2013 cch basic principles ch13

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2013 cch basic principles ch13

  1. 1. Chapter 13 Tax Accounting©2012 CCH. All Rights Reserved.4025 W. Peterson Ave.Chicago, IL 60646-60851 800 248 3248www.CCHGroup.com
  2. 2. Chapter 13 Exhibits 1. Computation of Taxable Income 2. Net Tax Liability 3. Accounting Periods 4. Election of the Tax Year 5. Partnerships 6. Partnership Accounting Period—Examples 7. Corporations, Estates, and Trusts 8. Change of Accounting Periods 9. IRS Permission or Consent 10. Exceptions to Permission Requirements 11. Short Tax Years 12. Short-Period Tax 13. Alternative Method 14. Short-Period ExampleChapter 13, Exhibit Contents A CCH Federal Taxation Basic Principles 2 of 88
  3. 3. Chapter 13 Exhibits 15. Accounting Methods 16. Cash Method 17. Constructive Receipt 18. Cash Basis Taxpayer Examples 19. Deductibility of Expenses 20. Limitations on Use of Cash Method 21. Accrual Method 22. Accrual Basis Taxpayer Examples 23. Prepaid Income and Expenses 24. Separate Sources of Income 25. Hybrid Methods 26. Change of Accounting Methods 27. Adjustment—Voluntary/Required Change 28. Change in Accounting Method ExampleChapter 13, Exhibit Contents B CCH Federal Taxation Basic Principles 3 of 88
  4. 4. Chapter 13 Exhibits 29. Inventories 30. Valuation of Inventory 31. Cost Methods 32. Uniform Capitalization Rules (UNICAP) 33. Cost Allocation Procedures 34. Simplified Retail Method 35. Inventory and UNICAP 36. Simplified Production Method 37. Lower-of-Cost-or-Market (LCM) Method 38. LCM Example 39. Valuation of Inventory Items 40. Inventory Valuation Example 41. Inventory Valuation Example—FIFO 42. Inventory Valuation Example—LIFOChapter 13, Exhibit Contents C CCH Federal Taxation Basic Principles 4 of 88
  5. 5. Chapter 13 Exhibits 43. Inventory Valuation Example—Weighted Average Cost 44. Dollar-Value LIFO Method 45. Double Extension Method 46. Dollar Value LIFO Example 47. Dollar Value LIFO Example—2009 48. Dollar Value LIFO Example—2010 49. Dollar Value LIFO Example—2011 50. Simplified Dollar-Value LIFO Method 51. Simplified Dollar-Value LIFO Example 52. Estimates of Inventory Shrinkage 53. Long-term Contracts 54. Capitalization of Expenses 55. Percentage-of-Completion Method 56. Modified Percentage-of-Completion MethodChapter 13, Exhibit Contents D CCH Federal Taxation Basic Principles 5 of 88
  6. 6. Chapter 13 Exhibits 57. Completed Contract Methods 58. Long-term Contracts Example 59. Installment Sales 60. Computation of Gain 61. Installment Sale Example 62. Dispositions of Installment Obligations 63. Disposition of Installment Obligation—Example 64. Repossessions of Personal Property 65. Repossessions of Real Property 66. Personal Property Repossessions—Example 67. Real Property Repossessions—Example 68. Advantages and Disadvantages of Installment MethodChapter 13, Exhibit Contents E CCH Federal Taxation Basic Principles 6 of 88
  7. 7. Computation of Taxable IncomeIndividuals S CorporationsIncome Broadly Conceived Income Broadly ConceivedLess: Exclusions Less: ExclusionsGross Income Gross IncomeLess: Deductions for Adjusted Gross Income Less: DeductionsAdjusted Gross Income Ordinary IncomeLess: Deductions from Adjusted Gross IncomeTaxable Income Estates and Trusts Income Broadly ConceivedC Corporations Less: ExclusionsIncome Broadly Conceived Gross IncomeLess: Exclusions Less: DeductionsGross Income Taxable IncomeLess: Deductions Routine SpecialTaxable Income Chapter 13, Exhibit 1 CCH Federal Taxation Basic Principles 7 of 88
  8. 8. Net Tax LiabilityIndividuals, C Corporations, and Estates and TrustsGross Tax LiabilityLess: CreditsNet Tax LiabilityLess: PrepaymentsNet Tax or Refund DueChapter 13, Exhibit 2a CCH Federal Taxation Basic Principles 8 of 88
  9. 9. Net Tax Liability Many of the income, deductions, and credit concepts you have learned in first 12 chapters apply to all entities However, there are numerous and substantial differencesChapter 13, Exhibit 2b CCH Federal Taxation Basic Principles 9 of 88
  10. 10. Accounting Periods Tax year - calendar year or fiscal year on the basis of which taxable income is determined  May not exceed 12 months Calendar year - ends on December 31 Fiscal year - ends on last day of any month other than December Taxpayer must correlate accounting, financial, and business practices with the fiscal year used for tax returns Tax return is required for a fractional part of a year  Known as a short tax yearChapter 13, Exhibit 3 CCH Federal Taxation Basic Principles 10 of 88
  11. 11. Election of the Tax Year New taxpayer may adopt any tax year without obtaining prior approval of IRS in first year.  First tax year must be adopted on or before time for filing the initial return Taxpayers who do not have books must use the calendar year Sole proprietors  Must use same period for business tax reporting purposes that they use for their personal booksChapter 13, Exhibit 4 CCH Federal Taxation Basic Principles 11 of 88
  12. 12. Partnerships Must use same tax year as that of its partners who have a majority interest If partners owning a majority interest have different tax years  Partnership must adopt same tax year as that of its principal partners  Principal partner - a partner having ≥5 percent interest in partnership profits or capital When neither condition is met  Partnership must use a year that results in least aggregate deferral of income to partners Partnership income is considered to be earned by partners on the last day of partnership’s tax yearChapter 13, Exhibit 5 CCH Federal Taxation Basic Principles 12 of 88
  13. 13. Partnership Accounting Period Examples1. X and Y form XY Partnership. X owns 60% of XY, so XY must use X’s tax year.2. A, B and C form ABC Partnership. They are equal owners. A and B are calendar taxpayers and C is a 5/31 year-end taxpayer. ABC must use the calendar year.Chapter 13, Exhibit 6a CCH Federal Taxation Basic Principles 13 of 88
  14. 14. Partnership Accounting Period Examples M (40%), N (40%) and O (20%) form MNO Partnership. They have the following tax year ends: M: December 31 N: April 30 O: June 30 MNO must use a 12/31 year end based as follows: Possible Tax Year Ends 4/30 6/30 12/31 Months Months MonthsPartner Interest Partner Year End Deferred Total Deferred Total Deferred TotalM 40% 12/31 8 3.2 6 2.4 0 0.0N 40% 4/30 0 0.0 10 4.0 4 1.6O 20% 6/30 2 0.4 0 0.0 6 1.2 3.6 6.4 2.8December 31 year end has the least aggregate deferral.Chapter 13, Exhibit 6b CCH Federal Taxation Basic Principles 14 of 88
  15. 15. Corporations, Estates, and Trusts Newly organized C corporation may select any tax year  May differ from that of the shareholders S corporation generally required to be a calendar year Estate may adopt any tax year Trusts must use calendar yearChapter 13, Exhibit 7 CCH Federal Taxation Basic Principles 15 of 88
  16. 16. Change of Accounting Periods In general, prior approval must be obtained  Usually obtained if there are substantial business reasons for change Usually involves a short-period tax yearChapter 13, Exhibit 8 CCH Federal Taxation Basic Principles 16 of 88
  17. 17. IRS Permission or Consent Taxpayer must file an application on Form 1128  On or before the 15th day of third calendar month following the end of short year  Should show that there is a substantial business purpose for change and that any tax cost to IRS is insignificant To prevent substantial distortion of income, an agreement between taxpayer and IRS is required If approval is granted, taxpayer must file an income tax return for short periodChapter 13, Exhibit 9 CCH Federal Taxation Basic Principles 17 of 88
  18. 18. Exceptions to Permission Requirements An individual whose income is derived solely from wages, salaries, interest, dividends, capital gains, pensions and annuities, or rents and royalties  May change from the fiscal year to calendar year Newly married individual  May adopt accounting period of other spouse without prior approval All partnerships, S corporations, and personal service corporations that conform their tax years to their owners’ tax year Other corporations have more restrictions to their annual accounting period without prior approvalChapter 13, Exhibit 10 CCH Federal Taxation Basic Principles 18 of 88
  19. 19. Short Tax Years Separate return is filed for short period beginning with day following the close of old tax year and ending with day preceding first day of new tax year The procedures are as follows: 1. Annualize short-period income 2. Determine tax on the annualized income 3. Determine short-period taxChapter 13, Exhibit 11 CCH Federal Taxation Basic Principles 19 of 88
  20. 20. Short-Period Tax Determine annualized income (AI) for short-period income (SPI): AI = SPI x (12/# months in short period) Determine tax (T) on annualized income: From rate schedules Determine short-period tax (SPT): SPT = T x (# months in short period/12)Chapter 13, Exhibit 12 CCH Federal Taxation Basic Principles 20 of 88
  21. 21. Alternative Method Annualization may result in inequities to taxpayer An exception to general rule may result in less tax:  Determine taxable income for the 12-month period beginning on the first day of the short period  Determine the tax on the taxable income for this 12-month period  Alternative short-period tax ASPT) = Tax on 12-month period × [ Taxable income for short period/Taxable income for 12-month period] Short-period tax computed in Step 3 cannot be less than it would have been if it had been computed on short-period taxable income without placing it on an annualized basisChapter 13, Exhibit 13 CCH Federal Taxation Basic Principles 21 of 88
  22. 22. Short-Period ExampleX Corporation uses a calendar yearIn 2012 it changed its accounting period to one ending on 4/30Taxable income for 1/1/12-12/31/12 is $50,000Taxable income for 1/1 – 4/30 is $24,000AI = $24,000 x (12/4) = $72,000T = $13,500SPT = $13,500 x (4/12) = $4,500Does alternative apply? Yes, as follows.1. TI = $50,0002. Tax = $7,5003. ASPT = $7,500 x ($24,000/$50,000) = $3,6004. (Tax on SPTI not annualized = $3,600), so ASPT = $3,600So X Corporation’s short-period tax = Lesser of $4,500 or $3,600 = $3,600Chapter 13, Exhibit 14 CCH Federal Taxation Basic Principles 22 of 88
  23. 23. Accounting Methods Must clearly reflect income.  Income should be reflected with as much accuracy as standard methods of accounting practice permit If method does not clearly reflect income  Tax computation is to be made under a method that IRS agrees will clearly reflect income The two most commonly used overall methods: (1) Cash method and (2) Accrual method Special treatment is accorded various types of revenue (e.g., installment sales) and many types of expenses (e.g., bad debts)Chapter 13, Exhibit 15 CCH Federal Taxation Basic Principles 23 of 88
  24. 24. Cash Method Vast majority of individuals and many businesses use it Income recognized in tax year when cash and/or cash equivalents are actually or constructively received Expenses generally deductible in tax year paid unless they are attributable to more than one year Cash equivalents may take many different formsChapter 13, Exhibit 16 CCH Federal Taxation Basic Principles 24 of 88
  25. 25. Constructive Receipt Income constructively received in tax year in which:  It is credited to the taxpayer’s account,  Set apart for the taxpayer, or  Made available to the taxpayer to draw upon  If the taxpayer’s control of its receipt is not subject to substantial limitations or restrictions The payer must:  Have ability to pay,  Set aside funds for payments, and  Not place substantial restrictions on taxpayer’s ability to access funds (or property) If these conditions are met, then taxpayer cannot deliberately turn back on income and thus select year of reportingChapter 13, Exhibit 17 CCH Federal Taxation Basic Principles 25 of 88
  26. 26. Cash Basis Taxpayer Examples1. X received a $1,000 check on 12/28/2011 but did not cash it until 1/2/2012. X has constructive receipt on 12/28/2011.2. On 12/15/2012, Y completed a job for Z, Z gave Y a $9,000 check. Y returned the check and asked Z to give it to him on 1/3/2013. Y has constructive receipt on 12/15/2012.3. A performs a service for B. B gives a 100 shares of stock worth $6,000. A has income of $6,000 at time of receipt. The stock’s FMV is a cash equivalent.Chapter 13, Exhibit 18 CCH Federal Taxation Basic Principles 26 of 88
  27. 27. Deductibility of Expenses Does not coincide with the recognition of income under cash method Expenses are recognized in year they are paid  Some expenditures are recognized as an expense over the asset’s life May be “paid” in cash or in property  Not by note of the taxpayer even if secured by collateralChapter 13, Exhibit 19 CCH Federal Taxation Basic Principles 27 of 88
  28. 28. Limitations on Use of Cash Method Three types of taxpayers cannot use cash method of accounting for tax purposes: 1. C corporations 2. Partnerships which have a C corporation as a partner 3. Tax shelters Small businesses can use cash method of accounting if have  Average annual gross receipts of $5 million or less over the past three years  The three-year period does not include current tax year in which determination is being made Gross receipts:  Deduct sales returns and allowances from gross receipts  Exclude dividends, interest, gross rents, other income, and net gains and losses from sales of capital and business assets Qualified personal service corporation may use the cash method of accountingChapter 13, Exhibit 20 CCH Federal Taxation Basic Principles 28 of 88
  29. 29. Accrual Method Income recognized in year:  All events that determine right to receive income have occurred  Amount can be determined with reasonable accuracy Expenses recognized in year:  Legal obligation to make payments comes into existence  All events that determine fact of the liability have occurred  Amount can be determined with reasonable accuracy All events test not met until economic performance with respect to item has occurred  Economic performance occurs if liability arises because a service or property is provided to taxpayer Taxpayer must keep adequate booksChapter 13, Exhibit 21a CCH Federal Taxation Basic Principles 29 of 88
  30. 30. Accrual Method Income recognized when:  Unconditional right to receive it  Amount is determinable with reasonable accuracy  Amount is collectible If taxpayer’s right to receive is dependent upon future events  Postpone income recognition until those contingencies occur or lapse If real doubt and uncertainty exist as to whether amount due will ever be collected  Postpone income recognitionChapter 13, Exhibit 21b CCH Federal Taxation Basic Principles 30 of 88
  31. 31. Accrual Basis Taxpayer Examples 1. Joe performed accounting work for Jerry. The agreed upon price was $20,000 and payment was due 30 days after completion. Joe finished the work on 7/8/12. Joe recognizes $20,000 on 7/8/12. 2. Assume the same as #1 except Jerry contests the quality of the work performed and has indicated that he will not pay any amount. Since the amount is not determinable, Joe does not recognize income on 7/8/12. Joe will recognize income when his claim against Jerry is reasonably determinable. 3. Jen performs legal work for ABC Company. In return, she receives rights to buy 10,000 shares of ABC Company if it goes public (currently it is not in the process of making an initial public offering). Jen does not recognize income when she receives the rights because the rights are contingent on ABC Company going public and there is no indication that this will happen.Chapter 13, Exhibit 22a CCH Federal Taxation Basic Principles 31 of 88
  32. 32. Accrual Basis Taxpayer Examples4. On 10/9/11, Ed signs a contract to perform legal services for Z Co. and receives $30,000 payment. The contract requires that Ed be available for 30 hours of consulting over the next three years. Under the claim of right doctrine, Ed must recognize $30,000 on 10/9/11.5. Assume the same facts as #4 except the contract period ends on 10/9/12. Ed may use his accrual method and recognize income as he performs the services.Chapter 13, Exhibit 22b CCH Federal Taxation Basic Principles 32 of 88
  33. 33. Prepaid Income and Expenses Generally taxable in year received Accrual-basis taxpayers may elect to recognize prepaid subscription income over subscription period  Applicable to all prepaid subscription income Membership organization that receives prepaid dues may elect to recognize income over time period it has a liability to render these services unless income relates to a liability that extends for more than 36 months Accrual-basis taxpayers can deduct interest only in period in which use of the money occurs Accrual-basis taxpayers may include prepayment for services in gross income in year of receipt  If certain conditions are met, the income may be spread over year of receipt and/or the following year (prepaid service income method)  To qualify for prepaid service income method, taxpayer must perform all services under an agreement by end of tax year following year of receiptChapter 13, Exhibit 23 CCH Federal Taxation Basic Principles 33 of 88
  34. 34. Separate Sources of Income Taxpayer with two or more separate and distinct businesses  Different accounting method may be used for each business  Must maintain separate books and records  May not shift profits and losses between businesses via inventory adjustments, sales, purchases, or expensesChapter 13, Exhibit 24 CCH Federal Taxation Basic Principles 34 of 88
  35. 35. Hybrid Methods Many combinations of permissible accounting methods may be used But a taxpayer’s choice is not unlimited  If cash method is used for income, it must also be used for expenses  If accrual method is used for expenses, it must also be used for income  Accrual method is required if inventories are an income-producing factorChapter 13, Exhibit 25 CCH Federal Taxation Basic Principles 35 of 88
  36. 36. Change of Accounting Methods IRS permission must be obtained Major changes in accounting method include: 1. Change to or from cash-basis method 2. Change in method of valuing inventory 3. Change from accrual method to a long-term contract method or vice versa 4. Change involving the adoption, use, or discontinuance of any other specialized method of computing income, such as the crop method by farmers 5. Certain changes in computing depreciation or amortization 6. Change for which the Code or Regulations specifically require consent If taxpayer’s method does not clearly reflect income, then IRS may prescribe a method which does Change in method does not include correction of mathematical and posting errors, or of errors in the computation of tax liabilityChapter 13, Exhibit 26 CCH Federal Taxation Basic Principles 36 of 88
  37. 37. Adjustment – Voluntary/Required Change Adjustments must be made in year of change to prevent items from being duplicated or entirely omitted Net adjustment = sum of positive and negative adjustments Adjustment period for taxpayer-initiated changes that result in a positive adjustment is four years  Tax year of change is first year  If adjustment is less than $25,000, may elect a one-year adjustment period Adjustment period is one year for negative adjustments A positive adjustment due to a change initiated by IRS generally is recognized over the four-year period as noted above  However, IRS can require that it be recognized over a shorter time periodChapter 13, Exhibit 27 CCH Federal Taxation Basic Principles 37 of 88
  38. 38. Change in Accounting Method ExampleKim Co. is a cash basis, calendar year taxpayer. It changed to the accrual method in 2012 and determined its net income as follows:Sales $800,000Cost of goods sold 500,000Gross profit 300,000Expenses 100,000Net Income $200,000On 12/31/2011, it had $30,000 in inventory, accounts receivable of $23,000 and $29,000 in accounts payable.Kim Co.s net adjustment to Net income is $24,000, based as follows: Positive adjustment for ending inventory $30,000 Positive adjustment for ending accounts receivable 23,000 Negative adjustment for ending accounts payable (29,000) Net adjustment $24,000Thus, it can add $6,000 ($24,000/4) to income in 2012, 2013, 2014, and 2015 or add $24,000 to the $200,000 in 2012.Chapter 13, Exhibit 28 CCH Federal Taxation Basic Principles 38 of 88
  39. 39. Inventories Must use the accrual method of accounting if inventories are an income-producing factor Cost of goods sold:  Recognized when inventory sold  Equals: Opening inventory + Inventory purchased or produced - Ending inventory Value of ending inventory a function of:  (1) What costs are included  (2) Cost flow assumptions madeChapter 13, Exhibit 29 CCH Federal Taxation Basic Principles 39 of 88
  40. 40. Valuation of Inventory Two fundamental requirements for valuation of inventory: 1. must conform as nearly as possible to best accounting practice in the trade or business 2. must clearly reflect income Inventory may be valued at cost or lower-of-cost-or- market If LIFO method used, then the taxpayer cannot use lower-of-cost-or-market Lower-of-cost-or-market must be applied to each item in inventoryChapter 13, Exhibit 30 CCH Federal Taxation Basic Principles 40 of 88
  41. 41. Cost Methods Cost of merchandise purchased equals: Invoice prices - Trade discounts + Incidental costs incurred to acquire the goods Cost of merchandise produced includes the cost of direct materials, direct labor, and indirect costs  Manufacturers must use absorption costing (full costing) to value inventories  Indirect costs that must be capitalized include repairs, maintenance, utilities, rent, and indirect labor and materials.  §263A expands definition of includible costs by requiring most entities (especially manufacturers) to use uniform capitalization (UNICAP) rulesChapter 13, Exhibit 31 CCH Federal Taxation Basic Principles 41 of 88
  42. 42. Uniform Capitalization Rules (UNICAP) Generally applies to:  Real or personal property produced by taxpayer  Real or personal property acquired by taxpayer for resale Under UNICAP, indirect costs include: 1. Factory repairs and maintenance; utilities; rent; depreciation, amortization, and depletion; small tools; and insurance 2. Indirect labor and production supervisory labor; administrative costs; indirect materials and supplies; rework, scrap, and spoilage; storage and warehousing costs; purchasing costs; handling, processing, assembly, repacking costs; and quality control and inspection costs 3. Taxes (other than income taxes) 4. Deductible contributions to pension, profit-sharing, stock bonus, or annuity plans 5. Interest, but only for real property, long-lived property, or property requiring more than two years to produceChapter 13, Exhibit 32 CCH Federal Taxation Basic Principles 42 of 88
  43. 43. Cost Allocation Procedures Once total additional §263A costs are identified, next step in costing inventory is to allocate these costs Direct capitalized costs:  Associated with specific production activities and products and allocated to them accordingly  Taxpayer may use any method which reasonably allocates such costs Indirect costs allocated to activities and products using one of three methods: a) Specific identification (costs are specifically identified with activities or products that directly benefit from the costs) b) Standard costing (costs are allocated to products based upon established standards) c) Burden rates (costs are allocated based on direct labor hours, direct labor costs, and similar expenses)Chapter 13, Exhibit 33 CCH Federal Taxation Basic Principles 43 of 88
  44. 44. Simplified Retail Method May elect to use to allocate costs under §263A Fully capitalize costs for: 1. Off-site storage and warehousing 2. Purchasing 3. Handling, processing, assembly Amount of mixed service costs (general and administrative costs) allocated requires two steps: 1. Determine amount of mixed service costs that are additional §263A costs 2. Allocate this amount to ending inventoryChapter 13, Exhibit 34a CCH Federal Taxation Basic Principles 44 of 88
  45. 45. Simplified Retail Method Amount of mixed service costs included under §263A is determined by multiplying such costs by ratio of: 1. Total labor costs included in off-site, storage, purchasing, and handling cost to 2. Total labor costs incurred in taxpayer’s business, excluding the labor included in the mixed service costs Once amount is determined, then allocated to ending inventory by multiplying amount in ending inventory that was purchased during year by the ratio of 1. Total additional §263A costs to 2. Taxpayer’s total purchases during yearChapter 13, Exhibit 34b CCH Federal Taxation Basic Principles 45 of 88
  46. 46. Inventory and UNICAP X Co. uses FIFO for its inventory. During the year it incurred: Storage costs = $200,000, Purchasing costs = $300,000, and Handling and processing costs = $100,000 Labor costs included in amounts above = $180,000 Mixed service costs = $250,000 Total labor costs, excluding amounts included in mixed service costs = $2,000,000• X’s beginning inventory (excluding additional Code Sec. 263A costs) = $1,000,000• Total purchases = $7,000,000• Ending inventory = $1,500,000 (excluding additional Code Sec. 263A costs)• Since X Co. uses the FIFO method, the full $1,500,000 of ending inventory is considered purchased during the year X Co.’s ending inventory i= $1,633,350, consisting of : Original cost of $1,500,000 + Capitalized additional Code Sec. 263A resale costs of $133,350 (determined below) • First, determine mixed service costs considered additional Code Sec. 263A costs using the labor ratios:  Labor ratio = $180,000/$2,000,000 = 9%  Mixed service costs considered additional Code 263A costs = 9% × $250,000 = $22,500 • Next, determine total additional Code Sec. 263A and allocate to ending inventory (using the additional Code Sec. 263A costs to purchases ratio)  Costs to purchase ratio = $622,500/$7,000,000 = 8.89%  Additional Code Sec. 263A costs allocated to ending inventory = 8.89% × $1,500,000 = $133,350Chapter 13, Exhibit 35 CCH Federal Taxation Basic Principles 46 of 88
  47. 47. Simplified Production Method Taxpayers may elect to use simplified production method to allocate capitalized costs for property produced  Cannot be used for property acquired for resale and for property produced by taxpayer for use in its business Additional §263A costs allocated based on an absorption ratio and the allocation requires two steps First, compute the absorption ratio -- this is the ratio of: 1. Total additional §263A costs incurred during the year to 2. Total §471 costs incurred during the year Second – additional §263A costs capitalized equals: Absorption ratio x amount of §471 costs incurred during the year which are included in the taxpayer’s ending inventory  If taxpayer uses FIFO, then absorption ratio is applied to §471 costs included in ending inventory  If taxpayer uses LIFO, then absorption ratio is applied to §471 costs included in this year’s increase in inventory (the incremental layer)Chapter 13, Exhibit 36 CCH Federal Taxation Basic Principles 47 of 88
  48. 48. Lower-of-Cost-or-Market (LCM) Method Ending inventory may be written down to a lower market value unless taxpayer is using LIFO Lower cost or market must be applied to each item of inventoryChapter 13, Exhibit 37 CCH Federal Taxation Basic Principles 48 of 88
  49. 49. LCM ExampleTom Co. uses LCM for inventory purposesCost and market information follows:Item Cost Market LCMA $10,000 $5,000 $5,000B 14,000 18,000 14,000C 6,000 4,000 4,000Total $30,000 $27,000 $23,000Its ending inventory is written down from $30,000 to $23,000Chapter 13, Exhibit 38 CCH Federal Taxation Basic Principles 49 of 88
  50. 50. Valuation of Inventory Items May use one of four cost flow assumptions to value their inventories:  Specific identification  First-in, first-out (FIFO)  Last-in, first-out (LIFO)  Weighted average Does not have to agree with actual physical flow of goods Must receive IRS approval to use LIFO If LIFO is used for tax purposes then also must be used for financial reporting purposesChapter 13, Exhibit 39 CCH Federal Taxation Basic Principles 50 of 88
  51. 51. Inventory Valuation ExampleTati Co. sells widgets. Following is a review of its inventory andpurchases for the year 1/1: 2,000 units in beginning inventory @ $20 5/6: 1,000 units purchased @ $22 7/10: 1,500 units @ $24 11/15: 500 units @ $23Tati Co. sold 4,000 units during the year for $200,000What is Tati Co.’s gross profit under FIFO, LIFO and weightedaverage inventory valuation systems?Chapter 13, Exhibit 40 CCH Federal Taxation Basic Principles 51 of 88
  52. 52. Inventory Valuation Example - FIFOSales $200,000Inventory 1/1 $40,000Purchases 69,500Available for sale $109,500Ending inventory 500@ $24 $12,000 500@ $23 11,500 23,500Cost of goods sold 86,000Gross profit $114,000Chapter 13, Exhibit 41 CCH Federal Taxation Basic Principles 52 of 88
  53. 53. Inventory Valuation Example - LIFOSales $200,000Inventory 1/1 $40,000Purchases 69,500Available for sale $109,500Ending inventory 1,000@ $20 20,000Cost of goods sold 89,500Gross profit $110,500Chapter 13, Exhibit 42 CCH Federal Taxation Basic Principles 53 of 88
  54. 54. Inventory Valuation Example—Weighted Average CostSales $200,000Inventory 1/1 $40,000Purchases 69,500Available for sale $109,500Ending inventory $109,500/5,000 = $21.90 1,000@ $21.90 21,900Cost of goods sold 87,600Gross profit $112,400Chapter 13, Exhibit 43 CCH Federal Taxation Basic Principles 54 of 88
  55. 55. Dollar-Value LIFO Method Increase in LIFO value is determined by:  Comparing the total dollar value of beginning and ending inventories at base-year (first LIFO year) prices  Then converting any dollar-value increase to current prices by means of an index Allowed to determine base-year dollars through the use of government indexes Several price index methods are permitted Double extension method is used most frequentlyChapter 13, Exhibit 44 CCH Federal Taxation Basic Principles 55 of 88
  56. 56. Double Extension Method1. Determine opening inventory at base-year prices (the prices in effect when LIFO was adopted)2. Determine ending inventory at base-year prices3. Compute the difference  The result is either an increase (increment) or a decrease (decrement)4. Determine a price index to value increment, if any  Index equals ending inventory at current prices/ending inventory at base-year prices5. Adjust inventory “layers” for any increment or decrement  Every increment represents a new layer  Any decrement uses up most recently added layer or layers first Chapter 13, Exhibit 45 CCH Federal Taxation Basic Principles 56 of 88
  57. 57. Dollar Value LIFO ExampleJenn Co started business in 2011 and uses the LIFO method. Inventory information follows:1/1/2011: inventory = $10,000 (base period, index = 1.0) inventory (actual prices) inventory (base-year prices)12/31/2011 $26,000 $21,00012/31/2012 $30,000 $16,00012/31/2013 $40,000 $29,000What amount did Jenn Co. use to value its ending inventory in 2011, 2012, and 2013?Chapter 13, Exhibit 46 CCH Federal Taxation Basic Principles 57 of 88
  58. 58. Dollar Value LIFO Example - 2011 1/1/2011 Index 12/31/20111/1/2011 inventory $10,000 1.0 $10,0002011 increase 11,000 1.2381 13,619Ending LIFO inventory $21,000 $23,619Keeping prices constant, the increment in inventory = $11,000 ($21,000 - $10,000)Index = $26,000/$21,000 = 1.2381Thus, Jenn Co. valued its ending inventory on 12/31/2011 at $23,619Chapter 13, Exhibit 47 CCH Federal Taxation Basic Principles 58 of 88
  59. 59. Dollar Value LIFO Example - 2012 1/1/2012 Index 12/31/20121/1/2011 base inventory $10,000 1.0 $10,000Remaining 2011 increase 6, 000 1.2381 7,429Ending LIFO inventory $16,000 $17,429Keeping prices constant, the increment in base inventory = $6,000 ($16,000 - $10,000)Thus, Jenn Co. valued its ending inventory on 12/31/2012 at $17,429Chapter 13, Exhibit 48 CCH Federal Taxation Basic Principles 59 of 88
  60. 60. Dollar Value LIFO Example - 2013 1/1/2013 Index 12/31/20131/1/2011 base inventory $10,000 1.0 $10,000Remaining 2011 increase 6, 000 1.2381 7,4292013 increase 13,000 1.3793 17,931Ending LIFO inventory $29,000 $35,360Keeping prices constant, the increment in base inventory = $6,000 ($16,000 - $10,000)Index = $40,000/$29,000 = 1.3793Thus, Jenn Co. valued its ending inventory on 12/31/2013 at $35,360Chapter 13, Exhibit 49 CCH Federal Taxation Basic Principles 60 of 88
  61. 61. Simplified Dollar-Value LIFO Method May elect to use simplified dollar-value LIFO method, but then must be used to value all LIFO inventories  May elect for any year in which average annual gross receipts for preceding three years do not exceed $5 million Taxpayer groups inventory into pools for each major category in the applicable government price index provided by Bureau of Labor Statistics Each pool is separately adjusted using appropriate government index Do not compute base period prices Use year-end inventory values and determine an assumed base period value by applying the government price index If resulting base period value exceeds opening inventory value at base period prices, then increment is valued using same indexChapter 13, Exhibit 50 CCH Federal Taxation Basic Principles 61 of 88
  62. 62. Simplified Dollar-Value LIFO ExampleAndy Inc. uses the simplified dollar-value LIFO method.Relevant inventory information follows: CPI2012: 1.102013: 1.14 Inventory – base year prices2012: $420,0002013: $500,000What ending inventory value will Andy Inc. use for 2013?Chapter 13, Exhibit 51a CCH Federal Taxation Basic Principles 62 of 88
  63. 63. Simplified Dollar-Value LIFO Example2012 inventory value $420,0002013 increase in inventory 64,727*2013 year-end inventory value $484,727*2013 increase in inventory:Ending inventory at assumed base-year prices = $500,000 x (1.1/1.14) = $482,456Increase at 2012 base prices = $482,456 - $420,000 = $62,456Increase at 2013 base prices = $62,456 x (1.14/1.1) = $64,727Chapter 13, Exhibit 51b CCH Federal Taxation Basic Principles 63 of 88
  64. 64. Estimates of Inventory Shrinkage Permits a business to determine its year-end closing inventory by using estimates for shrinkage (e.g., loss due to theft) Year-end physical count not necessary if:  Normally take a physical count of inventories at each business location on a regular and consistent basis and  Make proper adjustments to inventories and to estimating methods to extent estimates differ from actual shrinkage.Chapter 13, Exhibit 52 CCH Federal Taxation Basic Principles 64 of 88
  65. 65. Long-Term Contracts Any contract for manufacture, building, installation, or construction of property if such property is not completed within the taxable year into which contract is entered Two alternatives: (1) Percentage-of-completion method (or modified percentage-of-completion method in some cases), and (2) Completed-contract method (in limited circumstances) Method selected must be used for all long-term contracts in same trade or business All cost associated with contract are capitalized and deducted as profits are recognizedChapter 13, Exhibit 53 CCH Federal Taxation Basic Principles 65 of 88
  66. 66. Capitalization of Expenses The following expenses must be capitalized: 1. Cost recovery of assets employed for work on specific contracts 2. Pension costs representing current service costs 3. General and administrative expenses relating to specific contracts 4. R&D expenses with respect to specific contracts 5. Scrap and spoilage costsChapter 13, Exhibit 54 CCH Federal Taxation Basic Principles 66 of 88
  67. 67. Percentage-of-Completion Method Report income under the contract annually based on estimated progress Percentage of completion =  allocated costs to the contract and direct costs incurred by the close of the year/estimated total contract costs Income reported for year = Total contract price x Percentage Must use a look-back method in year contract is completed  Compare the actual completion level to the claimed level  Redetermine taxable income and tax liability accordingly  Interest is charged on any underpayment and is received for any overpayment Long-term contracts completed within two years of contract commencement are exempt from look-back method if gross contract price does not exceed lesser of $1,000,000 or 1 percent of taxpayer’s average gross receipts for the previous three years Many elect not to apply the look-back method for long-term contracts completed during year and in all subsequent years if actual contract taxable income is within 10 percent of estimated taxable income under percentage-of-completion method (using estimated contract price and costs)Chapter 13, Exhibit 55 CCH Federal Taxation Basic Principles 67 of 88
  68. 68. Modified Percentage-of-Completion Method Available for contracts less than 10 percent complete at end of year May elect to defer reporting any income from contract until at least 10 percent of work is completedChapter 13, Exhibit 56 CCH Federal Taxation Basic Principles 68 of 88
  69. 69. Completed Contract Methods No income until final completion of contract  All costs are accumulated and recognized at completion Only small construction contractors and home construction contractors can use  Those whose average gross receipts for three preceding tax years do not exceed $10,000,000Chapter 13, Exhibit 57 CCH Federal Taxation Basic Principles 69 of 88
  70. 70. Long-Term Contracts ExampleJames Co. is a small construction contractor.In 2012 it entered into a two-year building contract with Dan Co.Contract price is $4,000,000 and expected costs are $3,000,000.2012 actual costs: $1,500,0002013 actual costs: $1,200,000What gross profit will James Co. report in 2012 and 2013 under thepercentage-of-completion method and the completed-contractmethod?Chapter 13, Exhibit 58a CCH Federal Taxation Basic Principles 70 of 88
  71. 71. Long-Term Contracts ExamplePercentage-of-completion method 2012 2013Gross revenue* $2,000,000 $2,000,000Actual costs 1,500,000 1,200,000Gross profit $500,000 $800,000*2012: ($1,500,000/$3,000,000) x $4,000,000 = $2,000,000 2013: $4,000,000 - $2,000,000 = $2,000,000Chapter 13, Exhibit 58b CCH Federal Taxation Basic Principles 71 of 88
  72. 72. Long-Term Contracts ExampleCompleted-contract method 2012 2013Gross revenue $0 $4,000,000Actual costs 0 2,700,000Gross profit $0 $1,300,000Chapter 13, Exhibit 58c CCH Federal Taxation Basic Principles 72 of 88
  73. 73. Installment Sales Disposition of property where at least one payment is received after the close of tax year in which disposition occurs May be used by cash-basis taxpayers as a means to defer gain recognition or to spread gain recognition over several tax periods May not be used if property is disposed of at a loss Does not change character of gain (capital or ordinary) Any depreciation recapture under §1245 and §1250 recognized in year of sale Not available to all taxpayers Must use installment method for tax purposes if taxpayer disposes property under an installment contract and disposition qualifies for installment method  May make an irrevocable election not to use installment methodChapter 13, Exhibit 59 CCH Federal Taxation Basic Principles 73 of 88
  74. 74. Computation of Gain Step 1. Determine gross profit from the sale Step 2. Determine contract price  Generally equals amount seller will receive  Can never be less than gross profit Step 3. Compute gross profit percentage  Gross profit percentage = Gross profit/Contract price Step 4. Determine gain recognized in year of sale  Equals: Payments received × Gross profit percentageChapter 13, Exhibit 60 CCH Federal Taxation Basic Principles 74 of 88
  75. 75. Installment Sale Example Susan sold property (capital asset) for $500,000 (after all transaction costs) in 2012 She acquired the property five years ago for $200,000 There is a $50,000 liability on the property The buyer assumes the liability Susan will receive $300,000 in 2012 and $150,000 in 2013 What income (gain) will Susan report in 2012 and 2013?Chapter 13, Exhibit 61a CCH Federal Taxation Basic Principles 75 of 88
  76. 76. Installment Sale ExampleGain on sale: $500,000 - $200,000 = $300,000Contract price: $500,000 - $50,000 = $450,000Gross profit percentage: $300,000/$450,000 = 66.67%2012 income: $300,000 x 66.67% = $200,000 LTCG2013 income: $150,000 x 66.67% = $100,000 LTCGTotal income recognized: $300,000 LTCGChapter 13, Exhibit 61b CCH Federal Taxation Basic Principles 76 of 88
  77. 77. Installment Sale Example Susan sold property for $500,000 (after all transaction costs) in 2012 She acquired the property five years ago for $200,000 Total depreciation subject to §1245 recapture taken was $30,000 There is a $50,000 liability on the property The buyer assumes the liability Susan will receive $300,000 in 2012 and $150,000 in 2013 What income (gain) will Susan report in 2012 and 2013?Chapter 13, Exhibit 61c CCH Federal Taxation Basic Principles 77 of 88
  78. 78. Installment Sale ExampleGain on sale: $500,000 - $200,000 = $300,000Contract price: $500,000 - $50,000 = $450,000§1245 gain recognized on sale: $30,000Gross profit percentage: ($300,000-$30,000)/$450,000 = 60%2012 income: $300,000 x 60% = $180,000 §1231 gain (and $30,000 §1245 gain)2013 income: $150,000 x 60% = $90,000 §1231 gainTotal income recognized: $300,000Chapter 13, Exhibit 61d CCH Federal Taxation Basic Principles 78 of 88
  79. 79. Dispositions of Installment Obligations Must determine obligation’s AB and gain or loss on disposition AB of installment obligation equals  Face amount of obligation in excess of income that would have been reported if obligation had been paid in full Gain/loss = amount realized if obligation is sold (or obligation’s FMV if it is disposed of other than by sale) - AB Character of gain/loss is based on property sold under installment methodChapter 13, Exhibit 62 CCH Federal Taxation Basic Principles 79 of 88
  80. 80. Disposition of Installment Obligation— ExampleTom sold land (§1231 asset) in 2011 for $100,000His basis in the land was $30,000He received $25,000 in 2011 and $35,000 in 2012He sold the installment obligation in 2013 for $23,000What is Tom’s gain (loss) on the sale of the installment obligation in 2013?Chapter 13, Exhibit 63a CCH Federal Taxation Basic Principles 80 of 88
  81. 81. Disposition of Installment Obligation— Example2011:Realized gain: $100,000 - $30,000 = $70,000Gross profit percentage: $70,000/$100,000 = 70%Income reported in 2011: $25,000 x .7 = $17,500 §1231 gain-----------2012:Income reported: $35,000 x .7 = $24,500 §1231 gain-----------2013:Adjusted basis of installment obligation: $40,000 - $28,000 = $12,000Income reported from sale of installment obligation: $23,000 - $12,000 = $11,000 §1231 gainChapter 13, Exhibit 63b CCH Federal Taxation Basic Principles 81 of 88
  82. 82. Repossessions of Personal Property A taxable event.  Gain or loss equals:  Difference between FMV of property repossessed and AB of installment obligation Any costs incurred during repossession increase AB of installment obligation. Character of gain or loss recognized is same as character of gain or loss recognized on original sale Basis of repossessed property is its FMVChapter 13, Exhibit 64 CCH Federal Taxation Basic Principles 82 of 88
  83. 83. Repossessions of Real Property Loss is not recognized Gain recognized is lesser of:  (1) Cash and FMV of property received from buyer in excess of gain previously recognized by holder of installment obligation or  (2) Gain not yet recognized by holder of installment obligation (deferred gross profit), reduced by repossession costs  Character of gain is same as that recognized under original sale of property Basis of repossessed real property  AB of installment obligation, increased by repossession costs and by any gain recognized from repossessionChapter 13, Exhibit 65 CCH Federal Taxation Basic Principles 83 of 88
  84. 84. Personal Property Repossessions—ExampleKim sold a painting in 2011 for $80,000She acquired the painting in 2004 for $20,000Kim received $20,000 in 2011 and the remainder was due in 2012Kim was unable to collect the $60,000, and repossessed the painting in 2013 when it was worth $50,000She incurred $1,000 in repossession feesWhat are the tax consequences of the repossession?Chapter 13, Exhibit 66a CCH Federal Taxation Basic Principles 84 of 88
  85. 85. Personal Property Repossessions—Example2011:Realized gain: $80,000 - $20,000 = $60,000Gross profit percentage: $60,000/$80,000 = 75%Income reported in 2011: $20,000 x .75 = $15,000 LTCG----------2012:Nothing reported----------2013:Adjusted basis of installment obligation: $60,000 - $45,000 = $15,000Adjusted basis for repossession purposes = $15,000 + $1,000 = $16,000Income reported from repossession: $50,000 - $16,000 = $34,000 LTCGKim’s basis in the painting = $50,000Chapter 13, Exhibit 66b CCH Federal Taxation Basic Principles 85 of 88
  86. 86. Real Property Repossessions—ExampleGary sold land in 2011 for $200,000He bought the land in 2005 for $60,000He received $50,000 in 2011 and the balance was due in 2012Gary was unable to collect the $150,000, and in 2013 he repossessed the land when it was worth $190,000Repossession fees were $5,000What are the tax consequences of the repossession?Chapter 13, Exhibit 67a CCH Federal Taxation Basic Principles 86 of 88
  87. 87. Real Property Repossessions—Example2011:Realized gain: $200,000 - $60,000 = $140,000Gross profit percentage: $140,000/$200,000 = 70%Income reported in 2011: $50,000 x .70 = $35,000 LTCG----------2012:Nothing reported----------2013:Adjusted basis of installment obligation: $150,000 - $105,000 = $45,000(1) Excess of payments received – gain reported in previous years: $50,000 - $35,000 = $15,000(2) Gain not yet reported: $150,000 x .7 = $105,000Income reported from repossession: lesser of [(1) or (2)] – repossession fees= lesser of $15,000 or ($105,000 - $5,000) = $15,000 LTCGGary’s basis in the painting = $45,000 + $5,000 + $15,000 = $65,000Chapter 13, Exhibit 67b CCH Federal Taxation Basic Principles 87 of 88
  88. 88. Advantages and Disadvantages of Installment MethodAdvantages Disadvantages1. Tax liabilities deferred until 1. Default risk and potential proceeds are available collection costs2. Marginal tax rates may decline in 2. In periods of inflation - loss of purchasing power future years 3. Taxes deferred but so are3. Interest income, to some extent, collections may be converted to capital gains 4. Marginal tax rates may increase by charging a lower interest rate during collection years and a higher price (but the imputed 5. Although the holding period in the interest rules affect this) year of sale determines whether the4. Since the seller finances the transaction is short-term or long- purchase, sales are more easily term, the character of the gain is made determined in the year of collection 6. Depreciation recapture takes place in the year of saleChapter 13, Exhibit 68 CCH Federal Taxation Basic Principles 88 of 88

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