Business Income, Deductions, and Accounting Methods

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

2. Learning Objectives • Describe the general requirements for deducting business expenses and identify common business deductions. • Apply the limitations on business deductions to distinguish between deductible and nondeductible business expenses. • Identify and explain special business deductions specifically permitted under the tax laws. • Explain the concept of an accounting period and describe accounting periods available to businesses. • Identify and describe accounting methods available to businesses and apply cash and accrual methods to determine business income and expense deductions.

3. 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

4. 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?

5. 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.

6. Statutory Limits on Business Expense Deductions • Expenses 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 • Key man insurance premiums – no deduction if business is beneficiary of life insurance • Capital expenditures • Personal expenses

7. 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

8. 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?

9. 12-Month Rule Solution Ben can deduct all $10,000 for the utilities because: the benefit is not more than 12 months and the benefit ends prior to theend of next year. Ben can deduct $3,000 for insurance because: the payment is more than 12 months. Hence, Ben can only deduct 6 months ($500 per month). Ben can deduct $7,200 for interest because: the 12-month rule does not apply to interest.

10. Special Business Deductions • Losses on disposition of business assets • 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

11. Domestic Production Activities Deduction (DPAD) • An “artificial” deduction that subsidizes domestic manufacturing • Domestic production of tangible products qualifies for subsidy but income must be allocated between qualifying and nonqualifying activities • Subsidy is percentage (9 percent) of the lesser of qualified production activities income (QPAI) or modified AGI • Formula: • QPAI = domestic production gross receipts less expenses attributed to domestic production • Deduction is ultimately limited to 50% of wages allocated to qualified activities

12. DPAD Example Brian recorded $100,000 of receipts from a qualified domestic production activity. Brian allocated $55,000 of expenses to the qualified domestic production activity including $12,000 of wages. Brian had modified AGI of $47,000. What is Brian’s domestic production activities deduction?

13. DPAD Solution • Calculate QPAI: QDGR (receipts) $100,000 expenses − 55,000QPAI (qualifying income) $ 45,000 • QPAI cannot exceed modified AGI: Modified AGI is $47,000 so no limit • Calculate DPAD QPAI $ 45,000 2010 percent × 9% DPAD $ 4,050 • Limit DPAD to 50% of wages 50% of wages is $6,000 DPAD = $4,050

14. 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) • Recordkeeping • Document business purpose

15. 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)?

16. Travel Solution Ben can deduct the following amounts: 2 days 1 daybusinesspersonal Air fare (all or none) $ 1,200 $ 0 Hotel ($250 per day) 500 250 Meals ($90 per day × 50%) 90 45 Total Travel Deduction $ 1,790$ 295

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

18. Accounting Periods • Annual period • 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

19. 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-thru entities – a “required” tax year • Match to owners’ period (multiple owners for partnerships so this can be complicated)

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

21. Accounting Methods • 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

22. 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)

23. 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

24. Accrual Question Ben provides consulting services and bills Ace for $12,000. Ace disputes the amount claiming that $8,000 is the proper amount. How much income should Ben recognize under the accrual method this year? $ ________

25. 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

26. Advance Payment Example Ben provides dancing lessons. On September 30th of this year he received $2,400 full payment for a 2-year service contract. What amount of income must Ben recognize: (1) if he is on the cash method? (2) if he is on the accrual method?

27. Advance Payment Solution 1. If Ben uses the cash method, he must recognize income as received - $2,400 this year. 2. 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.

28. 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

29. UNICAP • 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)

30. 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

31. Accruing Business Expenses 1. All-events test • All events have occurred to establish the liability to pay • The amount is determinable with reasonable accuracy • Reserves for future liabilities not allowed 2. Economic performance has occurred

32. Economic Performance • Applies to accrual method taxpayers only • Taxpayer provides goods or services: • Performance occurs as taxpayer provides goods or services • Taxpayer using property or goods: • Performance occurs as goods are provided or • economic performance is otherwise expected within 3 ½ months of payment • Payment liabilities are performed only when paid • Interest and rent occurs ratably

33. Economic Performance Example Ben has signed a binding contract for Peter to provide Ben with repair services. Ben paid $1,500 to Peter and owes an additional $6,000 on the contract. The repairs will commence late next year. When can Ben claim the deduction if he uses the accrual method?

34. Economic Performance Solution Although the all events test is satisfied, Ben can only deduct $7,500 next year because that is when economic performance occurs (taxpayer liable for performing service).

35. Liability andeconomic performance (IRC §461) Deduct (IRC §162) Capitalize (IRC §263(a) or §471) Disallow Meals & Entertainment Spousal Travel Club Dues Lobbying Etc. 12-month rule

36. Choosing or Changing an Accounting Method • Accounting methods are generally adopted by use • A permissible method is adopted by using and reporting the method for one year • An impermissible method is adopted by using and reporting the method for two years • Generally method changes require IRS permission • Some changes are automatic • Permission is necessary to correct the use of an impermissible method