AC 371 Exam 3

economic performance test

- added by congress to address the abusive situation in which businesses claimed deductions and then did not pay the associated cash expenditures for many years, general requirement is that the business may not recognize a deduction until the underlying activity which generated the associated liability has occurred - for liability arose from receiving goods/services from another person: business deducts the expense only when the other person actually provides the goods/services - for liability arose from renting or leasing property from another person: business deducts the rental expense ratably over the term of the lease - for liability arose from the businesses providing goods/services to another person: business deducts as it provides goods/services to satisfy the liability - payment liabilities: deduct only when the business actually pays the liability * examples= tort/litigation, rebates, refunds, awards/prizes, state taxes except real property taxes, worker's compensation

netting rules for section 1231 gains and losses

- after applying the depreciation recapture rules, the remaining section 1231 gains and losses are netted together - when netting the section 1231 losses against section 1231 gains, the losses first offset regular section 1231 gains before offsetting un-recaptured section 1250 gains - if the gains exceed the losses, the net gain will be long-term capital gain, a portion of which could be taxed at a maximum rate of 25% (un-recaptured section 1250 gains) - if the losses exceed the gains, the net loss is treated as an ordinary loss

if the travel has both business and personal elements

- airfare: if the majority of the time is spent on business activities, all of the domestic airfare costs are deductible, but if the majority of the time spent is on personal activities, none of the domestic airfare costs are deductible - hotel/ lodging and incidentals: the costs associated with the time spent on business activities are deductible, but the costs associated with the time spent on personal activities are not deductible- generally, the expenses should be allocated on a per-day basis so that the days for business and personal purposes can be distinguished

installment sales

- applies when a taxpayer sells property and collects the sales proceeds over time (at least one payment received in a taxable year subsequent to the year of disposition of property) - does not apply to property sold at a loss - certain gains are not eligible for installment sale treatment and must be recognized in the year of sale: marketable securities, inventory, depreciation recapture component of gain (section 1245, section 1250)

special depreciation provisions: listed property

- business-owned assets that are used for both business and personal purposes - determine business use percentage for the year: 1. if the business use % equals or > 50%, can deduct calculated amount per appropriate depreciation tables multiplied by the business use % (also eligible for bonus depreciation and section 179 election) 2. less than 50% business use: must use the straight-line method and an alternative recovery period, which is often longer

research and experimentation costs

- businesses may either immediately expense or elect to capitalize and amortize over a period of not less than 60 months, beginning in the month benefits are first derived from the research - if connected with the acquisition of a patent, when the patent is obtained, any remaining basis in the R&E costs is added to the basis of the patent and amortized accordingly

rules for prepaid expenses

- businesses may immediately deduct the prepayment if: 1. the contract period does not last more than 12 months 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 - example= car insurance (typically 6 or 12 month policy) - exception for interest expense

depletion

- businesses recover their investment in natural resources through depletion - compute depletion under 2 methods: cost depletion and percentage depletion; and deduct the larger of the 2 amounts

percentage depletion

- calculated by multiplying the gross income from the resource by a fixed percentage - in many cases, percentage depletion will be larger than cost depletion - once the initial basis is exhausted, allowed to continue to deduct percentage depletion - limitation: percentage depletion cannot exceed 50% (or 100% for oil and gas properties) of taxable income before depletion expense

additional basis considerations

- conversion from personal to business use: basis= lesser of a) cost or b) FMV at the date of conversion - gift: basis is transferor's basis - inherited: basis is FMV on date

start-up costs

- costs incurred prior to the date that the trade or business actually begins - include costs of investigating the possibility of starting a business and the costs of acquiring a business (examples= location decisions, certain employee training) - same rules as organizational expenses: immediately expense up to $5,000; same phase-out - limitations are computed separately for organizational expenses and start-up costs (immediately expense $5,000 of start-up costs)

organizational expenses

- costs incurred to form and organize a business, generally incurred prior to the start of business of shortly after - costs associated with selling stock are not included in this category - examples: legal fees to draft incorporation documents or partnership agreements - can immediately expense up to $5,000, but immediate expensing is phased out at $55,000 - remainder is amortized on a straight-line basis over 15 years

travel and transportation

- costs of commuting are not deductible - vehicle used for business and personal purposes have 2 options: 1. deduct the actual costs associated with business miles (gas, repairs, maintenance, insurance, etc.) and the related depreciation 2. deduct the standard mileage rate released by the IRS annually multiplied by the number of miles driven for business purposes - travel expenses are deductible if the taxpayer is away from home overnight (includes meals, lodging, incidental expenses, conference registration fees) - if travel is solely for business, all of the costs of the travel are deductible, but the meals are still only 50% deductible

section 197 intangibles

- customer lists, patents, trademarks, goodwill purchased in an acquisition are examples - recovery period= 180 months (15 years) - straight-line method - full month convention (full month of amortization in month of purchase and month of disposition)

gain on the sale of depreciable real estate

- depreciable real estate= warehouse, office building, etc. - the lesser of a) recognized gain or b) accumulated depreciation is not treated as ordinary income but is instead taxed at a special maximum rate of 25% - this component is called the un-recaptured section 1250 gain - similar to the rule for tangible personal property, if the total gain on the sale of the depreciable real estate exceeds the un-recaptured section 1250 component the remaining gain is taxed at the long-term capital gain rates

real property

- depreciation is calculated using the mid-month convention and straight-line method - recovery periods: residential (27.5 years); nonresidential (39 years) - for real property, remember to select the column in the table which corresponds with the month in which the real property is placed in service

methods of cost recovery

- depreciation: tangible personal property and real property other than land (autos, equipment, machinery) - amortization: intangible property - depletion: natural resources

meals and entertainment

- entertainment expenses are not deductible - business meals: 50% of the total cost is allowable as a deduction for 2020 - if an expense involves both meals and entertainment, the amount attributable to meals must be separately stated on the invoice to support the 50% meal deduction

generally, taxpayers must immediately recognize the gain associated with the sale of an asset, unless a specific provision of the IRC allows for a deferral or exclusion

- example deferrals: like-kind exchanges, installment sales, involuntary conversions - example exclusions: gain on sale of principal residence

assets may be used for both business and personal expenses

- examples= home office, computers, cell phones - to determine the deductible amount for business use, we must allocate the cost based on the ratio of the amount devoted to business use divided by the total amount - for home offices, the deduction is generally based on the % of the square footage of the home devoted to business use (this deduction cannot exceed the amount of business income generated from the home office that year; excess carried forward) - for cell phones, internet, and computer charges, we generally use a ratio based on the hours devoted to the business use in comparison to total hours for which the devices/ service were used

examples of non-deductible business expenses

- fines and penalties - illegal bribes and kickbacks - political contributions and lobbying costs - entertainment expenses - expenses associated with tax-exempt income (ex= interest expense of state/local bonds, premiums paid for certain life insurance policies)

accounting method considerations- key differences between GAAP and tax accounting methods

- for GAAP reporting, businesses generally want to accelerate income and defer deductions, so that GAAP accounting income is as high as possible (principles of GAAP guidance exist to ensure income is not overstated to investors and creditors) - for tax purposes, businesses want the opposite, to defer income and accelerate deductions (provisions in the IRC and regulations exist to prevent the understatement of income to maximize tax revenues)

once the gain or loss is calculated, we must then determine the character of that gain or loss

- for inventory and accounts receivable associated with a trade or business, the character of the gain/ loss will be ordinary - for other assets used in a trade or business and held for more than one year, the assets are considered to be section 1231 assets - if the assets used in the trade or business are not held for more than one year, the character of that gain/ loss will be ordinary

half-year convention

- generally used, as long as the assets placed in service in Q4 do not exceed 40% of the total assets placed in service - the MACRS tables already consider the half-year of depreciation allowed in the year of acquisition, but the tables do not consider the half-year which would be required in the year of disposition. in the year of disposition, multiply the calculated amount from the table by 50% if the half-year convention applies

installment sales: to calculate the gain a taxpayer must recognize on each installment payment received, the taxpayer computes the gross profit percentage on the sale

- gross profit percentage= gross profit/ contract price - gross profit= sales price- adjusted basis - seller then multiplies the amount of payments received in a given year times the gross profit percentage

determining the character of gain/ loss for section 1231 assets

- if an asset used in a trade or business qualifies as a section 1231 asset, any loss recognized on the sale is ordinary in character - to determine the character of a gain, we must first consider whether the depreciation recapture rules apply (the depreciation recapture rules only apply in the case of a section 1231 asset which is sold at a gain) - the depreciation recapture rules only change the character of the gain, not the underlying calculation of the gain - when the depreciation recapture rules apply, the character of all or a portion of the gain on the sale of a section 1231 asset is re-characterized as ordinary income, if the depreciable asset is tangible personal property and is not real estate

patents

- if directly purchased, amortize over the remaining life of the parent on a straight-line basis - if self-created, amortize over the actual legal life, typically 20 years in the U.S.

cash method considerations

- income is recognized either when actually or constructively received - expenses are generally recognized when paid - biggest disadvantage is that a taxpayer may have a poor matching of income and expense under this method - expense deduction exception: payments to create a tangible or intangible asset must be capitalized (fixed assets like office equipment, computers, etc.) - current "immediate expensing" provisions allow the immediate deductions of shorter life assets - prepaid expenses exception to capitalization requirements: taxpayers can immediately deduct the prepayment of an expense if the contract period does not last more than one year, and the contract period does not extend beyond the end of the taxable year following the tax year in which the taxpayer makes the payment (cannot be used for interest expense, ex= auto insurance policies, see slides 9&10 for example problem)

accrual method considerations

- income recognition: recognize income when a) all of the events have occurred to fix the right to receive income and b) the amount can be determined with reasonable accuracy - generally, this will occur at the earliest of 3 dates: 1. date the service or sale is completed 2. date the payment is due 3. date the payment is received - disputed revenue would likely fail the recognition test (all events have not yet occurred to fix the right to receive income) - advance payments: exception which allows the deferral for one tax year, if elected: * exception does not apply to rent or interest income * businesses are not required to recognize security deposits received because their is an obligation to return the deposit * year 1 income recognition= pro-rata amount earned by the end of the year of receipt * year 2 income recognition: remaining amount of income

to compute the tax depreciation for an asset, you need to know:

- initial basis - depreciation method - recovery method/ depreciable life - applicable convention (what is deductible in the year of acquisition and the year of disposition)

mid-quarter convention

- laws were put in place to stop taxpayers from acquiring a significant amount of assets in Q4 and taking half year of depreciation even though the taxpayer only owned the assets for a few days before year-end - currently, the immediate expensing provisions of the tax cuts and jobs act make this less relevant - this will apply when more than 40% of the assets placed in service during the year are placed in service in Q4 - use the appropriate mid-quarter table for the quarter in which the asset is placed in service to calculate the tax depreciation for a given year

involuntary conversions

- occur when property is partially or wholly destroyed by a natural disaster or accident (hurricanes, floods, wildfires), stolen, condemned or seized by eminent domain by a governmental agency - designed to prevent taxpayers from having to recognize a gain in a time of financial distress if the insurance proceeds received exceed the basis in the property which was destroyed - key difference between involuntary conversions and like-kind exchanges: with an involuntary conversion, taxpayers may defer gains on both personal and real property - taxpayers may defer realized gains on the conversion if they acquire qualified replacement property within 2 years after the close of the tax year in which they receive the insurance proceeds - qualified replacement property must be both similar and related in service or use - gain recognized= lesser of a) gain realized or b) amount of insurance proceeds that are not reinvested in a qualified property

special depreciation provisions: section 179

- originally created as incentive for small businesses to purchase new or used tangible personal property - up to $1,040,000 of tangible personal property can be immediately expensed in 2020 - phaseout between $2,590,000 of asset purchases and $3,630,000 of asset purchases (no deduction if it above that) - also limited to business's taxable income before the section 179 expense deduction, cannot create losses, excess amount carried forward indefinitely - can choose which assets to expense

special depreciation provisions: bonus depreciation

- percentage is currently 100% for assets placed in service between 9/27/2017 and 12/31/2022; phaseout between 2022-2025 - mandatory for all taxpayers that qualify, but taxpayers may elect out on a property class basis; election is annual - when would business elect out? in NOL position, loss utilization limitations ma apply - main difference between the section 179 election and bonus depreciation is that a taxpayer can choose which assets to expense under section 179, but bonus is an all-or-nothing decision by property class

like-kind exchanges

- provides significant tax advantage by allowing a taxpayer to defer a gain that would have otherwise been recognized immediately - a taxpayer whose primary business is the buying/ selling of real property cannot use the like-kind exchange rules because the real property is deemed to be held for sale in the course of ordinary business

special depreciation provisions: luxury auto limits

- recall that businesses are allowed to deduct what is ordinary, necessary, and reasonable - each year the IRS provides a maximum amount for depreciation for autos placed in service that year ($10,100 for 2020) - can expense an additional $8,000 for bonus depreciation above the maximum, so the maximum total deduction for 2020 is $18,100 - limitations also apply for the section 179 deduction - exception for vehicles weighing more than 6,000 lbs

look back rule for section 1231 assets

- requires taxpayers who recognize the net section 1231 gains in the current year to re-characterize the gain as ordinary income to the extent that the taxpayer deducted ordinary section 1231 losses in the previous 5 year period

all-events test

- similar to the all-events test for income recognition, all events must have occurred to establish the liability giving rise to the deduction, and the amount must be determined with reasonable accuracy

choosing an overall accounting method

- small businesses generally can choose either the cash or accrual method - large C corporations and large partnerships with C corporation partners are generally required to use the accrual method - method adopted with first tax return filing - must be consistently applied

inventory considerations

- small businesses with average annual gross receipts of $26 million or less over the most recent 3 year period are not required to use the accrual method

rules related to expenses which have both a business and personal purpose

- taxpayers are not allowed to deduct personal expenses unless the deduction is expressly authorized by a specific provision in the law - many small business owners will often have expenditures that involve both a business and personal element (specific rules exist to calculate the business element)

considerations for a new business- selecting an accounting period

- the annual accounting period is 12 months long - choice of year-end: 1. calendar year (12/31) 2. fiscal year: last day of a month (other than december) - sole proprietorship: must be a calendar year end (same as individual proprietor's) - partnerships: generally must be consistent with the owners' tax years - corporations: can be a calendar or fiscal year (special type called 52/53 week year end is also available), consistent with the period used for book/GAAP accounting purposes

deduction recognition

- to recognize a deduction, both the all-events test and the economic performance test must be satisfied

special considerations for bad debt expense

- under the accrual method, a receivable is established when a customer purchases an item on credit, with a promise to pay at a certain point in the future - for GAAP purposes, the business estimates the amount of bad debt expense associated with customers who have not paid and accrues that amount as an offset to accounts receivable (allowance for doubtful accounts) - for tax purposes, business are only allowed to deduct the bad debt expense when the receivable is worthless and is written off during the tax year - businesses that use the cash method of accounting do not have accounts receivable and thus do not have bad debt expenses because they do not recognize income until they actually receive payment

rules for expenses subject to capitalization (such as fixed assets)

- under the current provisions for 2020, the expenses associated with the purchase of assets with a relatively short depreciable life (15 years or less) are immediately deductible - certain limits apply in the case of vehicles which are designated as luxury vehicles

tax consequences of like-kind exchanges

- when the like-kind exchange requirements are met, a taxpayer a) does not recognize gain or loss on the exchange and b) receives an exchanged or carried forward basis in the like-kind property received - exception: transfers which involve cash ("boot"): 1. value of like-kind exchange property given up may differ from the value of the like-kind exchange property that the taxpayer receives 2. cash (or other assets) may have to be transferred to equalize the values (the assumption of a liability is considered to be the receipt of cash/ boot) 3. if cash ("boot") is received, the taxpayer must recognize realized gain to the extent of the boot received 4. recognized gain= lesser of a) gain realized or b) cash/ boot received 5. if like-kind exchange property and cash/ boot are received, the basis in the property received= FMV of the like-kind property received MINUS deferred gain OR PLUS deferred loss

formula to calculate the amount of gain or loss on the sale of an asset

1. amount realized= cash received + FMV of property + buyer's assumption of liabilities - seller's expenses 2. adjusted basis= initial basis - accumulated depreciation - amount realized - adjusted basis= gain or loss

cost depletion

1. determine the number of units/ reserves that remain at the beginning of a year and allocate a pro-rata share of the property's adjusted basis to each unit 2. multiply the per-unit amount times the number of units sold during the year to determine the cost depletion - once entire cost is recovered, businesses are not allowed to use cost depletion determine depletion expense

steps to calculate depreciation for tangible personal property

1. determine whether the convention is half-year or mid-quarter by determining whether >40% of the qualified property placed in service during the year was placed in service in the last quarter of the year 2. locate the applicable table for convention 3. select the column that corresponds with the recovery period 4. find the row identifying the year of recovery

criteria for business expenses to be deductible

1. ordinary: normal or appropriate for the business under the circumstances 2. necessary: helpful or conducive to the business activity 3. reasonable: cannot be extravagant or exorbitant; if extravagant, the excess amount is assumed to be spent for personal rather than business reasons - to determine if extravagant, the expense is compared to the amount paid to unrelated individuals at the current market price

3 criteria which must be satisfied to qualify for like-kind exchange

1. property must be real property and it must be exchanged solely for like-kind property (real property located in the U.S. and real property located outside the U.S. are not considered like-kind) 2. both the real property which is given up and the real property which is received in the exchange must be "used in a trade or business" or "held for investment" by the taxpayer 3. exchange must meet certain time restrictions: exchange does not have to be simultaneous, but the transaction must be completed in a reasonable period of time - taxpayer must identify the like-kind replacement property within 45 days after transferring the property given up in the exchange and taxpayer must receive the replacement like-kind exchange property within 180 days after the taxpayer initially transfers property in the exchange - deferred like-kind exchanges must be facilitated through the use of qualified intermediaries (regular accountant/ CPA may not qualify)

4 categories of intangibles/ amortization

1. section 197 2. start-up expenditures and organizational costs 3. research and experimentation costs 4. patents and copyrights

depreciation methods

3 acceptable methods under MACRS: 1. double declining balance 2. 150 declining balance 3. straight-line

principles of cost recovery

capitalize the cost of assets with useful life of more than one year, then allocate cost recovery over the time during which the purchased assets are subject to wear, tear, and obsolescence

formula to calculate the amount of depreciation recapture

depreciation recapture= the lesser of a) gain recognized or b) the total accumulated depreciation

depreciation conventions

determine how much depreciation is allowed in the years of acquisition

if the total gain on the sale of tangible personal property exceeds the amount of the depreciation recapture, the remaining amount of the gain on the sale of the section 1231 business asset is a...

long-term capital gain (different rule for real estate)

adjusted basis

the cost that has not yet been recovered (initial basis - accumulated depreciation)

initial basis

the original cost

costs incurred after assets placed in service

to determine whether to immediately deduct or capitalize, need to analyze whether the cost was for routine maintenance or whether it results in the betterment, restoration, or new or different use for the property (capitalize if that is the case)

key starting point for cost recovery

when the asset is placed in service