Chapter 7 Accounting Periods & Methods & Depreciation Income Tax Fundamentals 2008 Gerald E. Whittenburg & Martha Altus-Buller Student’s Copy

©2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Accounting Periods  Problem when taxpayer’s tax year differs from calendar year – quite rare Partnerships don’t pay tax as an entity  Tax year must be the same tax year as 50% of partners  If majority of partners’ tax years are different, must use tax year of principal partners Principal partner is partner with at least 5% share in profits or capital  If principal partners have different tax years, partners required to use least aggregate deferral method (see pp. 7-2 – 7-3)

©2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Tax Year for Personal Service Corporation  A Personal Service Corporation (PSC) is a corporation with shareholder-employees whom provide a personal service For example, architects or dentists  Generally must adopt calendar year  Can adopt a fiscal year if Can prove business purpose or Fiscal year results in a deferral period of less than 3 months and  Shareholders’ salaries for deferral period are proportionate to salaries received during rest of the period or  Corporation limits its deduction [see next slide]

©2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Short Period Taxable Income  If taxpayer has a short year [other than first/last year of operation], tax calculated based on following example:  Example: In 2007, Fed-Mex changes from a calendar year to tax year ending 9/30. For the short period 1/1/07 – 9/30/07, Fed-Mex’s TI = $20,000. Calculate tax for the short period  Annualize TI 20,000 x 12/9 = 26,667  Tax on annualized TI 26,667 x 15% = 4,000  Allocate tax to short period 4,000 x 9/12 = $3,000  Individual taxpayers rarely change tax years

©2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. must use same method for tax & books Accounting Methods  There are three acceptable accounting methods for reporting taxable income [TI] Cash Hybrid Accrual  Must use one method consistently Make an election on your first return by filing using a particular method Must obtain permission from IRS to change accounting methods

©2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Accounting Methods [continued]  Accrual method Recognize income when earned and can be reasonably estimated Recognize deduction when incurred and can be reasonably estimated  Hybrid method An example of a hybrid taxpayer is one that utilizes cash method for receipts and disbursements, but accrual for cost of products sold

©2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Depreciation [Form 4562]  Depreciation is a process of allocating and deducting the cost of assets over their useful lives Does not mean devaluation of asset Land is not depreciated  Maintenance vs. depreciation Maintenance expenses are incurred to keep asset in good operating order Depreciation refers to deducting part of the original cost of the asset

©2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Personal Property Recovery Periods  With MACRS, each asset is depreciated according to an IRS-specified recovery period 3 year ADR* midpoint of 4 years or less 5 year Computer, cars and light trucks, R&D equipment, certain energy property & certain equipment 7 year Mostly business furniture and equipment and property with no ADR life *See book for Asset Depreciation Range [ADR] classifications

©2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Personal Property  Depreciation is determined using IRS tables Table 2 on p. 7-9 Salvage value not used in MACRS Tables based on half-year convention  1/2 year depreciation taken in year of acquisition  1/2 year depreciation taken in final year  May elect to use tables based on straight-line instead Table 3 on p  Must use either MACRS or straight-line for all property in a given class placed in service during that year

©2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Mid-Quarter Convention  Mid-quarter convention is required if taxpayer purchases 40% or more of total assets (except real estate) in the last quarter of tax year Must apply this convention to every asset purchased in the year Excludes real property and §179 property Must use special mid-quarter tables  Found at major tax service such as Commerce Clearing House [CCH] or Research Institute of America [RIA]

©2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Real Estate  Real assets depreciated based on a recovery period depending on type of property Real assets are depreciated using the straight-line method with a mid-month convention (Table 4 on p. 7-12) Used for real estate acquired after 1986  Treats all acquisitions/dispositions as occurring mid-month [mid-month convention]  27.5 years: Residential rental  39 years: Nonresidential

©2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Election to Expense - §179  §179 allows immediate expensing of qualifying property For 2007, the annual amount allowed is $125,000 Qualifying property is tangible personal property used in a business  But not real estate or off-the-shelf computer software  §179 election to expense is limited by 2 things If cost of qualifying property placed in service in a year > $500,000, then reduce §179 expense $ for $  For example, if assets purchased in current year = $600,000, then $100,000 reduction in §179 capability so limited to $125,000 – 100,000 = $25,000 election to expense and the remaining 575,000 of basis is depreciated over assets’ useful lives. Cannot take §179 expense in excess of taxable income - may carry forward any unused amount

©2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Election to Expense - §179  When using with regular MACRS, take §179 first, then reduce basis to calculate MACRS  For example In 2007, NanoPaint Inc. placed a seven-year piece of property into service costing $142,000 when taxable income = $1.25 million. Total asset purchases = $217,000. What is total depreciation including election to expense? First – claim $125,000 deduction under §179, reduce basis to $17,000, then multiply by 14.29% MACRS rate  [125,000] + [17,000 x 14.29%] = $127,429 total