Chapter 6 - Taxable Income from Business Operations

Method of Accounting

A consistent system for determining the point in time at which items of income and deduction are recognized for tax purposes.

Permanent Difference

A difference between financial statement income and taxable income that does not reverse over time When an expense or loss is realized for book purposes but never recognized for tax purposes. Nondeductible fines and penalties, entertainment costs, and the nondeductible 50 percent of business meals are good examples.

temporary difference

A difference between financial statement income and taxable income that reverses over time

NOL Carryforward

A net operating loss allowed as a deduction in the years following the year of loss. The amount deductible in any carryforward year is limited to 80 percent of taxable income.

Short Period Return

A tax return for a taxable year consisting of less than 12 months. When a firm has a convincing reason for changing its annual accounting period, the IRS usually grants permission for the firm to change its taxable year. If the firm lacks a convincing reason, the IRS may withhold permission for the change. In those cases in which the IRS grants permission. The firm files a Short Period Return.

Taxpayers subject to the excess business loss limitation

ABC LLC is a partnership with two equal partners, Alice and Beta Corporation. This year, ABC incurred an overall business loss of $(800,000), allocating $(400,000) of such loss to each partner. Beta's share of the loss is not subject to the excess business loss limitation, since Beta is a corporation. If Alice is married filing a joint return and the loss allocated from ABC is her only business activity, the excess business loss limitation will not apply because her loss is below the $518,000 threshold. If Alice is single, $141,000 of her loss exceeds the $259,000 threshold and is subject to the excess business loss limitation. A taxpayer's excess business loss equals the aggregate of deductions from the taxpayer's trades and businesses over the sum of aggregate business gross income and business gains plus the $518,000 or $259,000 threshold amount. Thus a taxpayer involved in multiple trades and businesses is allowed to net losses from one business against profits from another in applying the limitation.

Payment liabilities

Accrued liabilities for which economic performance does not occur until payment is made

Qualified Business Income (QBI)

Active trade or business income from nonservice businesses eligible for the Section 199A deduction This deduction effectively lowers the marginal tax rate on business income earned through sole proprietorships, partnerships, and S Corporation. Mr. Jones has a marginal tax rate of 37 percent. This year, he earned $100,000 of qualified business income through his sole proprietorship. After the 20 percent QBI deduction, Mr. Jones will pay tax on only $80,000 of business profit ($100,000 — $100,000 x 20 percent). Thus, Mr. Jones owes $29,600 of tax on his business income ($80,000 x 37 percent), an effective tax rate of 29.6 percent ($29,600 : $100,000).

Recurring Item Exception

An exception to the economic performance requirement under which a liability is considered incurred in a taxable year in which it meets the first two requirements of the all-events test and economic performance occurs within 81/2 months after year- end Omero Company, a calendar year taxpayer, sells digital cameras. Omero refunds the full purchase price of a camera to any customer who requests the refund in writing within 90 days of purchase. At the end of 2020, Omero accrued a $17,600 expense and a $17,600 liability for refunds payable with respect to refund requests received but unpaid. Omero paid all of these requests by September 15, 2021. If Omero hasn't adopted the recurring item exception as its method of accounting for refunds, economic performance (payment) occurred in 2021, and the $17,600 expense is deductible in 2021. If Omero has adopted this method of accounting, it can deduct the $17,600 accrued expense in 2020.

Net Operating Loss (NOL)

An excess of allowable deductions over gross income.

Hybrid Method of Accounting

An overall method of accounting that combines the accrual method for purchases and sales of inventory and the cash method for all other transactions LWT Company, a retail sporting goods store, uses a hybrid method of accounting under which it accounts for all transactions that don't involve inventory under the cash method. It accounts for inventory transactions under the accrual method by capitalizing all merchandise purchases to inventory, performing a physical count at year-end to determine ending inventory and cost of goods sold, and recording revenues from inventory sales when the sales occur.

Cash Method of Accounting

An overall method of accounting under which revenue is accounted for when payment is received and expenses are accounted for when payment is made Under the cash method, firms record expenses in the year the expense is paid, regardless of when the liability for the expense was incurred.

Accrual Method of Accounting

An overall method of accounting under which revenues are realized in the year the earnings process is complete and expenses are matched against revenues in the year the liability for the expense is incurred. Under the accrual method of accounting, firms record revenue when the revenue is realized. Realization occurs when the earnings process with respect to the provision of goods or services is complete, regardless of when payment for the goods or services is received.

Fiscal Year

Any 12 month period ending on the last day of any month except December The choice o fa calendar or fiscal year is usually dictated by the firm's operating cycle; firms want to close their books and calculate their profit at the end of a natural cycle of business activity. A retail clothing store might find that a February 28 fiscal year-end most accurately reflects an operating cycle that peaks during the holiday season and reaches its lowest point before the beginning of the spring season. A ski resort might use a May 31 fiscal year-end so that its financial statements reflect the profit from an operating cycle that ends when the snow melts off the slopes.

Changing a Taxable Year

As a general rule, a new business entity establishes its taxable year by filing an initial tax return on the basis of such year. The initial return reflects taxable income or loss from the date business began until the end of the year. As a result, an initial return typically reflects a short period of less than 12 months. After establishing a taxable year, a firm can't change its year unless it formally requests and receives permission to do so from the IRS

Provision of Services by Tax Payers

Bearden Inc., a calendar year corporation, sells tractors under a three-year warranty obligating Bearden to repair the tractors during the warranty period. In 2020, Bearden sold 218 tractors with warranty periods extending into 2023. At the end of 2020, Bearden accrued a $60,000 expense and a $60,000 liability for future warranty costs. This liability is fixed and determinable with reasonable accuracy. However, economic performance hasn't occurred because Bearden hasn't provided the repair service. Consequently, the accrued liability fails the all-events test and the $60,000 accrued expense is not deductible in 2020. Bearden can deduct its warranty cost in any future year in which it does provide the service.

Business Interest Limitation

Business interest in excess of 30 percent of adjusted taxable income is not currently deductible

Discharge of Debt Income

Calzo Company had an $18,000 overdue account payable to a major supplier. The supplier needed to settle the account as quickly and as advantageously as possible. After some negotiation, Calzo paid $14,000 cash to the supplier in full settlement of the account payable. Because Calzo extinguished an $18,000 liability with only $14,000 of assets, its net 5 worth increased by $4,000, an increase that Calzo must include in gross income.

Personal Service Corporation

Closely held corporation owned by individuals who perform services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting for the corporation's clientele. Personal service corporations are subject to a flat 35 percent tax rate Because the cash method can be manipulated to defer income and accelerate deductions, the tax law limits its use by large corporations. Corporations that average more than $26 million annual gross receipts can't use the cash method for tax purposes.

Accrual Method for Expenses

Firm ADM hired a plumber to repair some leaky pipes in the executive washroom. The plumber completed his repairs on December 19 and submitted his bill for $550. ADM recorded a $550 account payable and a $550 expense even though it didn't pay the bill until January 20 of the following year.

Accrual Method for Revenues

Firm ADM, a calendar year, accrual basis consulting business, performed client services during October and November and billed the client for $9,200 on December 8. ADM recorded a $9,200 account receivable and $9,200 revenue even though it didn't receive payment from the client until January 10 of the following year.

Noncash Receipts

Firm CM billed a client for a $12,000 consulting fee, and the client settled the bill by transferring $12,000 worth of marketable securities to the firm. CM records $12,000 revenue on the receipt of the securities, even though the transaction didn't involve the receipt of money. As this example suggests, the net income computed under the cash method doesn't equate to net cash flows. In other words, the terms income and cash are not synonymous, even for a cash basis taxpayer.

Cash Method for Expenses

Firm CM hired a temporary employee to help the secretarial staff with year-end paperwork. The temp completed the assignment on December 28, but CM didn't issue his $950 paycheck until January 15. CM incurred the $950 liability when the employee completed the job in a satisfactory manner. Even so, it will record the $950 expense when it makes payment in the following year. Under the cash method of accounting, an expense is recorded in the year when payment is made.

Cash Method for Revenues

Firm CM, a calendar year, cash basis consulting business, completed an engagement late in the year. On December 12, the firm mailed a bill to the client for its $20,000 consulting fee. If CM doesn't receive a check in payment before year- end, it doesn't record revenue for the year, even though the services were performed during the year. CM will record $20,000 revenue when it receives payment in the following year.

Prepaid Rent Income

Firm CRO leases real estate to a tenant for $30,000 annual rent. At the beginning of the year, CRO received a $90,000 payment from the tenant for three years' rent. For financial statement purposes, it reported $30,000 rent revenue on its income statement and $60,000 unearned revenue as a liability on its balance sheet. For tax purposes, CRO must recognize the entire $90,000 prepayment as income. The $60,000 excess of taxable income over book income is a 41 temporary difference that will reverse over the next two years.

Calculating Excess Business Loss

Graham is single and operates two businesses. This year, Business A generated $450,000 of taxable profit. Business B generated a $(975,000) loss. Graham's excess business loss is $(266,000) ($450,000 profit from Business A $975,000 loss from Business B + $259,000 threshold amount for single taxpayers).

Accounting for NOL Carryforward

Groh Inc. generated a $492,000 NOL in 2020. Groh accounted for the anticipated tax savings from the carryforward by recording a $103,320 deferred tax asset ($492,000 x 21 percent) and a matching $103,320 decrease in 2020 tax expense. In 2021, Groh Inc. generated $1,316,000 taxable income before consideration of its NOL carryforward. Groh could deduct the entire $492,000 carryforward, thereby reducing its 2021 tax payable by $103,320 ($492,000 x 21 percent). Groh accounted for the use of the carryforward by reducing the $103,320 deferred tax asset to zero and recording a matching $103,320 increase in 2021 tax expense.

Taxable Income

Gross income minus allowable deductions for the taxable year

Recognition

Inclusion of an item of income or deduction in the computation of taxable income

Permanent Book/Tax Differences

Kalvoni Inc. earned $114,000 tax-exempt interest, incurred $386,400 nondeductible expenses, and was allowed a $767,000 dividends-received deduction this year. If these were Kalvoni's only book/tax differences and its book income before tax was $4,712,000, its taxable income would be computed as follows: Book income before tax $4,712,000 Income never recognized (114,000) Expenses never deducted 386,400 Deduction never expensed (767,000) ----------------------------------------------------------- Taxable income $4,217,400 Kalvoni's $494,600 permanent excess of book income over taxable income represents a $103,866 permanent tax saving ($494,600 excess x 21 percent) for the corporation.

Key Person Life Insurance Policies

Insurance purchased by a firm on the life of a high-level employee. The firm is the beneficiary of the policy. OKD owns insurance policies on the lives of its CEO and five other corporate officers and paid $14,300 premiums on these policies this year. In November, the CEO was killed in a boating accident, and OKD received $750,000 of insurance proceeds. OKD can't deduct the $14,300 premium expense, and it doesn't include the $750,000 proceeds in gross Income.

Tax Expense Per Book

Kalvoni's audited financial statements must include its federal income tax expense for the year. The tax expense per books is based on Kalvoni's book income adjusted for its permanent book/tax differences: Book income before tax $4,712,000 Income never recognized (114,000) Expenses never deducted 386,400 Deduction never expensed (767,000) --------------------------------------------------- Adjusted book income 4,217,400 Tax rate .21 ---------------------------------------------------- Tax expense per book 885,654

Excess Business Loss Limitation

Limit on the deductibility of excess business losses of noncorporate taxpayers.

Fixed and Determinable Liability

MOP, a calendar year taxpayer, hired 113 temporary employees to work during the last two weeks of December 2020 but didn't receive a bill for their services from the employment agency before year-end. On the basis of its record of hours worked, MOP calculated that the bill would be $121,500. Consequently, MOP accrued a $121,500 expense and a $121,500 liability for temporary services payable for financial statement purposes. Because MOP's liability to pay for the services is fixed and the amount is determinable with reasonable accuracy, the accrual satisfies the first two requirements of the all-events test.

Prepaid Insurance

On November 28, 2019, Firm L, a calendar year taxpayer, paid a $9,930 premium to acquire a casualty insurance policy on its business equipment. • If the insurance policy has a one-year term from December 1, 2019, through November 30, 2020, its benefit has a duration of only 12 months and doesn't extend beyond 2020. Therefore, Firm L can deduct the $9,930 premium in 2019. • If the insurance policy has a one-year term from February 1, 2020, through January 31, 2021, its benefit has a duration of only 12 months, but this benefit extends beyond 2020. Therefore, Firm L must capitalize the $9,930 premium. It can amortize and deduct $9,103 (11/12 x $9,930) of the cost in 2020 and $827 (1/12 x $9,930) of the cost in 2021. • If the insurance policy has a three-year term from January 1, 2020, through December 31, 2022, its benefit has a three-year duration. Therefore, Firm L must capitalize the $9,930 premium and can amortize and deduct $3,310 (1/3 x $9,930) of the cost in 2020, 2021, and 2022.

Gross Income

Realized increases in wealth from whatever source derived. In the business context, gross profit from sales of goods, performance of services, and investments of capital. Gross receipts from sales $2,436,100 Cost of goods sold (1,606,400) Gross income from sales 829,700 Gross receipts from services 512,900 Rent revenue 38,100 Interest on money market account 1,010 --------------------------------------------- Gross income from commercial activities $1,381,710 The federal courts have consistently ruled that the concept of gross income from whatever source derived is broad enough to include any accession to wealth or increase in net worth. Consequently, firms may derive gross income from events or transactions occurring outside the course of their routine commercial activities.

Carryforward of Excess Business Loss

Recall that Graham's excess business loss this year is $(266,000). Graham must treat this loss as an NOL carryforward into future tax years. Next year, if Graham's taxable income before any NOL deduction is $300,000, only $(240,000) of his loss carryforward ($300,000 x 80 percent) will be deductible. The remaining $(26,000) will continue to carry forward into the future.

Liability not fixed and determineable

SFL Inc. provides a medical reimbursement plan for its 4,800 employees. At the end of each year, SFL estimates the reimbursable expenses incurred during the year for which employees have not yet filed written claims. On the basis of this estimate, SFL accrues a medical reimbursement expense and a corresponding liability for financial statement purposes. Because SFL's liability for a claim is not fixed until the written claim is filed, the accrual fails the all-events test.

Liability not Fixed and Determineable

SkyHigh Airlines issues travel vouchers to customers who voluntarily surrender their reserved seats on overbooked flights. The vouchers are for a stated dollar amount and can be used to purchase future tickets. The vouchers are valid for only one year, and many expire without being used. At the end of each year, SkyHigh accrues an unused travel voucher expense and a corresponding liability for financial statement purposes. Because SkyHigh's liability for a voucher is not fixed until the customer uses it to purchase a ticket, the accrual fails the all-events test 46

Payment Liability

Solange Inc., a calendar year taxpayer, was sued in 2018 by a customer who was injured on Solange's premises because of the corporation's alleged negligence. Solange accrued a $2 million estimated settlement expense and a $2 million contingent liability for 2018 financial statement purposes. In 2019, Solange and the customer agreed to a $1.5 million out- of-court settlement. Solange actually paid $1.5 million to the customer on April 6, 2020. Solange could not deduct any settlement expense in 2018 when the liability was accrued or in 2019 when the liability became fixed and determinable. Solange could deduct the $1.5 million settlement in 2020 because it made payment to the customer.

Prepaid Service Income

SueLee Company, a calendar year taxpayer, offers ballroom dancing lessons to its clients. In October 2019, SueLee entered into a contract that entitles Ms. Jax to take 60 lessons over the next 36 months. Each lesson costs $40, and Ms. Jax was required to prepay the entire $2,400 contract price. By the end of 2019, Ms. Jax had taken 9 lessons. Under the one-year deferral method, SueLee includes $360 of the $2,400 prepayment (9 lessons x $40) in 2019 income. SueLee must include the $2,040 remaining prepayment in 2020 income, regardless of when Ms. Jax takes the 51 lessons remaining under the contract.

Calander year

The 12-month period from January 1 through December 31

Allowance Method

The GAAP method for computing bad debt expense. The expense is based on the estimated losses from current year receivables. When an accrual basis firm sells goods or services and the purchaser doesn't pay cash at the point of sale, the firm records an account receivable for the sales price. Firms anticipate that some portion of their accounts receivable will never be collected because of defaults by customers to whom the firm extended credit. According to GAAP.

Deductions

The Internal Revenue Code allows a deduction for "all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business." According to judicial interpretation, an expense is ordinary if it is customary for a particular type of trade or business and is commonly or frequently incurred. An expense is necessary if it is appropriate and helpful for the development of the business and the generation of revenue. Because of this broad authorization, firms can deduct most routine operating expenses in the computation of taxable income. They can also deduct the various state, local, and foreign taxes incurred in carrying on their business activities.8 Firms can even deduct the cost of assets acquired for long-term use in their business; these cost recovery deductions (such as depreciation) are typically spread over some extended period of years.

Tax Policy Objectives

The accurate measurement of income is not the sole objective of the tax law. Congress wants the law to be consistent with public policy and political concerns, and the tax rules that achieve this consistency have nothing to do with income measurement. For instance, contributions 19 to political parties or candidates for public office and lobbying expenses are not deductible. Firms must report these expenses in their financial statements, but because Congress doesn't want to subsidize political activities, these expenses don't reduce taxable income.

Conservatism

When in doubt, financial statements should delay the realization of income and accelerate the realization of losses. at least, GAAP curbs any tendency of management to inflate book income by overstating revenues or understating expenses.

Deferred Tax Liability

The excess of tax expense per books over tax payable resulting from a temporary difference between book income and taxable income. In year 1, Holmes Inc. engaged in a second transaction generating $50,000 book income but only $27,200 taxable income. This $22,800 favorable book/tax difference generated a $4,788 deferred tax liability ($22,800 x 21 percent) on Holmes's balance sheet. This difference partially reversed in year 2 when Holmes reported $10,000 taxable income but no book income. To account for this partial reversal, Holmes reduced the deferred tax liability from the original transaction to $2,688 [$4,788 - ($10,000 x 21 percent)].

Deferred Tax Asset

The excess of tax payable over tax expense per books resulting from a temporary difference between book income and taxable income. In year 1, Holmes Inc. engaged in a transaction resulting in a $19,000 expense but only an $11,500 tax deduction. This $7,500 unfavorable book/tax difference generated a $1,575 deferred tax asset ($7,500 x 21 percent) on Holmes's balance sheet. This difference reversed in year 4 when Holmes reported a $7,500 tax deduction and no book expense. To account for this reversal, Holmes reduced the deferred tax asset from the original transaction to zero.

Direct Write off Method

The method for determining a bad debt deduction required by the tax law. Only receivables that are written off as uncollectible during the year are deductible.

Constructive Receipt

The point at which a taxpayer has unrestricted access to and control of income, even if the income item is not in the taxpayer's actual possession. In litigation between cash basis firms and the IRS, the courts have generally concluded that constructive receipt (incurred if no substantial barrier to the firm's control and possession of the income existed. In other words, a calendar year, cash basis firm can't defer income from one year to the next by holding the checks received from its customers in December and cashing the checks the following January.

Tax Benefit Rule

The recovery of an amount in an earlier year must be included in gross income in the year of recovery

Generally Accepted Accounting Principles (GAAP)

The set of accounting rules developed by the Financial Accounting Standards Board (FASB) and adhered to by the public accounting profession. According to GAAP only Accrual accounting correctly measures annual income

All-events test

The test for determining if an accrued expense is deductible The test is satisfied if the liability on which the accrued expense is based is fixed, the amount of the liability is determinable with reasonable accuracy, and economic performance with respect to the liability has occurred. This test consists of three requirements. First, the liability for the unpaid expense must be fixed because all events establishing the fact of the liability have occurred. Second, the amount of the liability must be determinable with reasonable accuracy. Third, economic performance with respect to the liability has occurred.

Taxable Income (2)

This year, Calzo Company incurred $722,900 deductible operating expenses and was allowed a $30,114 depreciation deduction. Consequently, Calzo's taxable income was $632,696. Gross income from commercial activities $1,381,710 Gross income from discharge of debt 4,000 Deductible operating expenses (722,900) Depreciation deduction (30,114) ---------------------------------------------------- Taxable income $632,696

Recovery of Bad Debt

Two years ago, Sela Company wrote off a $57,000 account receivable as uncollectible. The $57,000 write-off was included in Sela's $589,200 bad debt deduction for that year. This year, the debtor paid $57,000 cash to Sela to settle the old receivable. This recovery has no effect on Sela's book income but increases its taxable income by $57,000.

Advanced Payment for Inventory

Unsler Products, a calendar year taxpayer, manufactures and sells paper products. On November 16, 2019, Unsler received a $75,000 advanced payment from a customer for an order of paper that Unsler shipped from its warehouse on February 20, 2020. For financial statement purposes, Unsler reports advanced payments for inventory as revenue when the inventory is shipped. Consequently, Unsler can elect to include the $75,000 payment in taxable income in 2020, the year in which it is included in book income.

Section 482

When related parties enter into business transactions, the IRS has particular reason to scrutinize the methods of accounting used to report the tax consequences, and it has broad authority to challenge these methods. Section 482 of the Internal Revenue Code states that in the case of two or more businesses under common ownership or control, the IRS may "distribute, apportion, or allocate gross income, deduction, credits, or allowances" among the businesses to clearly reflect the income of each. The IRS typically invokes Section 482 when a method of accounting results in a beneficial shift of income between related parties.