Tax Accounting Methods

Accounting period

The taxpayer's annual period on the basis of which taxable income is computed Either a calendar or fiscal year typically consisting of 12 months Fiscal year is a 12-month period that ends on the last day of any month other than December Tax year must coincide with the taxpayer's books and records-- taxpayers who do not have books must use the calendar year

Instances in which IRS approval is not required to change to another accounting period

1) Newly married person may change tax years to conform to that of his/her spouse so that a joint return may be filed-- election must be made in either 1st or 2nd year after the marriage date 2) A change to a 52-53 week year that ends with reference to the same calendar month in which the former tax year ended 3) A taxpayer who erroneously files tax returns using an accounting period other than that on which his/her books are kept is not required to obtain permission to file returns for later years based on the way the books are kept 4) An existing partnership can change its tax year to which the partnership changes or if all principal majority interest have the same tax year to which the partnership changes or if all principal partners who do not have such tax year concurrently change to such a tax year

2 occasions the taxpayer's accounting period may be less than 12 months duration

1) when the taxpayer's first or final return is filed 2) if the taxpayer changes accounting periods

Instances of constructive receipt where taxpayers are required to report taxable income even though no cash is actually received

A check received after banking hours Interest credited to a bank savings account Bond interest coupons that have matured but have not been redeemed Salary available to an employee who does not accept payment Amount is not constructively received if: It is subject to substantial limitations or restrictions The payer does not have the funds necessary to make payment The amount is unavailable to the taxpayer

Partnerships

A partnership must use the same tax year of the partners who own the majority of partnership income and capital If a majority of partners do not have the same year, the partnership must use the tax year of its principal partners—those with more than a 5% interest in the partnership Purpose of the rules is to prevent partners from deferring partnership income by choosing a different tax year for the partnership

Instance when a change in tax years is required

A subsidiary corporation filing a consolidated return with its parent corporation must change its accounting period to conform to its parent's tax year

All-events test

Accrual method taxpayer reports an item of income when "all-events" have occurred that fix the taxpayer's right to receive the item of income and the amount can be determined with reasonable accuracy An expense is deductible when all events have occurred that establish the fact of the liability and the amount of the expense can be determined with reasonable accuracy

Installment sales

Any disposition of property where at least 1 payment is received after the close of the taxable year in which the disposition occurs Not applicable to sales of: inventory or marketable securities Key points about installment sales: 1) gains recaptured as ordinary income must be recognized in the year of the sale 2) if property is sold to a related party, and the related party sells property within 2 years from the date of the original sale, the deferred gain must be fully recognized at that time by the original seller 3) the Gross Profit Percentage (GPP) is used to calculate the gain and is applied to the down payment as well as the principal portion of the loan payments which are comprised of P&I

LIFO method

Assumes a last-in, first-out flow of costs The most recent cost of the inventory (usually the highest cost) is used to determine the cost of goods sold Method results in the lowest taxable income during periods of inflation because it shows the highest cost of goods sold and therefore the lowest profits Usually results in the lowest value for the inventory remaining at the end of the tax year since it is valued at earlier, usually lower purchase costs Once LIFO has been elected for tax purposes, the taxpayer's financial reports must also be prepared using LIFO LIFO cannot be used with the lower of cost or market method Main deterrent is that it is more complex

Lower of cost or market method

Available to all taxpayers other than those who determine cost using the LIFO method "market" refers to replacement cost On the date an inventory is valued, the replacement cost of each item in the inventory is compared with its cost—the lower figure is used as the inventory value Use this method for decreases in value of remaining inventory which would otherwise take years to show up in profit and loss sheets-- can be used to reduce current taxable income by increasing the COGs

3 primary overall accounting methods

Cash receipts and disbursements method Accrual method Hybrid method In general, once an accounting method is chosen it cannot be changed without IRS approval

Economic performance test

Economic performance occurs when the property or services are actually provided by the other party Requirement that economic performance take place before a deduction is allowed is waived if all of the following are met: 1) all-events test is satisfied 2) economic performance occurs within a reasonable period after the close of the tax year 3) item is recurring in nature 4) taxpayer is not in a tax shelter 5) either the amount is not material or the earlier accrual of the item results in a better matching of income and expense

Costs subject to long-term contract rules

Direct costs are subject to long-term contract rules—labor, materials, and overhead costs must be allocated to the contract and accounted for accordingly Selling, marketing and advertising expenses, expenses for unsuccessful bids and proposals, and research and development costs not associated with a specific contract may be deducted currently Administrative overhead must be allocated to long-term contracts Interest must be capitalized if the property being produced is real property, long-lived property, or property that requires more than 2 years to produce-- 1 year in the case of property costing more than $1 million

Natural business year

Ends at or soon after the peak income-earning period In general, at least 25% of revenues must occur during the last 2 months of the year in order to qualify as a natural business year Usually only reason IRS will allow a change in accounting periods

FIFO method

Flow of cost method that assumes the first goods purchased will be the first goods sold The ending inventory consists of the last goods purchased In some industries, such as electronics, FIFO may actually provide lower inventory values

S corporations and personal service corporations

Generally required to adopt a calendar year unless the corporation has a business purpose for electing a fiscal year Most tax years end on the last day of a month but the tax law allows taxpayers to use a tax year that always ends on the same day of the week—last Friday in October If the first return is filed late because of oversight, the option to choose a fiscal year is lost

Accounting for the income and expenses associated with long-term contracts

Generally use either the percentage of completion method or the modified percentage of completion method Under the percentage of completion method income from a project is reported in installments as the work progresses Under the completed contract method income from a project is recognized upon completion of the contract—used in limited instances Modified percentage of completion method is a hybrid that combines 2 methods

Amount of change

If the amount is small, recognizing the full amount of the net adjustment in the year of the change is both simple and equitable Reporting a large positive adjustment in one year could push the taxpayer into a higher marginal tax bracket and result in a significant tax increase-- taxpayer may not have the ability to pay the additional tax

Reporting amount of change when switching accounting methods

In the case of voluntary changes, taxpayers must agree to report the adjustment over a period not to exceed 4 years When the amount of the adjustment is $25,000 or less, taxpayers may elect to include the full amount in the current year In the case of a change spread out over 4 years, equal portions of the change are reported in each of the 4 years beginning with the year of the change

Long-term contracts

Include building, installation, construction, or manufacturing contracts that are not completed in the same tax year in which they began A manufacturing contract is long-term only if the contract involves the manufacture of either a unique item not normally carried in finished good inventory or items that normally require more than 12 calendar years to complete Contracts for services do NOT qualify for long-term contract treatment

Completed contract method

Income from a contract is reported in the taxable year in which the contract is completed-- true regardless of whether the contract price is collected in advance, upon completion, or in installments Costs associated with the contract are accumulated in a work-in-process account and deducted upon completion Use of this method may only be used in 2 circumstances: 1) by smaller companies for construction contracts that are expected to take 2 years or less to complete 2) for home construction contracts

Cost of inventory

Inventories may be valued at cost, market value, or the lower of the 2 In the case of merchandise purchased, cost is the invoice price less trade discounts, plus freight and other handling charges UNICAP rules are applicable only to taxpayers whose average gross receipts for the 3 preceding years exceed $10 million In the case of goods manufactured by the taxpayer, direct labor and materials along with manufacturing overhead must be included in inventory under UNICAP rules Interest must be inventoried if the property is real property, long-lived property, or property requiring more than 2 years to produce (one year in the case of property costing more than $1 million)

Prepaid income

Major exception to the normal operation of the accrual method Generally taxable in the year of receipt 2 exceptions to rule: 1) accrual-basis taxpayers may defer recognizing income in the case of certain advance payments for goods and in the case of certain advance payments for services to be rendered 2) taxpayer may defer advance payments for goods (inventory) if the taxpayer's method of accounting for the sale is the same for tax and financial accounting purposes

Constructive receipt

Means that the income is made available to the taxpayer so that he may draw upon it at any time Income is not constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions-- prevents taxpayers from deferring income that is otherwise available by merely "turning their backs" on it Taxpayer cannot defer income recognition by refusing to accept payment until a later taxable year

First/final tax year

Not required to annualize the year's income No provisions for personal exemptions or tax credits to be prorated Returns are prepared and filed and taxes are paid as though they are returns for a 12-month period ending on the last day of the short period

Changes in accounting periods

Once adopted an accounting period cannot normally be changed without approval of the IRS IRS will usually approve a change only if the taxpayer can establish a substantial business purpose for the change

Hybrid method

Some items of income or expense are reported under the cash basis and others are reported under the accrual method Most often encountered in small businesses that maintain inventories and are required to use the accrual method of accounting for purchases and sales of goods

4 methods to determine inventory costs

Specific identification method FIFO LIFO Lower of cost or market method the costs that must be included in inventory are referred to as the Uniform Capitalization Rules (UNICAP)

Percentage of completion method

Taxpayer reports a percentage of the gross income from a long-term contract based on the portion of work that has been completed The portion of the total contract price reported in a given year is determined by multiplying the total contract price by the percentage of work completed in the year % of completion = current year cost / expected total cost

Modified percentage of completion method

Taxpayers may elect to defer reporting any income from a contract until they have incurred at least 10% of estimated total cost If a contract has just been started in the end of the year, the taxpayer does not have to estimate the profit on the contract during that year—the next year the taxpayer will report profit on all work that has been completed, including work done during the first year This is assuming that at least 10% of the work has been completed as of the end of the taxable year If more than 10%of the costs are incurred during the first year, the modified percentage of completion is identical to the regular percentage of completion method

Changing from 1 accounting period to another

Taxpayers must annualize their income for the resulting short period-- prevents income earned during the resulting short period from being taxed at lower rates Steps to annualize: 1) determine modified taxable income 2) multiply modified taxable income by (12/number of months in the short period) 3) compute the tax on the resulting taxable income 4) multiply the resulting tax by the number of months in short period / 12

Accrual method

Taxpayers using this method generally report income in the year it is earned Income is earned when all the events that fix the right to receive the income have occurred and the amount of income can be easily determined This method must be used for sales and COGs if inventories are an income-producing factor to the business and average gross receipts over the last 3 years exceed $1 million

Capitalization requirements for cash method taxpayers

Taxpayers who use the cash method are required to capitalize fixed assets-- must also recover cost through depreciation or amortization Pre-paid expenses must be capitalized and deducted over the life of the asset if the life of the asset extends substantially beyond the end of the tax year Typically capitalization is required only if the life of the asset extends beyond the close of the tax year following the year of payment Notable exception to the one-year rule denies a deduction for prepaid interest-- cash-method taxpayers must capitalize such amounts and allocate interest over the prepayment period Taxpayer's note is not the equivalent of cash so if a cash-method taxpayer gives a note as payment he/she cannot take the deduction until the note is paid even if the note is secured by collateral

Cash method of accounting

Used by most individual taxpayers and most small businesses Income is reported in the year the taxpayer actually or constructively receives the income rather than in the year the income is earned Income can be received in the form of cash, other property, or services Accounts receivable considered to have no value under the cash method Prepaid income is taxed when received and not when earned often resulting in a mismatching of income and expenses

Changes in accounting methods

Usually results in duplication or omissions of items of income or expense In general, once an accounting method is chosen it cannot be changed without IRS approval Exception: taxpayers may adopt the LIFO inventory method without prior IRS approval Accounting method helps determine the taxable year in which income and expenses are reported for tax purposes

Look-back interest

When a contract is completed, a computation is made to determine whether the tax paid each year during the contract is more or less Interest is paid on any additional tax that would have been paid-- taxpayer receives interest on any additional tax that was paid Only applicable to contracts that have taken more than 2 years to complete Applicable only if the contract price equals or exceeds either 1% of the taxpayer's average gross receipts for the 3 taxable years preceding the taxable year the contract was entered into, or $1 million

Required payments and fiscal years

• Congress enacted Section 444, which allows partnerships, S corps, and personal service corps (such as incorporated medical practices) to elect a taxable year that results in a tax deferral of 3 months or less-- partnership with calendar-year partners may elect a Sept 30 year-end Partnerships and S corps making the Section 444 election must make annual required payments by April 15 of the following year-- purpose of required payment is to offset the tax deferral advantage obtained when fiscal years are used Amount of the required payment is determined by multiplying the maximum tax rate for individuals plus 1% (40.6%) times the previous year's taxable income times a deferral ratio Deferral ratio is equal to the number of months in the deferral period divided by the number of months in the taxable year If a business elects something other than a calendar year end, it will have to make tax payments for the time value of money benefit it gets for the tax deferral on reporting income Business can deduct the amount distributed to the business owners during the year but they will have to pay income taxes on any amount above $500 Personal service corps may elect a fiscal year end if they make minimum distributions to shareholders during the deferral period