©2003 South-Western College Publishing, Cincinnati, Ohio Chapter 7 Accounting Periods & Methods and Depreciation

© 2003 South-Western College PublishingTransparency 7-2 Objective Have a general understanding of the different accounting periods and methods allowed

© 2003 South-Western College PublishingTransparency 7-3 Tax Year for Individuals rIndividuals must use a calendar year as their tax year rBusinesses must use a calendar year as their tax year unless they can show a different “natural business year”

© 2003 South-Western College PublishingTransparency 7-4 Tax Years for Partnerships rPartnerships don’t pay taxes themselves but must file an informational tax return (1065) rTax year must be the same tax year as 50% of partners <If partner’s tax years are different, use tax year of principal owners (principal is 5% or more owner) or least deferral method <Otherwise use calendar year ÙMay use fiscal year if it results in a deferral period of no more than three months

© 2003 South-Western College PublishingTransparency 7-5 Tax Year for S Corporations rS Corporations don’t pay taxes themselves but must file an informational tax return (1120S) rThey must use a calendar year; however, <May elect a fiscal year if the S corporation can demonstrate a business purpose, or <A fiscal year results in a deferral period of less than 3 months and S corporation agrees to make annual “required tax payment.” Ùdeferral period = period of time from fiscal year-end to December 31 Ùrequired tax payment also applies to fiscal year-end partnerships

© 2003 South-Western College PublishingTransparency 7-6 Deferral Example S-Corp has taxable income of $360,000 for the year ended 5/30 and last year’s required tax payment = $15,000. Calculation The “required tax payment” = (cash flow in deferral period x 39.6%) - prior year’s tax payment Deferral period is 7 months. $360,000/12 x 7 months = $210,000 cash flow. ($210,000 x 39.6%) - $15,000 = $68,160 deposit due

© 2003 South-Western College PublishingTransparency 7-7 Tax Year for Personal Service Corporation rA Personal Service Corporation (PSC) is corporation with shareholder-employee who provides a personal service (like an architect or dentist) rGenerally must adopt calendar year rCan adopt a fiscal year if: <Can prove business purpose, or <Shareholders’ salaries for deferral period are proportionate to salaries received during rest of the period and corporation limits its deduction ÙPurpose is to keep the PSC from deducting one year’s worth of salary in beginning nine months. If salaries don’t remain constant, the PSC can only deduct pro rata amount

© 2003 South-Western College PublishingTransparency 7-8 Short Tax Periods rOccur when taxpayer changes from fiscal year-end to calendar year-end or visa versa rTaxpayer must annualize income (see example in text), calculate tax and then allocate it to the short period <At top of tax return must complete: “For Short Tax Year From _____ to _____”

© 2003 South-Western College PublishingTransparency 7-9 must use same method for tax & books Accounting Methods There are three acceptable accounting methods rCash rHybrid rAccrual rMust use one method consistently <Make an election on your first return by filing using a particular method <Must file Form 3115 within first 6 months after initial election to request permission from IRS to change accounting methods

© 2003 South-Western College PublishingTransparency 7-10 Accounting Methods (continued) rCash basis taxpayers <Can’t deduct prepaid rent or interest <Can’t use cash basis if taxpayer is a: Ùtrust with UBI (unrelated business income), or Ùpartnership with a corporation as a partner, or ÙC corporation <PSCs and farms may use cash basis, and entities with gross receipts < $5M rAccrual basis taxpayers <Must report prepaid interest or rent as income when received (i.e., use cash method) rHybrid basis taxpayers <Cash method but must use accrual for COGS

© 2003 South-Western College PublishingTransparency 7-11 Objective Understand the concept of depreciation and be able to calculate depreciation expense using MACRS tables

© 2003 South-Western College PublishingTransparency 7-12 Depreciation (Form 4562) rDepreciation is a process of allocating the cost of assets to expense over their useful life <Land is not depreciated rRules for depreciation have changed over the years <Pre-1980: depreciated using straight line method < : use ACRS tables <Post-1986: use MACRS tables

© 2003 South-Western College PublishingTransparency 7-13 Personal Property rEach asset is depreciated according to an IRS- specified recovery period <3 year Race horses, tractors <5 year Computer, cars and light trucks, R&D equipment <7 year Office furniture, machinery, property with no life <10 year Barges, vessels <15 year Land Improvements <20 year Utility plants, sewers

© 2003 South-Western College PublishingTransparency 7-14 Personal Property (continued) rDepreciation is determined using IRS tables (Table 2 in text) <Percentages from tables are based on the double- declining balance method of depreciation ÙApplied to cost basis without regard for estimated salvage value <May elect to use tables based on straight line instead <Tables include half year convention Ù1/2 year depreciation in year of acquisition and 1/2 year depreciation in year of disposition

© 2003 South-Western College PublishingTransparency 7-15 Personal Property (continued) rAlways use the half-year convention unless mid- quarter convention applies <Assumes asset owned half of year of purchase, regardless of true purchase date <Assumes asset owned half of year of disposition, regardless of true disposition date rMid-quarter convention is required if taxpayer purchases 40% or more of total assets in last quarter of tax year <Applies to every asset purchased in the year <Excluding real property and §179 property <Must use special mid-quarter tables

© 2003 South-Western College PublishingTransparency 7-16 March 15 - purchase furniture for $180,000. Furniture is a 7-year asset. Using tables: Year 1: $180,000 x.1429 = $25,722 Year 2: $180,000 x.2449 = $44,082 November 3 - purchase computer for $12,000. This is a 5-year asset. Using tables: Year 1: $12,000 x.20 = $2,400 Year 2: $12,000 x.32 = $3,840 Personal Property Example

© 2003 South-Western College PublishingTransparency 7-17 Bonus Depreciation Property rAdditional depreciation is available for assets purchased between 9/11/01 and 9/11/04 rAmount = 30% of adjusted basis <Only for new personal property with recovery period < 20 years rTake 30% bonus first, then regular MACRS depreciation on remaining basis rMay elect out of bonus if anticipate need for higher depreciation in future years

© 2003 South-Western College PublishingTransparency 7-18 Real Property rReal assets are placed in a recovery period depending on use <27.5 year: Residential rental <39 year: Nonresidential Ù31.5 year if placed in service before 5/13/93 rReal assets are depreciated using the straight-line method with a mid-month convention (Table 4) <Treats all acquisitions/dispositions as occurring in the middle of the month <There is no mid-quarter convention for real estate

© 2003 South-Western College PublishingTransparency 7-19 Objective Know when an election to expense the cost of an asset may be used

© 2003 South-Western College PublishingTransparency 7-20 Election to Expense - Section 179 r§179 allows immediate expensing of qualifying property <In 2002, the annual amount allowed is $24,000 <Qualifying property is tangible personal property used in a business r§179 limited: <If cost of qualifying property placed in service in a year exceeds $200,000, reduce §179 expense dollar for dollar <Cannot take §179 expense in excess of taxable income, but may carry forward any unused amount rIf using 30% bonus take §179 first, then 30%, then regular depreciation.

© 2003 South-Western College PublishingTransparency 7-21 In July 2002, purchase a tooling machine (7-year asset) for $39,000. The taxable income from business is $45,500 and total asset acquisitions for year are $82,453. Calculation Cost$39,000 §179 expense (24,000) Adjusted depreciable basis $15,000 less 30% bonus ( 4,500) Remaining depreciable basis$10,500 x Table % $ 1,500 Total depreciation: $20,000 + $4,500 + $1,500 = $30,000 Section 179 Example

© 2003 South-Western College PublishingTransparency 7-22 Objective Understand the limitations placed on depreciation of “listed” property and luxury automobiles

© 2003 South-Western College PublishingTransparency 7-23 Listed Property rSpecial rules exist to limit deductions on assets used both in a business and personally <Cars, cell phones, computers (unless used exclusively at business), entertainment equipment rLimitation depends on amount of business use 50% for business, can use MACRS <If asset used < 50% for business, must use straight line 50% to < 50%, must claim excess depreciation as income on Form 4797 rSeparate section on page 2 of Form 4562 for listed property

© 2003 South-Western College PublishingTransparency 7-24 Luxury Autos Limits rMaximum allowed amount is <Luxury auto limits x business use % <Depreciation on automobiles is also limited based on business use (5-year MACRS amount x business use %) rLuxury auto limits are quite low: <Depreciation on autos placed into service in 2001 is: ÙYear $3,060 ÙYear $4,900 ÙYear $2,950 ÙYear 2004 and subsequent years - $1,775 <Automobiles may be wholly depreciated, it will just take much longer than five years

© 2003 South-Western College PublishingTransparency 7-25 Special First-Year Depreciation for Automobiles rExtra depreciation of $4,600 is allowed <New autos placed in service between 9/11/01 and 9/11/04 and 50% for business rThe $4,600 increases the luxury auto limit rMay use 30% Bonus depreciation in addition to regular depreciation

© 2003 South-Western College PublishingTransparency 7-26 Luxury Auto Example In July 2002, purchase a new automobile (5-year asset) for $50,000. The automobile was used 60% of the time for business. Calculation 30% Bonus depreciation (50,000 X.3)$15,000 Regular depreciation (50, ,000).2 7,000 Total$22,000 Times business use percentage 60% X.60 Possible depreciation$13,200 Luxury limitation 60% of ($3,060 + $4,600)$ 4,596 Total depreciation: $4,596

© 2003 South-Western College PublishingTransparency 7-27 Objective Know the tax treatment for goodwill and certain other intangible assets

© 2003 South-Western College PublishingTransparency 7-28 Intangible Assets rSection 197 intangible assets (see list in text) acquired by purchase may be amortized based on a 15-year period <Many intangible assets are excluded from Section 197 provisions, for example, may not depreciate internally generated assets like patent and copyright rMust allocate for partial year in year of acquisition rReport in separate section of Form 4562

© 2003 South-Western College PublishingTransparency 7-29 Objective Be able to determine whether parties are classified as related for tax purposes and understand the tax treatment of related party transactions

© 2003 South-Western College PublishingTransparency 7-30 Related Party Transactions rRelated parties are: 50% owner <Brother/sister corporations <Parent/subsidiary corporations <Family members Ùspouses, lineal descendants, siblings Ùalso used for purposes of calculating ownership in corporations r§267 disallows losses on sales between related parties <When property is later sold to an unrelated party, all previously disallowed losses may be taken against gain <§267 also applies to unpaid interest and expenses between related parties

© 2003 South-Western College PublishingTransparency 7-31 The End! My head hurts!