Chapter 1

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. 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 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.

7. 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?

8. 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.

9. 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.

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

11. 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.

12. 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)?

13. 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.

14. 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.

15. 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.

16. 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).

17. 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

18. 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? $ ________

19. 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.

20. 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?

21. 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.

22. 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).

23. 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.

24. 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.

25. 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?

26. 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.