Tax Planning: Tax Accounting Methods (Module 13)

ABC Partnership begins operations on October 1, 2017 and elects a September 30 year-end under Section 444. The partnership's net income for the fiscal year ended September 30, 2018, is $100,000. ABC must make a required payment of what?

$10,150 ($100,000 x 40.6% x 3/12) on or before April 15, 2018.

What is the limit on annual gross receipts for more than 3 years for C corporations to be able to use the cash method of accounting?

$25 million

What are the three accounting methods?

- Cash method - Accrual method - Hybrid method

What are the two topics that are not applicable to the installment method?

- Inventory - Marketable Securities

Completed Contract Method

- income from a contract is reported in the taxable year in which the contract is completed. - This is true regardless of whether the contract price is collected in advance, upon completion, or in installments. - Costs associated with the contract are accumulated in a work-in-progress account and deducted upon completion.

A Natural Business Year

A natural business year ends at or soon after the peak income-earning period (for example, the natural business year for a department store that has a seasonal holiday business may end on January 31)

Which type of business entity cannot use NOL? a. Estates b. S corporations c. Regular corporations d. Trusts

B

Carol MacMillan owns and operates a group of retail appliance stores with combined sales of $40M. The stores have an extensive selection of appliances. She uses FIFO. What method of tax accounting is most appropriate for Carol's business? a. LIFO b. Cash c. Accrual d. Hybrid e. FIFO

C FIFO and LIFO are inventory methods, not accounting methods.

Which of the following is not an accounting method? a. Accrual b. Cash c. Last-in, first out d. Hybrid

C LIFO is an inventory method.

If a publicly-held company wanted to reduce taxes in an inflationary period, which type of inventory method would they use? a. FIFO b. LILO c. LIFO d. Cash

C There is no LILO method.

On May 1, 2019 John sold a rare art piece that he had bought several years ago at a cost of $22,000. The terms of the sale were a price of $56,000, with a 20% down payment on May 1, with the balance to be paid monthly over the next 5 years. The annual interest rate is 8%, compounded monthly. The first payment will be received on May 31st. What are the total amounts that John must report in 2019 as (1) ordinary income and (2) capital gains?

Capital Gains = $9,831 Ordinary Income = $2,274 Step 1: Calculate GPP $56k-$22k = $34k $34k / $56k = 0.6071 Step 2: Calculate Part 1 of Capital Gains 20% x 56K = $11,200 $11,200 x .6071 = $6,799.52 or $6800 Step 3: Calculate loan payment amount 44800 CHS PV 5 g n 8 g i PMT = $908.38 Step 4: Calculate Ordinary Income Do not clear calculator from previous step 8 f amort = $2,273.99 or $2,274 Step 5: Capital Gain Part 2: Calculate gain on principal from the total payments Do not clear calculater from previous step x><y = $4,993.0705 x 0.6071 = $3,031 Step 6: Add both capital gain parts $3,031 + $6,800 = $9,831

Individual taxpayers and small businesses use the __________ method of accounting

Cash

Long-term Contracts

Contracts include building, installation, construction, or manufacturing contracts that are not completed in the same tax year in which they began. The accounting method selected by a taxpayer must be used for all long-term contracts in the same trade or business.

Which type of taxpayers must use the accrual method of accounting? A. Taxpayers with inventories B. Taxpayers using the completed contract method C. Taxpayers who have met the all-events test D. Taxpayers who do not use the hybrid method

Correct Answer: A. Taxpayers with inventories Explanation: The accrual method must be used for sales and costs of goods sold if inventories are an income producing factor of the business.

When preparing a tax return for a short period, the taxpayer should annualize the income if the short return: Why? A. is the last return for a decedent who died on November 23. B. is the first return for a corporation created on June 12. C. is a return for June 1 to December 31, for a corporation changing from a fiscal year to a calendar year. D. is the last return for a partnership, which is terminated on October 12.

Correct Answer: C. is a return for June 1 to December 31, for a corporation changing from a fiscal year to a calendar year. Explanation: Taxpayers who change from one accounting period to another must annualize their income for the resulting short period. This prevents income earned during the resulting short period from being taxed at lower rates.

When accounting for long-term contracts, all of the following accounting methods are acceptable EXCEPT? A. The completed contract method B. The percentage of completion method C. The modified percentage of completion method D. The cash method of accounting

Correct Answer: D. The cash method of accounting Explanation: Taxpayers must use accounting methods that clearly reflect income, which the cash method does not.

Percentage of Completion: Formula

Current Year Cost / Expected Total Cost

If a company elects the FIFO method of inventory control, how will the inventory be reflected on the balance sheet? a. It will be understated. b. It will be based on the accrual method. c. It will be based on the cash method. d. It will reflect current cost.

D

How many years can a NOL be carried forward? a. Lifetime b. 18 c. 2 d. 20

D NOL = Net Operating Loss

An NOL cannot be used by which of the following entities? a. Regular C Corporations b. Trusts c. Self-employed persons d. S Corporations

D S-Corps and partnerships cannot use NOLs (Net Operating Loss)

On average, Compuchat produces $15 million in annual revenues. Identify the easiest accounting method it may elect. Why? a. Hybrid b. LIFO c. Accrual d. Cash

D The cash method is now available with annual revenues not exceeding $25 million. It is the easiest accounting method to maintain.

A positive adjustment is subtracted from income, whereas a negative adjustment is added to income. True or false? Why?

False A positive adjustment is added to income, whereas a negative adjustment is subtracted from income

Among inventory accounting methods, FIFO normally results in the lowest taxable income. True or False? Why?

False The LIFO method results in the lowest taxable income during periods of inflation because it shows the highest cost of goods sold and therefore the lowest profits

How is the accounting period determined for partnerships?

Generally must use the tax year of the majority owners of the partnership. If the majority partners do not have the same tax year, they are required to use the tax year of the principal partners who have more than 5% ownership.

The tax rules related to accounting periods essentially require most partnerships, S corporations, and personal service corporations to report on the calendar year basis. In addition, almost all individual taxpayers also report on the calendar year basis. What impact does this have on accountants?

It causes the "accounting busy season". Crunching all auditing and accounting into a short period of time. The accounting profession has tried to push for change but no success

What inventory tax method may not use the lower of cost or market method?

LIFO

If taxpayers want to adopt the LIFO inventory method, do they need prior IRS approval?

No

How is prepaid income taxed in the accural method?

Prepaid income is generally taxable in the year of receipt. For example, if a lender receives interest for January in the preceding December, it is taxable in the year received, whether the lender uses the cash or accrual method. This treatment, of course, differs from financial accounting, where the interest would be reported as it accrues.

On July 1, 2019, Acme Corporation, a cash-basis, calendar-year taxpayer, pays an insurance premium of $3,000 for a policy that is effective July 1, 2019 to June 30, 2020. In what year is the expense tax deductible?

The full $3,000 is deductible in 2019.

How are Series E & Series EE bonds taxed under the cash method?

The interest is not taxed until the bond matures because that's when its received. If desired to defer the interest further and avoid paying tax on the interest income, you could exchange the Series EE bond for a Series HH bond within one year.

What do you think "reasonable accuracy" means in regards to the all-events test?

The phrase reasonable accuracy means that approximate amounts are ascertainable. Although the word accuracy means exactness or precision, when it is used with the word reasonable it implies something less than an exact amount

Look-Back Interest

When using the regular or modified percentage completion method you could potentially under-estimate you tax liabilities. If so then the taxpayer will pay interest on top of the additional tax owed

Section 444

allows partnerships, S corporations, and personal service corporations (such as incorporated medical practices) to elect a taxable year that results in a tax deferral of three months or less. For example, a partnership with calendar-year partners may elect a September 30 year-end.

How is the accounting period chosen for S Corporations and Personal Service Corporations?

are required to adopt a calendar year unless the corporation has a business purpose for electing a fiscal year. Taxpayers willing to make certain required payments or distributions may choose a fiscal year.

For example, in December of the current year, Troy, who owns an apartment building, collects the first and last months' rent from the tenant. How would the cash method handle this?

Troy must report two months' rent in the current year. The actual expenses associated with the last month's rental are not incurred until the last month. However, Troy must report two months' income this year, but may only deduct one month's expenses.

The term "constructive receipt" means the taxpayer has access to the income at any time. True or false?

True Constructive receipt means the income is made available to the taxpayer so that he may draw upon it at any time. However, income is not constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions

Taxpayers using the accrual method of accounting generally report income in the year it is __________

earned

Hybrid Method

is a combination of the cash and accrual method. Some items of income or expense are reported under a cash basis and others are reported under the accrual method. This method is often seen in small businesses that maintain inventories.

Instances of constructive receipt where taxpayers are required to report taxable income even though no cash is actually received include examples like?

- A check received after banking hours - Interest credited to a bank savings account - Bond interest coupons that have matured but have not been redeemed - Salary available to an employee who does not accept payment

How does changing your accounting period work?

- Changes in the accounting period cannot be changed without consent from the IRS. - The IRS approves of a change only if the taxpayer is able to establish a substantial business purpose for the change. - There are also a few instances where IRS approval is not required to change an accounting period such as a newly married person changing tax years to match his or her spouse so that a joint return may be filed.

When are the two times that completed contract method can be used?

- First, the method can be used by smaller companies for construction contracts that are expected to take two years or less to complete; - Second, for home construction contracts.

What are the three key points about installment sales?

- Gains captured as ordinary income must be recognized in the year of the sale, unless its a section 1231 gain - If property is sold to related party and then subsequently sold within 2 years then the deferred gain is fully recognized at that time by the original seller - Gross Profit Percentage (GPP) is used to calculate gain

Lower of Cost or Market Method

- On the date an inventory is valued, the replacement cost of each item in the inventory is compared with its cost. -The lower figure is used as the inventory value. - available to all taxpayers other than those who determine cost using the LIFO method. - The term "market" refers to replacement cost.

What are the four methods that taxpayers may determine inventory costs by?

- Specific identification method - FIFO - LIFO - Lower of Cost or Market Method

Accrual Method

- is used for sales and costs of goods sold if inventories are income-producing factors of a business. Taxpayers report income in the year it is earned. - Income is earned when all the events that fix the right to receive the income have occurred and the amount of income can be easily determined.

Constructive receipt

- means that the income is made available to the taxpayer so that he may draw upon it at any time. - - However, income is not constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions. This rule prevents taxpayers from deferring income that is otherwise available by merely "turning their backs" on it. A taxpayer cannot defer income recognition by refusing to accept payment until a later taxable year.

If a tax method is voluntarily changed, how are adjustments reported to the IRS?

- taxpayers must agree to report the adjustment over a period not to exceed four years. - In the case of a change spread out over four years, equal portions of the change are reported in each of the four years beginning with the year of the change.

Percentage of Completion Method

- the taxpayer reports a percentage of the gross income from a long-term contract based on the portion of work that has been completed. - The portion of the total contract price reported in a given year is determined by multiplying the total contract price by the percentage of work completed in the year. - The percentage is determined by dividing current year costs by the expected total costs.

Interest must be capitalized if the property being produced is which of the following? 1. Long-lived 2. Costing more than $1 million in less than 1 year 3. Real 4. Requiring more than 2 years to produce

1, 3, 4 Interest must be capitalized if the property being produced is real property, long-lived property, or property that requires more than two years to produce (one year in the case of property costing more than $1 million).

Returns for periods less than 12 months are acceptable for the following two reasons, what are they?

1. When the taxpayer's first or final return is filed 2. when the taxpayer changes accounting periods.

Which of the following businesses or entities cannot use the cash method of accounting? 1. A CPA firm doing business as a partnership 2. A trust 3. A large department store chain 4. A C corporation with $35 million of annual gross receipts for more than 3 years

3, 4 The limit on C corporations is $25 million. A large department store chain uses the accrual method because of inventory.

The look-back interest adjustment involves which of the following? 1. Calculation of interest on an installment sale 2. Calculation of additional tax due if actual cost rather than estimated cost has been used for the percentage of completion method 3. Calculation of gross profit on an installment sale collection 4. Calculation of interest on additional tax due if actual cost rather than estimated cost had been used on the percentage of completion method

4 When a contract is completed, a computation is made to determine whether the tax paid each year during t he contract is more or less. The tax that would have been paid is also estimated, if the actual total cost of the contract had been used rather than the estimated cost. Interest is paid on any additional tax that would have been paid

During an inflationary period, Company A is using the LIFO form of inventory control. If it changes to FIFO, which of the following will be true? Why? a. Net business income will be higher. b. Tax liability will be lower. c. Net business income will be lower. d. Inventory cost will be understated.

A FIFO indicates that Company A sell its lowest cost goods first. Thus its income would increase. If Company A went from FIFO to LIFO its inventory cost would be understated and both its net business income and tax liability would be lower.

How are accounts receivable used in the cash method?

Accounts receivable or other unsupported promises to pay are considered to have no value under the cash method and, as a result, no income is recognized until the receivable is collected. The fact that prepaid income is taxed when received and not when earned often results in a mismatching of income and expenses.

All Events test for the Accural Method

An accrual-method taxpayer reports an item of income when "all events" have occurred that fix the taxpayer's right to receive the item of income and the amount can be determined with reasonable accuracy.

Which of the following can use the installment method of tax recognition? a. The property is sold at a loss. b. The property sold is undeveloped land. c. The property sold is publicly traded securities. d. The property is sold to a son, who in turn sells the property within one year of the original purchase date.

B The only answer that can use the installment method is undeveloped land.

Tina Adams owns a consignment shop. She operates her business as an S Corporation. Typical annual revenues are $750,000. She takes in all kinds of inventory and the turnover based on good pricing and sales keeps her profitable month after month. What type of tax accounting does she use? Why? a. FIFO b. Cash c. Accrual d. Hybrid e. Conduit

B Tina's S Corporation may implement the cash method of accounting. The cash method would be the easiest to maintain.

Due to inflation, inventory costs have risen. Jack LaRue wants to sell LaRue, Inc. for the best possible price. He wants profits to look as strong as possible. What should he do if he is currently valuating inventory using LIFO? Why? a. Change to FIFO b. Stay with LIFO c. Use specific identification d. Use a weight average of LIFO or FIFO

C As an alternative to FIFO or LIFO, businesses may value inventory under a specific identification method. If a taxpayer can specifically identify what to sell he can create a gain, a loss, or neutralize the gain or loss. By doing this, he could create the best profit. If he changed to FIFO, that would increase his earnings.

ABC Corporation had an unprofitable year in 2015, losing $5 million. Prior to 2015, the company was marginally profitable. In 2016, the corporation broke even. With the development of a new product in 2017, the company made $10 million. How much NOL can the company use? Why? a. $10 million this year. b. None, ABC is an S corporation. c. $5 million this year. d. Zero, the company is profitable in 2017.

C Presuming ABC is a regular corporation, 2017 NOL rules allow a company to carry back a loss 2 years or it can be carried forward for 20 years. The 2015 loss of $5 million can be used in 2017 against the $10 million gain.

On January 31, 2019, John sold an antique desk that he used in his business for $15,000. John's original cost was $9,000, and John had taken cost recovery of $5,064. The terms of the sale were 10% down, and the balance to be paid in 48 monthly payments at a rate of 7%, with the first payment beginning on February 28, 2019. What must John report in 2019 as ordinary income and capital gain?

Capital Gains = $1,707.84 Ordinary Income = $5,850.41 Step 1: Assess Recapture Value the prior cost recovery of $5,064 must be recaptured under section 1245 as ordinary income and be recognized fully in the year of the sale Step 2: Calculate GPP (15k-9k)/15k = 40% Step 3: Calculate monthly payment 13500 CHS PV 48 n 7 g i PMT = $323.27 Step 4: Calculate the interest collected over first partial year 11 f amort = $786.41 Step 5: Calculate total payments over first partial year $323.27 x 11 = $3,555.97 Step 6: Calculate the total principal paid over first partial year $3,555.97-$786.41 = $2,769.61 Step 7: Apply GPP to down payment & Principal Amount to find total capital gains (1500+2769.61) x 40% = $1,707.84 Step 8: Calculate the total ordinary income (the interest plus recapture amount) 786.41 + 5064 = $5,850.41

All of the following are acceptable accounting tax years EXCEPT? Why? A. A corporate tax year ending on February 15th B. A corporate tax year ending on the last Friday in April C. A partnership tax year ending on December 31 with three equal tax partners whose tax year ends on September 30, October 31, and November 30. D. An S corporation's tax year ending on December 31.

Correct Answer: A. A corporate tax year ending on February 15th Explanation: A tax year must fall at the end of the month or be specified as a specific day at the end of the month such as the last Friday in April.

Why is LIFO inventory recommended during inflationary periods? Why? A. It tends to reduce inventory values and increase the cost of goods sold B. It tends to reduce inventory values and decrease the cost of goods sold C. It tends to increase inventory values and decrease the cost of goods sold D. It tends to increase inventory values and increase the cost of goods sold

Correct Answer: A. It tends to reduce inventory values and increase the cost of goods sold Explanation: LIFO inventory is often recommended because, during inflationary periods, it tends to reduce inventory values and increase the cost of goods sold. This will reduce taxable income. In certain industries, such as the computer industry, however, costs are declining, and LIFO actually may result in a higher inventory value.

The tax year must coincide with the year used to keep the taxpayer's books and records. A. True B. False

Correct Answer: A. True Explanation: The tax year must coincide with the year used to keep the taxpayer's books and records. Taxpayers who do not have books must use a calendar year.

How is the LIFO method adopted in the initial year that inventories are maintained? A. With IRS approval B. By using the LIFO method C. By filing Form 970 D. By filing Form 3115

Correct Answer: B. By using the LIFO method Explanation: The LIFO method may be adopted in the initial year that inventories are maintained by merely using the method in that year.

A taxpayer must use the same accounting method on a personal tax return as the taxpayer's business. Why? A. True B. False

Correct Answer: B. False Explanation: An overall accounting method used in one business does not have to be the same method used in another business or for non-business income and deductions.

If a majority of the partners do not have the same tax year, they should use the ________ partners' tax year

Principal If a majority of partners do not have the same tax year, the partnership must use the tax year of its principal partners (those with more than 5% interest in the partnership)

Jane begins a new retail business which has sales of $400,000 during the first year. She has no receivables as all sales are for cash. She purchases $240,000 of merchandise during the year. At the end of the year she has not paid for $30,000 of the merchandise she purchased, and she has $50,000 of inventory on hand. Other expenses of the business were $150,000. As her average gross receipts are less than $1 million she can use either the cash or accrual method. What is her net income under the cash method?

Sales = $400k Purchases = $210k Inventory= $50k Cost of sales = $210k (Amount actually paid for inventory during the year) Gross Profit = $190k Expenses = $150k Net Income = $40k

Jane begins a new retail business which has sales of $400,000 during the first year. She has no receivables as all sales are for cash. She purchases $240,000 of merchandise during the year. At the end of the year she has not paid for $30,000 of the merchandise she purchased, and she has $50,000 of inventory on hand. Other expenses of the business were $150,000. As her average gross receipts are less than $1 million she can use either the cash or accrual method. What is her net income under the accrual method?

Sales = $400k Purchases = $240k Inventory= $50k Cost of sales = $190k (Inventory used (240k-40k)) Gross Profit = $210k Expenses = $150k Net Income = $60k

Beth owns an ordinary life insurance policy with a cash surrender value. Does she need to report the income as it increases? Why?

She need not report any income as the cash surrender value increases, because the requirement that she cancel the policy in order to collect the cash surrender value constitutes a substantial restriction. If she cancels the policy, she reports as income the difference between the cash surrender value collected and net premiums paid.

A client would like to know what balance on their mortgage will be due to the bank at the end of 1, 5, and 10 years. They just borrowed $275,000 at a fixed rate of 7.25%, compounded monthly, for 30 years. What are the answers?

Step 1: Enter Loan Information to Calculate Payment. 360 N 275,000 CHS PV 7.25 g i PMT = 1,875.98 Step 2: Calculate 1 year 12 f amort = $19,850.21 (interest for first year) X><Y = $2,661.61 (principal for first year) RCL PV = $272,338.39 (balance at end of year 1) Step 3: Calculate 5 Year 48 f amort = $77,250.51 (interest for four more years) X><Y = $12,796.76 (principal paid in next four years) RCL PV = $259,541.64 (balance at end of year 5) Step 4: Calculate 10 Year 60 f amort = $90,370.91 (interest for five more years) X><Y = $22,188.17 (principal paid in next five years) RCL PV = $237,35346 (balance at end of year 10)

Procedures for Changing LIFO

The LIFO method can be adopted in the initial year when inventories are maintained by simply using that method in that year. Form 970 must be complete and sent with the return.

Accounting Period

The taxpayer's annual period on the basis of which taxable income is computed. An accounting period is either a calendar year or fiscal year typically consisting of 12 months.

Cash Method

is used by most individual taxpayers and small businesses. Under this method, income is reported in the year the taxpayer constructively receives the income rather than in the year it is earned.

Modified Percentage Completion Method

taxpayers may elect to defer reporting any income from a contract until they have incurred at least 10% of the estimated total cost. This is because at the beginning of a contract, it is difficult to estimate total costs