Taxable Income from Business Operations

1. Chapter 5 Taxable Income from Business Operations

2. TAXABLE INCOME FROM BUSINESS OPERATIONS • Business profit as taxable income • The taxable year • Methods of accounting • Book-tax income differences • Accounting method issues in computing taxable income • NOLs

3. Business Profit as Taxable Income • Taxable income = gross income less allowable deductions • Gross income means “all income from whatever source derived.” §61 • Includes discharge of debt income. • Expenses are only deductible if specifically allowed by the Code (§61). • Includes all ordinary and necessary expenses … in carrying on any trade or business.” (§162).

4. Discharge of Indebtedness Income (not in book) • A taxpayer must report income when • A creditor cancels the taxpayer’s debt • The amount of income recognized is generally the amount of the debt forgiven • Reduction of debt not income for: • Discharges under Federal bankruptcy law, or • Discharges that occur when the debtor is insolvent.

5. The Taxable Year(1 of 2) • 12-month period • Generally same as its financial year. • Individuals use a calendar year. • Business FYE generally the same for financial and tax. • Need IRS permission to change tax year. • Most common reason is merger of firms with different year-ends.

6. The Taxable Year(2 of 2) • Short-year return • Only occurs when tax year changed and reporting period is < 12 months. • Short-year tax liability • Compute short-year taxable income • Annualize income • Multiply by (12 mo)/(# of mo in short yr) • Compute tax on annualized income • Compute tax for short year • Multiply annualized tax liability by (# of mo in short yr)/(12 mo)

7. Methods of Accounting • Overall method must clearly reflect income. • Establish a method by using it in the first tax return. • Requires IRS permission to change. • Realization and matching principles • Cash and accrual methods

8. Realization and Matching Principles • REALIZATION principle • Earnings process complete. • MATCHING principle • Match expenses with revenues. • Exceptions due to risks of tax evasion, convenience for gov’t or taxpayer, ability to pay, economic incentives.

9. Cash & Accrual Accounting(1 of 2) • CASH method mandatory where taxpayer's records reflect only cash transactions and no inventories. • ACCRUAL method mandatory for: • Purchases and sales where inventories must be used. • C corps and ptrshps w/ C corp partner. • Small corps (avg. annual gross receipts < $5M) may use cash basis.

10. Cash & Accrual Accounting(2 of 2) • HYBRID method • Use accrual for inventories (CGS), but cash for everything else.

11. Book-Tax Income Differences (1 of 2) • GAAP vs. tax conservatism • GAAP - protect s/hs and creditors: don’t overstate book income. • Tax - protect gov’t revenues: don’t understate taxable income. • Contrary result may arise due to economic incentives - e.g. accelerated. depreciation.) • Tax policy effect on measuring inc. • e.g., fines, penalties, lobbying exp.

12. Book-Tax Income Differences (2 of 2) • Temporary vs. permanent differences • Permanent differences do not reverse; • Temporary differences reverse over the life of the entity. • GAAP current tax expense is based on book income. • GAAP deferred tax expense is the tax effect of temporary differences (not permanent) reversing in the future.

13. Permanent Differences(1 of 2) • Examples of permanent non-deductible expenses (deductible for fin stmts) • 50% meals and entertainment • Political contributions & lobby expenses • Fines and penalties • Interest expense to generate tax-exempt municipal bond income • Premiums on key employee life insurance paid by corporation. • Goodwill.

14. Permanent Differences(2 of 2) • Examples of permanent tax preferences that make taxable income less than book income: • Tax-exempt municipal bond income • Life insurance proceeds on key employee policies.

15. Meals and Entertainment Expenses • Qualified M&E expenses only 50% deductible. • Must be directly related to (business discussion takes place) or associated with (directly preceding or proceeding a business meeting) a business activity. • Taxpayer must be present at meals. • Expense must not be lavish or extravagant.

16. Temporary Differences • Examples of temporary differences: • Depreciation • Timing of accruals • Capital losses • Corps: only deductible against cap gains • Individuals: up to $3,000/yr deductible against ordinary income • Bad debts (allowance vs. write-off) • Cash versus accrual accounting

17. Tax Expense & Deferred Taxes • GAAP total tax expense (SFAS109) • = current + deferred tax expense • In simple situations, this approximates tax rate on book income + or - permanent differences.

18. Acctg Method Issues in Computing Taxable Income • Cash method issues • Accrual method issues • Summary of cash vs. accrual • Section 482

19. Cash Method Issues(1 of 2) • Constructive receipt of income. • Report when a person has unrestricted access to and control of the income. • NO constructive receipt if the amount is available only on surrender of a valuable right, or if there are substantial limits on the right to receive it.

20. Cash Method Issues(2 of 2) • Prepaid expenses • Use accrual recognition when expense covers more than the following tax year. • Exception: prepaid interest must be capitalized and deducted over the period for which interest is actually charged.

21. Accrual Method Issues • Prepaid income • Advanced payments received for merchandise • Advances and deposits • Related party accruals • Bad debts • Accrued expenses

22. Prepaid Income • Prepaid income taxed when received under the Claim of Right Doctrine, not when the services are performed. • Government has the right to tax income when the taxpayer has unrestricted right to use such income amounts. • Examples: Rent, bonuses, services • Use accrual method for service inc. if completed by end of following tax year.

23. Advanced Payments Received for Merchandise • Advance payments received for merchandise or construction • Delay tax until earned (goods delivered). • OK to use accrual method if used for all tax reporting and financial reporting. • Small contractors may use completed contract method instead of % of completion for accounting for long-term contracts.

24. Long-Term Contracts (not in book)(1 of 2) • Completed contract method • Real estate construction contract or home construction contract (≤ 4 units) if • < 2 yrs to complete & gross receipts < $10M. • Deduct expenses when incurred, and recognize income when completed.

25. Long-Term Contracts (not in book)(2 of 2) • Percentage of completion method • Income recognized = (C/T) x P • C = Contract costs incurred during the period • T = Estimated total cost of the contract • P = Contract price

26. Advances and Deposits • A deposit that guarantees the customer's payment of amounts owed to the creditor is an advance payment includible in income. (E.g., apartment last months’ rent?). • True security deposits are not an advance payment and not includable in income. (e.g., apt security damage deposit).

27. Related Party Accruals • The paying party cannot deduct an expense until the receiving party includes the receipt in income. • Prevents accrual basis taxpayers from deducting an expense before related cash basis taxpayer recognizes the income.

28. Bad Debts • GAAP - allowance method • Tax - direct write-off method. • Record income if account repaid later. • Cash basis taxpayer cannot deduct bad debt unless there was an actual cash loss or if amount was previously included in income.

29. Accrued Expenses • All Events Test requires • Liability is fixed. • Amount determined with reasonable accuracy. • Economic Performance test for nonrecurring expenses also requires that all activities to satisfy the liability have occurred - often requires payment.

30. Summary of Cash & Accrual Tax Issues

31. Section 482 • IRS has authority to “distribute, apportion, or allocate gross income, deduction, credits or allowances” among businesses to CLEARLY REFLECT income of each. • Transfer pricing • Critical for multi-jurisdictional taxation

32. Net Operating Losses • When NOLs can be used: • Carryback 2 yrs, carryforward 20 yrs. • Carryback to oldest year first. • Election available to forgo carryback. • NPV tax benefit if taxpayer expects sufficiently higher tax rate in future. • GAAP allows recording tax benefit for EV of future NOL deductions. • New rules only apply temporarily.

33. End of Chapter 5