Chapter 1 Business Income, Deductions, and
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Chapter 1 Business Income, Deductions, and Accounting Methods Learning Objectives Describe the general requirements for deducting business expenses and identify common business deductions. Apply the limitations on business deductions to
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Chapter 1 Business Income, Deductions, and Accounting Methods<br>
02
Learning Objectives Describe the general requirements for deducting business expenses and identify common business deductions.
Apply the limitations on business deductions to distinguish between deductible and nondeductible business expenses.
Identify and explain special business deductions specifically permitted under the tax laws.
Explain the concept of an accounting period and describe accounting periods available to businesses.
Identify and describe accounting methods available to businesses and apply cash and accrual methods to determine business income and expense deductions.<br>
Apply the limitations on business deductions to distinguish between deductible and nondeductible business expenses.
Identify and explain special business deductions specifically permitted under the tax laws.
Explain the concept of an accounting period and describe accounting periods available to businesses.
Identify and describe accounting methods available to businesses and apply cash and accrual methods to determine business income and expense deductions.<br>
03
Business Income and Deductions Schedule C – Trade or business income
Includes revenue from services and sales activities
Gross profit from sales − cost of goods is a return of capital
Business income does not include excluded and deferred income
Deductions must be directly connected to business activity
Ordinary and necessary means conducive to profit generation
Reasonable in amount means not extravagant<br>
Includes revenue from services and sales activities
Gross profit from sales − cost of goods is a return of capital
Business income does not include excluded and deferred income
Deductions must be directly connected to business activity
Ordinary and necessary means conducive to profit generation
Reasonable in amount means not extravagant<br>
04
Reasonableness Example 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?<br>
In comparison, other employees with Ben’s responsibilities are only paid $30,000 per year.
What is Rick’s business deduction for employing Ben?<br>
05
Reasonableness Solution A reasonable amount for compensating Ben is $30,000 rather than $45,000.
Hence, Rick can only deduct $30,000.
The extra $15,000 ($45,000 paid minus $30,000 deduction) is a gift from Rick to Ben.<br>
Hence, Rick can only deduct $30,000.
The extra $15,000 ($45,000 paid minus $30,000 deduction) is a gift from Rick to Ben.<br>
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Statutory Limits on Business Expense Deductions Expenses against public policy
No deduction for fines, bribes, lobby expenditures, or political contributions
Expenses relating to tax-exempt income
Interest on loan where proceeds invested in municipal bonds
Key man insurance premiums – no deduction if business is beneficiary of life insurance
Capital expenditures
Personal expenses<br>
No deduction for fines, bribes, lobby expenditures, or political contributions
Expenses relating to tax-exempt income
Interest on loan where proceeds invested in municipal bonds
Key man insurance premiums – no deduction if business is beneficiary of life insurance
Capital expenditures
Personal expenses<br>
07
Capital Expenditures Does the expenditure provide future benefit (beyond this year)?
If so, capitalize rather than deduct.
12-month rule for prepaid expenses:
Deduct if benefit < 12 months and
Benefits do not extend beyond end of next tax year
Does not apply to interest<br>
If so, capitalize rather than deduct.
12-month rule for prepaid expenses:
Deduct if benefit < 12 months and
Benefits do not extend beyond end of next tax year
Does not apply to interest<br>
08
12-Month Rule Example 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?<br>
$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?<br>
09
12-Month Rule Solution Ben can deduct all $10,000 for the utilities because:
the benefit is not more than 12 months and
the benefit ends prior to the end of next year.
Ben can deduct $3,000 for insurance because:
the payment is more than 12 months. Hence, Ben can only deduct 6 months ($500 per month).
Ben can deduct $7,200 for interest because:
the 12-month rule does not apply to interest.<br>
the benefit is not more than 12 months and
the benefit ends prior to the end of next year.
Ben can deduct $3,000 for insurance because:
the payment is more than 12 months. Hence, Ben can only deduct 6 months ($500 per month).
Ben can deduct $7,200 for interest because:
the 12-month rule does not apply to interest.<br>
10
Special Business Deductions Losses on disposition of business assets
Recognized losses are deductible
Casualty losses are limited to lesser of decline in value (repair cost) or basis
Basis is amount of loss if business asset is completely destroyed<br>
Recognized losses are deductible
Casualty losses are limited to lesser of decline in value (repair cost) or basis
Basis is amount of loss if business asset is completely destroyed<br>
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Domestic Production Activities Deduction (DPAD) An “artificial” deduction that subsidizes domestic manufacturing
Domestic production of tangible products qualifies for subsidy but income must be allocated between qualifying and nonqualifying activities
Subsidy is percentage (9 percent) of the lesser of qualified production activities income (QPAI) or modified AGI
Formula:
QPAI = domestic production gross receipts less expenses attributed to domestic production
Deduction is ultimately limited to 50% of wages allocated to qualified activities<br>
Domestic production of tangible products qualifies for subsidy but income must be allocated between qualifying and nonqualifying activities
Subsidy is percentage (9 percent) of the lesser of qualified production activities income (QPAI) or modified AGI
Formula:
QPAI = domestic production gross receipts less expenses attributed to domestic production
Deduction is ultimately limited to 50% of wages allocated to qualified activities<br>
12
DPAD Example Brian recorded $100,000 of receipts from a qualified domestic production activity.
Brian allocated $55,000 of expenses to the qualified domestic production activity including $12,000 of wages.
Brian had modified AGI of $47,000.
What is Brian’s domestic production activities deduction?<br>
Brian allocated $55,000 of expenses to the qualified domestic production activity including $12,000 of wages.
Brian had modified AGI of $47,000.
What is Brian’s domestic production activities deduction?<br>
13
DPAD Solution Calculate QPAI:
QDGR (receipts) $100,000 expenses − 55,000 QPAI (qualifying income) $ 45,000
QPAI cannot exceed modified AGI:
Modified AGI is $47,000 so no limit
Calculate DPAD
QPAI $ 45,000 2010 percent × 9% DPAD $ 4,050
Limit DPAD to 50% of wages
50% of wages is $6,000 DPAD = $4,050<br>
QDGR (receipts) $100,000 expenses − 55,000 QPAI (qualifying income) $ 45,000
QPAI cannot exceed modified AGI:
Modified AGI is $47,000 so no limit
Calculate DPAD
QPAI $ 45,000 2010 percent × 9% DPAD $ 4,050
Limit DPAD to 50% of wages
50% of wages is $6,000 DPAD = $4,050<br>
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Business Expenses with Personal Benefits No deduction for purely personal expenditures
unless otherwise allowable – e.g. charity, medical, etc.
Mixed motive?
Primary motive for some expenditures (all or nothing)
Business travel (away from home overnight)
Otherwise, allocate deduction to business portion.
Arbitrary percentage (50% meals and entertainment)
Basis for allocation (mileage or time)
Recordkeeping
Document business purpose<br>
unless otherwise allowable – e.g. charity, medical, etc.
Mixed motive?
Primary motive for some expenditures (all or nothing)
Business travel (away from home overnight)
Otherwise, allocate deduction to business portion.
Arbitrary percentage (50% meals and entertainment)
Basis for allocation (mileage or time)
Recordkeeping
Document business purpose<br>
15
Travel Example 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)?
What amounts are deductible if Ben spent one day in a meeting (primarily personal)?<br>
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)?
What amounts are deductible if Ben spent one day in a meeting (primarily personal)?<br>
16
Travel Solution Ben can deduct the following amounts:
2 days 1 day business personal
Air fare (all or none) $ 1,200 $ 0
Hotel ($250 per day) 500 250
Meals ($90 per day × 50%) 90 45
Total Travel Deduction $ 1,790 $ 295<br>
2 days 1 day business personal
Air fare (all or none) $ 1,200 $ 0
Hotel ($250 per day) 500 250
Meals ($90 per day × 50%) 90 45
Total Travel Deduction $ 1,790 $ 295<br>
17
Accounting for Taxable Income We’ve learned to identify:
Business gross income and
Deductible expenses
Now we need to match income and deductions to a specific period
Accounting methods match income and expense to a specific period<br>
Business gross income and
Deductible expenses
Now we need to match income and deductions to a specific period
Accounting methods match income and expense to a specific period<br>
18
Accounting Periods Annual period
Full tax year is 12 months long
Short tax year is < 12 months
Year ends
Calendar year ends 12/31
Fiscal year end depends upon choice:
Last day of a month (not December)
52/53 week year end is the same day of a specific month<br>
Full tax year is 12 months long
Short tax year is < 12 months
Year ends
Calendar year ends 12/31
Fiscal year end depends upon choice:
Last day of a month (not December)
52/53 week year end is the same day of a specific month<br>
19
Choosing an Accounting Period Proprietorships – same as proprietor
“C” corporations and individuals – choice made on first tax return and is consistent with book accounting period
Flow-thru entities – a “required” tax year
Match to owners’ period (multiple owners for partnerships so this can be complicated)<br>
“C” corporations and individuals – choice made on first tax return and is consistent with book accounting period
Flow-thru entities – a “required” tax year
Match to owners’ period (multiple owners for partnerships so this can be complicated)<br>
20
Accounting Methods Comparison of financial and tax methods
Financial accounting is “conservative”
GAAP is slow to recognize income, but quick to recognize losses or expenses
Objective is to avoid misleading investors & creditors
Tax accounting is much less conservative
Quick to recognize income but likely to defer deductions
Objective of Congress is to maximize tax revenues<br>
Financial accounting is “conservative”
GAAP is slow to recognize income, but quick to recognize losses or expenses
Objective is to avoid misleading investors & creditors
Tax accounting is much less conservative
Quick to recognize income but likely to defer deductions
Objective of Congress is to maximize tax revenues<br>
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Accounting Methods Permissible “overall” methods:
Cash – recognize income when received
Accrual – recognize income when earned or received (whichever is first generally)
Hybrid – mix of accrual and cash depending upon accounts (e.g. sales on accrual)
Methods are adopted with first tax return
Large corporations must use accrual<br>
Cash – recognize income when received
Accrual – recognize income when earned or received (whichever is first generally)
Hybrid – mix of accrual and cash depending upon accounts (e.g. sales on accrual)
Methods are adopted with first tax return
Large corporations must use accrual<br>
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Cash Method Income recognized when actually or constructively received
Expenses recognized when paid
Pros and cons:
Flexible
Simple and relatively inexpensive
Not GAAP – poor matching of income and expense.
Not available for some business organizations (large C corporations typically)<br>
Expenses recognized when paid
Pros and cons:
Flexible
Simple and relatively inexpensive
Not GAAP – poor matching of income and expense.
Not available for some business organizations (large C corporations typically)<br>
23
Accrual Income Income is recognized when earned or received
All-events test – recognize income when all the events have occurred which fix the right to receive such income and
the amount can be determined with reasonable accuracy
Earliest of these dates:
Complete service or sale
Payment is due
Payment is received<br>
All-events test – recognize income when all the events have occurred which fix the right to receive such income and
the amount can be determined with reasonable accuracy
Earliest of these dates:
Complete service or sale
Payment is due
Payment is received<br>
24
Accrual Question 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?
$ ________<br>
How much income should Ben recognize under the accrual method this year?
$ ________<br>
25
Accrual – Prepaid Income Advance payments for services:
Allowed to defer recognition for one year unless income is earned or recognized for financial records
Not applicable to payments relating to rent or interest income
Advance payments for goods:
Elect one of two methods of recognition
Full inclusion method – recognize prepayments as income
Deferral method – include in period earned for tax or financial purposes<br>
Allowed to defer recognition for one year unless income is earned or recognized for financial records
Not applicable to payments relating to rent or interest income
Advance payments for goods:
Elect one of two methods of recognition
Full inclusion method – recognize prepayments as income
Deferral method – include in period earned for tax or financial purposes<br>
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Advance Payment Example Ben provides dancing lessons. On September 30th of this year he received $2,400 full payment for a 2-year service contract.
What amount of income must Ben recognize:
(1) if he is on the cash method?
(2) if he is on the accrual method?<br>
What amount of income must Ben recognize:
(1) if he is on the cash method?
(2) if he is on the accrual method?<br>
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Advance Payment Solution 1. If Ben uses the cash method, he must recognize income as received - $2,400 this year.
2. If Ben uses the accrual method, then he can elect to defer advances for services for a year.
This year Ben would recognize $300 - the income earned from September 30 (3/24 × $2,400).
Next year Ben would recognize the remaining $2,100 - income can only be deferred one year.<br>
2. If Ben uses the accrual method, then he can elect to defer advances for services for a year.
This year Ben would recognize $300 - the income earned from September 30 (3/24 × $2,400).
Next year Ben would recognize the remaining $2,100 - income can only be deferred one year.<br>
28
Inventories Inventories must be accounted for under the accrual method if sales of goods constitute a “material” income producing factor
Purchases accrued with accounts payable
Sales accrued with accounts receivable
Cash method taxpayers may use cash method for other (non-inventory) accounts
Technique is called the “hybrid” method<br>
Purchases accrued with accounts payable
Sales accrued with accounts receivable
Cash method taxpayers may use cash method for other (non-inventory) accounts
Technique is called the “hybrid” method<br>
29
UNICAP Inventory (purchased or produced) must be accounted for using tax version of “full absorption” rules
Indirect costs are allocated to inventories (not expensed)
Costs of selling, advertising, and research need not be capitalized
Exception for “small” businesses (average annual gross receipts < $10 million)<br>
Indirect costs are allocated to inventories (not expensed)
Costs of selling, advertising, and research need not be capitalized
Exception for “small” businesses (average annual gross receipts < $10 million)<br>
30
Inventory Flow Assumptions First-in, First-out (FIFO)
Last-in, Last-out (LIFO)
Same method for financial and tax records
“Book-tax conformity” requirement
Generates lowest taxable income in time of inflation
Specific identification<br>
Last-in, Last-out (LIFO)
Same method for financial and tax records
“Book-tax conformity” requirement
Generates lowest taxable income in time of inflation
Specific identification<br>
31
Accruing Business Expenses 1. All-events test
All events have occurred to establish the liability to pay
The amount is determinable with reasonable accuracy
Reserves for future liabilities not allowed
2. Economic performance has occurred<br>
All events have occurred to establish the liability to pay
The amount is determinable with reasonable accuracy
Reserves for future liabilities not allowed
2. Economic performance has occurred<br>
32
Economic Performance Applies to accrual method taxpayers only
Taxpayer provides goods or services:
Performance occurs as taxpayer provides goods or services
Taxpayer using property or goods:
Performance occurs as goods are provided or
economic performance is otherwise expected within 3 ½ months of payment
Payment liabilities are performed only when paid
Interest and rent occurs ratably<br>
Taxpayer provides goods or services:
Performance occurs as taxpayer provides goods or services
Taxpayer using property or goods:
Performance occurs as goods are provided or
economic performance is otherwise expected within 3 ½ months of payment
Payment liabilities are performed only when paid
Interest and rent occurs ratably<br>
33
Economic Performance Example Ben has signed a binding contract for Peter to provide Ben with repair services. Ben paid $1,500 to Peter and owes an additional $6,000 on the contract. The repairs will commence late next year.
When can Ben claim the deduction if he uses the accrual method?<br>
When can Ben claim the deduction if he uses the accrual method?<br>
34
Economic Performance Solution Although the all events test is satisfied, Ben can only deduct $7,500 next year because that is when economic performance occurs (taxpayer liable for performing service).<br>
35
Choosing or Changing an Accounting Method Accounting methods are generally adopted by use
A permissible method is adopted by using and reporting the method for one year
An impermissible method is adopted by using and reporting the method for two years
Generally method changes require IRS permission
Some changes are automatic
Permission is necessary to correct the use of an impermissible method<br>
A permissible method is adopted by using and reporting the method for one year
An impermissible method is adopted by using and reporting the method for two years
Generally method changes require IRS permission
Some changes are automatic
Permission is necessary to correct the use of an impermissible method<br>