Ch. 9: Business Income, Deductions, & Accounting Method

This year (year 0) Elizabeth agreed to a three-year service contract with an engineering consulting firm to improve efficiency in her factory. The contract requires Elizabeth to pay the consulting firm $1,500 for each instance that Elizabeth requests its assistance. The contract also provides that Elizabeth only pays the consultants if their advice increases efficiency as measured 12 months from the date of service. This year Elizabeth requested advice on three occasions and she has not yet made any payments to the consultants. How much should Elizabeth deduct in year 0 under this service contract if she uses the accrual method of accounting?

$0 Because the liability is contingent on a future event (increase in efficiency) occurring after the end of the year, the liability is not fixed. (Fails #1 of all-events test.) Therefore, as an accrual-method business, Elizabeth is not allowed to recognize any deduction for this contract in year 0 even though the consultants have provided services on three different occasions by the end of the year.

Michelle operates a food truck. Michelle provided a candidate with free advertising painted on her truck during the candidate's campaign for city council. Michelle paid $500 to have the ad prepared and an additional $200 to have the ad removed from the truck after the candidate lost the election. What amount can she deduct as an ordinary and necessary business deduction?

$0 No deduction for expenditures for political purposes (in cash or in kind).

Matt hired Apex Services to repair his business equipment. On November 1, of year 0, Matt paid $2,000 for the repairs that he expects to begin in early March of year 1. What amount of the cost of the repairs can Matt deduct in year 0 if he uses the accrual method of accounting for his business?

$0 The $2,000 cost of the repairs is not deductible in year 0 because actual performance is not reasonably expected to occur within 3.5 months. But, the $2,000 cost will be deducted in year 1 because economic performance occurs when the services are performed.

This year William provided $4,200 of services to a large client on credit. Unfortunately, this client has recently encountered financial difficulties and has been unable to pay William for the services. Moreover, William does not expect to collect for his services. William has "written off" the account and would like to claim a deduction for tax purposes. What amount of deduction for bad debt expense can William claim this year if he uses the cash method?

$0 Under the cash method, William would not be able to claim a bad debt expense deduction because, under this method he has not yet recognized the income for his services as he has not been paid.

This year (year 0) Elizabeth agreed to a three-year service contract with an engineering consulting firm to improve efficiency in her factory. The contract requires Elizabeth to pay the consulting firm $1,500 for each instance that Elizabeth requests its assistance. The contract also provides that Elizabeth only pays the consultants if their advice increases efficiency as measured 12 months from the date of service. This year Elizabeth requested advice on three occasions and she has not yet made any payments to the consultants. How much should Elizabeth deduct in year 0 under this service contract if she uses the cash method of accounting?

$0 Under the cash-method, Elizabeth would only deduct payments made to the consultants by the end of the year. In this situation, she had not paid the consultants anything by year end, so she would not deduct any expense associated with the contract.

Circuit Corporation (CC) is a calendar-year, accrual-method taxpayer. CC manufactures and sells electronic circuitry. On November 15, year 0, CC enters into a contract with Equip Corp (EC) that provides CC with exclusive use of EC's specialized manufacturing equipment for the five-year period beginning on January 1 of year 1. Pursuant to the contract, CC pays EC $100,000 on December 30, year 0, which covers payment for the entire period that CC will use EC's equipment. How much of this expenditure is CC allowed to deduct in year 0 and in year 1?

$0 in year 0 and $20,000 (=100,000/5yrs) in year 1. Because CC is leasing property from EC, economic performance on the contract occurs ratably over the five-year period from January 1 of year 1 through December 31 of year 5. Consequently, CC is not allowed to deduct any of the expenditure in year 0 and is allowed to deduct one-fifth of the contract price in year 1 (and in each of the four succeeding years).

Ben paid the following to attend a business meeting in Chicago: Airfare (first class) -$ 1,200 Hotel (three nights) -$ 750 Meals (three days) -$ 270 What amounts are deductible if Ben spent two days in meetings (primarily business)?

$1,790 Airfare $1,200 (primarily business) Hotel $500 (=750/3*2) Meals $90 (=270*50%/3*2)

Matt hired Apex Services to repair his business equipment. On November 1, of year 0, Matt paid $2,000 for the repairs that he expects to begin in early March of year 1. What amount of the cost of the repairs can Matt deduct in year 0 if he uses the cash method of accounting and he expects the repairs to be done by early February?

$2,000 The $2,000 cost of repairs is deductible in year 0 because Matt is a cash-method taxpayer and this is a routine repair that meets the 12-month rule.

Matt hired Apex Services to repair his business equipment. On November 1, of year 0, Matt paid $2,000 for the repairs that he expects to begin in early March of year 1. What amount of the cost of the repairs can Matt deduct in year 0 if he uses the cash method of accounting for his business?

$2,000 The $2,000 cost of repairs is deductible in year 0 because Matt is a cash-method taxpayer and this is a routine repair that meets the 12-month rule.

Matt hired Apex Services to repair his business equipment. On November 1, of year 0, Matt paid $2,000 for the repairs that he expects to begin in early March of year 1. What amount of the cost of the repairs can Matt deduct in year 0 if he uses the accrual method and he expects the repairs to be done by early February?

$2,000 The $2,000 cost of the repairs is deductible in year 0 because actual performance is reasonably expected within 3.5 months.

Ben provides dancing lessons. On September 30 of this year, he received $2,400 full payment for a 2-year service contract. What amount of income must Ben recognize if he is on the cash method?

$2,400

Ben, a cash basis taxpayer, makes the following payments on June 30 of this year: $10,000 for the next 10 months of utilities. $12,000 for insurance over the next 24 months. $9,600 for the next 8 months of interest on a business loan. What amounts are deductible this year?

$20,200 Ben can deduct all $10,000 for the utilities because: - The benefit does not exceed 12 months and - The benefit ends prior to the end of next year. Ben can deduct $3,000 for insurance because: - The benefit exceeds 12 months. - Hence, Ben can only deduct 6 months in this year. - 6/24*$12,000 Ben can deduct $7,200 for interest because: - The 12-month rule does not apply to interest. - 6/8*$9,600

Ben paid the following to attend a business meeting in Chicago: Airfare (first class) -$ 1,200 Hotel (three nights) -$ 750 Meals (three days) -$ 270 What amounts are deductible if Ben spent one day in a meeting (primarily personal)?

$295 Airfare $0 (primarily personal) Hotel $250 (=750/3*1) Meals $45 (=270*50%/3*1)

Rick owns a business that employs his brother, Ben. Ben is paid $45,000 per year by Rick's business. In comparison, other employees with Ben's responsibilities are only paid $30,000 per year. What is Rick's business deduction for employing Ben?

$30,000 A reasonable amount for compensating Ben is $30,000 rather than $45,000. The extra $15,000 ($45,000 paid minus $30,000 deduction) is a gift from Rick to Ben.

Ben provides dancing lessons. On September 30 of this year he received $2,400 full payment for a 2-year service contract. What amount of income must Ben recognize if he is on the accrual method?

$300 = 2,400/(24)*3 *Next year Ben would recognize the remaining $2,100—income can only be deferred one year.

This year William provided $4,200 of services to a large client on credit. Unfortunately, this client has recently encountered financial difficulties and has been unable to pay William for the services. Moreover, William does not expect to collect for his services. William has "written off" the account and would like to claim a deduction for tax purposes. What amount of deduction for bad debt expense can William claim this year if he uses the accrual method?

$4,200 Under the accrual method, §166 provides that William can claim a bad debt deduction for the account receivable if it is partially or completely uncollectible. Because William does not expect to collect for his services and he has written off the receivable, he is allowed to deduct the full $4,200 of services that he has included in income under the accrual method.

Michelle operates a food truck. She paid $750 to reserve a parking place for her food truck for the fall football season outside the local football arena. She also paid $95 for tickets to a game for her children. What amount can she deduct as an ordinary and necessary business deduction?

$750 The cost of the reserve parking ($750) is deductible, but the cost of the tickets is likely personal and not deductible.

Ben provides consulting services and bills Ace for $12,000. Ace disputes the amount claiming that $8,000 is the proper amount. How much income should Ben recognize under the accrual method this year?

$8,000 because revenue is contingent on claim (under dispute).

All-events test: recognize income when...

(1) All the events have occurred which fix the right to receive such income and (2) The amount can be determined with reasonable accuracy

Two primary advantages of cash method

(1) the cash method provides the business with more flexibility to time income and deductions by accelerating or deferring payments (timing tax planning strategy) (2) bookkeeping for the cash method is easier.

Cash Method

- Income recognized when actually or constructively received. - Expenses recognized when paid.

Requirements for Deduction of Business Expenses

- Must pass all-events test - Economic performance has occurred

Requirements for LIFO

- Same method for financial and tax records - "Book-tax conformity" requirement

Economic performance occurs when the taxpayer pays liabilities associated with:

-Workers' compensation, tort, breach of contract, or violation of law. -Rebates and refunds. -Awards, prizes, and jackpots. -Insurance, warranties, and service contracts provided to the business. *This relates to insurance, warranties, and product service contracts that cover the taxpayer and not a warranty that the taxpayer provides to others. -Taxes. -Other liabilities not provided for elsewhere.

3 permissible "overall" methods

1. Cash 2. Accrual 3. Hybrid

Businesses meet the all-events requirement on the earliest of the following three dates:

1. Complete service or sale 2. Payment is due 3. Payment is received

3 requirements for business expense deductions:

1. Directly connected to business activity 2. Ordinary and necessary means conducive to profit generation. 3. "Reasonable-in-amount" means

5 limits on business expense deductions:

1. Expenditures against public policy 2. Expenses relating to tax-exempt income 3. Capital expenditures 4. Personal expenditures 5. Business interest limitation

2 pros of cash method

1. Flexible 2. Simple and relatively inexpensive

UNICAP rules

1. Inventory (purchased or produced) must be accounted for using tax version of "full absorption" rules. 2. Indirect costs are allocated to inventories (not expensed). 3. Costs of selling, advertising, and research need not be capitalized. 4. Exception for "small" businesses (average annual gross receipts < $26 million)

How do you determine the deduction for a personal expenditure with a mixed motive?

1. Primary motive for some expenditures (e.g. travel) - All or nothing 2. Otherwise, allocate deduction to business portion - Arbitrary percentage (e.g. 50% meals) - Basis for allocation: Mileage or time

In 2021 and 2022, the cost of food and beverages are 100% deductible in the following 3 cases:

1. business meals as long as the expense is for food and beverages provided by a restaurant (including take-out and delivery) 2. when the amounts paid are treated as compensation to an employee 3. when the food and beverages are provided during employee recreational activities as long as the activity is not limited to highly compensated individuals

Full tax year

12 months long

Calendar year end

12/31

Generally, eligible business meals are ___% deductible.

50%

Short tax year

< 12 months long

Accounting period for Flow-through entities

A "required" tax year. Match to owners' period (multiple owners for partnerships so this can be complicated).

When the asset is completely destroyed or stolen, the business calculates the amount of the loss as:

A sale of the asset for the insurance proceeds, if any. Loss = Insurance Proceeds - Adj. Tax Basis of the Asset

Income recognition (Cash Method)

Actually or constructively received.

Prepaid Income

Advance payments for goods and services, i.e. unearned revenue.

Financial Accounting Objective

Avoid misleading investors and creditors

Hannah's business uses the accrual method of accounting and accounts for inventory with specific identification. In year 0, Hannah received a $4,500 payment with an order for inventory to be delivered to the client early next year. Hannah has the inventory ready for delivery at the end of year 0 (she purchased the inventory in year 0 for $2,300). How would Hannah account for the inventory-related transactions if she uses the cash method of accounting and her annual sales are usually less than $100,000?

Because Hannah's average annual gross receipts are less than $26 million, she may use the cash method and deduct the cost of the inventory when she purchases it (as supplies). Consequently, she would report the $4,500 as income when she received it and she would deduct the $2,300 cost of inventory (as supplies) in year 0 when she paid for it. This $2,200 net increase to income is the same effect on income as if she was using the accrual method.

Business interest expense deduction limit:

Business Interest Income + (30% * Adj. Taxable Income)

Accounting period for Proprietorships

Calendar year (same as proprietor)

When can a short tax year be used?

Can be used in the initial year, last year, or when there is a change in the tax year (e.g. acquisition)

Expenditures for tangible assets with a useful life of more than one year (Cash Method)

Capitalize and apply cost recovery. *Same as accrual method.

Financial accounting is _____ while tax accounting is much less _____. (Same word)

Conservative

Accounting period for C Corporations

Consistent with book accounting period. Can be: - calendar year-end - fiscal year-end - 52/53-week year-end

12-month Rule for Prepaid Expenses

Deduct if: - Benefit ≤ 12 months - Benefits do not extend beyond end of next tax year - DNA to interest expense

General deduction recognition (Accrual Method)

Deduct once all-events test and economic performance test are both satisfied.

General deduction recognition (Cash Method)

Deduct when paid; economic performance does not apply.

Fiscal year end

Depends upon choice: - Last day of a month - 52/53-week year-end is the same day of a specific month (e.g. last or closest Saturday of July)

Are casualty losses deducted for AGI or from AGI?

For AGI

Hannah's business uses the accrual method of accounting and accounts for inventory with specific identification. In year 0, Hannah received a $4,500 payment with an order for inventory to be delivered to the client early next year. Hannah has the inventory ready for delivery at the end of year 0 (she purchased the inventory in year 0 for $2,300). When does Hannah recognize the $2,200 of gross profit ($4,500 revenue minus $2,300 cost of the inventory) if she does not elect to use the deferral method?

If Hannah is an accrual method taxpayer using specific identification for the goods, she can elect either the full inclusion or deferral method to account for prepayment for goods. Under the full inclusion method, Hannah would recognize the entire $2,200 of gross profit in year 0.

When should a business expenditure be capitalized rather than deducted?

If the expenditure provides future benefit beyond this year.

Hannah's business uses the accrual method of accounting and accounts for inventory with specific identification. In year 0, Hannah received a $4,500 payment with an order for inventory to be delivered to the client early next year. Hannah has the inventory ready for delivery at the end of year 0 (she purchased the inventory in year 0 for $2,300). How would Hannah account for the inventory-related transactions if she uses the cash method of accounting and her annual sales are usually over $50 million per year?

In this case, even though she uses the cash method for non-inventory-related items, Hannah must use the accrual method for accounting for her inventory because her average annual gross receipts exceed $26 million. In this case, Hannah is on the hybrid method of accounting. She will recognize the $2,200 of gross profit in year 0.

Accrual Income

Income is recognized when earned or received.

The _____ method generates the lowest taxable income in time of inflation.

LIFO

Inventory Flow Assumptions

LIFO, FIFO, & Specific Identification

This year, Amy purchased $2,000 of equipment for use in her business. However, the machine was damaged in a traffic accident while Amy was transporting the equipment to her business. Note that, because Amy did not place the equipment into service during the year, she does not claim any depreciation expense for the equipment. After the accident, Amy had the choice of repairing the equipment for $1,800 or selling the equipment to a junk shop for $300. Amy sold the equipment. What amount can Amy deduct for the loss of the equipment?

Loss = ($1,700) Loss = 300 - 2,000

This year, Amy purchased $2,000 of equipment for use in her business. However, the machine was damaged in a traffic accident while Amy was transporting the equipment to her business. Note that, because Amy did not place the equipment into service during the year, she does not claim any depreciation expense for the equipment. After the accident, Amy could not replace the equipment so she had the equipment repaired for $2,300. What amount can Amy deduct for the loss of the equipment?

Loss = (2,000) Lesser of Adj. Basis (2,000) or Repair Cost (2,300) = 2,000 Loss = 0 - 2,000

This year, Amy purchased $2,000 of equipment for use in her business. However, the machine was damaged in a traffic accident while Amy was transporting the equipment to her business. Note that, because Amy did not place the equipment into service during the year, she does not claim any depreciation expense for the equipment. After the accident, Amy repaired the equipment for $800. What amount can Amy deduct for the loss of the equipment?

Loss = (800) Lesser of Adj. Basis (2,000) or Repair Cost (800) = 800 Loss = 0 - 800

When the asset is damaged but not completely destroyed, the amount of the loss is:

Loss = Insurance Proceeds - Lesser of: (1) the asset's adjusted tax basis (2) repair cost: the decline in the value of the asset due to the casualty

Tax Accounting Objective

Maximize tax revenues

All-events test

Must be passed to deduct a business expense for tax purposes. Requirements: - All events have occurred to establish the liability to pay. - The amount is determinable with reasonable accuracy. - Reserves for future liabilities not allowed.

1 con of cash method

Poor matching of income and expense

Losses on Disposition of Business Property

Recognized business casualty losses and casualty losses associated with rentals and royalties when assets are stolen, damaged, or completely destroyed by a force outside of their control of the business.

Which tax schedule reports trade or business income?

Schedule C

Hannah's business uses the accrual method of accounting and accounts for inventory with specific identification. In year 0, Hannah received a $4,500 payment with an order for inventory to be delivered to the client early next year. Hannah has the inventory ready for delivery at the end of year 0 (she purchased the inventory in year 0 for $2,300). When does Hannah recognize the $2,200 of gross profit from the inventory sale if she elects to use the deferral method?

Spring of year 1 when she delivers the inventory because that is when she would have recognized the income if she had not received a prepayment.

Adjusted Taxable Income

Taxable income allocable to the business computed without regard to: - Interest income - Interest expense - Depreciation, amortization, and depletion - Net operating loss carryovers

Advance payment for goods and services (Cash Method)

Taxable on receipt.

Unearned rent and interest income (Cash Method)

Taxable on receipt. *Same as accrual method

Unearned rent and interest income (Accrual Method)

Taxable on receipt. *Same as cash method

Income recognition (Accrual Method)

Taxable once the all-events test is satisfied.

Advance payment for goods and services (Accrual Method)

Taxed when received or taxpayers can elect to be taxed in the following year of receipt if not earned by end of year of receipt.

No deduction for purely personal expenditures UNLESS...

Unless otherwise allowable (e.g. charity, medical, etc.).

On November 1 of year 0, Charlie borrowed $50,000 from St. Landry Bank for use in his business. In December, Charlie paid interest of $4,500 relating to the 12-month period from November of year 0 through October of year 1. How much interest, if any, can Charlie deduct in year 0 if his business uses the cash method of accounting for tax purposes? Accrual method?

a) and b) $750 under either cash or accrual method of accounting. Charlie can only deduct two months of interest ([$4,500/12] ×2) because prepaid interest is not deductible under either method of accounting.

This year MH Inc. reported $1 million of taxable income on $50 million of revenue. The revenue included $250,000 of interest income. In calculating the taxable income, MH deducted: $340,000 of depreciation $210,000 of interest expense What is MH's maximum business interest deduction this year?

a. Taxable Income 1,000,000 b. Less: Interest Income 20,000 c. Plus: - Depreciation 40,000 - Interest Expense 470,000 d. Adjusted taxable income 1,490,000 e. Times 30%: 447,000 f. Plus: Interest Income 20,000 g. Maximum interest deduction 467,000 h. Interest Expense 470,000 i. Business Interest Deduction 467,000 [lesser of (g) or (h)]

Large corporations must use _____ method.

accrual

Inventories must generally be accounted for under the _____ method if sales of goods constitute a "material" income-producing factor.

accrual *This is the case even for cash-method taxpayers ("hybrid" method).

For financial reporting purposes, accrual accounting uses an _____ method to account for BDE.

allowance

TP incurs liability from: "interest expense" Economic performance occurs when:

as accrued. *Technically does not fall within the economic performance rules but it is a similar concept.

The business interest limitation does not apply to any taxpayer with:

average annual gross receipts of $26 million or less for the prior 3 taxable years.

Cash method can be used by taxpayers with:

average annual gross receipts of $26 million or less over the three prior tax years (but not tax shelters).

Primary advantage of the accrual method

better matches revenues and expenses

TP incurs liability from: "activities creating 'payment' liabilities" Economic performance occurs when:

business actually makes payment.

Business income does not include _____ and _____ income.

excluded; deferred

A business adopts a 52/53-week year-end by:

filing a special election with the IRS.

A business adopts a calendar year-end or fiscal year-end by:

filing its initial tax return.

Methods are adopted with _____ tax return.

first

§166 provides that a TP can claim a bad debt deduction for the account receivable if:

it is partially or completely uncollectible.

Taxpayers with average annual gross receipts of $26 million or less over the three prior tax years can opt to treat purchases of goods for sale as:

non-inventory.

Allowed to defer recognition of prepaid income for _____ unless income is:

one year; 1. earned or recognized for financial records 2. generated from payments relating to rent or interest income

Tax accounting is _____ to recognize income, but _____ to defer deductions.

quick; slow

TP incurs liability from: "renting or leasing property from another person" Economic performance occurs when:

ratably over the time period during which the taxpayer is entitled to use the property or money.

Once tax year is established, a business can generally change it by:

receiving permission from the IRS.

Financial accounting (GAAP) is _____ to recognize income, but _____ to recognize losses or expenses.

slow; quick

TP incurs liability from: "providing goods and services to another person." Economic performance occurs when:

taxpayer incurs costs to satisfy the liability or provide the goods and services.

Accrual method taxpayers must use direct write-off method for tax purposes. This means they can only deduct bad debt expense when:

the debt actually becomes worthless during the taxable year

If TP incurs liability from: "receiving goods and services from another person" Economic performance occurs when:

the goods or services are provided to the taxpayer or with payment if the taxpayer reasonably expects actual performance within 3½ months.