1. Chapter 7 Accounting Periods and Methods and Depreciation Income Tax Fundamentals 2012 Gerald E. Whittenburg & Martha Altus-Buller 2012 Cengage Learning

2. Learning Objectives  Determine different accounting periods and methods for tax periods  Understand concept of depreciation  Calculate depreciation using MACRS tables and identify when §179 election to expense may be applied  Apply listed property and luxury automobile limitations  Understand tax treatment of intangibles  Determine whether parties are considered related and how to treat related party transactions 2012 Cengage Learning

3. Accounting Periods  Rarely, a taxpayer’s tax year will differ from the calendar year  In a partnership  The 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 defined as partner with at least 5% share in profits or capital  If principal partners have different tax years, partnership generally required to use least aggregate deferral method Note: Partnerships don’t pay tax as an entity 2012 Cengage Learning

4. Accounting Periods  Partnerships/S-Corporations may elect to adopt a different fiscal tax year from the one prescribed on previous slide, but only o If entity can demonstrate that natural business cycle easily conforms to fiscal year other than calendar year Such as a golf course in Denver, CO (natural business cycle ends in October) Note: S-Corporations don’t pay tax as an entity 2012 Cengage Learning

5. Required Tax Payment  Even though S-Corporations and partnerships don’t pay tax, the entity must make an estimated payment if choosing to use a fiscal year-end different from calendar year-end ◦ Estimated taxes are calculated as Estimated deferral period taxable income x (Highest individual tax rate + 1%) ◦ Estimate deferral period taxable income by using average monthly income from preceding fiscal year 2012 Cengage Learning

6. Required Tax Payment Example Example San Juan River Expeditions Inc., an S-Corp, has taxable income of $360,000 for the year ended 9/30/11 with a three-month deferral period. The company made a $15,000 payment last year. What’s their current required tax payment? 2012 Cengage Learning

7. Solution Example San Juan River Expeditions Inc., an S-Corp, has taxable income of $360,000 for the year ended 9/30/11 with a three-month deferral period. The company made a $15,000 payment last year. What’s their current required tax payment? Solution The required tax payment = (Estimated taxable income in deferral period x 36%) - prior year’s tax payment Deferral period is 3 months (October – December) [($360,000/12) x 3 months] = $90,000 ($90,000 x 36%) = $32,400 ($32,400 - 15,000) = $17,400 estimated tax payment due in current year 2012 Cengage Learning

8. Tax Year for Personal Service Corporation  A Personal Service Corporation (PSC) is a corporation with shareholder-employee(s) who provide a personal service, such as architects or dentists  Generally, a PSC must adopt calendar year  However, 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 salaries deduction 2012 Cengage Learning See next slide

9. PSC Limit on Salaries Deduction  Purpose is to keep the PSC from deducting one year’s salary in first nine months  If salaries don’t remain constant, the PSC can only deduct pro rata amount ◦ Based on a required formula 2012 Cengage Learning

10. Short Period Taxable Income (TI)  If taxpayer has a short year (other than first or last year of operation), tax is calculated based on following example: °In 2011, Organic Dairy LLC changes from a calendar year to tax year ending 9/30. For the short period 1/1/11 – 9/30/11, Organic Dairy LLC’s taxable income = $20,000* Steps to calculate tax for the short period Annualize TI $20,000 x 12/9 = 26,667 Estimated 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 *Note: Calculations for short year TI requires special adjustments 2012 Cengage Learning

11. must use same method for tax & books Accounting Methods  There are three acceptable accounting methods for reporting taxable income ◦ 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 2012 Cengage Learning

12. Accounting Methods  Cash receipts/disbursements method ◦ This method most common for individuals ◦ Recognize income when cash actually or constructively received ◦ Recognize deduction in year of payment Exception - can’t deduct prepaid rent or interest ◦ Can’t use cash basis if taxpayer is a C corporation Partnership with a corporation as a partner Tax exempt trust with unrelated business income ◦ Doesn’t apply to certain organizations 2012 Cengage Learning

13. Accounting Methods (continued)  Accrual method ◦ Recognize income when earned and can be reasonably estimated ◦ Recognize deductions 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 2012 Cengage Learning

14. Depreciation  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 Report depreciation on Form 4562 2012 Cengage Learning

15. Depreciation Methods  Straight-line depreciation is easiest, for accounting purposes, and is calculated as (Cost of asset – salvage value)/Years in estimated life  Modified Accelerated Cost Recovery System (MACRS), for tax purposes, allows capital assets to be written off over a period identified in tax law ◦ Accelerated method used for all assets except real estate 2012 Cengage Learning

16. 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 Computers, cars and light trucks, R&D equipment, certain energy property and certain equipment ◦ 7 year Mostly business furniture and equipment and property with no ADR life *See Table 7.1 on page 7-9 for Asset Depreciation Ranges (ADR) for recovery periods for all classes of assets 2012 Cengage Learning

17. Calculating Depreciation for Personal Property  Depreciation is determined using IRS tables ◦ MACRS rates found in Table 7.2 on page 7-10 ◦ Rates multiplied by cost (salvage value not used in MACRS) ◦ Tables based on half-year convention  Means 1/2 year depreciation taken in year of acquisition and 1/2 year taken in final year  May elect to use tables based on straight-line instead (percentages in Table 7.3 on page 7-11) Note: Must use either MACRS or straight-line for all property in a given class placed in service during that year 2012 Cengage Learning

18. Using Tables – Personal Property 2012 Cengage Learning Example 1: On March 15, Ceramatech Co. purchased furniture for $180,000; what is the recovery period and depreciation? (assume no bonus depreciation taken) Use Table 1 to see it’s a 7-year asset Use Table 2 to get percentages Year 1: $180,000 x.1429 = $25,722 Year 2: $180,000 x.2449 = $44,082 Example 2: On February 3, Bad Boy Bling LLC bought a computer for $12,000; what is the recovery period and depreciation? (assume no bonus depreciation taken) Use Table 7.1 to see it’s a 5-year asset Use Table 7.2 to get percentages Year 1: $12,000 x.20 = $2,400 Year 2: $12,000 x.32 = $3,840

19. Mid-Quarter Convention  Mid-quarter convention is required if taxpayer purchases more than 40% 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) 2012 Cengage Learning

20. 100% Bonus Depreciation For property place in service after 9/8/10 and before 1/1/12  Additional depreciation immediately available  Applies only to new property for use in business  Amount = 100% of adjusted basis  May elect out of bonus (or chose to only use 50% bonus depreciation) if have current NOL or anticipate need for higher depreciation in future years 2012 Cengage Learning

21. Personal Property Depreciation Example Example Nicole purchases a cherry desk and executive chair for use in her engineering firm on July 16, 2011 for $8,150. What is her depreciation for 2011 using half-year convention and MACRS tables? 2012? (Assume Nicole didn’t take bonus depreciation as she anticipates higher income in subsequent years). How would 2011 depreciation change if she had taken 50% bonus depreciation? 2012 Cengage Learning

22. Solution Example Nicole purchases a cherry desk and executive chair for use in her engineering firm on July 16, 2011 for $8,150. What is her depreciation for 2011 using half-year convention and MACRS tables? 2012? (Assume Nicole didn’t take bonus depreciation as she assumes higher income in subsequent years). How would 2011 depreciation change if she had taken 50% bonus depreciation? Solution Using Table 1, we can see that business furniture has a 7-year life. Table 2 shows the percentages to use for recovery years 1 and 2; therefore 2011 depreciation = $1,165 ($8,150 x.1429) 2012 depreciation = $1,996 ($8,150 x.2449) If bonus depreciation were taken: 2011 depreciation = 50% bonus depreciation + MACRS % to remaining basis $8,150 x 50% = $4,075 bonus depreciation $4,075 x.1429 = $582 MACRS depreciation Total depreciation = $4,657 ($4,075 + $582) 2012 Cengage Learning $8,150 X 50% = $4,075 remaining depreciable basis

23. Real Estate  Real assets depreciated based on a recovery period – 2 types of real property o 27.5 years Residential real estate o 39 years Nonresidential real estate o Real assets are depreciated using the straight-line method with a mid-month convention  Mid-month convention assumes all purchases made in middle of month  Used for real estate acquired after 1986  Rates found on Table 7.4 on page 7-13 Note: Different rates apply for real property acquired before 1981 and after 1980 but before 1987 2012 Cengage Learning

24. Real Estate Example Example Gwen purchased a residential tri-plex on 8/1/11 for $290,000 (including land cost of $50,000). What is her depreciation for 2011? 2012? 2012 Cengage Learning

25. Solution Example Gwen purchased a residential tri-plex on 8/1/11 for $290,000 (including land cost of $50,000). What is her depreciation for 2011? 2012? Solution Since land is not depreciable, only $240,000 may be multiplied by percentages from Table 7.4 on page 7-13 (27.5-year residential real property). The purchase occurred in the eighth month; therefore, depreciation equals 2011 $240,000 x 1.364% = $3,274 2012 $240,000 x 3.636% = $8,726 2012 Cengage Learning

26. Election to Expense - §179  §179 allows immediate expensing of qualifying property ◦ For 2011, the annual amount allowed is $500,000 ◦ Qualifying property is tangible personal property used in a business – can be new or used  §179 election to expense is limited by 2 things ◦ If cost of qualifying property placed in service in a year > $2,000,000, then reduce §179 expense dollar for dollar  For example, if assets purchased in current year = $2.1 million, taxpayer must reduce §179 by $100,000. Therefore, election to expense is limited to = $400,000 ($500,000 – 100,000). The remaining $1.7 million of basis is depreciated over assets’ useful lives (including bonus depreciation) if applicable. ◦ Cannot take §179 expense in excess of taxable income  New law allows up to $250,000 to be taken to §179 for certain rental and leasehold improvements and restaurant properties 2012 Cengage Learning

27. Election to Expense - §179  When using with regular MACRS, take §179 first, then reduce basis to calculate bonus depreciation, then reduce basis to calculate MACRS  For example ◦ In 2011, NanoPaint Inc.’s taxable income = $1.25 million. They placed a 7-year piece of property into service costing $842,000 – it was their only asset purchase in 2011. What is total depreciation, including election to expense? ◦ Assuming no bonus depreciation will be claimed (a) first take $500,000 deduction under §179 (b) reduced basis of $342,000 is multiplied by.1429 from MACRS tables  Total depreciation and Section 179 = $548,872 ($500,000 + (342,000 x.1429) 2012 Cengage Learning

28. §179 Example 2012 Cengage Learning Example On 7/11/11, O’Neill Machinery LLC purchases a used tooling machine (7-year asset) for $659,000. The taxable income from the business is $1,445,500. What is the company’s total depreciation deduction for the current year, including §179 and MACRS?

29. Solution Example On 7/11/11, O’Neill Machinery LLC purchases a used tooling machine (7-year asset) for $659,000. The taxable income from the business is $1,445,500. What is the company’s total depreciation deduction for the current year, including §179 and MACRS? Solution Asset purchases didn’t exceed $2,000,000 and doesn’t exceed TI, so no reduction in §179 required: Cost$659,000 §179 expense ( 500,000) Adjusted depreciable basis $159,000 x Table %.1429 MACRS $ 22,721 Note: Can’t take bonus depreciation since it’s used property; Total depreciation equivalent to $500,000 + 22,721 = $522,721 2012 Cengage Learning

30. Listed Property  Special rules exist to limit deductions on assets that lend themselves to personal use, called ‘listed property’ ◦ Cars and trucks/vans under 6000 lbs. gross vehicle weight with specific exclusions ◦ Computers (unless used exclusively at business) ◦ Equipment used for entertainment, recreation or amusement  If asset used <= 50% for business (or if business use falls below 50% in subsequent years) must use straight-line and election to expense not allowed  If asset used > 50% for business, must use MACRS  Separate section (Part V) on page 2 of Form 4562 2012 Cengage Learning

31. Luxury Auto Limitations  IRS limits annual depreciation expense that may be claimed on passenger auto  Maximum allowed amount is luxury auto limits x business use %  Luxury auto limits are quite low ◦ Annual depreciation limit on ‘luxury’ autos placed into service in 2011 are as follows  2011 - $3,060 (or $11,060 if taking bonus depreciation * )  2012 - $4,900  2013 - $2,950  2014 and subsequent years - $1,775 *Only allowed if used more than 50% in business and purchased new during 2011 2012 Cengage Learning

32. Exception to Luxury Auto Limitations  Passenger auto includes any 4-wheeled vehicle manufactured primarily for use on public streets and weighing less than 6000 lbs. ◦ Some SUVs weigh more than 6000 lbs. and so can be expensed under §179 ◦ Beginning 10/22/04, could ‘only’ expense $25,000 and then depreciate remainder using five year MACRS percentages ◦ In 2011, these SUVs qualify for 100% bonus depreciation 2012 Cengage Learning

33. Luxury Auto Example Example On 3/15/11, Jim purchased a new automobile for $50,000; it is a passenger auto weighing less than 6000 lb. The automobile is used 60% for business and Jim wants to know how much depreciation to claim if he elects out of the bonus depreciation rules. What if he chooses the bonus depreciation? What if the vehicle weighed more than 6000 lbs? 2012 Cengage Learning

34. Solution Example On 3/15/11, Jim purchased a new automobile for $50,000; it is a passenger auto weighing less than 6000 lb. The automobile was used 60% for business and Jim wants to know how much depreciation to claim if he elects out of the bonus depreciation rules. What if he does take bonus depreciation? What if the car weighs more than 6000 lbs? Solution Regular depreciation ($50,000 x 20%) 10,000 Times business use percentage 60% X.60 Possible depreciation 6,000 “Luxury auto” limitation (60% of $3,060) $ 1,836 If Jim elects bonus depreciation, gets Bonus depreciation 11,060 Times business use percentage 60%.60 Depreciation $ 6,636 A vehicle weighing more than 6000 lbs. could be fully expensed in year of purchase under §179. Depreciation = $50,000 x 60% = $30,000 2012 Cengage Learning

35. Intangible Assets  §197 intangible assets are acquired by purchase ◦ Amortized over 15-years beginning in month acquired, includes assets such as  Goodwill (value attributable to expected continuation of customers’ patronage)  Covenant not to compete  Franchise or trademark ◦ Many intangible assets are excluded from §197  May not amortize self created assets like patents and copyrights 2012 Cengage Learning

36. Amortization Example Example FionaWear Inc. purchased a small textile company in May 2011 for $980,000. $54,000 of the purchase price was allocated to goodwill in the buy-sell agreement. How much goodwill may FionaWear amortize in 2011? 2012 Cengage Learning

37. Solution Example FionaWear Inc. purchased a small textile company in May 2011 for $980,000. $54,000 of the purchase price was allocated to goodwill in the buy-sell agreement. How much goodwill may FionaWear amortize in 2011? Solution $54,000/15 years = $3,600/12 months = $300 per month §197 amortization $300 x 8 months = $2,400 2012 Cengage Learning

38. Related Party Transactions §267  Restricted transaction between related parties include ◦ Recognizing losses on sales between related parties ◦ One accrual basis and one cash basis taxpayer as pertains to expensing unpaid expenses and interest  Related parties are: ◦ Family members such as spouses, lineal descendants, siblings ◦ A corporation and more than 50% owner ◦ Brother/sister corporations ◦ Parent/subsidiary corporations ◦ Complex ‘constructive ownership’ rules 2012 Cengage Learning

39. Related Party Transactions §267  Losses disallowed between related parties ◦ When property sold later to an unrelated party, all previously disallowed losses may be taken against gain  May not avoid tax when one taxpayer uses cash method for expenses and interest and the other taxpayer uses accrual method 2012 Cengage Learning

40. The End! 2012 Cengage Learning My head hurts!