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  • Note Hobbies are not businesses. Personal activity that may generate revenue. Taxpayer generally has burden of proving their intent to make a profit. Specific factors listed in Regulations such as: History of income or loss Elements of personal pleasure or recreation Deductions only allowed to extent of revenue.
  • Bad debts are discussed in two places – once in front and more details near the end of the chapter. It is important to note that cash basis taxpayers have NO accounts receivable so there is no bad debt deduction. It might also be noted that in contrast to bad debts, cash basis taxpayers can deduct bad loans – they have basis in these assets. However, this brings up whether a lone is a business loan (ordinary) or nonbusiness (short term capital). Best to save this discussion for capital assets. Business losses are also rather complex (e.g. section 1231 treatment) – this chapter merely serves to introduce the notion that business losses are deductible rather than discuss the nature of the deduction.
  • Note that the time spent on an activity may not be conclusive for the primary purpose – a question of fact and circumstance
  • Note that the 52/53 week can facilitate closing of books.
  • Note that the first year for most fiscal year entities are typically short years Note that some exceptions are skipped – the “natural” business year end and the deferral year end
  • We skip a discussion of inventory flows here, but a slide may be added if students are confused.
  • These rules only apply to accrual basis taxpayers.
  • Include a few of the key examples from the book.
  • Chap008

    1. 1. Chapter 8 Business Income, Deductions, and Accounting Methods Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin
    2. 2. Learning Objectives <ul><li>Describe the general requirements for deducting business expenses and identify common business deductions. </li></ul><ul><li>Apply the limitations on business deductions to distinguish between deductible and nondeductible business expenses. </li></ul><ul><li>Identify and explain special business deductions specifically permitted under the tax laws. </li></ul><ul><li>Explain the concept of an accounting period and describe accounting periods available to businesses. </li></ul><ul><li>Identify and describe accounting methods available to businesses and apply tax accrual methods to determine business income and expense deductions. </li></ul>8-
    3. 3. Business income and deductions <ul><li>All income from whatever source derived.” </li></ul><ul><ul><li>Includes revenue from services and lease activities. </li></ul></ul><ul><ul><li>Gross profit from sales (cost of goods is a return of capital). </li></ul></ul><ul><ul><li>Business income does not include excluded (ex. exempt interest) and deferred income (ex. installment sales; some gains on sales of assets). </li></ul></ul><ul><li>Deductions must be directly connected to business activity. </li></ul><ul><ul><li>“ Ordinary and necessary” means conducive to profit generation. </li></ul></ul><ul><ul><li>“ Reasonable in amount” means not extravagant (ex. would you have to pay the same amount to others?). </li></ul></ul>8-
    4. 4. Reasonableness example <ul><li>Rick owns a business that employs his brother, Ben. </li></ul><ul><li>Ben is paid $45,000 per year by Rick’s business. </li></ul><ul><li>In comparison, other employees with Ben’s responsibilities are only paid $30,000 per year. </li></ul><ul><li>What can Rick’s business deduct for employing Ben? </li></ul>8-
    5. 5. Reasonableness solution <ul><li>A reasonable amount for compensating Ben is $30,000 rather than $45,000. </li></ul><ul><li>Rick can only deduct $30,000 </li></ul><ul><li>What is the tax status of the extra $15,000 paid to Ben? </li></ul><ul><li>The extra $15,000 ($45,000 paid minus $30,000 deduction) is a gift from Rick to Ben. </li></ul>8-
    6. 6. Statutory limits on business expense deductions <ul><li>Expenses against/related to public policy </li></ul><ul><ul><li>No deduction for fines, bribes, lobby expenditures, or political contributions </li></ul></ul><ul><li>Expenses relating to tax-exempt income </li></ul><ul><ul><li>Interest on loan where proceeds invested in municipal bonds. </li></ul></ul><ul><ul><li>Key man insurance premiums – no deduction if business is beneficiary of life insurance. </li></ul></ul><ul><li>Capital expenditures (depreciate instead) </li></ul><ul><li>Personal expenses </li></ul>8-
    7. 7. Capital expenditures <ul><li>Answer the accounting question – D oes the expenditure provide future benefits (beyond this year)? </li></ul><ul><ul><li>If so, then capitalize and depreciate rather than deduct currently. </li></ul></ul><ul><li>12-month rule for prepaid expenses : </li></ul><ul><ul><li>Deduct if benefit < 12 months and benefits do not extend beyond end of next tax year. </li></ul></ul><ul><ul><li>Does not apply to rent and interest. </li></ul></ul>8-
    8. 8. Specifically authorized business deductions <ul><li>Start-up expenditures </li></ul><ul><ul><li>Capitalize and elect to expense/amortize </li></ul></ul><ul><li>Bad debts </li></ul><ul><ul><li>Accrual taxpayers can use direct write off only </li></ul></ul><ul><li>Losses on disposition of business assets </li></ul><ul><ul><li>Sales or exchanges where loss is recognized </li></ul></ul><ul><ul><li>Casualty loss is limited to lesser of decline in value (repair cost) or basis </li></ul></ul><ul><ul><li>Basis is amount of loss if business asset is completely destroyed </li></ul></ul><ul><li>DMD – domestic manufacturing deduction </li></ul>8-
    9. 9. 12-month rule example <ul><li>Ben makes the following payments on June 30 of this year: </li></ul><ul><ul><li>Pays $10,000 for the next 10 months of utilities </li></ul></ul><ul><ul><li>Pays $12,000 for insurance over next 24 months </li></ul></ul><ul><ul><li>Pays $ 9,600 for next 8 months of rent </li></ul></ul><ul><ul><li>What amounts are deductible this year? </li></ul></ul>8-
    10. 10. 12-month rule solution <ul><li>On June 30: </li></ul><ul><li>Ben paid $10,000 for the next 10 months of utilities. </li></ul><ul><ul><li>Deduct all $10,000 because benefit < 12 months and ends prior to end of next year. </li></ul></ul><ul><li>Ben paid $12,000 for insurance over next 24 months </li></ul><ul><ul><li>Deduct $3,000 ($500/month x 6 months)(12-month rule does not apply because period > 12 months)( just pro-rate ) </li></ul></ul><ul><li>Ben paid $ 9,600 for next 8 months of rent </li></ul><ul><ul><li>Deduct $7,200 ($1,200 per month x 6 months)(12-month rule does not apply to rent or interest) </li></ul></ul>8-
    11. 11. Business expenses with personal benefits <ul><li>No deduction for purely personal expenditures </li></ul><ul><ul><li>unless otherwise allowable (ex. Itemized deductions) </li></ul></ul><ul><li>Mixed motive (personal and business purpose)? </li></ul><ul><ul><li>Primary motive determines deductibility for some expenditures (all or nothing). </li></ul></ul><ul><ul><ul><li>Uniforms (not adaptable to ordinary use). </li></ul></ul></ul><ul><ul><ul><li>Business travel (away from home overnight). </li></ul></ul></ul><ul><ul><li>Otherwise, allocate deduction to business portion. </li></ul></ul><ul><ul><ul><li>Arbitrary percentage (50% M&E rule). </li></ul></ul></ul><ul><ul><ul><li>Basis for allocation (mileage or time). </li></ul></ul></ul><ul><li>Recordkeeping </li></ul><ul><ul><li>Document business purpose. </li></ul></ul><ul><ul><li>Travel, meals and entertainment, mixed use assets </li></ul></ul>8-
    12. 12. Travel example <ul><li>Ben paid the following to attend a business meeting in Chicago: </li></ul><ul><ul><li>Air fare (first class) - $ 1,200 </li></ul></ul><ul><ul><li>Hotel (three nights) - $ 750 </li></ul></ul><ul><ul><li>Meals (three days) - $ 270 </li></ul></ul><ul><ul><li>What amounts are deductible if Ben spent two days in meetings (primarily business)? </li></ul></ul><ul><ul><li>What amounts are deductible if Ben spent one day in a meeting (primarily personal) </li></ul></ul>8-
    13. 13. Travel solution <ul><li>Ben can deduct the following amounts: </li></ul><ul><li> 2 days 1 day </li></ul><ul><li>business personal </li></ul><ul><ul><li>Air fare (all or none) $ 1,200 $ 0 </li></ul></ul><ul><ul><li>Hotel ($250 per day) 500 250 </li></ul></ul><ul><ul><li>Meals ($90 per day x 50%) 90 45 </li></ul></ul><ul><ul><li>Total Travel Deduction $ 1,790 $ 295 </li></ul></ul>8-
    14. 14. Problems <ul><li>Problem 46, p104 </li></ul><ul><li>a. No deduction for fines. </li></ul><ul><li>b. $785 deduction. </li></ul><ul><li>c. No deduction for bribes (against public policy). </li></ul>
    15. 15. Problems <ul><li>Problem 47, p104 </li></ul><ul><li>a. $0. The interest expense is not deductible (expense associated with tax-exempt income). </li></ul><ul><li>b. $0. Capital expenditures are not deductible. </li></ul><ul><li>c. Only $10,000 is deductible and the remaining $5,000 is either unreasonable in amount or against public policy (as a bribe). </li></ul><ul><li>d. $0. The amount paid to install a machine is capitalized because the cost benefits the useful life of the machine. </li></ul>
    16. 16. Problems <ul><li>Problem 57, p107 (see p.80 for help) </li></ul><ul><li>a. For the complete destruction of a business asset, Amy can claim a casualty loss deduction for the tax basis of the machine less any recovery. Hence, Amy can claim a casualty deduction for $1,700 ($2,000-$300) </li></ul><ul><li>b. For partial destruction of a business asset, Amy can claim a casualty loss deduction for the lesser of the economic loss (the cost of repair) or the tax basis of the machine. In this case, Amy can deduct $800. </li></ul><ul><li>c. For partial destruction of a business asset, Amy can claim a casualty loss deduction for the lesser of the economic loss (the cost of repair) or the tax basis of the machine. In this case Amy can deduct $2,000. </li></ul>
    17. 17. Accounting for taxable income <ul><li>We’ve learned to identify: </li></ul><ul><ul><li>Business gross income and </li></ul></ul><ul><ul><li>Deductible expenses </li></ul></ul><ul><li>Now we need to match these flows to a specific period . </li></ul><ul><ul><li>Accounting periods determine beginning and end of accounting cycle. </li></ul></ul><ul><ul><li>Accounting methods match income and expense to a specific period. </li></ul></ul>8-
    18. 18. Accounting periods <ul><li>Annual period </li></ul><ul><ul><li>Full tax year is 12 months long. </li></ul></ul><ul><ul><li>Short tax year is < 12 months. </li></ul></ul><ul><li>Year ends </li></ul><ul><ul><li>Calendar year is 12/31. </li></ul></ul><ul><ul><li>Fiscal year depends upon choice: </li></ul></ul><ul><ul><ul><li>Last day of a month (not December). </li></ul></ul></ul><ul><ul><ul><li>52/53 week year end is the same day of a specific month. </li></ul></ul></ul><ul><ul><ul><ul><li>Example: last Friday in June. </li></ul></ul></ul></ul>8-
    19. 19. Choosing an accounting period <ul><li>Proprietorships – same as proprietor. </li></ul><ul><ul><li>Prevents mismatch of income. </li></ul></ul><ul><li>“ C” corporations – choice made on first tax return. </li></ul><ul><li>Flow-thru entities – a “required” tax year. </li></ul><ul><ul><li>Partnerships, “S” corporations, LLCs and other hybrid entities. </li></ul></ul><ul><ul><li>Match to owners’ period (multiple owners for partnerships so this can be complicated). </li></ul></ul>8-
    20. 20. Accounting methods <ul><li>Comparison of financial and tax methods </li></ul><ul><ul><li>Financial accounting is “conservative” </li></ul></ul><ul><ul><ul><li>GAAP is slow to recognize income, but quick to recognize losses or expenses. </li></ul></ul></ul><ul><ul><ul><li>Objective is to avoid misleading investors & creditors. </li></ul></ul></ul><ul><ul><li>Tax accounting is much less conservative. </li></ul></ul><ul><ul><ul><li>Objective of Congress is to maximize tax revenues. </li></ul></ul></ul><ul><ul><ul><li>More likely to recognize income and defer losses and expenses. </li></ul></ul></ul>8-
    21. 21. Accounting methods <ul><li>Permissible “overall” methods: </li></ul><ul><ul><li>Cash – recognize income when received. </li></ul></ul><ul><ul><li>Accrual – recognize income when earned or received (whichever is first generally). </li></ul></ul><ul><ul><li>Hybrid – use accrual for some accounts. </li></ul></ul><ul><li>Methods are adopted with first tax return. </li></ul><ul><ul><li>Proprietorships can use either cash or accrual. </li></ul></ul><ul><ul><li>Other flow-thru entities also typically have choice. </li></ul></ul><ul><ul><li>“ C” corporations must typically use accrual. </li></ul></ul>8-
    22. 22. Cash method <ul><li>Income recognized when actually or constructively received. </li></ul><ul><li>Expenses recognized when paid. </li></ul><ul><li>Pros and cons: </li></ul><ul><ul><li>Flexible. </li></ul></ul><ul><ul><li>Simple and relatively inexpensive. </li></ul></ul><ul><ul><li>Not GAAP – poor matching of income and expense. </li></ul></ul><ul><ul><li>Not available for some business organizations (C corporations typically). </li></ul></ul>8-
    23. 23. Accrual method - Income <ul><li>Income is recognized when earned or received </li></ul><ul><ul><li>“ All events test” – recognize income when all the events have occurred which fix the right to receive such income and </li></ul></ul><ul><ul><li>The amount can be determined with reasonable accuracy </li></ul></ul><ul><li>“ Recognize” income on earliest of these dates: </li></ul><ul><ul><li>Completes service or sale </li></ul></ul><ul><ul><li>Payment is due </li></ul></ul><ul><ul><li>Payment is received </li></ul></ul>8-
    24. 24. Accrual Income question <ul><li>Ben provides consulting services and bills Ace for $12,000. Ace disputes the amount claiming that $8,000 is the proper amount. </li></ul><ul><li>How much income should Ben recognize under the accrual method this year? </li></ul><ul><ul><li>$ ________? </li></ul></ul><ul><ul><ul><li>($8,000 - the undisputed amount satisfies the all events test) </li></ul></ul></ul>8-
    25. 25. Accrual – prepaid income <ul><li>Advance payments for services : </li></ul><ul><ul><li>Allowed to defer recognition for one year unless income is earned or recognized for financial records. </li></ul></ul><ul><ul><li>Not applicable to payments relating rent or interest income. </li></ul></ul><ul><li>Advance payments for goods : </li></ul><ul><ul><li>Elect one of two methods of recognition. </li></ul></ul><ul><ul><li>Full inclusion method – recognize prepayments as income. </li></ul></ul><ul><ul><li>Deferral method – include in period earned for tax or financial purposes. </li></ul></ul>8-
    26. 26. Prepaid income example <ul><li>Ben provides dancing lessons. </li></ul><ul><li>On September 30 th of this year he received $2,400 full payment for a 2-year service contract. </li></ul><ul><li>What amount of income must Ben recognize this year? next year?: </li></ul><ul><li>(1) if he is on the cash method? </li></ul><ul><li>(2) if he is on the accrual method? </li></ul>8-
    27. 27. Advance payment solution <ul><li>If Ben uses the cash method , he must recognize income as received - $2,400 this year. </li></ul><ul><li>If Ben uses the accrual method , then he can elect to defer the unearned revenue for a year. </li></ul><ul><li>This year Ben would recognize $300 - the income earned from September 30 (3/24 x $2,400). </li></ul><ul><li>Next year Ben would recognize $2,100 - the remaining income which can only be deferred one year. </li></ul>8-
    28. 28. Inventories <ul><li>Inventories must be accounted for under the accrual method if sales of goods constitute a “material” income producing factor. </li></ul><ul><ul><li>Purchases accrued with A/P (debit/credit?). </li></ul></ul><ul><ul><li>Sales accrued with A/R (debit/credit?). </li></ul></ul><ul><li>If sales are not material or taxpayer is “small”, then goods are expensed as “supplies.” </li></ul><ul><li>Cash method taxpayers may use cash method for other (non inventory) accounts. </li></ul><ul><ul><li>Technique is called the “hybrid” method (rare). </li></ul></ul>8-
    29. 29. Inventories - UNICAP ( Uni form Cap italization) <ul><li>Indirect costs are allocated to inventories (not expensed). (see Ex 8-17, p88) </li></ul><ul><li>Costs of selling, advertising, and research need not be capitalized. </li></ul><ul><li>Does not apply for “small” businesses (average annual gross receipts < $10 million). </li></ul>8-
    30. 30. Inventory flow assumptions <ul><li>Last-in, Last-out (LIFO) </li></ul><ul><ul><li>Generates lowest taxable income in time of inflation. </li></ul></ul><ul><ul><li>“ Book-tax conformity” requirement </li></ul></ul><ul><ul><ul><li>If use for tax records; must use for book (F/Ss); why? </li></ul></ul></ul><ul><li>First-in, First-out (FIFO) </li></ul><ul><ul><li>Generates highest taxable income in time of inflation. </li></ul></ul><ul><ul><li>No “Book-tax conformity” requirement; why? </li></ul></ul><ul><li>Specific identification </li></ul>8-
    31. 31. Accrual method - deductions (i.e. when can you deduct expenses that haven’t been paid yet?) <ul><li>Both rules below must be met: </li></ul><ul><li>All events test </li></ul><ul><ul><li>All events have occurred to establish the liability to pay. </li></ul></ul><ul><ul><li>The amount is determinable with reasonable accuracy. </li></ul></ul><ul><ul><li>Reserves for future liabilities not allowed. </li></ul></ul><ul><li>Economic performance has occurred. </li></ul><ul><ul><li>Mere liability is NOT ENOUGH! </li></ul></ul>8-
    32. 32. Economic performance <ul><li>Taxpayer liable for providing goods or services? </li></ul><ul><ul><li>Performance occurs as taxpayer provides goods or services….deduct related costs in this period </li></ul></ul><ul><li>Taxpayer liable for buying goods or services? </li></ul><ul><ul><li>Performance occurs as goods or services are provided, or </li></ul></ul><ul><ul><li>economic performance is otherwise expected within 3 ½ months of payment (deduct amounts paid by year end). </li></ul></ul><ul><li>Payment liabilities (rebates, warranty costs, tort claims, and taxes) are performed only when paid. </li></ul><ul><li>Interest and rent occurs ratably (deduct over time). </li></ul>8-
    33. 33. Economic performance example <ul><li>Ben has signed a binding contract for Peter to provide repair services. Ben paid $1,500 and owes an additional $6,000 on the contract. The repairs will commence in the fall of next year. </li></ul><ul><li>When can Ben claim the deduction if he uses the accrual method? </li></ul><ul><li> Answer: Although the all events test is satisfied, Ben can only deduct $7,500 next year because that is when economic performance occurs. </li></ul>8-
    34. 34. 8- Liability is incurred under IRC § 461 Capitalize (e.g., IRC §§ 263(a) or 471) Deduct (e.g., IRC § 162) 12-month rule Disallow Meals & Entertainment Spousal Travel Club Dues Lobbying Etc.
    35. 35. Choosing or changing an accounting method <ul><li>Accounting methods are generally adopted via use. </li></ul><ul><ul><li>A permissible method is adopted by using and reporting the method for one year. </li></ul></ul><ul><ul><li>An impermissible method is adopted by using and reporting the method for two years (penalties imposed). </li></ul></ul><ul><li>Generally method changes require permission of the IRS. </li></ul><ul><ul><li>a business purpose is critical - not tax avoidance. </li></ul></ul><ul><ul><li>Some changes are automatic (cash to accrual method). </li></ul></ul><ul><ul><li>Permission is necessary to correct the use of an impermissible method. </li></ul></ul>8-
    36. 36. Chapter Summary <ul><li>LO1: we learned how to identify common business deductions. </li></ul><ul><li>LO2: we applied various statutory limitations to determine deductible amounts. </li></ul><ul><li>LO3: we reviewed the special deductions specifically allowed for businesses. </li></ul><ul><li>LO4: we reviewed the accounting periods available for calculating business income. </li></ul><ul><li>LO5: we summarized and compared the accrual and cash methods of accounting for income and deductions. </li></ul>8-
    37. 37. To Do… <ul><li>In-Class Problems: </li></ul><ul><ul><li>20,22,25,51,52,61,70 </li></ul></ul><ul><li>Homework (due Saturday @ 11:59pm): </li></ul><ul><ul><li>10,21,28,40,49,64,72,83 </li></ul></ul><ul><li>Ch 8 Quiz (due Saturday @ 11:59pm) </li></ul><ul><li>Chapter 9 Pre-Class Questions </li></ul><ul><ul><li>1,4,15,23,27,31 </li></ul></ul>