Chapter 08

1. Chapter 08 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 – not a business deduction. • 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.

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 can Rick’s business deduct for employing Ben?

4. Reasonableness solution • A reasonable amount for compensating Ben is $30,000 rather than $45,000. • Rick can only deduct $30,000 • What is the tax status of the extra $15,000 paid to Ben? 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 • 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

6. Capital expenditures • Answer the accounting question – does the expenditure provide future benefits (beyond this year)? • If so, then 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.

7. 12-month rule example • Ben, a cash basis taxpayer, makes the following payments on June 30 of this year: • Pays $10,000 for the next 10 months of utilities • Pays $12,000 for insurance over next 24 months • Pays $ 9,600 for 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 is not more than 12 months and the benefit ends prior to end 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.

9. Special business deductions • Start-up and organizational expenditures • Expense up to $5,000 and capitalize/amortize the rest. • Bad debts • Accrual taxpayers can only use direct write off method. • 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.

10. Domestic production activities deduction (DPAD) • An “artificial” deduction that subsidizes domestic manufacturing. • Domestic production of tangible products qualifies for subsidy for income must 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.

11. DMD 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?

12. DPAD solution • Calculate QPAI: QDPR (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 percent age x 9% DPAD $ 4,050 • Limit DPAD to 50% of wages 50% of wages is $6,000 DPAD=$4,050

13. 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.

14. Travel example • Ben paid the following to attend a business meeting in Chicago: • Air fare (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)

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

16. Accounting for taxable income • We’ve learned to identify: • Business gross income and • Deductible expenses • Now we need to match these flows to a specific period. • Accounting methods match income and expense to a specific period.

17. 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. • Example: last Friday in June.

18. Choosing an accounting period • Proprietorships – same as proprietor. • Prevents mismatch of income. • “C” corporations and individuals – choice made on first tax return for those with books. • Flow-thru entities – a “required” tax year. • Match to owners’ period (multiple owners for partnerships so this can be complicated).

19. 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 and defer losses and expenses. • Objective of Congress is to maximize tax revenues.

20. 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.

21. 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).

22. 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: • Completes service or sale • Payment is due • Payment is received

23. 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? $ ________? • ($8,000 - the undisputed amount satisfies the all events test)

24. 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 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.

25. 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?

26. 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 x $2,400). Next year Ben would recognize the remaining $2,100 - income can only be deferred one year.

27. 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.

28. 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

29. Accruing business expenses • 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. • Economic performance has occurred.

30. 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.

31. 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? Answer: 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).

32. 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 permission of the IRS. • Some changes are automatic. • Permission is necessary to correct the use of an impermissible method.