McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 08 Business Income, Deductions, and Accounting Methods

8-2 Learning Objectives 1) Describe the general requirements for deducting business expenses and identify common business deductions. 2) Apply the limitations on business deductions to distinguish between deductible and nondeductible business expenses. 3) Identify and explain special business deductions specifically permitted under the tax laws. 4) Explain the concept of an accounting period and describe accounting periods available to businesses. 5) Identify and describe accounting methods available to businesses and apply tax accrual methods to determine business income and expense deductions.

8-3 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 – not a business deduction. 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.

8-4 Statutory limits on business expense deductions 1. Expenses against public policy No deduction for fines, bribes, lobby expenditures, or political contributions 2. 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. 3. Capital expenditures 4. Personal expenses

8-5 Capital expenditures Answer the accounting question – does the expenditure provide future benefits (beyond this year)? If so, then 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.

8-6 Specifically authorized business deductions Start-up expenditures Capitalize and elect to expense/amortize Bad debts Accrual taxpayers can use direct write off only Cash basis taxpayers have no deduction Losses on disposition of business assets Sales or exchanges for recognized losses Casualty loss is limited to lesser of decline in value (repair cost) or basis Basis is amount of loss if business asset is completely destroyed

8-7 Domestic production activities deduction (DPAD) An “artificial” deduction that subsidizes domestic manufacturing. Domestic production of tangible products qualifies for subsidy for income must 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.

8-8 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). Uniforms (not adaptable to ordinary use). 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, meals and entertainment, mixed use assets

8-9 Accounting for taxable income We’ve learned to identify: Business gross income and Deductible expenses Now we need to match these flows to a specific period. Accounting periods determine beginning and end of accounting cycle. Accounting methods match income and expense to a specific period.

8-10 Accounting periods Annual period 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.  Example: last Friday in June.

8-11 Choosing an accounting period Proprietorships – same as proprietor. Prevents mismatch of income. “C” corporations and individuals – choice made on first tax return for those with books. Flow-thru entities – a “required” tax year. Partnerships, “S” corporations, LLCs and other hybrid entitles. Match to owners’ period (multiple owners for partnerships so this can be complicated).

8-12 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. Objective of Congress is to maximize tax revenues. More likely to recognize income and defer losses and expenses.

8-13 Accounting methods 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. Proprietorships can use either cash or accrual. Other flow-thru entities also typically have choice. “C” corporations must typically use accrual.

8-14 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).

8-15 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: Completes service or sale Payment is due Payment is received

8-16 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 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.

8-17 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. If sales are not material or taxpayer is “small”, then goods are expensed as “supplies.” Cash method taxpayers may use cash method for other (non-inventory) accounts. Technique is called the “hybrid” method.

8-18 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).

8-19 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

8-20 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. and 2. Economic performance has occurred. Mere liability is NOT ENOUGH!

8-21 Economic performance Taxpayer liable for providing goods or services? Performance occurs as taxpayer provides goods or services. Taxpayer liable for using property or goods? Performance occurs as goods are provided or economic performance is otherwise expected within 3 ½ months of payment. Payment liabilities (rebates, warranty costs, tort claims, and taxes) are performed only when paid. Interest and rent occurs ratably.

8-22 Choosing or changing an accounting method Accounting methods are generally adopted via 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 permission of the IRS. a business purpose is critical - not tax avoidance. Some changes are automatic. Permission is necessary to correct the use of an impermissible method.