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Chapter 7 Accounting Periods & Methods & Depreciation

Chapter 7 Accounting Periods & Methods & Depreciation. Income Tax Fundamentals 2011 Gerald E. Whittenburg & Martha Altus- Buller Student Copy. Accounting Periods.

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Chapter 7 Accounting Periods & Methods & Depreciation

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  1. Chapter 7Accounting Periods & Methods & Depreciation Income Tax Fundamentals 2011 Gerald E. Whittenburg & Martha Altus-Buller Student Copy 2011 Cengage Learning

  2. Accounting Periods • Partnerships/S-Corporations may elect to adopt a different fiscal tax year from the one prescribed on previous slide, but only • If entity can demonstrate that natural business cycle easily conforms to fiscal year other than calendar year • Such as golf course (natural cycle in Denver ends in October) Note: S-Corporations don’t pay tax as an entity 2011 Cengage Learning

  3. Tax Year for Personal Service Corporation • A Personal Service Corporation (PSC) is a corporation with shareholder-employee(s) who provide a personal service, such as architects or dentists • Generally must adopt calendar year • However, can adopt a fiscal year if • Can prove business purpose or • Fiscal year results in a deferral period of less than 3 months and • Shareholders’ salaries for deferral period are proportionate to salaries received during rest of the period or • Corporation limits its salaries deduction See next slide 2011 Cengage Learning

  4. Short Period Taxable Income (TI) • If taxpayer has a short year (other than first or last year of operation), tax is calculated based on following example: • In 2010, Flo-Mex changes from a calendar year to tax year ending 9/30. For the short period 1/1/10 – 9/30/10, Flo-Mex’ taxable income = $20,000* Steps to calculate tax for the short period Annualize TI $20,000 x 12/9 = 26,667 Estimated tax on annualized TI $26,667 x 15% = 4,000 Allocate tax to short period $ 4,000 x 9/12 = 3,000 • Individual taxpayers rarely change tax years *Note: Calculations for short year TI requires special adjustments 2011 Cengage Learning

  5. Accounting Methods • There are three acceptable accounting methods for reporting taxable income (TI) • Cash • Hybrid • Accrual • Must use one method consistently • Make an election on your first return by filing using a particular method • Must obtain permission from IRS to change accounting methods must use same method for tax & books 2011 Cengage Learning

  6. Accounting Methods (continued) • Accrual method • Recognize income when earned and can be reasonably estimated • Recognize deductions when incurred and can be reasonably estimated • Hybrid method • An example of a hybrid taxpayer is one that utilizes cash method for receipts and disbursements, but accrual for cost of products sold 2011 Cengage Learning

  7. Depreciation • Depreciation is a process of allocating and deducting the cost of assets over their useful lives • Does not mean devaluation of asset • Land is not depreciated • Maintenance vs. depreciation • Maintenance expenses are incurred to keep asset in good operating order • Depreciation refers to deducting part of the original cost of the asset Complete Form 4562 to reflect depreciation 2011 Cengage Learning

  8. Personal Property Recovery Periods • With MACRS, each asset is depreciated according to an IRS-specified recovery period • 3 year ADR* midpoint of 4 years or less • 5 year Computers, cars and light trucks, R&D equipment, certain energy property & certain equipment • 7 year Mostly business furniture & equipment and property with no ADR life *See Table 7.1 on page 7-9 for Asset Depreciation Ranges (ADR) for recovery periods for all classes of assets 2011 Cengage Learning

  9. Calculating Depreciation for Personal Property • Depreciation is determined using IRS tables • MACRS rates found in Table 7.2 on page 7-10 • Rates multiplied by cost (salvage value not used in MACRS) • Tables based on half-year convention • Means 1/2 year depreciation taken in year of acquisition and 1/2 year taken in final year • May elect to use tables based on straight-line instead (percentages in Table 7.3 on page 7-11) Note: Must use either MACRS or straight-line for all property in a given class placed in service during that year 2011 Cengage Learning

  10. Mid-Quarter Convention • Mid-quarter convention is required if taxpayer purchases 40% or more of total assets (except real estate) in the last quarter of tax year • Must apply this convention to every asset purchased in the year • Excludes real property and §179 property • Must use special mid-quarter tables • Found at major tax service such as Commerce Clearing House (CCH) or Research Institute of America (RIA) 2011 Cengage Learning

  11. 50% Bonus Depreciation Reinstated for 2008-2010 • Additional depreciation immediately available • Applies to assets with recovery period of twenty years or less plus computer software, leasehold improvements and water utility property • Amount = 50% of adjusted basis • Take 50% bonus first, then regular MACRS depreciation on remaining basis • May elect out of bonus if anticipate need for higher depreciation in future years 2011 Cengage Learning

  12. Real Estate • Real assets depreciated based on a recovery period – 2 types of real property • 27.5 years Residential real estate • 39 years Nonresidential real estate • Real assets are depreciated using the straight-line method with a mid-month convention • Mid-month convention assumes all purchases made in middle of month • Used for real estate acquired after 1986 • Rates found on Table 7.4 on page 7-13 Note: Different rates apply for real property acquired before 1981 and after 1980 but before 1987 2011 Cengage Learning

  13. Election to Expense - §179 • §179 allows immediate expensing of qualifying property • For 2010, the annual amount allowed is $500,000 • Qualifying property is tangible personal property used in a business • But not real estate or property used in residential real estate rental business • §179 election to expense is limited by 2 things • If cost of qualifying property placed in service in a year > $2,000,000, then reduce §179 expense dollar for dollar • For example, if assets purchased in current year = $2.1 million, taxpayer must reduce §179 by $100,000. Therefore, election to expense is limited to = $400,000 ($500,000 – 100,000). The remaining $1.7 million of basis is depreciated over assets’ useful lives (including bonus depreciation) if applicable. • Cannot take §179 expense in excess of taxable income 2011 Cengage Learning

  14. Election to Expense - §179 • When using with regular MACRS, take §179 first, then reduce basis to calculate bonus depreciation, then reduce basis to calculate MACRS • For example • In 2010, NanoPaint Inc.’s taxable income = $1.25 million. They placed a 7-year piece of property into service costing $842,000 – it was their only asset purchase in 2010. What is total depreciation, including election to expense? • Assuming bonus depreciation will be claimed – first take $500,000 deduction under §179, reduce basis to $342,000, then multiply by 50% to get bonus depreciation and then remaining basis ($171,000) by .1429 from MACRS tables • Total depreciation and Section 179 = $695,436 ($500,000 + 171,000 + *24,436) = $695,436 *(remaining basis of $171,000 x .1429) 2011 Cengage Learning

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