Chapter 6 Taxable Income from Business Operations McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

6-2 Objectives Describe the relationship between business operating cycle and taxable year Identify the permissible methods of accounting for tax purposes Explain why tax policy objectives affect the taxable income computation Apply the cash method of accounting to compute taxable income Contrast the principles of conservatism reflected by GAAP and by the tax law

Objectives (continued) 6-3 Objectives (continued) Differentiate between a permanent and a temporary book/tax difference Explain the difference between tax expense per books and tax payable Apply the tax accounting rules for prepaid income and accrued expenses Explain how the NOL deduction smooths taxable income over time

Taxable Income Taxable income = gross income less allowable deductions 6-4 Taxable Income Taxable income = gross income less allowable deductions Gross income “means all income from whatever source derived” Deductions are allowed by legislative grace and include “all ordinary and necessary expenses … in carrying on any trade or business”

Taxable Income Good rule of thumb: 6-5 Taxable Income Good rule of thumb: Receipts are taxable unless a specific rule states that the receipt is nontaxable Expenses are deductible only if a specific rule states that the expense is deductible

6-6 Taxable Year A taxable year is generally the 12-month period corresponding to a firm’s fiscal year Individuals generally use a calendar year Firms generally choose a tax year that reflects their annual operating cycle

6-7 Taxable Year Examples Discuss the choice of a taxable year for the following businesses: Retail plant and garden center French bakery Chimney cleaning business Moving and transport business Software consulting business

6-8 Taxable Year A new business establishes its taxable year by filing an initial tax return based on such year Changing tax years requires IRS permission The first return after the change may reflect a short period of less than 12 months The taxable income reported on the short-period return must be annualized – mathematically inflated to reflect 12 months of business operations

6-9 Taxable Year Example: Acme had a fiscal year ending on June 30. It changed to a year ending September 30. For the three months ended 9/30, Acme earned $25,000 income Annualized income = $100,000 [($25,000/3) × 12] Tax on $100,000 = $22,250 Tax for 3-month short period = $5,563 [($22,250/12) × 3]

Tax Methods of Accounting 6-10 Tax Methods of Accounting A overall tax accounting method determines the year in which a taxpayer recognizes items of income, gain, deduction, and loss The Internal Revenue Code (IRC) permits firms to use the following accounting methods: Cash Accrual Combined (hybrid)

Tax Methods of Accounting 6-11 Tax Methods of Accounting Section 482 grants IRS broad powers to “distribute, apportion, or allocate income” among businesses to clearly reflect the income of each Huge issue in international taxation More discussion in Chapter 13

Methods of Accounting: Policy Objectives 6-12 Methods of Accounting: Policy Objectives Public policy No deduction for fines, political contributions Why? Congress doesn’t want to subsidize bad behavior with a tax deduction or finance the lobbying efforts of special interest groups Only 50% of meal and entertainment expense is deductible Lavish meals and entertainment involve more pleasure than business and should not be subsidized with federal tax dollars

Methods of Accounting: Policy Objectives 6-13 Methods of Accounting: Policy Objectives Economic incentives State and local bond interest income is tax-exempt (and related expenses are nondeductible) Why? To help local governments raise funds by lowering the cost of capital Businesses can write-off equipment faster for tax purposes than GAAP useful life To encourage firms to make capital investments

6-14 Cash Method Under the cash method, gross income includes cash or property actually received during the tax year – regardless of when the sale occurred or services were provided Deductions are usually taken in the year cash or property is paid – regardless of when the expense was incurred

6-15 Cash Method A CPA receives free automobile repair work in exchange for preparing the mechanic’s tax return Does the CPA recognize income under the accrual method of accounting? Yes – services have been provided and income has been earned What if the CPA uses the cash method of accounting? Yes – cash method income includes the receipt of non-cash goods or services

Cash Method Income Constructive receipt of income 6-16 Cash Method Income Constructive receipt of income Occurs when taxpayer has unrestricted access to and control of the income – even if not in the taxpayer’s actual possession No constructive receipt exists if the income is available only on surrender of a valuable right or if there are substantial barriers to receipt

6-17 Cash Method Income A calendar year, cash basis firm wants to defer income from this year to next year. Can it defer income recognition if: It holds the checks received from customers in December in its vault and does not cash them until January? No – the income has been constructively received

Cash Method Deductions 6-18 Cash Method Deductions Cash method - deduct expenses when paid. A check is paid on the date it is mailed When does it make sense for a cash basis firm to pay an expense early? When the tax savings from the deduction are greater than the opportunity cost of the early payment

6-19 Capital Expenditures If an expenditure results in a benefit that extends beyond 12 months, the expenditure is capitalized to an asset account The cost of the asset may be recovered over time (through depreciation, amortization, or cost of goods sold) Major repairs may result in a dispute with the IRS concerning deduction versus capitalization

Cash Method Deductions - Inventory 6-20 Cash Method Deductions - Inventory Inventory must be accounted for on the accrual method, even for cash basis taxpayers Hybrid method of accounting Purchases and sales of inventories are accounted for under the accrual method and all other transactions are accounted for under the cash method

Limitations on Corporations Using Cash Method 6-21 Limitations on Corporations Using Cash Method Corporations that average more than $5 million in annual gross receipts can’t use the cash method Prohibition applies to partnerships with a corporate partner Personal service corporations (providing professional services such medical, legal, and accounting services) may use the cash method

Accrual Method of Accounting 6-22 Accrual Method of Accounting Under the accrual method, taxpayers recognize income when the right to the income is fixed and the amount of income can be determined with reasonable accuracy Taxpayers deduct expenses when all events have occurred that establish the fact of the liability for the expense and the amount of the liability can be determined with reasonable accuracy

6-23 Book-Tax Differences Financial accounting (GAAP) and tax accounting reflect contrasting principles of conservatism GAAP seeks to protect shareholders and creditors: Don’t overstate book income Tax law seeks to protect government revenues: Don’t understate taxable income

Permanent Book-Tax Differences 6-24 Permanent Book-Tax Differences Permanent differences between book income and taxable income do not reverse in future years Examples Tax-exempt interest on state and local bonds Key-person life insurance premiums and proceeds 50% nondeductible meals and entertainment Political contributions Fines and penalties Domestic production activities deduction

Temporary Book-Tax Differences 6-25 Temporary Book-Tax Differences Temporary differences occur when an item of income or expense is taken into account in a different year (or years) for book purposes than for tax purposes Examples Depreciation and amortization Receipt of prepaid income Accrued expenses that fail the all-events test Net capital losses Bad debts (allowance vs. direct write-off)

Favorable or Unfavorable Differences 6-26 Favorable or Unfavorable Differences A permanent or temporary difference that causes an excess of book income over taxable income is described as favorable A permanent or temporary difference that causes an excess of taxable income over book income is described as unfavorable

Tax Expense per Books Versus Tax Payable 6-27 Tax Expense per Books Versus Tax Payable Tax expense per books is based on book income adjusted for all permanent book/tax differences Tax payable is based on taxable income Temporary differences increase or decrease the firm’s deferred tax assets and liabilities Favorable differences increase deferred tax liabilities (or decrease deferred tax assets) Unfavorable differences increase deferred tax assets (or decrease deferred tax liabilities)

6-28 Example ABC Company earned $100,000 operating income and $2,000 municipal bond interest this year. ABC purchased an asset for $20,000 which it expensed and deducted for tax purposes but capitalized for book purposes. Book depreciation was $5,000. ABC’s tax rate is 35% Compute ABC’s book and tax income Compute ABC’s tax expense per books and tax payable Determine the change in ABC’s deferred tax accounts for the year

6-29 Solution Book income = $97,000 ($100,000 operating income + $2,000 interest - $5,000 depreciation) Taxable income = $80,000 ($100,000 operating income - $20,000 deduction) Tax expense per books = $33,250 (35% × $95,000 (book income - $2,000 favorable permanent difference for tax-exempt interest)) Tax payable = $28,000 (35% × taxable income) $5,250 excess of tax expense over tax payable = increase in deferred tax liability

Temporary Differences: Prepaid Income 6-30 Temporary Differences: Prepaid Income Prepaid income may be taxed when received even though it has not been earned Prepaid (unearned) income is not included in book income Common examples are prepaid rent and prepaid interest Creates an unfavorable temporary book/tax difference resulting in a deferred tax asset

Prepaid Income Example 6-31 Prepaid Income Example Acme, an accrual basis, calendar year taxpayer, received a $12,000 prepayment of four months’ rent from a tenant. The rent was for December of this year and January through March of the next year. How much book income does Acme report this year? Acme reports $3,000 rent income (December rent) How much taxable income does Acme report this year? Acme reports $12,000 taxable income

One-Year Rule for Prepaid Service Income 6-32 One-Year Rule for Prepaid Service Income Prepayments for future services to be rendered to clients or customers are accounted for under a special one-year deferral method The prepayment for services rendered in the year of receipt is taxable in that year The remaining payment is taxable in the following year

Temporary Differences: Accrued Expenses 6-33 Temporary Differences: Accrued Expenses An accrued expense is deductible only if it passes the all events test: All events that establish the liability have occurred The amount must be determinable with reasonable accuracy Economic performance with respect to the liability has occurred

6-34 Economic Performance Liability relating to the provision of services, property or the use of property to the taxpayer by another party: Economic performance occurs when the other party provides the services, property, or use of property Liability relating to the provision of services or property by the taxpayer to another party: Economic performance occurs when the taxpayer provides the services or property

Economic Performance – Payment Liabilities 6-35 Economic Performance – Payment Liabilities The economic performance requirement defers the deduction until payment is made for accrued: Legal settlements for workers compensation, tort, breach of contract Customer rebates/refunds Awards, prizes, jackpots Taxes imposed by a governmental authority

Recurring Item Exception 6-36 Recurring Item Exception Taxpayers may adopt the recurring item exception as a method of accounting for: Liabilities routinely incurred from year to year and properly accrued under GAAP Economic performance occurs within 8½ months after year-end Taxpayer may deduct the corresponding expense in the year of accrual

Accrued Expense Example 6-37 Accrued Expense Example ABC Company has two accrued expenses at year end December’s utility bill to be paid in 30 days Estimated legal settlement under workers compensation claim Which accrual can be deducted on the current year tax return? Accrued utility expense

Special Accrual Rules Compensation accruals Related party accruals 6-38 Special Accrual Rules Compensation accruals Employer cannot deduct expense unless compensation paid within 2½ months after the close of year Related party accruals The payer can’t deduct an accrued expense until the year that the recipient recognizes income Bad debt expense GAAP requires the allowance method For tax purposes, the direct write-off method is required

Net Operating Loss (NOL) 6-39 Net Operating Loss (NOL) An excess of deductible business expenses over gross income is a net operating loss (NOL) An NOL yields no current tax savings but may be deductible in an earlier or later tax year NOLs can be carried back two years Carryback deduction generates tax savings in the form of a refund of prior year tax Taxpayers can elect to give up this carryback NOLs can be carried forward 20 years Carryforward generates only future tax savings

6-40 Accounting for NOLs An NOL results in a negative tax expense (tax benefit) for book purposes but no current tax refund This book/tax difference results in a deferred tax asset equal to the expected future tax savings from the NOL carryforward The deferred tax asset will reverse in future years when taxable income (but not book income) is reduced by the NOL carryforward deduction

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