Here are the steps to solve this example: 1. O'Neill Machinery's taxable income is $1,445,500 which is greater than the $659,000 cost of the asset, so the full $500,000 Section 179 deduction can be taken. 2. The Section 179 deduction reduces the asset basis to $159,000 ($659,000 original cost - $500,000 Section 179 deduction). 3. The MACRS depreciation on the remaining $159,000 basis is 14.29% of $159,000 = $22,701 (using the MACRS table for a 7-year asset). 4. The total depreciation deduction for the current year is

1. Chapter 7
Accounting Periods and
Methods and Depreciation
Income Tax Fundamentals 2012
Gerald E. Whittenburg &
Martha Altus-Buller
2012 Cengage Learning

2. Learning Objectives
 Determine different accounting periods and methods
for tax periods
 Understand concept of depreciation
 Calculate depreciation using MACRS tables and
identify when §179 election to expense may be
applied
 Apply listed property and luxury automobile
limitations
 Understand tax treatment of intangibles
 Determine whether parties are considered related
and how to treat related party transactions
2012 Cengage Learning

3. Accounting Periods
 Rarely, a taxpayer’s tax year will differ from the calendar
year
 In a partnership
 The tax year must be the same tax year as 50% of partners’
 If majority of partners’ tax years are different, must use tax
year of ‘principal partners’
 Principal partner defined as partner with at least 5% share in
profits or capital
 If principal partners have different tax years, partnership
generally required to use least aggregate deferral method
Note: Partnerships don’t pay tax as an entity
2012 Cengage Learning

4. Accounting Periods
Partnerships/S-Corporations may elect to
adopt a different fiscal tax year from the
one prescribed on previous slide, but only
o If entity can demonstrate that natural
business cycle easily conforms to fiscal year
other than calendar year
• Such as a golf course in Denver, CO (natural
business cycle ends in October)
Note: S-Corporations don’t pay tax as an entity
2012 Cengage Learning

5. Required Tax Payment
 Even though S-Corporations and partnerships
don’t pay tax, the entity must make an
estimated payment if choosing to use a fiscal
year-end different from calendar year-end
◦ Estimated taxes are calculated as
Estimated deferral period taxable income
x
(Highest individual tax rate + 1%)
◦ Estimate deferral period taxable income by
using average monthly income from
preceding fiscal year
2012 Cengage Learning

6. Required Tax Payment Example
Example
San Juan River Expeditions Inc., an S-Corp, has
taxable income of $360,000 for the year
ended 9/30/11 with a three-month deferral
period. The company made a $15,000
payment last year. What’s their current
required tax payment?
2012 Cengage Learning

7. Solution
Example
San Juan River Expeditions Inc., an S-Corp, has taxable income of
$360,000 for the year ended 9/30/11 with a three-month deferral period.
The company made a $15,000 payment last year. What’s their current
required tax payment?
Solution
The required tax payment =
(Estimated taxable income in deferral period x 36%) - prior year’s tax payment
Deferral period is 3 months (October – December)
[($360,000/12) x 3 months] = $90,000 ($90,000 x 36%) = $32,400
($32,400 - 15,000) = $17,400 estimated tax payment due in current year
2012 Cengage Learning

8. Tax Year for
Personal Service Corporation
 A Personal Service Corporation (PSC) is a corporation with
shareholder-employee(s) who provide a personal service,
such as architects or dentists
 Generally, a PSC must adopt calendar year
 However, can adopt a fiscal year if
◦ Can prove business purpose
or
◦ Fiscal year results in a deferral period of less than 3 months
and
 Shareholders’ salaries for deferral period are proportionate to
salaries received during rest of the period
or
 Corporation limits its salaries deduction
See next slide
2012 Cengage Learning

9. PSC Limit on
Salaries Deduction
 Purpose is to keep the PSC from
deducting one year’s salary in first nine
months
 If salaries don’t remain constant, the PSC
can only deduct pro rata amount
◦ Based on a required formula
2012 Cengage Learning

10. Short Period Taxable Income (TI)
 Iftaxpayer has a short year (other than first or last
year of operation), tax is calculated based on following
example:
° In 2011, Organic Dairy LLC changes from a calendar year to
tax year ending 9/30. For the short period 1/1/11 – 9/30/11,
Organic Dairy LLC’s taxable income = $20,000*
Steps to calculate tax for the short period
Annualize TI $20,000 x 12/9 = 26,667
Estimated tax on annualized TI $26,667 x 15% = 4,000
Allocate tax to short period $ 4,000 x 9/12 = 3,000
 Individual taxpayers rarely change tax years
*Note: Calculations for short year TI requires special adjustments
2012 Cengage Learning

11. Accounting Methods
 There
are three acceptable accounting
methods for reporting taxable income
◦ Cash
must use same method
◦ Hybrid for tax & books
◦ Accrual
 Must use one method consistently
◦ Make an election on your first return by filing using a
particular method
◦ Must obtain permission from IRS to change
accounting methods
2012 Cengage Learning

12. Accounting Methods
 Cash receipts/disbursements method
◦ This method most common for individuals
◦ Recognize income when cash actually or
constructively received
◦ Recognize deduction in year of payment
• Exception - can’t deduct prepaid rent or interest
◦ Can’t use cash basis if taxpayer is a
• C corporation
• Partnership with a corporation as a partner
• Tax exempt trust with unrelated business income
◦ Doesn’t apply to certain organizations
2012 Cengage Learning

13. Accounting Methods
(continued)
 Accrual method
◦ Recognize income when earned and can be
reasonably estimated
◦ Recognize deductions when incurred and can
be reasonably estimated
 Hybrid method
◦ An example of a hybrid taxpayer is one that
utilizes cash method for receipts and
disbursements, but accrual for cost of products
sold
2012 Cengage Learning

14. Depreciation
 Depreciationis a process of allocating and
deducting the cost of assets over their useful
lives
◦ Does not mean devaluation of asset
◦ Land is not depreciated
 Maintenance vs. depreciation
◦ Maintenance expenses are incurred to keep asset in
good operating order
◦ Depreciation refers to deducting part of the original cost
of the asset
Report depreciation on Form 4562
2012 Cengage Learning

15. Depreciation Methods
 Straight-line
depreciation is easiest, for
accounting purposes, and is calculated as
(Cost of asset – salvage value)/Years in estimated life
 Modified Accelerated Cost Recovery System
(MACRS), for tax purposes, allows capital
assets to be written off over a period identified
in tax law
◦ Accelerated method used for all assets except real
estate
2012 Cengage Learning

16. Personal Property
Recovery Periods
 WithMACRS, each asset is depreciated according
to an IRS-specified recovery period
◦ 3 year ADR* midpoint of 4 years or less
◦ 5 year Computers, cars and light
trucks, R&D equipment, certain energy
property and certain equipment
◦ 7 year Mostly business furniture and equipment
and property with no ADR life
*See Table 7.1 on page 7-9 for Asset Depreciation
Ranges (ADR) for recovery periods for all classes of assets
2012 Cengage Learning

17. Calculating Depreciation
for Personal Property
 Depreciation is determined using IRS tables
◦ MACRS rates found in Table 7.2 on page 7-10
◦ Rates multiplied by cost (salvage value not used in
MACRS)
◦ Tables based on half-year convention
 Means 1/2 year depreciation taken in year of acquisition and 1/2
year taken in final year
 May elect to use tables based on straight-line
instead (percentages in Table 7.3 on page 7-11)
Note: Must use either MACRS or straight-line for all
property in a given class placed in service during that year
2012 Cengage Learning

18. Using Tables – Personal Property
Example 1: On March 15, Ceramatech Co. purchased furniture for
$180,000; what is the recovery period and depreciation? (assume no
bonus depreciation taken)
Use Table 1 to see it’s a 7-year asset
Use Table 2 to get percentages
Year 1: $180,000 x .1429 = $25,722
Year 2: $180,000 x .2449 = $44,082
Example 2: On February 3, Bad Boy Bling LLC bought a computer for
$12,000; what is the recovery period and depreciation? (assume no
bonus depreciation taken)
Use Table 7.1 to see it’s a 5-year asset
Use Table 7.2 to get percentages
Year 1: $12,000 x .20 = $2,400
Year 2: $12,000 x .32 = $3,840
2012 Cengage Learning

19. Mid-Quarter Convention
 Mid-quarter convention is required if taxpayer
purchases more than 40% of total assets (except
real estate) in the last quarter of tax year
◦ Must apply this convention to every asset purchased in
the year
◦ Excludes real property and §179 property
◦ Must use special mid-quarter tables
 Found at major tax service such as Commerce Clearing
House (CCH) or Research Institute of America (RIA)
2012 Cengage Learning

20. 100% Bonus Depreciation
For property place in service
after 9/8/10 and before 1/1/12
 Additional depreciation immediately available
 Applies only to new property for use in business
 Amount = 100% of adjusted basis
 May elect out of bonus (or chose to only use
50% bonus depreciation) if have current NOL or
anticipate need for higher depreciation in future
years
2012 Cengage Learning

21. Personal Property
Depreciation Example
Example
Nicole purchases a cherry desk and executive
chair for use in her engineering firm on July 16,
2011 for $8,150. What is her depreciation for
2011 using half-year convention and MACRS
tables? 2012? (Assume Nicole didn’t take
bonus depreciation as she anticipates higher
income in subsequent years).
How would 2011 depreciation change if she had
taken 50% bonus depreciation?
2012 Cengage Learning

22. Solution
Example
Nicole purchases a cherry desk and executive chair for use in her engineering firm on
July 16, 2011 for $8,150. What is her depreciation for 2011 using half-year
convention and MACRS tables? 2012? (Assume Nicole didn’t take bonus
depreciation as she assumes higher income in subsequent years).
How would 2011 depreciation change if she had taken 50% bonus depreciation?
Solution
Using Table 1, we can see that business furniture has a 7-year life. Table 2 shows the
percentages to use for recovery years 1 and 2; therefore
2011 depreciation = $1,165 ($8,150 x .1429)
2012 depreciation = $1,996 ($8,150 x .2449)
If bonus depreciation were taken:
2011 depreciation = 50% bonus depreciation + MACRS % to remaining basis
$8,150 X 50% $8,150 x 50% = $4,075 bonus depreciation
= $4,075
remaining
$4,075 x .1429 = $582 MACRS depreciation
depreciable Total depreciation = $4,657 ($4,075 + $582)
basis
2012 Cengage Learning

23. Real Estate
 Realassets depreciated based on a
recovery period – 2 types of real property
o 27.5 years Residential real estate
o 39 years Nonresidential real estate
o Real assets are depreciated using the straight-line
method with a mid-month convention
 Mid-month convention assumes all purchases made
in middle of month
 Used for real estate acquired after 1986
 Rates found on Table 7.4 on page 7-13
Note: Different rates apply for real property acquired
before 1981 and after 1980 but before 1987
2012 Cengage Learning

24. Real Estate Example
Example
Gwen purchased a residential tri-plex on
8/1/11 for $290,000 (including land cost of
$50,000). What is her depreciation for
2011? 2012?
2012 Cengage Learning

25. Solution
Example
Gwen purchased a residential tri-plex on 8/1/11 for
$290,000 (including land cost of $50,000). What is her
depreciation for 2011? 2012?
Solution
Since land is not depreciable, only $240,000 may be
multiplied by percentages from Table 7.4 on page 7-13
(27.5-year residential real property). The purchase
occurred in the eighth month; therefore, depreciation
equals
2011 $240,000 x 1.364% = $3,274
2012 $240,000 x 3.636% = $8,726
2012 Cengage Learning

26. Election to Expense - §179
 §179 allows immediate expensing of qualifying property
◦ For 2011, the annual amount allowed is $500,000
◦ Qualifying property is tangible personal property used in a business –
can be new or used
 §179 election to expense is limited by 2 things
◦ If cost of qualifying property placed in service in a year > $2,000,000,
then reduce §179 expense dollar for dollar
 For example, if assets purchased in current year = $2.1 million, taxpayer
must reduce §179 by $100,000. Therefore, election to expense is limited
to = $400,000 ($500,000 – 100,000). The remaining $1.7 million of basis is
depreciated over assets’ useful lives (including bonus depreciation) if
applicable.
◦ Cannot take §179 expense in excess of taxable income
 New law allows up to $250,000 to be taken to §179 for certain
rental and leasehold improvements and restaurant properties
2012 Cengage Learning

27. Election to Expense - §179
 When using with regular MACRS, take §179 first, then
reduce basis to calculate bonus depreciation, then reduce
basis to calculate MACRS
 For example
◦ In 2011, NanoPaint Inc.’s taxable income = $1.25 million. They
placed a 7-year piece of property into service costing $842,000 – it
was their only asset purchase in 2011. What is total depreciation,
including election to expense?
◦ Assuming no bonus depreciation will be claimed (a) first take
$500,000 deduction under §179 (b) reduced basis of $342,000 is
multiplied by .1429 from MACRS tables
 Total depreciation and Section 179 = $548,872 ($500,000 +
(342,000 x .1429)
2012 Cengage Learning

28. §179 Example
Example
On 7/11/11, O’Neill Machinery LLC purchases a
used tooling machine (7-year asset) for
$659,000. The taxable income from the
business is $1,445,500. What is the
company’s total depreciation deduction for
the current year, including §179 and MACRS?
2012 Cengage Learning

29. Solution
Example
On 7/11/11, O’Neill Machinery LLC purchases a used tooling machine (7-year
asset) for $659,000. The taxable income from the business is $1,445,500.
What is the company’s total depreciation deduction for the current year,
including §179 and MACRS?
Solution
Asset purchases didn’t exceed $2,000,000 and doesn’t exceed TI, so no
reduction in §179 required:
Cost $659,000
§179 expense ( 500,000)
Adjusted depreciable basis $159,000
x Table % .1429
MACRS $ 22,721
Note: Can’t take bonus depreciation since it’s used property;
Total depreciation equivalent to $500,000 + 22,721 = $522,721
2012 Cengage Learning

30. Listed Property
 Special rules exist to limit deductions on assets that lend
themselves to personal use, called ‘listed property’
◦ Cars and trucks/vans under 6000 lbs. gross vehicle weight
with specific exclusions
◦ Computers (unless used exclusively at business)
◦ Equipment used for entertainment, recreation or amusement
 If asset used <= 50% for business (or if business use falls
below 50% in subsequent years) must use straight-line
and election to expense not allowed
 If asset used > 50% for business, must use MACRS
 Separate section (Part V) on page 2 of Form 4562
2012 Cengage Learning

31. Luxury Auto Limitations
 IRS limits annual depreciation expense that may be
claimed on passenger auto
 Maximum allowed amount is luxury auto limits x
business use %
 Luxury auto limits are quite low
◦ Annual depreciation limit on ‘luxury’ autos placed into
service in 2011 are as follows
 2011 - $3,060 (or $11,060 if taking bonus depreciation*)
 2012 - $4,900
 2013 - $2,950
 2014 and subsequent years - $1,775
*Only allowed if used more than 50%
in business and purchased new during 2011
2012 Cengage Learning

32. Exception to
Luxury Auto Limitations
 Passenger auto includes any 4-wheeled vehicle
manufactured primarily for use on public streets
and weighing less than 6000 lbs.
◦ Some SUVs weigh more than 6000 lbs. and so can be
expensed under §179
◦ Beginning 10/22/04, could ‘only’ expense $25,000 and
then depreciate remainder using five year MACRS
percentages
◦ In 2011, these SUVs qualify for 100% bonus
depreciation
2012 Cengage Learning

33. Luxury Auto Example
Example
On 3/15/11, Jim purchased a new automobile for
$50,000; it is a passenger auto weighing less than
6000 lb. The automobile is used 60% for
business and Jim wants to know how much
depreciation to claim if he elects out of the bonus
depreciation rules. What if he chooses the bonus
depreciation? What if the vehicle weighed more
than 6000 lbs?
2012 Cengage Learning

34. Solution
Example
On 3/15/11, Jim purchased a new automobile for $50,000; it is a passenger auto weighing
less than 6000 lb. The automobile was used 60% for business and Jim wants to know
how much depreciation to claim if he elects out of the bonus depreciation rules. What if
he does take bonus depreciation? What if the car weighs more than 6000 lbs?
Solution
Regular depreciation ($50,000 x 20%) 10,000
Times business use percentage 60% X .60
Possible depreciation 6,000
“Luxury auto” limitation (60% of $3,060) $ 1,836
If Jim elects bonus depreciation, gets
Bonus depreciation 11,060
Times business use percentage 60% .60
Depreciation $ 6,636
A vehicle weighing more than 6000 lbs. could be fully expensed in year of purchase under
§179. Depreciation = $50,000 x 60% = $30,000
2012 Cengage Learning

35. Intangible Assets
 §197intangible assets are acquired by
purchase
◦ Amortized over 15-years beginning in month
acquired, includes assets such as
 Goodwill (value attributable to expected continuation
of customers’ patronage)
 Covenant not to compete
 Franchise or trademark
◦ Many intangible assets are excluded from
§197
 May not amortize self created assets like patents and
copyrights
2012 Cengage Learning

36. Amortization Example
Example
FionaWear Inc. purchased a small textile
company in May 2011 for $980,000. $54,000 of
the purchase price was allocated to goodwill in
the buy-sell agreement. How much goodwill
may FionaWear amortize in 2011?
2012 Cengage Learning

37. Solution
Example
FionaWear Inc. purchased a small textile company in
May 2011 for $980,000. $54,000 of the purchase
price was allocated to goodwill in the buy-sell
agreement. How much goodwill may FionaWear
amortize in 2011?
Solution
$54,000/15 years = $3,600/12 months = $300 per
month
§197 amortization $300 x 8 months = $2,400
2012 Cengage Learning

38. Related Party Transactions §267
 Restricted transaction between related parties include
◦ Recognizing losses on sales between related parties
◦ One accrual basis and one cash basis taxpayer as pertains to
expensing unpaid expenses and interest
 Related parties are:
◦ Family members such as spouses, lineal descendants,
siblings
◦ A corporation and more than 50% owner
◦ Brother/sister corporations
◦ Parent/subsidiary corporations
◦ Complex ‘constructive ownership’ rules
2012 Cengage Learning

39. Related Party Transactions §267
 Losses disallowed between related parties
◦ When property sold later to an unrelated party, all
previously disallowed losses may be taken against gain
 Maynot avoid tax when one taxpayer uses cash
method for expenses and interest and the other
taxpayer uses accrual method
2012 Cengage Learning

40. My head hurts!
The End!
2012 Cengage Learning