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  • 1. Chapter 18 Accounting Periods and Methods Individual Income Taxes© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 1
  • 2. The Big Picture (slide 1 of 3)• Belinda, Pearl, Inc. (a C corp.), and Tweety, Inc. (an S corp.), are going to form the Silver Partnership.• The ownership interests and tax years of the partners are as follows: Partner Partnership Interest Tax Year Ends Belinda 25% December 31 Pearl, Inc. 35% November 30 Tweety, Inc. 40% June 30 – The partnership will begin business on April 1, 2012. 2
  • 3. The Big Picture (slide 2 of 3)• The partners have several issues they would like for you to address.• A potential conflict exists among the partners regarding when the tax year should end for Silver. – Belinda and Pearl would like a year-end close to their own year-ends. • Tweety would like to have a June 30 year-end. – Who makes this decision? • Tweety, since it owns more of the partnership? • Belinda and Pearl, since collectively they own more of the partnership? 3
  • 4. The Big Picture (slide 3 of 3)• Silver will begin business on April 1, 2012 – Will the first tax year be a ‘‘short’’ tax year or a ‘‘long’’ tax year? – Will annualization of the net income of the partnership be required?• When will the partners report their share of Silver’s net income or net loss on their respective income tax returns?• Belinda is a cash basis taxpayer, and the other partners use the accrual method to report their incomes. – What accounting method must be used to compute Belinda’s share of the partnership income?• Read the chapter and formulate your response. 4
  • 5. Accounting Periods (slide 1 of 3)• Taxable year – The tax year may be shorter but is usually not longer than 12 months – Taxpayer elects a tax year by the timely filing of the initial return – Permission to change taxable years must be obtained from the IRS 5
  • 6. Accounting Periods (slide 2 of 3)• Types of taxable years – Calendar year: January 1 – December 31 – Fiscal year: must start on the first day of a month and end the last day of a month, other than December, 12 months later • Example: July 1 – June 30 6
  • 7. Accounting Periods (slide 3 of 3)• Types of taxable years – 52/53 week year: ends on same day of week that is either closest to its normal monthly year-end or occurs last in its year • Example: year-end is always the last Saturday in April 7
  • 8. Accounting Periods— Partnerships• Tax year-end must be that of (in descending order) – Majority interest partners • Own a > 50% interest in partnership capital & profits – Principal partners • Partner with a 5% or more interest in partnership capital or profits – Least aggregate deferral of income 8
  • 9. The Big Picture - Example 3 Least Aggregate Deferral Method (Slide 1 of 3)• Return to the facts of The Big Picture on p. 18-1.• The Code and Regulations eliminate the need for the Silver partners to bargain among themselves over the tax year-end.• The partnership’s tax year must end on November 30 – Using that year-end results in the least aggregate deferral of partnership income. – See the following calculation. 9
  • 10. The Big Picture - Example 3 Least Aggregate Deferral Method (Slide 2 of 3)• Return to the facts of The Big Picture on p. 18-1. 10
  • 11. The Big Picture - Example 3 Least Aggregate Deferral Method (Slide 3 of 3)• Return to the facts of The Big Picture on p. 18-1. 11
  • 12. Accounting Periods— S Corps and PSCs• Generally, these entities must have a calendar year – Other tax years may be available if certain requirements can be met 12
  • 13. Accounting Periods—Other Allowable Year-Ends• Partnerships, S corps, and PSCs can elect to have other fiscal year-ends if any of the following are met: – A valid business purpose can be shown – §444 election is made and year-end results in no more than a 3-month deferral • Requires certain payments – §444 election was made to retain the same year as was used for the fiscal year ending in 1987 • Requires certain payments 13
  • 14. Accounting Periods—Valid Business Purpose• IRS acknowledges only one valid business purpose for using a fiscal year-end – Conforming the tax year to the entity’s natural business year (seasonal businesses) • Example: a September 30 year-end may be a natural business year-end for a swim suit manufacturer 14
  • 15. Accounting Periods—§444 Deferral and Required Tax Payments• Partnerships and S corporations (not their owners) must make tax payments at the highest individual rate plus 1% (e.g., 36%) on estimated deferral period income – The amount due is reduced by the amount of required tax payments for the previous year 15
  • 16. Accounting Periods—§444 Deferral and Required Salary Payments• PSCs must pay shareholder-employees salaries during the deferral period that are at least proportionate to their salaries for the preceding fiscal year – Failure to make required salary payments reduces PSCs deduction for salaries paid to shareholder- employees 16
  • 17. Example of §444 Deferral and Required Salary Payments• PSC has October 31 year-end and cannot satisfy the business purpose test for a fiscal year – Provides 2 month deferral – Has one shareholder-employee with $60,000 in salary for prior fiscal year – PSC should pay shareholder-employee at least $10,000 in salary during the deferral period • $60,000 × 2/12 = $10,000 17
  • 18. Change in Accounting Period• Must obtain IRS consent before changing tax year• IRS will not consent to a change unless taxpayer demonstrates a substantial business purpose for change, such as changing to natural business year 18
  • 19. Change in Accounting Period—Natural Business Year• Objective test: At least 25% of entity’s gross receipts are realized in the final 2 months of the desired tax year for 3 consecutive years• IRS usually establishes certain conditions that the taxpayer must accept if approval for change is to be granted – In particular, if the taxpayer has a net operating loss (NOL) for the short period, the IRS requires that the loss be carried forward • The loss cannot be carried back to prior years 19
  • 20. Accounting Periods— Short Taxable Year• A short taxable year is a period of less than 12 calendar months – Can occur in the first taxable year, the last taxable year, or when there is a change in the taxable year• If the short-period year is caused by a change in taxable year, the short-year income must be annualized – Necessary due to the progressive tax rate structure 20
  • 21. Mitigation of the Annual Accounting Period Concept (slide 1 of 2)• Several Code provisions provide relief from harsh results produced by the combined effects of an arbitrary accounting period & a progressive rate structure, for example – NOL carryover rules • A loss in one year can be carried back 2 years & carried forward for 20 years – Special relief is provided for casualty losses pursuant to a disaster and for reporting insurance proceeds from destruction of crops 21
  • 22. Mitigation of the Annual Accounting Period Concept (slide 2 of 2)• Farmers and fishermen – Often subject to wide fluctuations in income • Allowed to use an averaging system that helps avoid higher marginal tax rates associated with a large amount of income received in one year • Crop insurance proceeds may be received in a year before the income from the crop would have been realized – Allowed to defer reporting the income until the year following the disaster • Section 451(e) provides similar relief when livestock must be sold on account of drought or other weather-related conditions 22
  • 23. Accounting Methods (slide 1 of 10)• There are 3 generally permissible overall methods of accounting – Cash receipts and disbursements method – Accrual method – Hybrid method• Generally, any of the three methods of accounting may be used – Must be consistently employed and clearly reflect income• In most cases the taxpayer is required to use the accrual method for sales and costs of goods sold if inventories are an income-producing factor 23
  • 24. Accounting Methods (slide 2 of 10)• Cash receipts and disbursements method – Income is recognized when it is actually or constructively received – Expenses are deductible when they are paid • Most courts have applied the “one year rule” for prepaid expenses – Requires that prepaid expenses whose benefits extend beyond the end of the following tax year must be capitalized 24
  • 25. The Big Picture - Example 14 Cash Equivalent (Slide 1 of 2)• Return to the facts of The Big Picture on p. 4-1 in Chapter 4.• Recall that Dr. Cliff Payne has opened a dental practice as a sole proprietorship and does not accept credit cards.• In the 2nd year of business, he adopts a policy requiring that patients either pay cash when services are performed or give him a note receivable with interest at the market rate. – Generally, the notes can be sold to the local banks for 95% of their face amount. 25
  • 26. The Big Picture - Example 14 Cash Equivalent (Slide 2 of 2)• Return to the facts of The Big Picture on p. 4-1 in Chapter 4.• At the end of the 2nd year, Dr. Payne has $60,000 in notes receivable from patients.• The notes receivable are a cash equivalent and have a fair market value of $57,000 ($60,000 X 95%).• Therefore, Dr. Payne must include the $57,000 in his gross income for this year. 26
  • 27. Accounting Methods (slide 3 of 10)• Cash receipts and disbursements method - Restrictions on use – Cash method cannot be used by corporations, partnerships with a corporate partner, and tax shelters • Exceptions: – Farming business – Qualified PSC – An entity that is not a tax shelter whose average annual gross receipts for most recent three-year period are $5 million or less 27
  • 28. Accounting Methods (slide 4 of 10)• Restrictions on use of cash method (cont’d) – As an administrative convenience, the IRS permits the following entities to use the cash method • Entities with $1 million or less average annual gross receipts during last three-year period (even if buying and selling inventory) , and • Certain entities with average annual gross receipts of greater than $1 million but not more than $10 million during last three-year period with the following restrictions – Inventory on hand at the end of the tax year cannot be deducted until the inventory is sold (i.e., must be capitalized) – Not eligible are entities whose principal business activity is selling goods, manufacturing, mining, and certain publishing activities 28
  • 29. Accounting Methods (slide 5 of 10)• Special Rules for Small Farmers – Although inventories are material to farming operations, the IRS allows small farmers to use the cash method of accounting • Applies to unincorporated farms and closely held farming corps with gross receipts < $25 million – Must still capitalize costs of raising trees with preproduction period > two years 29
  • 30. Accounting Methods (slide 6 of 10)• Special Rules for Small Farmers (cont’d) – Farmers producing crops that take > 1 year from planting to harvesting can elect to use the crop method to report income • Under the crop method, costs of raising crops are capitalized and then deducted in year income from crop is realized – Cash basis farmers must capitalize the purchase price of animals, whether acquired for sale or breeding • The costs of raising the animal can be expensed 30
  • 31. Accounting Methods (slide 7 of 10)• Accrual method: Income – Income is recognized when it is earned • Income is earned when all events have occurred to fix the taxpayer’s rights to the income, and • The amount can be determined with reasonable accuracy 31
  • 32. Accounting Methods (slide 8 of 10)• Accrual method: Deductions – Expenses are deductible when they meet the all events test and the economic performance test – Economic performance test is waived for certain recurring items 32
  • 33. Accounting Methods (slide 9 of 10)• Hybrid method involves the use of more than one method – e.g., A combination of cash and accrual methods – Generally used when inventory is a material factor • e.g., Accrual accounting used for determining gross profit from inventory & cash accounting used to report other income & expenses 33
  • 34. Accounting Methods (slide 10 of 10)• Change in accounting method – Taxpayer elects accounting method for subsequent years by filing the initial return – Must obtain permission from IRS to change accounting methods • Adjustments may be required to prevent distortion of taxable income – Correction of error is not a change in accounting method 34
  • 35. Disposition Of Net Adjustment From Change in Accounting Method (slide 1 of 2)• Required changes in accounting methods are the result of an IRS examination – IRS will not require a change unless the net adjustment is positive • Adjustment generally must be included in gross income for the year of the change • Additional tax and interest on the tax will be due – If adjustment is > $3,000, the taxpayer can elect to calculate tax by spreading adjustment over one or more previous years 35
  • 36. Disposition Of Net Adjustment From Change in Accounting Method (slide 2 of 2)• For voluntarily changes from incorrect methods and to facilitate changes from one correct method to another – IRS generally allows the taxpayer to spread a positive adjustment into future years • 1/4th of the adjustment is applied to the year of change, and 1/4th of the adjustment is applied to each of the next 3 taxable years • A negative adjustment can be deducted in the year of the change 36
  • 37. Installment Method (slide 1 of 11)• Installment method of reporting gain allows the taxpayer to recognize gain as payments on the sale are received 37
  • 38. Installment Method (slide 2 of 11)• To qualify for installment treatment, the taxpayer must receive at least one payment after the year of sale• May elect out of installment treatment 38
  • 39. Installment Method (slide 3 of 11)• Installment treatment is not allowed for the following: – Gains on property held for sale in the ordinary course of business – Depreciation recapture under §1245 and §1250 – Sale of securities traded on established markets• As an exception to the first item (above), the installment method may be used to report gains from sales of the following – Time-share units (e.g., the right to use real property for two weeks each year) – Residential lots (if the seller is not to make any improvements) – Any property used or produced in the trade or business of farming 39
  • 40. Installment Method (slide 4 of 11)• Computing the gain recognized: – Gain recognized each year is dependent on the payments received during the year – Recognized Gain = Total gain × Payments Received Contract Price 40
  • 41. Installment Method (slide 5 of 11)• Definitions – Total gain = selling price less selling expenses less adjusted basis of property – Contract price = Sales price less liabilities assumed by buyer • Generally is equal to amount (other than interest) seller will receive from purchaser 41
  • 42. Installment Method (slide 6 of 11)• If liabilities assumed by buyer exceed the seller’s basis and selling expenses – The difference must be added to the contract price and to payments received in year of sale 42
  • 43. Installment Method (slide 7 of 11)• Depreciation recapture under §1245 & §1250 – Depreciation recapture is ineligible for installment treatment • All recapture must be recognized in year of sale – Because most, if not all, of the gain on the sale of tangible property is §1245 recapture, benefit of installment treatment is generally limited to sales of real property 43
  • 44. Installment Method (slide 8 of 11)• Imputed interest – Deferred payment contracts where the sales price exceeds $3,000 • Reasonable rate of interest (at least the applicable Federal rate) must be charged by taxpayer on the outstanding balance • Failure to charge adequate interest will result in imputed interest at Federal rate 44
  • 45. Installment Method (slide 9 of 11)• Related party installment sales – Limitations on the use of the installment method • Nondepreciable property: disposition of property by related purchaser generally accelerates recognition of gain on installment obligation for related seller • Depreciable property: installment method is not available on sale to controlled entity (i.e., more than 50% interest) unless it can be demonstrated that tax avoidance was not a principal purpose 45
  • 46. Installment Method (slide 10 of 11)• Disposition of obligation – Generally, disposition of an installment obligation triggers recognition of remaining deferred gain • The gift or cancellation of an installment note is treated as a taxable disposition by the donor – The amount realized from the cancellation is the face amount of the note if the parties (obligor and obligee) are related to each other • Exceptions are provided for the following transfers – Tax-free incorporations under § 351 – Contributions of capital to a partnership (transferor partner is taxed on the income when the partnership collects) – Certain corporate liquidations – Transfers due to the taxpayer’s death, and – Transfers between spouses or incident to divorce • In such situations, the deferred profit is shifted to the transferee – Transferee is responsible for payment of tax on subsequent collections 46
  • 47. The Big Picture - Example 33 Disposition of Installment Obligations• Return to the facts of The Big Picture on p. 18-1.• Assume that Belinda’s capital contribution to the partnership in 2012 was an installment obligation with a basis of $40,000 and a face amount of $100,000. – In 2013, the partnership collected the $100,000.• The transfer in 2012 was not a taxable disposition, but in 2013 when the receivable is collected, Belinda is required to recognize a gain of $60,000. 47
  • 48. Installment Method (slide 11 of 11)• Interest on deferred taxes – Required to pay interest on the deferred taxes related to the excess obligation amount (excess of $5 million) when • Installment obligation is from sale of property for more than $150,000, and • Sum of such obligations outstanding at year-end exceeds $5 million 48
  • 49. Long-Term Contracts (slide 1 of 5)• Long-term contract defined – A building, installation, construction, or manufacturing contract that is not completed within the same taxable year in which it began • A manufacturing contract is long-term only if a contract to manufacture: – A unique item not normally carried in finished goods inventory, or – Items that normally require more than 12 months to complete 49
  • 50. Long-Term Contracts (slide 2 of 5)• Methods of accounting for long-term contracts – Completed contract: Home construction and certain other real estate construction contracts if • The contract is expected to be completed within the two-year period beginning on the commencement date of the contract • The contract is performed by a taxpayer whose average annual gross receipts for the 3 preceding taxable years do not exceed $10 million – Percentage of completion: All other contracts 50
  • 51. Long-Term Contracts (slide 3 of 5)• Completed contract method – Income recognition occurs when the contract is completed and accepted 51
  • 52. Long-Term Contracts (slide 4 of 5)• Percentage of completion – A portion of the gross contract price is included in income each year as the work progresses – Amount of revenue accrued: • (Costs incurred in tax year/total estimated costs) × contract price = revenue accrued in tax year – Current year costs are deductible 52
  • 53. Long-Term Contracts (slide 5 of 5)• Percentage of completion lookback provisions – In the year that the contract is completed, the profit and related taxes must be recalculated • If taxpayer overpaid taxes, interest on the overpayment is paid to taxpayer • If taxpayer underpaid taxes, interest on the underpayment is due from taxpayer 53
  • 54. Inventories (slide 1 of 4)• Generally, tax accounting and financial accounting for inventories are much the same – Inventories are necessary to clearly reflect the income of businesses engaged in the production and/or sale of goods – Inventories should include all finished goods, goods in process, and raw materials and supplies – Inventory rules must give effect to the best accounting practices, consistently followed from year to year – All items included in inventory should be valued at either cost or the lower of cost or market value 54
  • 55. Inventories (slide 2 of 4)• Determining Inventory Cost – For merchandise purchased, cost is the invoice price less trade discounts plus freight and other handling charges • Cash discounts approximating a fair interest rate can be deducted or capitalized providing the method used is consistently applied• Uniform Capitalization rules under Section 263A – Provide that for inventory and property produced by the taxpayer, the following must be capitalized • The direct cost of such property, and • Such property’s share of those indirect costs (including taxes) part or all of which are allocable to such property 55
  • 56. Inventories (slide 3 of 4)• Lower of Cost or Market – Except for those taxpayers who use the LIFO method, inventories may be valued at the lower of cost or market (replacement cost)• Taxpayers using LIFO must value inventory at cost 56
  • 57. Inventories (slide 4 of 4)• A taxpayer may use any of the following methods, provided the method is consistently applied – Specific Identification – First in, first out (FIFO) – Last in, first out (LIFO) – Average cost method• Farmers who do not use the cash method may elect to use the farm price method or the unit-livestock-price method rather than one of the inventory methods above 57
  • 58. Refocus On The Big Picture (slide 1 of 4)• Selection of a tax year - A very precise set of rules are used to determine the tax year for a partnership, applied in the following sequence: – Majority interest tax year - Use the tax year of partners with a common year-end that collectively own > 50% interest in capital and profits. – Principal partners’ tax year - Use this tax year if all principal partners (5% or greater interest in capital or profits) have the same tax year. – Least aggregate deferral tax year - The tax year of the principal partners (grouped by a common year-end) that produces the least aggregate deferral of income. 58
  • 59. Refocus On The Big Picture (slide 2 of 4)• Alternatively, the partnership can select its tax year based on a business purpose for the tax year selected. – The only business purpose the IRS recognizes is to conform to the entity’s natural business year.• Therefore, from the data provided, it appears that Silver will determine its tax year by using the least aggregate deferral method. – Based on this method, Silver’s tax year will end on November 30 (see the calculations in Example 3). 59
  • 60. Refocus On The Big Picture (slide 3 of 4)• Short Tax Year - Silver will have a short tax year – Begins on April 1, 2012 – Ends on November 30, 2012 • As determined by the least aggregate deferral method.• Silver will not have to annualize income reported on its first income tax return. – Note, however, that annualization will be required if Silver ever changes its tax year.• Partner’s Reporting of Share of Net Income - Each partner will receive a Schedule K–1 that reports the partner’s share of net income. – From a timing perspective, the partner will include the Schedule K–1 items on the partner’s income tax return only if a partnership tax year ends within or with the partner’s tax year. 60
  • 61. Refocus On The Big Picture (slide 4 of 4)• Partnership’s Accounting Method - Silver Partnership must use the accrual method to compute its income because one of its partners (Pearl, Inc.) is a C corporation. – Thus, even though Belinda is a cash basis taxpayer, her share of the partnership income will be computed by the accrual method. 61
  • 62. If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA trippedr@oneonta.edu SUNY Oneonta© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 62

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