Chapter 7 Accounting Periods & Methods & Depreciation

1. Chapter 7Accounting Periods & Methods & Depreciation Income Tax Fundamentals 2010 Gerald E. Whittenburg & Martha Altus-Buller Student Copy 2010 Cengage Learning

2. Accounting Periods • Partnerships/S-Corporations may elect to adopt a different fiscal tax year from the one prescribed on previous slide, but only • If entity can demonstrate that natural business cycle easily conforms to fiscal year other than calendar year • Such as golf course (natural cycle in Denver ends in October) Note: S-Corporations don’t pay tax as an entity 2010 Cengage Learning

3. Tax Year for Personal Service Corporation • A Personal Service Corporation (PSC) is a corporation with shareholder-employee(s) whom provide a personal service, such as architects or dentists • Generally 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 See next slide 2010 Cengage Learning

4. Short Period Taxable Income (TI) • If taxpayer has a short year (other than first/last year of operation), tax is calculated based on following example: • In 2009, Flo-Mex changes from a calendar year to tax year ending 9/30. For the short period 1/1/09 – 9/30/09, Flo-Mex’s taxable income = $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 *Chapter 1, page 1-3 2010 Cengage Learning

5. 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 must use same method for tax & books 2010 Cengage Learning

6. 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 2010 Cengage Learning

7. 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 Complete Form 4562 to reflect depreciation 2010 Cengage Learning

8. 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 & certain equipment • 7 year Mostly business furniture & equipment & property with no ADR life *See Table 1 for Asset Depreciation Ranges (ADR) for all classes of assets 2010 Cengage Learning

9. Calculating Depreciation for Personal Property • Depreciation is determined using IRS tables • Table 2 • Salvage value not used in MACRS • Tables based on half-year convention • That 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 • Must use either MACRS or straight-line for all property in a given class placed in service during that year 2010 Cengage Learning

10. 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) 2010 Cengage Learning

11. 50% Bonus Depreciation Reinstated for two years only (2008-2009) • Additional depreciation is available for assets purchased in 2008-2009 • Available for assets with recovery period of twenty years or less plus computer software, leasehold improvements and water utility property • Amount = 50% of adjusted basis • Take 50% bonus first, then regular MACRS depreciation on remaining basis • May elect out of bonus if anticipate need for higher depreciation in future years 2010 Cengage Learning

12. 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 • Mid-month convention assumes all • Used for real estate acquired after 1986 • 27.5 years Residential rental • 39 years Nonresidential 2010 Cengage Learning

13. Election to Expense - §179 • §179 allows immediate expensing of qualifying property • For 2009, the annual amount allowed is $250,000 • Qualifying property is tangible personal property used in a business • But not real estate or property used in residential real estate rental business • §179 election to expense is limited by 2 things • If cost of qualifying property placed in service in a year > $800,000, then reduce §179 expense dollar for dollar • For example, if assets purchased in current year = $900,000 taxpayer must reduce §179 by $100,000. Therefore, election to expense is limited to = $150,000 ($250,000 – 100,000). The remaining $750,000 of basis is depreciated over assets’ useful lives. • Cannot take §179 expense in excess of taxable income 2010 Cengage Learning

14. Election to Expense - §179 • When using with regular MACRS, take §179 first, then reduce basis to calculate MACRS • For example • In 2009, NanoPaint Inc.’s taxable income = $1.25 million. They placed a 7-year piece of property into service costing $342,000 – it was their only asset purchase in 2009. What is total depreciation, including election to expense? • Assuming bonus depreciation not claimed – first take $250,000 deduction under §179, reduce basis to $92,000, then multiply by .1429 from MACRS tables • Total depreciation expense = $263,147 ($250,000) + ($92,000 x .1429) 2010 Cengage Learning