Understanding Taxable Income and Deductions in Business Operations

1. Chapter 6 Taxable Income from Business Operations

2. Taxable Income • Taxable income = gross income less allowable deductions • Gross income “means all income from whatever source derived.” AKA Broadly Conceived. • Deductions are allowed through legislative grace, and include all ordinary and necessary expenses … in carrying on any trade or business.” • Good rule of thumb: receipts are taxable UNLESS you can find a law that says it is excluded. Expenses are deductible ONLY if you can find a law that says it is deductible.

3. Taxable Year • 12-month period which generally corresponds to its fiscal year. • Individual taxpayers must generally choose a calendar year. • Firms generally choose a year = end of an annual operating cycle. • Changing tax years requires permission - most common reason is merger of firms with different year-ends.

4. Accounting Methods • Overall method by which taxpayers determine their income, deductions and credits, as well as the time realized and recognized. Section 482 grants IRS broad powers to “distribute, apportion, or allocate income” among businesses to CLEARLY REFLECT income of each. BIG issue in multi-jurisdictional taxation (Ch 12) • CONSISTENTLY APPLIED • Establish a method by using it in the first tax return. • Requires IRS permission to change.

5. Cash Method • Under the cash method, gross income includes cash or property actually RECEIVED during the tax year. • Deductions are usually taken in the year cash or property is PAID. • Cash method income includes receipt of noncash goods • Anti-abuse provision: Constructive receipt doctrine. • Occurs when taxpayer 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.

6. Exceptions - Cash Method • Cash method - deduct expenses when PAY. A check is payment when mailed. • An asset must be capitalized. The cost of the asset may be recovered over the asset life (e.g. depreciation, cost of goods sold). Major repairs may result in IRS dispute regarding expense versus capitalization. • Inventory must be accounted for on the accrual method, even for cash basis taxpayers. This is called a HYBRID method of accounting.

7. Cash Method Deductions - Prepaid Expenses • Where an expense (e.g., rent or an insurance premium) covers more than the following tax year, the deduction must be spread over the period to which the expense applies. • However, prepaid interest must be capitalized and deducted over the period for which interest is actually charged even if prepayment < next tax year. • Exception - deduct prepaid interest (points) on the purchase of a home. Does not apply to refinancing.

8. Accrual Method of Accounting • Under the accrual method, report income when the right to the income and the amount of the income can be determined with reasonable accuracy. (REALIZATION) • MATCH expenses against revenues. Deduct when ALL EVENTS have occurred that determine the existence of the liability and the amount of the liability can be determined with reasonable accuracy.

9. Book-Tax Differences • Contrasting principles of conservatism. • GAAP - protect shareholders and creditors: don’t overstate book income. • Tax - protect government revenues: Don’t understate taxable income. (Contrasting result may arise due to economic incentives - e.g. accelerated depreciation.)

10. Book-Tax Permanent Differences • Permanent differences do not reverse; Temporary differences reverse over the life of the firm. • Examples of permanent differences • 50% meals and entertainment • political contributions • fines and penalties • interest expense to generate tax-exempt municipal bond income • premiums on life insurance • Tax-exempt municipal bond income • Life insurance proceeds

11. Temporary Book-Tax Differences • Examples of temporary differences: • Depreciation • Timing of accruals • Capital losses • Bad debts (allowance vs. writeoff) • Cash versus accrual accounting

12. Accrual Expenses Exceptions • Related Party Accruals • The paying party cannot deduct an expense until the year that a receiving party deducts the expense. • Prevents accrual basis taxpayers from accruing an expense but delaying payment.

13. Chapter 10 Sole Proprietorships, Partnerships, LLCs, and S Corporations

14. Business Organizations • Taxpayer = owners = flow-through entities • sole proprietorship • partnerships • LLCs • S Corporations • Taxpayer = corporation • C Corporation is taxed first, then shareholders may be taxed on distributions (double taxation).

15. Sole Proprietorship • Business income and expenses are reported on Schedule C, filed with the individual form 1040. • Net income or loss on Schedule C is ordinary income or loss; combine this net with other items of gross income. • If the Schedule C business loss > other sources of income, the NOL (net operating loss) can be carried back 2 years and forward 20 years.

16. Employment Taxes • FICA = 6.2% /6.2% Social Security tax (on wages up to $117,000/$118,500 in 2014/15), respectively + 1.45% Medicare tax on all wages. Both employer and employee must pay this tax. • Employers withhold income taxes and the employee’s share of FICA. • Employers must remit the withheld taxes to the federal (and state if applicable) governments. • Self-employed taxpayers must pay SE (self-employment) tax, equal to 2 x FICA, 15.3% of net earnings from self-employment. (See footnote 20 for details). 1/2 of SE tax is deductible on Form 1040.

17. Passthrough Entities • Partnerships (includes LLCs) and S Corps are not taxed as entities. Investors pay tax on their share of entity income. • Single level of taxation. • Cash distributions are generally NOT taxable.

18. Benefits of Passthrough Losses • Pass through loss is generally deductible in the year the loss is generated at the individual’s marginal tax rate. • Corporation loss must be carried (back) forward and used to offset income in a taxable year where profits are reported. NOL deduction provides a benefit at the corporation’s tax rate in the year the NOL offsets profits.

19. Passthrough Entities Only Have a Single Level of Tax • The preceding example illustrates the benefits of a pass-through entity: • a) use losses immediately • b) single level of taxation