from his apartment. His gross income for the current tax year is $31,000. Business expenses not associated with his home office total $27,000. Expenses associated with the home office total $4,750. How much of the home-office expense, if any, may Randy deduct for the current year? a.$0 b.$275 c.$4,000 d.$4,

©2013, College for Financial Planning, all rights reserved. Module 2 End of Slides CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAM Income Tax Planning