©2015, College for Financial Planning, all rights reserved. Session 4 Tax Accounting, Sole Proprietorships and Partnerships CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAM Income Tax Planning

Session Details Module2 Chapter(s)1 -3 LOs2-1 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. 4-2

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” 4-3

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. 4-4

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 4-5

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 4-6

Inventory Valuation Last-In, First-Out (LIFO) 4-7 Advantages over FIFO Increases COGS 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) 4-8 Advantages In times of declining prices, matches higher-priced inventory items against revenues Ending inventory figure represents current cost (replacement) figure Higher earnings figure in time of inflation Disadvantages Higher earnings figure in inflationary times results in greater tax liability

Sole Proprietorship 4-9 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

General 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 Losses deductible only to extent of basis in partnership Basis = cash plus adjusted basis of property contributed plus share of debt, plus flow-through of income minus flow-through of losses and distributions Partners liable for self-employment tax 4-10

Limited Partnerships 4-11 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

Self-Employed Health Insurance Above the line deduction Sole prop, partner, >2% shareholder in S corp. No effect on SE income Health insurance and qualified LTC premiums Taxpayer, spouse, and children through age 26 Limitations o No participation in subsidized plan o Limited to business earned income o Plan must be in business name (unless sole proprietorship) 4-12

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. 4-13

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. 4-14

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. 4-15

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. 4-16

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 4-17

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. 4-18

©2015, College for Financial Planning, all rights reserved. Session 4 End of Slides CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAM Income Tax Planning