Business Income Taxes - Chapter 9 - Business Income, Deduction, and Accounting Methods

Limitations on Business Deductions

- No business deductions are allowable for expenditures that are against public policy (bribes), lobbying expenses, or are political contributions. - Expenditures that benefit a period longer than 12 months generally must be capitalized. - No deductions are allowable for expenditures associated with the production of tax-exempt income. - Personal expenditures are not deductible.

Business interest limitation

- The deduction of business interest expense is limited to business interest income plus 30 percent of the business's adjusted taxable income. - Adjusted taxable income is taxable income allocable to the business computed without interest income and before depreciation and interest expense deductions. - Disallowed business interest expense can be carried forward indefinitely.

To claim a tax deduction for a business expense, it must meet:

1. the all events test AND 2. the economic performance test

How does a business adopt a business year?

A business adopts a calendar year-end or fiscal year-end by filing its initial tax return. In contrast, a business adopts a 52/53-week year-end by filing a special election with the IRS. Once a business establishes its tax year, it generally must receive permission from the IRS to change.

Three types of tax years:

A calendar year ends on December 31. A fiscal year ends on the last day of a month other than December. A 52/53-week year. This is a fiscal year that ends on the same day of the week that is the last such day in the month or on the same day of the week nearest the end of the month. For example, a business could adopt a 52/53-week fiscal year that (1) ends on the last Saturday in July each year or (2) ends on the Saturday closest to the end of July (although this Saturday might be in August rather than July)

Accrual method

A system of accounting based on the accrual principal, under which revenue is recognized (recorded) when earned, and expenses are recognized when incurred.

Short tax year

A tax year can consist of a period less than 12 months (a short tax year) in certain circumstances. For instance, a business may report income for such a short year in its first year of existence (for example, it reports income on a calendar year-end and starts business after January 1) or in its final year of existence (for example, a calendar-year business ends its business before December 31). Short tax years in a business's initial or final year are treated the same as full years. A business also may have a short year when it changes its tax year, and this can occur when the business is acquired by new owners. In these situations, special rules may apply for computing the tax liability of the business.

Mixed-Motive Expenditures

Activities that involve a mixture of business and personal objectives - Special limits are imposed on expenditures that have both personal and business benefits. - Only 50 percent of business meals are deductible. - Contemporaneous written records of business purpose are required.

Ordinary and necessary examples

An expense is not necessarily required to be typical or repetitive in nature to be considered ordinary. For example, a business could deduct the legal fees it expends to defend itself in an antitrust suit. Although an antitrust suit would be atypical and unusual for most businesses, defending the suit would probably be deemed ordinary because it would be expected under the circumstances. A necessary expense is an expense that is helpful or conducive to the business activity, but the expenditure need not be essential or indispensable. For example, a deduction for metric tools would qualify as ordinary and necessary even if there was only a small chance that a repairman might need these tools. The "ordinary and necessary" requirements are applied on a case-by-case basis, and while the deduction depends on individual circumstances, the IRS is often reluctant to second-guess business decisions.

Ordinary and Necessary Business Expenses

An expense that is normal or appropriate for the business under the circumstances

Business meals

Because everyone needs to eat, even business meals contain a significant personal element. To allow for this personal element, taxpayers may deduct only 50 percent of actual business meals. In addition, to deduct any portion of the cost of a meal as a business expense, (1) the amount must be reasonable under the circumstances, (2) the taxpayer (or an employee) must be present when the meal is furnished, and (3) the meal must be directly associated with the active conduct of the taxpayer's business.

Economic performance

Even when businesses meet the all-events test, they still must clear the economic performance hurdle to recognize the tax deduction. Congress added the economic performance requirement because in some situations taxpayers claimed current deductions and delayed paying the associated cash expenditures for years. Thus, the delayed payment reduced the real (present value) cost of the deduction. This requirement specifies that businesses may not recognize a deduction for an expense until the underlying activity generating the associated liability has occurred. Thus, an accrual-method business is not allowed to deduct a prepaid business expense even if it qualifies to do so under the 12-month rule (discussed above) unless it also has met the economic performance test with respect to the liability associated with the expense.

Congress enacted the UNICAP rules primarily for two reasons

First, the rules accelerate tax revenues for the government by deferring deductions for the capitalized costs until the business sells the associated inventory. Thus, there is generally a one-year lag between when businesses initially capitalize the costs and when they deduct them. Second, Congress designed the "uniform" rules to reduce variation in the costs businesses include in inventory and Congress intended these provisions to apply to large manufacturers and resalers.

Advance payments for goods and services

For financial reporting purposes, a business does not immediately recognize income on payments it receives for services to be provided in the future. For financial reporting purposes, an advance payment for goods and services is recorded as a debit for cash received and a credit to a liability account (unearned income). The business then recognizes the financial income from the services or sales as it performs the services or provides the goods. In contrast, for tax purposes, the all-events test generally requires businesses receiving advance payments for goods and services to recognize the income when they receive the payment, rather than when they deliver the goods or perform the services. This rule is called the full inclusion method. The law provides an exception to immediate recognition. Specifically, businesses receiving advance payments for goods and services may elect to defer recognizing the advance as income until the tax year following the year they receive the payment. This one-year deferral method does not apply (1) if (or to the extent to which) the income is actually earned by the end of the year of receipt, (2) to the extent that the advance was included in financial reporting income, or (3) if the advance was for interest or rent (taxpayers must recognize unearned interest and rental income on receipt).

Changing accounting methods

Once a business has adopted an accounting method, it must generally receive permission to change the method, regardless of whether it is a permissible or an impermissible method. A taxpayer requests permission to change accounting methods by filing Form 3115 with the IRS. The IRS automatically approves certain types of accounting method changes, but for others the business must provide a good business purpose for the change and pay a fee. The IRS also requires permission when a business must change from using an impermissible method; this requirement helps the IRS to certify that the business properly makes the transition to a permissible method. In essence, the IRS requires the business to report its own noncompliance. Why would a business do so? Besides complying with the tax laws, a business might report its own noncompliance to receive leniency from the IRS. Without getting into the details, the IRS is likely to assess fewer penalties and less interest expense for noncompliance when the business reports the noncompliance before the IRS discovers it on its own

Arm's length amount

Price in transactions among unrelated taxpayers, where each transacting party negotiates for his or her own benefit.

The specific requirements for the economic performance test differ based on whether the liability has arisen from:

Receiving goods or services from another person. Use of property. Providing goods or services to another person. Certain activities creating payment liabilities

Business property use

Several types of property may be used for both business and personal purposes. For example, business owners often use automobiles, computers, or cell phones for both business and personal purposes. However, because expenses relating to these assets are deductible only to the extent the assets are used for business purposes, taxpayers must allocate the expenses between the business and personal use portions. For example, if a full year's expense for a business asset is $1,000, but the asset is only used for business purposes 90 percent of the time, then only $900 of expense can be deducted ($1,000 × 90%).

These rules for determining tax years available to business are summarized as follows:

Sole proprietorships: Because individual proprietors must report their business income on their individual returns, proprietorships use a calendar year-end to report their business income. Flow-through entities: Partnerships and S corporations are flow-through entities (partners and S corporation owners report the entity's income directly on their own tax returns), and these entities generally must adopt tax years consistent with the owners' tax years. Because owners are allocated income from flow-through entities on the last day of the entity's taxable year, the tax laws impose the tax year consistency requirement to minimize income tax deferral opportunities for the owners. C corporations: C corporations are generally allowed to select a calendar, fiscal, or 52/53-week year-end.

all events test for income

The all-events test requires that businesses recognize income when (1) all events have occurred that determine or fix their right to receive the income and (2) the amount of the income can be determined with reasonable accuracy. Assuming the amount of income can be determined with reasonable accuracy, businesses meet the all-events requirement on the earliest of the following three dates: 1. When they complete the task required to earn the income. Businesses earn income for services as they provide the services, and they generally earn income from selling property when the title of the property passes to the buyer. 2. When the payment for the task is due from the customer. 3. When the business receives payment for the task. Generally, beginning in 2018, the all-events test is satisfied no later than the tax year in which such income is recognized on their financial statements.

Businesses are generally allowed to deduct losses incurred when selling or disposing of business assets

The calculation of losses from business property dispositions can be complex, but the main idea is that businesses realize and recognize a loss when the asset's tax basis exceeds the sale proceeds.

Accounting Methods

The procedure for determining the taxable year in which a business recognizes a particular item of income or deduction, thereby dictating the timing of when a taxpayer reports income and deductions.

IRC §162, the provision authorizing business deductions is relatively broad and ambiguous

There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. This provision authorizes taxpayers to deduct expenses for "trade or business" activities. The tax code does not define the phrase "trade or business," but it's clear that the objective of business activities is to make a profit. Thus, the law requires that a business expense be made in the pursuit of profits rather than the pursuit of other, presumably personal, motives.

Recurring item exception (economic performance)

This exception is designed to minimize the cost of applying economic performance to expenses that occur on a regular basis. Under this exception, accrual method taxpayers can deduct certain accrued expenses even if economic performance has not occurred by year-end. A recurring item is a liability that is expected to recur in future years and is either not material in amount or deducting the expense currently matches with revenue. Payment liabilities, such as insurance, rebates and refunds, are deemed to meet the matching requirement. In addition, the all-events test must be satisfied at year-end and actual economic performance of the item must occur within a reasonable time after year-end (but prior to the filing of the tax return, which could be up to 8½ months with an extension). As a final note, the recurring item exception does not apply to workers' compensation or tort liabilities.

Limitations on accruals to related persons

To prevent businesses and related persons from working together to defer taxes, the tax laws prevent an accrual-method business from accruing (and deducting) an expense for a liability owed to a related person using the cash method until the related person recognizes the income associated with the payment

Expenses that do not help businesses generate taxable income are not allowed to offset taxable income (T/F)

True For example, this restriction disallows interest expense deductions for businesses that borrow money and invest the loan proceeds in municipal (tax-exempt). It also disallows deductions for life insurance premiums businesses pay on policies that cover the lives of officers or other key employees and compensate the business for the disruption and lost income they may experience due to a key employee's death. Because the death benefit from the life insurance policy is not taxable, the business is not allowed to deduct the insurance premium expense associated with this nontaxable income.

Business Transportation

Under certain conditions, sole proprietors and self-employed taxpayers may deduct the cost of travel and transportation for business purposes. Transportation expenses include the direct cost of transporting the taxpayer to and from business sites. However, the cost of commuting between the taxpayer's home and regular place of business is personal and, therefore, not deductible. If the taxpayer uses a vehicle for business, the taxpayer can deduct the costs of operating the vehicle plus depreciation on the vehicle's tax basis. Alternatively, in lieu of deducting these costs, the taxpayer may simply deduct a standard amount for each business mile driven. The standard mileage rate represents the per-mile cost of operating an automobile (including depreciation or lease payments). For 2018, the standard mileage rate has been set at 54.5 cents per mile. To be deductible, the transportation must be for business reasons. If the transportation is primarily for personal purposes, the cost is not deductible.

Income from business includes

gross profit from inventory sales (sales minus cost of goods sold), income from services provided to customers, and income from renting property to customers. Just like individuals, businesses are allowed to exclude certain types of realized income from gross income, such as municipal bond interest.

Amount of Casualty Loss

he amount of the loss deduction depends on whether the asset is (1) completely destroyed or stolen or (2) only partially destroyed. When its asset is completely destroyed or stolen, the business calculates the amount of the loss as though it sold the asset for the insurance proceeds, if any. That is, the loss is the amount of insurance proceeds minus the adjusted tax basis of the asset. If the asset is damaged but not completely destroyed, the amount of the loss is the amount of the insurance proceeds minus the lesser of (1) the asset's adjusted tax basis or (2) the decline in the value of the asset due to the casualty. For individuals, business casualty losses and casualty losses associated with rentals and royalties are deducted for AGI.

Businesses also capitalize the cost to create or acquire:

intangible assets such as patents, goodwill, start-up costs, and organizational expenditures. They recover the costs of capitalized intangible assets either through amortization (when the tax laws allow them to do so) or upon disposition of the assets. Prepaid expenses are also subject to capitalization, but there is a special exception

Schedule C income

is subject to both individual income and self-employment taxes

The overriding requirement for any tax accounting method

is that the method must "clearly reflect income" and be applied consistently

payment liabilities

liabilities of accrual method businesses for which economic performance occurs when the business actually pays the liability for, among others: worker's compensation; tort; breach of contract or violation of law; rebates and refunds; awards, prizes, and jackpots; insurance, warranties, and service contracts provided to the business; and taxes.

allowance method

method used for financial reporting purposes; under this method, bad debt expense is based on an estimate of the amount of the bad debts in accounts receivable at year-end.

Mixed motive expenditures are:

of particular concern to lawmakers and the IRS because of the tax incentive to disguise nondeductible personal expenses as deductible business expenses

Entities other than sole proprietorships report income

on tax forms separate from the owners' tax returns. For example, partnerships report taxable income on Form 1065, S corporations report taxable income on Form 1120S, and C corporations report taxable income on Form 1120. Of all these entity types, generally only C corporations pay taxes on their income.

Cash Method

recognizes revenue when property or services are actually or constructively received. This is generally true no matter when the business sells the goods or performs the service that generates the revenue. Likewise, a business adopting the cash method generally recognizes deductions when the expense is paid. Thus, the timing of the liability giving rise to the expense is usually irrelevant.

12 month rule

regulation that allows prepaid business expenses to be currently deducted when the contract does not extend beyond 12 months and the contract period does not extend beyond the end of the tax year following the year of the payment.

direct write-off method

required method for deducting bad debts for tax purposes. Under this method, businesses deduct bad debt only when the debt becomes wholly or partially worthless.

All Events Test

requires that income or expenses are recognized when (1) all events have occurred that determine or fix the right to receive the income or the liability to make the payments and (2) the amount of the income or expense can be determined with reasonable accuracy.

Uniform Cost Capitalization Rules (UNICAP rules)

specify that inventories must be accounted for using full absorption rules to allocate the indirect costs of productive activities to inventory.

When a taxpayer's activity does not meet the "for profit" requirement:

t is treated as a hobby, an activity motivated by personal objectives. A taxpayer engaged in a hobby cannot deduct expenses associated with that activity (commencing in 2018).

Whether a business uses the cash or the accrual method of accounting, it must capitalize expenditures for:

tangible assets such as buildings, machinery and equipment, furniture and fixtures, and similar property that have useful lives of more than one year (12 months). For tax purposes, businesses recover the cost of capitalized tangible assets (other than land) through depreciation.

Economic Performance Test

the third requirement that must be met for an accrual method taxpayer to deduct an expense currently. The specific event that satisfies the economic performance test varies based on the type of expense.

In many circumstances, if businesses want to defer taxable income

they must also defer book income.

481 adjustment

a change to taxable income associated with a change in accounting methods.

Accounting period

a fixed period in which a business reports income and deductions

Tax year

a fixed period in which a business reports income and deductions, generally twelve months.

Casualty Loss

a loss arising from a sudden, unexpected, or unusual event such as a "fire, storm, or shipwreck" or loss from theft.

In reporting financial statement income, businesses have incentives to select accounting methods permissible under GAAP that:

accelerate income and defer deductions. In contrast, for tax planning purposes, businesses have incentives to choose accounting methods that defer income and accelerate deductions.

In order to meet the ________ ________ test for deducting an expense, everything necessary to deduct the liability giving rise to the deduction must have occurred, and the business must be able to determine the _____ of the liability with reasonable accuracy

all events amount

LIFO method

an accounting method that values the cost of assets sold under the assumption that assets are sold in the reverse order in which they are purchased (last purchased, first sold).

FIFO method

an accounting method that values the cost of assets sold under the assumption that the assets are sold in the same order in which they are purchased (first purchased, first sold).

Recurring Item

an election under economic performance to currently deduct an accrued liability if the liability is expected to persist in the future and is either not material or a current deduction better matches revenue.

Specific identification method

an elective method for determining the cost of an asset sold. Under this method, the taxpayer specifically chooses the assets that are to be sold.

Reasonable in amount

an expenditure is reasonable when it is neither extravagant or exorbitant

The courts and IRS test for extravagance by:

comparing the amount of the expense to a market price or an arm's length amount. If the amount of the expense is within the range of amounts typically charged in the market by unrelated persons the amount is considered to be reasonable.

Generally, when accrual-method businesses incur a liability relating to a business expense, they account for it by

crediting a liability account (or by crediting cash if they pay the liability at the time they incur it) and debiting an expense account.

Accrual of Business-Expense Deductions

- Both all event and economic performance are required for deducting accrued business expenses - The all events test requires that the business be liable for the payment - Economic performance generally requires that the underlying activity generating the liability has occurred in order for the associated expense to be deductible.

business expenses

- Business expenses must be incurred in pursuit of profits, not personal goals. - A deduction must be ordinary and necessary (appropriate and helpful). - Only reasonable amounts are allowed as deductions.

Inventories

- Businesses must use the accrual method to account for substantial inventories. - The UNICAP rules require capitalization of most indirect costs of production. - The LIFO method is allowed if also used for financial reporting purposes.

Related persons include:

- Family members, including parents, siblings, and spouses. - Shareholders and C corporations when the shareholder owns more than 50 percent of the corporation's stock. - Owners of partnerships and S corporations no matter the ownership percentage.

Revenue recognition under accrual method

- Income is recognized when earned (all-events) or received (if earlier). - The all-events test requires that the business has the right to income. - Taxpayers can generally elect to defer recognition of prepaid (unearned) income for goods and services (for one year).

Accounting periods

- Individuals and proprietorships generally account for income using a calendar year-end. - Corporations are allowed to choose a fiscal year - Partnerships and other flow-through entities generally use a tax year consistent with their owner's tax years.

More on accrual method accounting

Businesses using the accrual method to determine taxable income follow rules similar to GAAP with two basic differences.35 First, as we discuss below, requirements for recognizing taxable income tend to be structured to recognize income earlier than the recognition rules for financial accounting. Second, requirements for accruing tax deductions tend to be structured to recognize less accrued expenses than the recognition rules for financial reporting purposes. These differences reflect the underlying objectives of financial accounting income and taxable income. The objective of financial accounting is to provide useful information to stakeholders such as creditors, prospective investors, and shareholders. Because financial accounting methods are designed to guard against businesses overstating their profitability to these users, financial accounting tends to bias against overstating income. In contrast, the government's main objective for writing tax laws is to collect revenues. Thus, tax accounting rules for accrual-method businesses tend to bias against understating income. These differences will become apparent as we describe tax accounting rules for businesses.

Categories of payment liabilities

Economic performance occurs when the taxpayer pays liabilities associated with: - Workers' compensation, tort, breach of contract, or violation of law. - Rebates and refunds. - Awards, prizes, and jackpots. - Insurance, warranties, and service contracts provided to the business. (Note: This relates to insurance, warranties, and product service contracts that cover the taxpayer and not a warranty that the taxpayer provides to others.) - Taxes. - Other liabilities not provided for elsewhere.

Business travel expenses

Expenditures incurred while "away from home - overnight", including the cost of transportation, meals, lodging, and incidental expenses. A taxpayer is considered to be away from home overnight if the travel is away from the primary place of business and of sufficient duration to require sleep or rest (typically this will be overnight). When a taxpayer travels solely for business purposes, all of the costs of travel are deductible (but only 50 percent of meals). When the travel has both business and personal aspects, the deductibility of the transportation costs depends upon whether business is the primary purpose for the trip. If the primary purpose of a trip is business, the transportation costs are fully deductible, but meals (50 percent), lodging, and incidental expenditures are limited to those incurred during the business portion of the travel. If the taxpayer's primary purpose for the trip is personal, the taxpayer may not deduct any transportation costs to arrive at the location but may deduct meals (50 percent), lodging, transportation, and incidental expenditures for the business portion of the trip. The primary purpose of a trip depends upon facts and circumstances and is often the subject of dispute.

Education expenses or expenditures

Expenditures made by a taxpayer for education, such as tuition and books, are often related to a taxpayer's business aspirations. However, educational expenditures are not deductible as business expenses unless the taxpayer is self employed and the education maintains or improves skills required by the individual in his existing trade or business. Education expenses necessary to meet minimum requirements for an occupation are not deductible. For example, tuition payments for courses to satisfy the education requirement to sit for the CPA exam are not deductible. This is an example of education that qualifies the taxpayer for a new trade or business rather than improving his skills in an existing trade or business. However, education expense necessary to maintain the skill of a self employed taxpayer would be a deductible business expense.

Personal Expenses

Expenses incurred for personal motives. Personal expenses are not deductible for tax purposes.

inventory cost flow methods

FIFO: First in, first out LIFO: Last in, first out Specific ID: high value items (cars, diamonds etc) In general terms, when costs are increasing, a business using the FIFO method will report a higher gross margin than if it used the LIFO method. The opposite is true if costs are decreasing.

Comparison of Accrual and Cash Methods

From a business perspective, the two primary advantages of adopting the cash method over the accrual method are that (1) the cash method provides the business with more flexibility to time income and deductions by accelerating or deferring payments (timing tax planning strategy) and (2) bookkeeping for the cash method is easier. For example, a cash-method taxpayer could defer revenue by waiting to bill clients for goods or services until after year-end, thereby increasing the likelihood that customers would send payment after year-end. There are some concerns with this tax strategy. For example, delaying the bills might increase the likelihood that the customers will not pay their bills at all. The primary advantage of the accrual method over the cash method is that it better matches revenues and expenses. For that reason, external financial statement users who want to evaluate a business's financial performance prefer the accrual method. Consistent with this idea, the cash method is not allowed for financial reporting under GAAP. Although the cash method is by far the predominate accounting method among sole proprietors, it is less common in other types of businesses. As we noted previously, tax laws generally prohibit large C corporations and partnerships with corporate partners from using the cash method of accounting.

More on cash method accounting

Keep in mind that a cash-method business receiving payments in noncash form (as property or services) must recognize the noncash payments as gross income when the goods or services are received. Also, in certain circumstances, a business expending cash on ordinary and necessary business expenses may not be allowed to currently deduct the expense at the time of the payment. For example, cash-method taxpayers (and accrual-method taxpayers) are not allowed to deduct prepaid interest expense and cannot usually deduct prepaid expenses or payments that create a tangible or intangible asset. However, the regulations provide a 12-month rule for prepaid business expenses to simplify the process of determining whether to capitalize or immediately expense payments that create benefits for a relatively brief period of time, such as insurance, security, rent, and warranty service contracts. When a business prepays business expenses, it may immediately deduct the prepayment if (1) the contract period does not last more than a year and (2) the contract period does not extend beyond the end of the taxable year following the tax year in which the taxpayer makes the payment. If the prepaid expense does not meet both these criteria, the business must capitalize the prepaid amount and amortize it over the length of the contract whether the business uses the cash or accrual method of accounting

Chapter 9 summary

LO 9-1 Identify common business deductions. Ordinary and necessary business expenses are allowed as deductions to calculate net income from activities entered into with a profit motive. Only reasonable amounts are allowed as business expense deductions. Extravagant or excessive amounts are likely to be characterized by personal motives and are disallowed. LO 9-2 Determine the limits on deducting business expenses. The law specifically prohibits deducting expenses that are against public policy (such as fines or bribes) and expenses that produce tax-exempt income. Expenses benefiting more than 12 months must be capitalized and special limits and record-keeping requirements are applied to business expenses that may have personal benefits, such as meals. The deduction of business interest expense is limited to business interest income plus 30 percent of the business's adjusted taxable income. Adjusted taxable income is taxable income before depreciation and interest deductions allocable to the business activity. Disallowed business interest expense can be carried forward indefinitely. LO 9-3 Identify special business deductions specifically permitted under the tax laws. Special calculations are necessary for deductions such as the deduction for casualty losses. The deduction when an asset is damaged (not destroyed) is limited to the lesser of the reduction in value or the adjusted tax basis of the asset. LO 9-4 Describe accounting periods available to businesses. Accounting periods and methods are chosen at the time of filing the first tax return. There are three types of tax years—calendar year, fiscal year, and 52/53-week year—and each tax year is distinguished by year-end. LO 9-5 Apply cash and accrual methods to determine business income and expense deductions. Under the cash method, taxpayers recognize revenue when they actually or constructively receive property or services and they recognize deductions when they actually pay the expense. Taxpayers, including C corporations and partnerships with C corporation partners but not tax shelters, can elect to use the cash method if their average annual gross receipts is $25 million or less. Under this rule, C corporations and partnerships with C corporation partners can elect to use the cash method. Under the accrual method, the all-events test requires that income be recognized when all the events have occurred that are necessary to fix the right to receive payments and the amount of the payments can be determined with reasonable accuracy. Except for taxpayers who meet the $25 million gross receipts test, the accrual method must be used to account for sales and purchases for businesses where inventories are an income-producing factor. Under the accrual method, accrued expenses can be deducted only when the all-events test and the economic performance test both have been met. The application of the economic performance test depends, in part, on the type of business expense. Changes in accounting method or accounting period typically require the consent of the IRS and a §481 adjustment to taxable income. A negative adjustment is included in income for the year of change, whereas a positive adjustment is spread over four years.

Flow-through entities

Legal entities like partnerships, limited liability companies, and S corporations that do not pay income tax. Income and losses from flow-through entities are allocated to their owners.

UNICAP rules

Under these uniform cost capitalization rules, large businesses are generally required to capitalize more costs to inventory for tax purposes than they capitalize under financial accounting rules. Under GAAP, businesses generally include in inventory only those costs incurred within their production facility. In contrast, the UNICAP rules require businesses to allocate to inventory the costs they incur inside the production facility and the costs they incur outside the facility to support production (or inventory acquisition) activities. For example, under the UNICAP provisions, a business must capitalize at least a portion of the compensation paid to employees in its purchasing department, general and administrative department, and even its information technology department, to the extent these groups provide support for the production process. In contrast, businesses immediately expense these items as period costs for financial accounting purposes. The regulations provide guidance on the costs that must be allocated to inventory. Selling, advertising, and research are specifically identified as costs that do not have to be allocated to inventory under the UNICAP provisions.

Receiving goods and (or) services from another person

When a business agrees to pay another person for goods or services, the business deducts the expense associated with the liability only when the other person provides the goods or services (assuming the all-events test is met for the liability). An exception to this general rule occurs when a business hires another person to provide goods or services and the business actually pays the liability before the other person provides the goods or services. In this circumstance, the business may treat the actual payment as economic performance as long as it reasonably expects the other person to provide the goods or all of the services within three and one-half months after the payment

Tax consequences of changing accounting methods

When a business changes from one accounting method to another, the business determines its taxable income for the year of change using the new method. Furthermore, the business must make an adjustment to taxable income that effectively represents the cumulative difference, as of the beginning of the tax year, between the amount of income (or deductions) recognized under the old accounting method and the amount that would have been recognized for all prior years if the new method had been applied. This adjustment is called a §481 adjustment. The §481 adjustment prevents the duplication or omission of items of income or deduction due to a change in accounting method. If the §481 adjustment increases taxable income, the taxpayer recognizes the total adjustment spread evenly over four years beginning with the year of the change (25 percent of the full adjustment each year). If the adjustment decreases taxable income, the taxpayer recognizes it entirely in the year of change.

Bad debt

When accrual method businesses sell a product or a service on credit, they debit accounts receivable and credit sales revenue for both financial and tax purposes. However, because businesses usually are unable to collect the full amount of their accounts receivable, they incur bad debt expense (a customer owes them a debt that the Page 9-25customer will not pay). For financial reporting purposes, the business estimates the amount of the bad debt, debits bad debt expense, and credits an allowance for doubtful accounts. However, for tax purposes, businesses are allowed to deduct bad debt expense only when the debt actually becomes worthless within the taxable year. Consequently, for tax purposes, businesses determine which debts are uncollectible and write them off by debiting bad debt expense and directly crediting the actual account receivable account that is uncollectible. This required method of determining bad debt expense for tax purposes is called the direct write-off method. In contrast, the method used for financial reporting purposes is called the allowance method. Businesses reporting taxable income on the cash method of accounting are not allowed to deduct bad debt expenses, because they do not include receivables in taxable income (they do not credit revenue until they actually receive payment).