1. Chapter 5 Taxable Income from Business Operations McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., All Rights Reserved.

2. Objectives Describe how taxable year relates to operating cycle
Identify tax methods of accounting
Explain why tax policy affects the computation of taxes
Apply the cash method to compute taxable income
GAAP conservatism versus tax conservatism
Book-tax permanent and temporary income differences
Explain the difference between tax expense per books and tax payable.
Accrual basis exceptions for prepaid income and accrued expenses
Net Operating Losses (NOLs)

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

4. Taxable Income Good rule of thumb:
Receipts are taxable UNLESS you can find a law that says the receipt is excluded.
Expenses are deductible ONLY if you can find a law that says the expense is deductible.

5. Taxable Year
A taxable year is generally a 12-month period which corresponds to a firm’s fiscal year.
Individual taxpayers must generally choose a calendar year.
Firms generally choose a year = end of an annual operating cycle.

6. Question 1:
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

7. Taxable Year
A new business establishes it’s taxable year by filing an initial tax return based on such a year.
Changing tax years requires permission of the IRS.
Because of the change, the first return 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.

8. 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 has income of $25,000.
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].

9. Tax Methods of Accounting
A tax method is an overall method by which taxpayers determine their income, deductions and credits, as well as the time realized and recognized.
The Internal Revenue Code (IRC) permits firms to use the following methods:
Cash
Accrual
Combined (hybrid)

10. Tax Methods of Accounting
Section 482 grants IRS broad powers to “distribute, apportion, or allocate income” among businesses to CLEARLY REFLECT income of each.
This is a BIG issue in multi-jurisdictional taxation.
This will be addressed in Ch. 12.

11. Taxable Methods of Accounting - Other policy objectives
Public policy
no deduction for fines, political contributions
Why?
Congress does not want to subsidize bad behavior with a tax deduction or finance the
lobbying efforts of special interest groups.
Limits on meal and entertainment expenses; only 50% deductible
Lavish meals and entertainment involve more pleasure than business and should not be subsidized with federal tax dollars.

12. Taxable Methods of Accounting - Other policy objectives
Economic incentives
State and local bond interest income is exempt. (Likewise, related expenses are nondeductible).
Why?
To help local governments raise funds by lowering the effective cost of debt.
Businesses can write-off equipment faster for tax purposes than GAAP useful life.
To encourage firms to replace equipment often which helps businesses maintain a competitive edge.

13. 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.

14. Cash Method
A taxpayer receives “free” automobile repair work in exchange for preparing the mechanic’s tax return.
Does income need to be recognized if the taxpayer uses the accrual method of tax accounting?
Yes. Services have been provided and income has been earned.
What if the taxpayer uses the cash method of accounting?
Yes. Cash method income includes the receipt of non-cash goods.

15. 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 amount is available only on surrender of a valuable right, or if there are substantial limits on the right to receive it.

16. Cash Method Income
A calendar-year, cash-basis firm would like to defer income from the current year to the following year. Can it defer recognizing income this year if:
The company holds the checks received from its customers in December in its vault and does not cash them until January?
No. The income has been constructively received.

17. Cash Method Deductions
Cash method - deduct expenses when PAID. A check is payment when 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.

18. Cash Method Deductions – Capital Assets
If an expenditure results in a benefit that extends beyond 12 months, a capital asset exists.
The cost of the asset may be recovered over the asset life (e.g. through depreciation or cost of goods sold).
Major repairs may result in a dispute with the IRS regarding taking a current year deduction versus capitalization.

19. Cash Method Deductions - Inventory
Inventory must be accounted for on the accrual method, even for cash basis taxpayers.
This is called a hybrid method of accounting.
Under this method, purchases and sales of inventories are accounted for under the accrual method and all other transactions under the cash method.

20. Cash Method Deductions - Prepaid Expenses
Generally when an expense is prepaid, the total payment is considered to be income to the recipient in the year it is received.
More on this later…

21. Limitations on Corporations Using Cash Method
Corporations that average more than $5 million in annual gross receipts cannot use the cash method.
Service firms can have up to $10 million of average annual gross receipts before they must use accrual method.
However, personal service corporations (professional services like medical, legal, accounting) of any size may still use the cash method.

22. Accrual Method of Tax Accounting
Under the accrual method, taxpayers report income when the right to the income and the amount of the income can be determined with reasonable accuracy (i.e., when realization occurs).
In addition, expenses are matched against revenues. Expenses are deducted when ALL EVENTS have occurred that determine the existence of the liability and the amount of the liability can be determined with reasonable accuracy.

23. Book-Tax Differences
Financial Accounting and Tax Accounting exhibit 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.
However, a contrasting result may arise due to economic incentives - e.g. accelerated depreciation.

24. Book-Tax Permanent Differences
Permanent differences do not reverse in future time periods; Temporary differences reverse over the life of the firm.
Examples of permanent non-deductible expenses
50% meals and entertainment
political contributions
fines and penalties
interest expense to generate tax-exempt municipal bond income
premiums on life insurance

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 of temporary differences:
Depreciation
Timing of accruals
Capital losses
Bad debts (allowance vs. direct write-off)
Cash versus accrual accounting

26. GAAP Tax Expense Versus Tax Payable
GAAP current tax expense = tax on taxable income.
GAAP deferred tax expense = the tax effect of temporary differences reversing in the future.
Total tax expense per books (SFAS109) = current +/- deferred tax expense.
In simple situations (APB11)
Pre-tax book income + / - permanent differences = adjusted book income x tax rate; less credits = Total tax expense per books (same # as SFAS 109).

27. Book – Tax Differences
ABC Company earns $100,000 in operating income during the year and it receives $2,000 in municipal bond interest. ABC Company buys an asset for $20,000 which it completely expenses under the tax law but which it straight-line depreciates for four years under GAAP. Assume a stable 35% tax rate. What is the total tax expense per the books per SFAS 109?

28. GAAP Tax Expense Versus Tax Payable
GAAP current tax expense = $100,000 operating income less $20,000 Section 179 expense = $80,000 taxable income x .35 = $28,000
GAAP deferred tax expense = ($5,000 annual depreciation x 3 years) = $15,000 x .35 = $5,250
Total tax expense per books (SFAS 109) = $28,000 + $5,250 = $33,250
Or Pre-tax book income ($100, ,000 – 5,000) – permanent difference ($2,000) = $95,000
x .35 = $33,250 (APB11)

29. Temporary Differences: Prepaid Income
Prepaid income is taxed when received under the Claim of Right Doctrine
The government has the right to tax income when the taxpayer has the unrestricted right to use such income amounts.
However, when a prepaid expense (e.g., rent or insurance) covers more than the following tax year, the deduction must be spread over the tax years to which the expense applies.

30. Prepaid Expenses Example
Cheryl moves into a new apartment on December 1st. She pays $650 for December’s rent and an additional $650 for last month’s rent on a two-year lease.
How much income will the landlord recognize in the current year if he uses the accrual method?
$650 for December’s rent
The cash method?
$1,300 for December and last month’s rents

31. Temporary Differences: Prepaid Services
Advance payments received for services to be performed must be reported by an accrual basis taxpayer in the year received.
Exception: A taxpayer can elect to defer advance payments over the period services are performed if they are received under an agreement requiring all the services to be performed by the end of the following tax year.

32. Accrued Expenses, All Events Test
The tax law allows a deduction for an accrued expense only if it meets the All Events Test:
1) All events that establish the liability have already occurred, and
2) The amount must be determinable with reasonable accuracy.
If an accrued expense meets these two requirements and is a recurring item that the firm treats in a consistent manner every year, the expense is deductible in the current year.

33. Accrued Expenses – Economic Performance
The Economic Performance requirement delays the deduction until payment is made (like the cash basis) for:
legal settlements (tort, contract breach, violating law),
customer rebates/refunds,
awards, prizes,
state income taxes.

34. Accrued Expenses ABC Company has two accruals at year end:
December’s utility bill to be paid in 30 days
Customer rebate checks to be issued during the 1st quarter of the new year.
Which accrual(s) can be deducted on the current year tax return?
Only the accrual for utilities

35. Accrual Expenses Exceptions
Related Party Accruals
The paying party cannot deduct an expense until the year that a receiving party recognizes the income.
This rule prevents accrual basis taxpayers from accruing an expense but delaying payment.
Bad Debts
GAAP requires the allowance method.
For tax purposes, the direct write-off method is required.
The taxpayer will record income if the account is repaid later.

36. Summary Cash vs Accrual

37. Net Operating Losses (NOL)
If operations result in an excess of deductible expenses over gross income, a NOL results.
A problem exists as excess deductions yield no current tax savings. This problem arises due to artificial time divisions (years).

38. Net Operating Losses (NOL)
The Solution: carryback the NOL 2 years, carryforward 20 years.
If the NOL is carried back to prior years, the taxpayer enjoys the tax savings immediately in the form of a cash refund.
If carried forward, the NOL deduction becomes less valuable the longer the time period over which it is deducted.

39. Net Operating Losses (NOL)
GAAP now allows firms to record a tax benefit for the expected value of future NOL deductions as a deferred tax asset.
The taxpayer may elect to FOREGO CARRYBACK and carryforward only.
This might increase the net present value of the tax benefit if the taxpayer expects a sufficiently higher tax rate in the future.