1. Business Income, Deductions, and Accounting Methods
Chapter 9
Business Income, Deductions, and Accounting Methods

2. 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
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
Note that hobbies are not businesses.
Personal activity that may generate revenue.
Taxpayer generally has burden of proving their intent to make a profit.
Specific factors listed in regulations such as:
History of income or loss
Elements of personal pleasure or recreation
Deductions only allowed to extent of revenue.

3. Reasonableness Example
Rick owns a business that employs his brother, Ben. Ben is paid $45,000 per year by Rick’s business.
In comparison, other employees with Ben’s responsibilities are only paid $30,000 per year.
What is Rick’s business deduction for employing Ben?

4. Reasonableness Solution
A reasonable amount for compensating Ben is $30,000 rather than $45,000.
Hence, Rick can only deduct $30,000.
The extra $15,000 ($45,000 paid minus $30,000 deduction) is a gift from Rick to Ben.

5. Statutory Limits on Business Expense Deductions
Expenditures against Public Policy
No deduction for fines, bribes, lobby expenditures, or political contributions
Expenses Relating to Tax-Exempt Income
Interest on loan where proceeds invested in municipal bonds. Interest must be related to taxable income.
Key employee insurance premiums—no deduction if business is beneficiary of life insurance
Capital Expenditures
Personal Expenditures

6. Capital Expenditures
Does the expenditure provide future benefit (beyond this year)?
If so, 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 expense

7. 12-month Rule Example
Ben, a cash basis taxpayer, makes the following payments on June 30 of this year:
$10,000 for the next 10 months of utilities.
$12,000 for insurance over the next 24 months.
$9,600 for the next 8 months of interest on a business loan.
What amounts are deductible this year?

8. 12-month Rule Solution
Ben can deduct all $10,000 for the utilities because:
The benefit does not exceed 12 months and
The benefit ends prior to the end of next year.
Ben can deduct $3,000 for insurance because:
The benefit exceeds 12 months. Hence, Ben can only deduct 6 months in this year ($500 per month).
Ben can deduct $7,200 for interest because:
The 12-month rule does not apply to interest.

9. Special Business Deductions
Losses on Disposition of Business Property
Recognized losses are deductible
Casualty losses are limited to lesser of decline in value (repair cost) or basis
Basis is amount of loss if business asset is completely destroyed
Bad debts are discussed in two places—once in front and more details near the end of the chapter. It is important to note that cash basis taxpayers have NO accounts receivable so there is no bad debt deduction.
It might also be noted that in contrast to bad debts, cash basis taxpayers can deduct bad loans—they have basis in these assets. However, this brings up whether a loan is a business loan (ordinary) or nonbusiness (short-term capital). Best to save this discussion for capital assets.
Business losses are also rather complex (e.g., section 1231 treatment)—this chapter merely serves to introduce the notion that business losses are deductible rather than to discuss the nature of the deduction.

10. 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)
Business travel (away from home overnight)
Otherwise, allocate deduction to business portion
Arbitrary percentage (50% meals and entertainment)
Basis for allocation (mileage or time)
Record keeping
Document business purpose

11. Travel Example
Ben paid the following to attend a business meeting in Chicago:
Airfare (first class) - $ 1,200
Hotel (three nights) - $ 750
Meals (three days) - $ 270
What amounts are deductible if Ben spent two days in meetings (primarily business)?
What amounts are deductible if Ben spent one day in a meeting (primarily personal)?

12. Travel Solution Ben can deduct the following amounts:
Primarily Primarily business personal
Airfare (all or none) $ 1, $
Hotel ($250 per day)
Meals ($90 per day × 50%)
Total Travel Deduction $ 1, $ 295
Note that the time spent on an activity may not be conclusive for the primary purpose—a question of fact and circumstance.

13. Accounting for Taxable Income
We’ve learned to identify
Business gross income
Deductible expenses
Now we need to match income and deductions to a specific period
Accounting methods match income and expense to a specific period

14. Accounting Periods Annual period Year-ends
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
Note that the 52/53 week can facilitate closing of books.

15. Choosing an Accounting Period
Proprietorships—same as proprietor
C corporations and individuals—choice made on first tax return and is consistent with book accounting period
Flow-through entities—a “required” tax year
Match to owners’ period (multiple owners for partnerships so this can be complicated)
Note that the first year for most fiscal year entities are typically short years.
Note that some exceptions are skipped—the “natural” business year-end and the deferral year-end.

16. Accounting Methods Financial and Tax Accounting Methods
Financial accounting is “conservative”
GAAP is slow to recognize income, but quick to recognize losses or expenses
Objective is to avoid misleading investors and creditors
Tax accounting is much less conservative
Quick to recognize income but likely to defer deductions.
Objective of Congress is to maximize tax revenues

17. Accounting Methods (2) 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
Large corporations must use accrual

18. 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)

19. 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:
Complete service or sale
Payment is due
Payment is received

20. 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 to 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

21. Advance Payment Example
Ben provides dancing lessons. On September 30 of this year he received $2,400 full payment for a 2-year service contract.
What amount of income must Ben recognize
if he is on the cash method?
if he is on the accrual method?

22. Advance Payment Solution
If Ben uses the cash method, he must recognize income as received—$2,400 this year.
If Ben uses the accrual method, then he can elect to defer advances for services for a year.
This year Ben would recognize $300—the income earned from September 30 (3/24 × $2,400).
Next year Ben would recognize the remaining $2,100—income can only be deferred one year.

23. 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
Cash-method taxpayers may use cash method for other (non-inventory) accounts
Technique is called the “hybrid” method

24. UNICAP Indirect costs are allocated to inventories (not expensed)
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)

25. 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
The most famous method: SWAG
We skip a discussion of inventory flows here, but a slide may be added if students are confused.