acc 331 CHPT 9: Business income, business deductions, and accounting methods

Rachael operates a hair salon as a sole proprietorship. This year she attends a hair styling convention in Chicago to learn about the latest trends and techniques in hair design and hair products. She spends $800 to attend seminars at the convention. a) How much of these expenses can Rachel deduct?

800 Helps w/ her job

Practice Problems Below

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Jana owns a restaurant. She strongly supports a candidate who is running for State Representative. To support the candidate's campaign, Jana allows the candidate to hold a fundraising dinner at her restaurant. Jana incurred $3,000 of expenses for food and staffing the restaurant that evening. How much of these expenditures can Jana deduct?

0 Expenditure supporting politics

Mellor Inc. employs Rick, who generates a great deal of revenue for Mellor. Rick suffered a heart attack several years ago. This year, Mellor purchased a "key employee" term-life insurance policy for $850 that will pay Mellor $20,000 if Rick passes away within the next twelve months. What amount of the life insurance policy premiums can Mellor deduct?

0 Expense incurred in connection w/ tax exempt income Life insurance proceeds would be tax exempt and expenses incurred in connection w/ generating tax exempt income are not deductible

Rachael decides she does not enjoy hair styling as much as she used to. She decides to take a graphic design course at the local community college. The course costs $2,500, which Rachel pays out of her hair salon's banking account. How much of this expenditure can Rachel deduct?

0 not in relation to her job

On December 28, 2019, Mike paid $2,400 for a 12-month insurance policy providing coverage from February 2, 2020 through January 31, 2021.

0 Length of contract period is OK Making payment in 2019, end of contract period extends beyond tax period (extends past Dec 31st), goes to 2021 Second condition of 12-month rule is violated. Capitalize and amortize the full amount

Bob owns a lawn care service. One of Bob's employees inappropriately disposed of debris, which violated a city ordinance. As a result, the city fined Bob's business $3,000. How much of this payment can Bob deduct?

0 Not a deductible expenditure against public policy

In October 2019, Jim, an accrual basis taxpayer, enters into a one-year $8,000 contract for an online advertising campaign for Jim's business. The advertising agency agreed that Jim would owe nothing under the contract unless his sales increase by at least 20 percent over the next six months. (all events test for accrual deductions) a) What amount can Jim deduct in 2019 for this contract?

0. All events test is not satisfied b/c Jim might not have to pay anything if his sales haven't increased by 20% as of march 2020

a) What if Jim were a cash basis taxpayer?

0. He hasn't made any payment yet.

Mike is a calendar year taxpayer and uses the cash method of accounting for his business activities. What amount can he deduct in 2019 under the following scenarios? (prepaid expenses, 12 month rule) a) On July 1, 2019, Mike paid $2,400 for a 12-month insurance policy that covers his business from July 1, 2019 through June 30, 2020.

2,400 Both conditions of the 12- month rule for pre-paid expenses are satisfied

a) What amount associated with this liability to Michigan Plumbing is Ken allowed to deduct in 2019 and 2020 if he is a cash-basis taxpayer?

2019: 1500 2020: 4000 Deduction when paid

a) Alternatively, assume Ken expects Michigan Plumbing to start and finish the work in January. What amount associated with this liability to Michigan Plumbing is Ken allowed to deduct in 2019 and 2020?

2019: 1500 2020: 4000 Economic performance with payment if actual performance is within 3 ½ months.

a) In what year would Jay deduct the refunds if he were a cash-basis taxpayer?

2020 b/c year in which they were paid

Jay, an accrual basis taxpayer, operates a lawn care and snow removal business. If clients are not completely satisfied with his work, Jay offers a $100 refund with no questions asked. The number of customers who request refunds varies dramatically from year-to-year. Near the end of 2019, Jay had five clients request refunds. However, Jay was so busy during the holiday season that he didn't pay the refunds until January 2020. (economic performance; returning item exception) a) When should Jay deduct the customer refunds?

2020 when they are actually paid b/c they are a payment liability

Meal deductions

50% of the cost of business meals may be deducted (entertainment expense are not deductible) Sophia was negotiating an agreement with a new client. The meeting took longer than expected, and at 7pm Sophia suggested they go to Stillwater Grill to eat and finish the agreement. Sophia paid $100 for the meal. How much of this expenditure can Sophia deduct? $50. This was a business meal, so Sophia can deduct 50 percent of cost of the meal (100 x 50% = $50).

Chris took a prospective client out to dinner at Dusty's Wine Cellar to discuss business. After dinner, Chris took the client to a theater performance at the Wharton Center. Chris paid $150 for the meal and $200 for the tickets. The amounts are reasonable under the circumstances. What amount of these expenditures can Chris deduct as business expenses?

75 50% of meal is deductible (.5 x 150) Entertainment is not deductible (don't include 200)

Overall accounting method

A taxpayer's accounting method for tax purposes determines when income is reported and when an expense is deductible on the tax return in general, a taxpayer's accounting method for tax purposes can be different from its accounting method for financial reporting purposes however, large C-corps or large partnerships wit ha C-corps as an owner are required to sue the accrual method

Accrual method (accrual income)

Accrual income (tax is recognized earlier than in financial accrual) In general, gross income is recognized when the all events test is satisfied. The all events test requires that all events have occurred to entitle the taxpayer to receive the income and the amount of income can be dendrite with reasonable accuracy. All events have occurred to fix the taxpayer's right to receive income on the earliest of: -When title/ownership of property passes to the buyer or services have been performed for the customer/client -when payment for the work is due -when the business receives payment for the work -when income is recognized on the financial statements Taxation of advance payments of income (unearned income) =prepaid rent and interest income are recognized in the year received. (note that security deposits from rental customers are not recognized as income when received b/c the taxpayer has a liability to return the deposits) -In general, advance payments for goods and services are recognized in the year payment is received. but, taxpayers can elect to defer recognition of the unearned portion of advance payment for goods and services until the tax year following the year they receive payment. Deferral is not available if the advance payment was included in financial accounting income. e.g.In October 2019, Jaron received a payment of $6,000 from a client for 12 months of services to be provided from November 1, 2019 through October 31, 2020. Jaron is an accrual-basis taxpayer and elects to defer recognizing income whenever possible. How much of the payment must Jaron recognize as income in 2019? $1,000. Under the general rule, Jaron would have to recognize the entire advance payment as income in the year received. However, Jaron can elect to defer the portion of the payment that was not earned during 2019 until the tax year following the year of payment (i.e., 2020). Thus, Jaron only needs to recognize income of $1,000 (= 6,000*(2/12)) for the services actually provided in 2019.

Activity for economic performance Occurs Chart

Activity - Economic performance: Receiving goods or services from another person - 1) when goods or services are delivered/provided to business, or 2) upon payment if the taxpayer reasonably expects the other person to perform within 3 and 1/2 months of payment Renting or leasing property - over rental/lease period Providing goods or services to another person - As costs are incurred to provide goods/services "Payment" liabilities (e.g. worker's compensation, rebates) - When business actually makes payments

On December 20, 2019 Ken, an accrual-basis taxpayer, hires a Michigan Plumbing to perform plumbing-related repairs and maintenance for his business property. Ken makes a down payment of $1,500 and agrees to pay the remaining $4,000 when Michigan Plumbing finishes the work. Ken expects Michigan Plumbing to start the work in January and finish in early May. (economic performance test) a) What amount associated with this liability to Michigan Plumbing is Ken allowed to deduct in 2019 and 2020?

Actual performance isn't expected till May which is passed the 3 ½ performance rule 2019: 0 2020: 1500 Economic performance will occur when services are provided

ABC Enterprises borrows $150,000 to purchase machinery and pays $11,000 in interest expense for the year. ABC Enterprise reports gross income of $80,000 and incurred $56,000 of deductible expenses (excluding $4,000 of depreciation and the $11,000 of interest on the loan). ABC Enterprises also generated investment income of $8,000. Assuming the business interest limitation applies, what amount of interest expense can ABC Enterprises deduct in the current year?

Adjusted Taxable Income: 80,000 - 56,000 = 24,000 (No business interest income) 0 + 30% * 24,000 = 7,200; (they were given interest income but no info on business interest income) 7,200 deductibles in current year; the remaining business interest expense is carried forward

Airfare $800 Hotel $200 per day Meals $50 per day Incidentals $20 per day a) Assume two days of the trip were for business and four days were for vacation. How much of the expenditures are deductible?

Airfare: 0 (mainly personal and domestic, dont deduct) Meals: 50% * 2 * 50 = 50 Hotel: 200 * 2 = 400 Incidentals: 20 * 2 = 40 =490

Clara is self-employed and takes a six-day trip to Denver, Colorado. She incurred the following expenses: Airfare $800 Hotel $200 per day Meals $50 per day Incidentals $20 per day a) Assume four days of the trip were for business and two days were for vacation. How much of the expenditures are deductible?

Airfare: 800 (if mainly business and domestic, deduct all transportation ) Meals: 50% * 50 * 4 = 100 (50% of business portion) Hotel: 4 * 200 = 800 (business portion only) Incidentals: 20 * 4 = 80 (business portion only) = 1780

Necessary

An expense is necessary if it is appropriate and helpful to the taxpayer's business activity (i.e., a reasonable and prudent business person would incur the expense) The expense does not need to be essential or indispensable to be considered necessary e.g.Silly Corp. decided to spend $200,000 to have its logo on a professional soccer team's jersey for this season. Can Silly deduct this expenditure? Yes. Even though the expenditure is not critical to the daily operations of its business, the intent of the expenditure is to attract more customers to help Silly's business. Thus, the expenditure qualifies as necessary.

Limitations on business interest deductions (increase their tax of debt)

Business interest expense is interest paid or incurred in financing a business (e.g. interest on a loan taken out to purchase machinery. The deduction for business interest expense is limited to: Business interest income + 30% of adjusted taxable income Adjustable taxable income excludes (subtract): -Income and expense not allocated to this trade -Business interest income and business interest expense (this does not include investment income or investment interest expense.) -any net operating loss deductions -depreciation, amortization, and depletion deduction Any business interest expense not allowed as a deduction for a taxable year is carried forward indefinitely . the limitation does not apply to taxpayers with average gross receipts <= $26 million for the prior three years e.g. Hope Corporation has adjusted taxable income of $300,000, $20,000 of business interest income, and $120,000 of business interest expense. The limitation on business interest deductions applies to Hope. What is Hope's business interest deduction for the year? $110,000. The business interest deduction is limited to business interest income + 30% of adjusted taxable income, which equals $110,000 (= 20,000 + 30%*300,000). The non-deductible interest of $10,000 (= 120,000 - 110,000) is carried forward indefinitely.

Transportation Deductions

Businesses can deduct the cost of transportation between business sites They can deduct either the actual cost of operation a vehicle (including deprecation) or a standard mileage rate (58 cents per mile in 2019) Commuting from home to the regular place of business is a personal expense, and therefore is not deductible

Capital expenditures

Businesses must capitalize expenditures for tangible properties (e.g. buildings, machinery, furniture, computers) with a useful life of more than one year. The cost of these assets is recovered over time through depreciation Businesses must capitalize costs incurred to create or acquired intangible assets (e.g. patents, goodwill, start up costs, and organizational expenditures) the cost of these assets may be recovered over time through amortization or when the asset is disposed of prepaid expense are also capitalized and deducted over the contract period. however, the 12 month rule for prepaid expenses allows certain prepaid expenses to be immediately deducted e.g. Cai operates a sole proprietorship and uses the cash method of accounting. This year, he purchased land for $80,000 to use in his business. How much of this expenditure can Cai deduct this year? $0. Land has a useful live of more than one year, so Cai must capitalize the expenditure. Cash method and accrual method taxpayers are required to capitalize these types of expenditures.

Accounting peirods

Businesses report their income and deductions over a a fixed accounting period (also referred to as a tax year) the possible tax years include: -Calendar year that ends December 31st -fiscal year that ends on the last day of a month other than December -52/53 week year that ends on the same day of the week (e.g. last Saturday in January each year or the Saturday closets to the end of January each year) The tax year a business is allowed to use depends on the type of entity: Sole proprietorship - use a calendar year to match the owner's individual tax return Flow through entities - must adopt a tax year consistent with the owners' tax years C corps - may use a calendar, fiscal, or 52/53 week year

a) Alternatively, suppose that Jay expected that $500 of refunds would typically be requested during the year and $500 is an immaterial amount for his business. Can Jay deduct the refunds in 2019?

Deduct 500 in 2019 b/c of the recurring item exception

Expenses associated with the production of tax exempt income

Expenses incurred in the generation/production of tax exempt income are not deductible. Examples include interest expenses on loans taken out to acquire tax exempt investments and life insurance premiums paid by a business to cover key executives where the business is the beneficiary (e.g. municipal bond) JB Corp. took out a loan and used the money to purchase a tax-exempt bond. JB paid $3,000 of interest expense on the loan. How much the interest expense can JB deduct this year? $0. Because the loan proceeds were used to purchase a tax-exempt bond, the interest expense is associated with the production of tax-exempt income, and therefore is not deductible.

Accrual deductions

Expenses must satisfy the all events test and economic performance test to be deducted the all events test for deductions requires all events have occurred to establish the taxpayer's liability (e.g., signing of a contract) and the amount of the liability can be determined with reasonable accuracy The economic performance test requires that the underlying activity generating the liability has occurred. When economic performance occurs depends on the activity that creates the liability See chart If the economic performance test has not been satisfied by year end, an expense may still be deducted under the recurring item exception. An expense can be deducted under the recurring item exception if the: -amount is expected to recur in future years, -amount is either not material or deducting the expense matches it with revenue, -All events test is satisfied at year end, and -Actual economic performance is expected within a reasonable time after year end but prior to the filing of the tax return the 12 month rule for prepaid expense also applies to accrual basis taxpayers E.g Robin, Inc. rented an auditorium at a local community college for a jazz festival that took place on December 21st of the current year. Robin is responsible for cleaning up the auditorium after the festival and hired a cleaning company to do the work for $2,000. Because the college was closed over the holidays, the cleaning company performed the work on January 4th of the following year. Robin paid the cleaning company when the job was finished. How much of the cost of the cleaning can Robin deduct in the current year? $0. The economic performance test has not been satisfied in the current year. Robin is receiving services from another party, so economic performance occurs when the other party provides the services, or upon payment if performance is expected within 3 ½ months. Robin can deduct the $2,000 in the following year when economic performance has occurred. see exhibit 9-4 for comparison of cash and accrual methods

a) On July 1, 2019, Mike paid $2,400 for an 18-month policy providing coverage from July 1, 2019 to December 31, 2020.

First condition of 12-month rule is violated -> capitalize and amortize (6/18) of coverage were provided so 6/18 * 2400 = 800

Property use

If property is used for both business and personal purposes, taxpayers must allocated the expense between the business and personal use portions the business use portion is deductible

Cash method

In general, gross income is recognized when cash, property, or services is actually or constructively received In general, expense are deducted in the year paid. However, if the expenses creates an asset with a useful life that extends beyond the current tax year, the expense must be capitalized and is generally recovered over its useful life 12 month rule for prepaid expense (applies to cash-basis and accrual basis taxpayers) : -Prepaid business expense may be deducted if the: --Contract period does not last more than one year, and --contract period does not extend beyond the end of the tax year following the year of payment -Does not apply to prepaid interest expense -(For accrual basis taxpayers, the economic performance test must be satisfied) e.g. Brian uses the cash method of accounting for his business. On January 1, 2019, he paid $3,600 for an 18-month insurance policy for his business. How much of this payment may he deduct in 2019? $2,400. Brian is not able to deduct the full $3,600 in 2019 because the payment is a prepaid expense whose benefits extend beyond the end of the tax year. The prepaid insurance cannot be deducted under the 12-month rule for prepaid expenses because the contract period is more than one year. As a result, Brian can deduct the portion of the payment that relates to insurance coverage provided in 2019 (2,400 = 3,600*(12/18)).

Business Gross Income

Includes all income from whatever source derived business income includes: Gross profit from the sale of inventory (sales - cost of goods sold) Income from services provided to customers Income from renting property to customers

Basic formula for Federal Income Tax

Income (broadly defined) Less: exclusions (income that is not subjected to tax) = Gross Income (income that is subjected to tax) Less: Deductions = Taxable Income Federal income tax on taxable income (see tax rate schedules) Less: Tax Credits (including federal income tax withheld and other prepayments of Federal income taxes) = Tax owed (or refunded)

Personal expenditures

Personal living and family expenses cannot be deducted as business expenses the cost of uniforms or special clothing purchased for use in the business is deductible if they are not appropriate to wear as ordinary clothing educational expenses are deductible if the taxpayer is self employed and the education maintains or improves skills in her existing trade or business. Educational expenses that enable the taxpayer to enter a new occupations are not deductible Andy owns an auto-repair shop. He spent $600 to purchase coveralls with the shop name and logo on them to wear while working on cars. Can Andy deduct this expenditure? Yes. Clothing is generally considered a personal expenditure, but because Andy purchased the coveralls for use in the business and they are not appropriate to wear as ordinary clothing, the cost of the clothing is deductible.

Reasonable in amount

Reasonableness is assessed by comparing the expense to the fair market price (i.e. what a taxpayer would pay in an arm's length transaction) any excess amount over the fair market price is not deductible Reasonableness is most likely to be an issue in transactions between related parties (e.g. family members) Tom pays his son $20,000 for part-time cleaning work at Tom's small business. Tom could have hired a cleaning service to do the work for $12,000. Can Tom deduct this expenditure? Tom can deduct $12,000. Because he could have hired a cleaning service to do the work for $12,000, the $8,000 excess over the fair market price of the services will not be considered reasonable in amount, and therefore will not be deductible as a business expense.

Mixed Motive Expneditures

Some expenses have both a business and personal aspect The amount of the expense that is deductible depends on the type of expense e.g. Meal Transportation Travel Property use

Bad debt expnese

Taxpayers are required to use the direct write off method accrual method taxpayers are allowed to deduct bad dept expense if a receivable becomes worthless during the year (note cash basis taxpayers will not deduct bad debt expense b/c they do not include receivables ins taxable income only take a deduction for bad debt expense if there is a receivables that is deemed to be worthless

Business Deductions

Trade and business expenses are allowed as deductions provided they are: Ordinary Necessary Reasonable in amount e.g. of common deductions: Depreciation Employee compensation and benefits Insurance Rent Repairs Utilities

Travel deduction

Travel expense includes transportation, meals (50% deductible), lodging, and incidental expenses when the taxpayer is away from home overnight if the travel is primarily for business purposes all transportation costs are deductible, and the deduction for meals (50%), lodging, and incidental expenses is limited to the business portion of the travel If the travel is primarily for personal purposes, the transportation costs are not deductible, and the deduction for meals (50%), lodging, and incidental expense is limited to the business portion of the travel If the travel is international and includes business and personal aspects, the transportation cost is allocated between the business and personal portion of the trip. the business portion of the transportation cost is deductible, and the deduction for meals (50%), lodging, and incidental expense is limited to the business portion of the travel E.g. Dan is a sole proprietor. He travelled to Australia this year. Five days of the trip were devoted to business activities, and two days were for sightseeing. Dan spent $2,800 on the airfare, $200 per day for a hotel room, and $75 a day for meals. How much of these expenses can Dan deduct? $3,188. Because the trip involved international travel, the transportation cost must be apportioned between the business and personal travel. Therefore, $2,000 of the airfare is deductible (= 2,800*(5/7)). Dan can deduct $1,000 for the hotel (= 200*5). Dan can deduct $188 for meals (= 75*5*50%).

Ordinary

an expense is ordinary if its normal, usual or customary under regular business circumstances The expense does not need to be recurring to be considered ordinary e.g.Shock Inc. paid $150,000 in legal fees to defend itself in a lawsuit. Shock has never been involved in a lawsuit before, and it hopes it is never involved in a lawsuit again. Can Shock deduct the legal fees? Yes. Even though this might be the only lawsuit Shock is ever involved in, the legal fees are considered ordinary business expenses because a business would be expected to incur legal fees when it is involved in a lawsuit. Thus, the legal fees are ordinary under the circumstances.

Specific business deductions

losses on dispositions of business property: In general, businesses are allowed to deduct losses incurred when selling or disposing of property Business casualty losses: a casualty occurs when an asset of a business is stolen, damaged, or destroyed by a force outside the business' control. Business are allowed to deduct casualty losses

Expenditures against public policy

payment that are gains the law or result from breaking the law are not necessary expenses and therefore are not deductible e.g. fines, penalties, illegal bribes, and illegal kickbacks Chase is a sole proprietor. He paid a $100 speeding ticket that he received when he was driving to a meeting with a client. Can Chase deduct this expenditure? No. The speeding ticket is a fine/penalty for violating the law, and therefore it is not a deductible business expense.

political contributions and lobbying costs

taxpayers are not allowed to deduct political contributions and most lobbying expenses e.g.Walker Inc. contributed $3,000 to the state governor's re-election campaign. Can Walker deduct this expenditure? No. The expenditure was a political contribution, and therefore it is not a deductible business expense.

Limitations on business deductions

the tax law limits a business' ability to deduct certain expenses