Chapter 19

Q66. As an example in the case of compensation for services, no determination can be made as to the right to such compensation or the amount thereof until the services are completed, the amount of compensation is ordinarily income for the taxable year in which the determination can be made, while in cash method such amount is includible in gross income when actually or constructively received.

XXX

Q16. Under code section 451, what is the general rule for taxable year of inclusion?

A16. The amount of any item of gross income shall be included in the gross income for the taxable year in which received by the taxpayer, unless, under the method of accounting used in computing taxable income, such amount is to be property accounted for as of a different period

Q17. What does code section 461(a) say is the general rule for taxable year of deduction?

A17. The amount of any deduction or credit allowed by this subtitle shall be taken for the taxable year which is the proper taxable year under the method of accounting used in computing taxable income

Q18. Code section 448 describes the limitations of what?

A18. The limitation on use of cash method of accounting

Q19. What type of entities are prevented from using cash method accounting for tax?

A19. C Corps, partnership which has a C Corp as a partner, or a tax shelter

Q2. For purposes of this subtitle, what is mean by the term "taxable year"

A2. (1). The taxpayer's annual accounting period, if it is a calendar year or a fiscal year (2). The calendar year, or (3). The period for which the return is made, if a return is made for a period of less than 12 months

Q20. Are their exceptions to this rule?

A20. Yes, tons of exceptions, must review section 448

Q21. Code section 460 discusses special rule for what types of contracts?

A21. Long-term contracts

Q22. What is the general rule on what type of method must be used for LT contracts?

A22. In the case of any long-term contract, the taxable income from such contract shall be determined under the percentage of completion method

Q23. Are their exceptions to this?

A23. Yes, numerous, need to look at code section 460

Q24. Does the IRS recognize a uniform method of accounting for all taxpayers?

A24. No, it is recognized that no uniform method of accounting can be prescribed for all taxpayers

Q25. So what should each taxpayer do?

A25. Each taxpayer shall adopt such forms and systems as are, in their judgment, best suited to their needs. However, no method of accounting is acceptable unless, in the opinion of the commissioner, it clearly reflects income.

Q26. A method of accounting which reflects the consistent application of GAAP in a particular trade or business in accordance with accepted conditions or practices in that trade or business will be generally regarded as what?

A26. Will ordinarily be regarded as clearly reflecting income, providing all items of gross income and expense are treated consistently from year to year.

Q27. If a taxpayer does not regularly employ a method of accounting which clearly reflects his income then what?

A27. The computation of taxable income shall be made in a manner which, in the opinion of the commissioner, does clearly reflect income.

Q28. Can a taxpayer utilize a combination of methods?

A28. In accordance with the following rules, any combination of the foregoing methods of accounting will be permitted in connection with a trade or business if such combination clearly reflects income and is consistently used.

Q3. What is the annual accounting period?

A3. The term "annual accounting period" means the annual period on the basis of which the taxpayer regularly computes his income in keeping his books

Q30. Can a taxpayer using one method of accounting in computing items of income and deductions of his trade or business compute other items of income and deductions not connected with his trade or business under a different method of accounting?

A30. Yes, you can do this.

Q31. Federal income taxes are computed on what basis and over what period?

A31. Federal income taxes are computed on the basis of a net income figure (taxable income) for a twelve month period (the taxable year)

Q32. In what situations would a shorter than 12 month period be considered a full taxable year?

A32. Upon the death of a taxpayer or the creation of a new taxable entity such as a corporation or a trust (code section 442(a)(2)).

Q33. What if a short period arises out of a change in taxpayer's accounting period? How is income treated?

A33. Income must be "annualized" (detailed in 443(b))

Q34. A taxpayer may use what two types of taxable years in computing their numbers?

A34. A taxpayer may use the calendar year which of course ends on December 31st, or a fiscal taxable year which ends on the last day of any other month.

Q35. The choice between calendar year and fiscal year depends largely on what?

A35. Depends largely on how the taxpayer maintains financial records.

Q36. A taxpayer's taxable year generally is what?

A36. Is the annual period on the basis of which the taxpayer regularly computes income in keeping financial books.

Q37. If the taxpayer does not keep books or does not have an annual accounting period, then?

A37. Then a calendar year must be used as the taxable year

Q38. After a taxpayer has chosen an accounting period, approval of the Commissioner is required for what?

A38. Approval of the Commissioner is required for a change of accounting period.

Q39. What are the two principle accounting methods?

A39. The principal accounting methods are the cash receipts and disbursements method and the accrual method.

Q4. What is a Calendar year?

A4. The term "calendar year" means a period of 12 months ending on December 31st

Q40. Which method is typically used by individuals?

A40. Cash method

Q41. How does it very generally work?

A41. Generally, under the cash receipts and disbursements method in the computation of taxable income, all items which constitute gross income (whether in the form of cash, property, or services) are to be included for the taxable year in which actually or constructively received. Expenditures are to be deducted for the taxable year in which actually made.

Q42. Who typically uses accrual method?

A42. The accrual method of accounting is often used and sometimes MUST be used by businesses.

Q43. How does the accrual method work, very generally?

A43. It generally measures tax liability by including an item in income at the time the taxpayer becomes entitled to it and allowing a deduction at the time a deductible obligation becomes fixed and certain

Q44. Are the cash and accrual methods the exclusive methods?

A44. No, although the cash and accrual methods are the principal accounting methods, they are not exclusive. The code approves some statutory variations in the methods of accounting.

Q45. Can everyone use the cash method of accounting?

A45. No, the Code specifically provides that some taxpayers may not use the cash method of accounting

Q46. What is behind some accepted departures from straight cash or accrual method accounting? Example?

A46. The matching concept, an example would be a business activity that could involve the building or sale of major structures such as hotels or bridges work on which may extend over several years.

Q47. In these situations, what method must be used?

A47. The percentage of completion must be used (which requires income or losses from such contract to be partially reported under the % of completion method of accounting, there are exceptions).

Q48. What about another method?

A48. In some situations (there are specific ones), a taxpayer may use the "completed contract method" of accounting under which the taxpayer is permitted to determine and report net profit on the project upon completion of the entire contract

Q49. If you are allowed to use a hybrid method of accounting combing some aspects of cash and accrual concepts, what is the basic statutory requirement for doing this?

A49. The method used must clearly reflect income.

Q5. What is a fiscal year?

A5. The term "fiscal year" means a period of 12 months ending on the last day of any month other than December.

Q50. Although a taxpayer may initially adopt a specific accounting method, why would they need the consent of the Commissioner in order to change accounting methods?

A50. Approval is required so as to avoid distortion of one's income by means of an accounting method change, and the Commissioner may require adjustments to prevent duplication or omission of amounts as a result of the change

Q72. In the Kahler case (received a check on 12/31) what is the exception that the court discussed that would preclude a check from being counted as being includable in taxable income?

A72. If the check has a restriction like a post-dated and therefore not cashable until a certain date

Q73. Why was the doctrine of constructive receipt conceived by the Treasury?

A73. To prevent a taxpayer from choosing the year in which to return income merely by choosing the year in which to reduce it to possession. Thereby the Treasury may subject income to taxation when the only thing preventing its reduction to possession is the violation of the taxpayer

Q74. Why did Hornung lose his case?

A74. The courts say that he had not obtained constructive receipt of the vehicle in the year that he had won it. The Corvette was in the possession of a Chevrolet dealer in NYC the day he won it (he was in Green Bay), he had neither the title nor keys to the car, and nothing was given or presented to petitioner to evidence his ownership or right to possession of the car at that time

Q75. What happens if you prepay interest? Can you get an earlier deduction?

A75. Under code section 461(g), if the taxable income of the taxpayer is computed under the cash receipts and disbursements method of accounting, interest paid by the taxpayer which, under regulations prescribed by the Secretary, shall be charged to capital account and shall be treated as paid in the period to which so allocable. Real wording, the answer is no you can't do that. To be deductible it must have been paid and incurred

Q76. Is there an exception to this rule?

A76. Yes for points paid in respect of any indebtedness incurred in connection with the purchase or improvement of, and secured by, the principal residence of the taxpayer.

Q77. So how does a taxpayer treat prepaid expenses?

A77. A taxpayer must capitalize prepaid expenses

Q78. Example - N corporation, an accrual method taxpayer, pays $10K to an insurer to obtain three years of coverage under a property and casualty insurance policy. How should this be treated/

A78. The $10K is a prepaid expense and must be capitalized under this paragraph. Paragraph (d)(2) does not apply to the payment because the policy has no cash value

Q79. Example - X Corporation, a cash method taxpayer, enters into a 24-month lease of office space. At the time of the lease signing, X prepays $240K. No other amounts are due under the lease. How is this treated?

A79. The $240K is a prepaid expense and must be capitalized under this paragraph (d)(3).

Q8. What happens if a taxpayer to whom section 441(g) applies adopts an annual accounting period other than a calendar year?

A8. The taxpayer shall be treated as having changed his annual accounting period

Q80. Is there an exception to this capitalization rule?

A80. A taxpayer is not required to capitalize under this section amounts paid to create (or to facilitate the creation of) any right or benefit for the taxpayer that does not extend beyond the earlier of (1). 12 months after the first date on which the taxpayer realizes the right or benefit, or (2). The end of the taxable year following the taxable year in which the payment is made

Q81. Would a taxpayer using the cash and disbursement method also be entitled to certain deductions in the computation of taxable income which do not involve cash disbursements during the taxable year? Examples?

A81. Yes, think about deprecation, depletion etc...

Q82. What about an expenditure that results in the creation of an asset having a useful life which extend substantially beyond the close of the taxable year?

A82. Such an expenditure may not be deductible, or may be deductible only in part, for the taxable year in which made. As an example, think about an expenditure for the construction of improvements by the lessee on leased property where the estimated life of the improvements is in excess of the remaining period of the lease.

Q83. What would you do in that situation?

A83. In such a case, in lieu of the allowance for depreciation provided by section 167, the basis shall be amortized ratably over the remaining period of the lease.

Q84. When would a charitable contribution in the form of a check be deductible?

A84. A charitable contribution in the form of a check is deductible, in the manner and to the extent provided by section 170(a) which is that in the taxable year in which the check is delivered provided the check is honored and paid and there are no restrictions as to time and manner of payment.

Q85. So is there a big difference in regards to timing between paying by cash or paying by check?

A85. No, payment by check is essentially the same as payment in cash. From the standpoint of a cash method taxpayer, one has paid a deductible expense when one hands over a check.

Q86. What is the rule regarding the mail and a check?

A86. Payment is effected when one places a check in the mail. We have "paid" a bill when we mail out the checks.

Q87. What is the qualifying item in regards to checks?

A87. There is a requirement that the check is honored and paid in due course when presented to the drawee bank. If you write a check for $10K but only $5K in your account then can't take a $10K deduction and vice versa.

Q29. Example - A taxpayer using an accrual method of accounting with respect to purchases and sales may use the cash method in computing all other items of income and expense.

A taxpayer who uses the cash method of accounting in computing gross income from his trade or business shall use the cash method in computing expenses of such trade or business

Q1. Taxable income shall be computed on the basis of what time period?

A1. On the basis of the taxpayer's taxable year

Q10. What happens if no method of accounting has been regularly used by the taxpayer, or if the method used does not clearly reflect income?

A10. The computation of taxable income shall be made under such method as, in the opinion of the Secretary, does clearly reflect income

Q100. How do code section 163(a) and 163(h) differ?

A100. Section 163(a) allows a deduction for all interest paid or accrued within the table are on indebtedness, while section 163(h) provides that in the case of a taxpayer other than a corporation, no deduction shall be allowed for personal interest paid or accrued during the taxable year

Q11. What are the three main methods that are permissible?

A11. The cash receipts and disbursement method; an accrual method are usable; but also any other method permitted by this chapter

Q12. Can you use a combination of methods?

A12. Any combination of the ongoing methods permitted under regulations prescribed by the Secretary.

Q13. If a taxpayer engages in more than one trade or business, can they use different methods of accounting for each one?

A13. Yes, under code section 446(d), a taxpayer engaged in more than one trade or business may, in computing taxable income, use a different method of accounting for each trade or business.

Q14. What must a taxpayer do if they change the method of accounting in the basis of which they regularly computes income in keeping his books?

A14. Before computing his taxable income under the new method, would secure the consent of the Secretary

Q15. What can happen if there is a failure to request a change of method of accounting?

A15. If the taxpayer does not file with the Secretary a request to change the method of accounting, the absence of the consent of the Secretary to a change in the method of accounting shall not be taken into account to (1). To prevent the imposition of any penalty, or the addition of any amount to tax under this title, or (2). To diminish the amount of such penalty or addition to tax

Q51. Explain the concept of "preserving the integrity of the taxable year"

A51. As a general principal each taxable year stands alone and each year's tax liability is computed separately. As an example, if one reported an item of income as accrued in year one, and in year two it became apparent that collection would never be made, taxable income for year one is not to be adjusted (the year is not reopened) and, if un-collectability is to affect taxability, it will affect liability for year two, rather than year one

Q52. What does it mean to have constructive receipt?

A52. Income although not actually reduced to a taxpayer's possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given.

Q53. What if the taxpayer's control of its receipt is subject to substantial limitations or restrictions?

A53. This would prevent a constructive receipt

Q54. What if a corporation credits its employees with bonus stock, but the stock is not available to such employee until some future date?

A54. The mere crediting on the books of the corporation does not constitute receipt

Q55. Would a requirement that a deposit from an account and the earnings thereon, must be withdrawn in multiples of even amount be a substantial limitation or restriction on taxpayers control over the receipts?

A55. No

Q56. Would the fact that the taxpayer would forfeit (example, three months interest upon withdrawal or redemption before maturity of a one year or less CD be consisted a limitation or restriction)?

A56. No

Q57. What about a requirement that the earnings may be withdrawn only upon a withdrawal of all or part of the deposit or account?

A57. No

Q58. Under code section 446 taxable income shall be computed under the method of accounting on the basis of?

A58. On the basis of which the taxpayer regularly computes his income in keeping his books

Q59. What is the exception to this rule? What would you do?

A59. If no method of accounting has been regularly used by the taxpayer, or if the method used does not clearly reflect income; the computation of taxable income shall be made under such method as, in the opinion of the Secretary, does clearly reflect income.

Q6. According to code section 441(g), the taxpayer's taxable year shall be the calendar year if? 3 items

A6. (1). If the taxpayer keeps no books (2). The taxpayer does not have an annual accounting period; or (3). The taxpayer has an annual accounting period, but such period does not qualify as a fiscal year

Q60. What if a taxpayer is engaged in more than 1 business? Must he use the same system in both?

A60. No, a taxpayer engaged in more than one trade or business may, in computing taxable income, use a different method of account for each trade or business.

Q61. Can you change your accounting method? What has to happen?

A61. Except as otherwise expressly provided in this chapter, a taxpayer who changes the method of accounting on the basis of which he regularly computes his income in keeping his books shall, before computing his taxable income under the new method, secure the consent of the Secretary.

Q62. Under regulation 1.446-1(c)(1)(i) what are the two permissible methods to compute taxable income?

A62. (1). Cash receipts and disbursements method (2). Accrual method

Q63. Under the cash and disbursement method, when would you have taxable income and when would you have a deduction?

A63. All items which constitute gross income (whether in the form of cash property, or services) are to be included for the taxable year in which actually or constructively received. Expenditures are to be deducted for the taxable year for the taxable year in which actually made

Q64. Gains, profits, and income are to be included in gross income for the taxable year in?

A64. In which they are actually or constructively received by the taxpayer unless includible for a different year in accordance with the taxpayer's method of accounting

Q65. Under the accrual method of accounting, when is income booked?

A65. Income is includible in gross income when all the events have occurred which fix the right to receive such income and the amount thereof can be determined with reasonable accuracy

Q67. What happens if an amount of income is properly accrued on the basis of a reasonable estate and the exact amount is subsequently determined?

A67. The difference if any shall be taken into account for the table year in which such determination is made.

Q68. What happens to the extent that income is attributable to the recovery of bad debts for accounts charged off in prior years?

A68. It is includable in the year of recovery in accordance with the taxpayer's method of accounting, regardless of the date when the amounts were charged off

Q69. In regards to constructive receipt, what if you had amounts payable with respect to interest coupons which have matured and are payable but which have not been cashed?

A69. These would be constructively received in the taxable year during which the coupons mature, unless it ca be shown that there are no funds available for payment of the interest during such year

Q7. According to code section 442 if a taxpayer changes his annual accounting period, the new accounting period shall become the taxpayer's taxable year only if what?

A7. Only if the change is approved by the Secretary

Q70. What is the rule on dividends on corporate stock for construct receipt?

A70. Dividends on corporate stock are constructively received when unqualifiedly made subject to the demand of the shareholder.

Q71. What happens if a dividend is declared payable on December 31st and the corporation followed its usual practice of paying the dividends by checks mailed so that the shareholders would not receive them until January of the following year?

A71. Such dividends are not considered to have been constructively received in December

Q88. What is the rule in regards to credit card payments?

A88. Under revenue ruling 71-216, the service said that since the cardholder's use of the credit card creates the cardholder's own debt to a third party, the use of a bank credit card to make a charitable contribution is equivalent to the use of borrowed funds to make a contribution. The general rule is that when a deductible payment is made with borrowed money, the deduction is not postponed until the year in which the borrowed money is repaid. Such expense must be deducted in the year they are paid and not when the loans are repaid. So in short, a taxpayer who made a contribution to a qualified charity by a charge to the taxpayer's bank credit card, is entitled to a charitable contribution deduction under section 170(a) of the code in the year the charge was made

Q89. After reading the Vander Poel case, what did we learn about the difference between the doctrine of constructive receipt and the doctrine of constructive payment?

A89. Basically, under the doctrine of constructive receipt a taxpayer must report income they gain as soon as they could have received it, even if they don't cash the check for a while. On the other hand, the taxpayer who writes the check cannot deduct the expense until the check is actually cashed, regardless of when it was signed. The two are NOT the same

Q9. What does code section 446 say about the general rule for methods of accounting?

A9. Taxable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books

Q90. In the Boylston Market v. commissioner case, how did the court say that capital expenditures need to be treated for tax purposes?

A90. Must be depreciated over the life of the asset (in this example, the court said that when they prepaid an insurance policy (3 years up front), they could depreciate it over the life of the policy. Basically, this case said that an expenditure which results in the creation of an asset that has a useful life extending "substantially beyond" the close of the taxable year may not be fully deducted in the year the payment is made. Instead the deductions must be pro-rated over the asset's useful life (regulation 1.461-1(a)(1)

Q91. In determining whether an asset has a useful life extending "substantially beyond" the close of the taxable year, what was the rule the court decided on?

A91. The court adopted a one year rule

Q92. What happens under this rule?

A92. Under this rule, prepaid expenses (other than those governed by a specific statute) may be deducted in the year they are paid, even though they span a period that touches two taxable years, as long as the expenses do not relate to a period greater than one year

Q93. In regards to regulations on capitalization of amounts to acquire, create, or enhance intangible assets, what is the general rule regarding prepayments?

A93. The regulations generally require a cash method taxpayer to capitalize prepayments for benefits to be received in the future. Thus if a cash method taxpayer prepays $240K as rent on a 24-month lease of office space, the prepayment must be capitalized

Q94. Is there a safe harbor related to this?

A94. Yes there is a 12-month safe harbor under which a taxpayer is not required to capitalize amounts paid to create or enhance an intangible asset if the amounts do not create or enhance any right or benefit for the taxpayer that extends beyond the earlier of (1). 12 months after the first date on which the taxpayer realizes the right or benefit (2). The end of the taxable year following the taxable year in which the payment is made

Q95. Example, Assume a taxpayer pays $10K on December 1 of year 1 to obtain a property insurance policy for the taxpayer's business. The policy has a one-year term that begins on December 15 of year one. What would happen?

A95. In that case, the 12-month safe harbor would permit the taxpayer to deduct the prepayment in year one because the benefit of the insurance contract does not extend more than 12 months beyond December 15 of year one, nor beyond the end of the year following the year the payment is made (year two).

Q96. What if the term of the one year insurance policy had instead begun on February 1 of year two?

A96. The payment on December 1 of year one would have had to be capitalized in year one because the benefit of the payment would extend into year 3 and beyond the end of the year following the year of the payment.

Q97. How does code section 461(g) say that cash basis tax payers need to treat prepaid interest?

A97. The statutes requires cash method taxpayers to allocate deductions for prepaid interest to the periods to which they relate and to do so by way of capitalization and amortization

Q98. Is there an exception to this statute?

A98. Yes, the statute makes an exception for "points', a loan processing fee pad at the inception of a loan, which is treated as a current payment of interest. The exception is limited to amounts customarily charged in connection with indebtedness incurred to purchase or improve a principal residence

Q99. Interest on a mortgage loan and points paid upfront (with separate funds) are called what and treated how?

A99. This is called qualified residence interest 163(h)(3)