ACCT 5400 Chapter 8 – Flashcards
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business gross income
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rules for determining this and related deductions for expenses are mostly the same as for the individual, this includes all income from whatever source derived (examples: gross profit from inventory sales (sales - COGS), income from services provided to customers, and income from renting property to customers) businesses may exclude and defer certain types of income
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business deductions
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taxable income should reflect net increases in wealth from a business, expenses must be (for those carrying or trade or business): ordinary, necessary, in the pursuit of profit (for profit requirement), and in reasonable amount (applied on a case by case basis)
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definition of business
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trade or business activities are made in the pursuit of profit (rather than other, presumably personal motives), must meet "for profit" requirement to deduct normal business expenses if not activity is treated as a hobby (include in gross income and deduct hobby expenses as itemized)
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ordinary expense
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an expense that is normal or appropriate (reasonable expectation) for the business under the circumstances, expense doesn't have to be typical or repetitive in nature to meet this definition
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necessary expense
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an expense that is helpful or conducive to the business activity, but the expenditure need not be essential or indispensable (purchasing a tool you don't think you'd use but could ending up needing on a rare basis counts), if the expense can help generate profits (at any level) this requirement is met
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expenses in reasonable amount
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ordinary and necessary expenses made for profit are only deductible to the extent they are in reasonable amount (not extravagant nor exorbitant), if expense is in an unreasonable amount courts determine the excess over reasonable is considered personal expenditure (not deductible)
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IRS test for extravagant business expense
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(determining this is very subjective) compare the amount of the expense to a market price (non related party/arms length amount), if these are amounts are equal then expense is considered reasonable, extravagance usually occurs when TP enjoy some incidental benefit from the expenditure (entertainment, luxury)
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limitations on business deductions
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congress specifically prohibits or limits a business's ability to deduct certain expenditures that appear to otherwise meet the general business expense deductibility requirements, includes: expenditures against public policy, political contributions/lobbying costs, capital expenditures, personal expenditures, expenses associated with production of tax exempt income, and mixed motive expenditures
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expenditures against public policy
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(even if incurred as part of business activities) businesses are not allowed to deduct fines, penalties, illegal bribes, or illegal kickbacks (only if imposed by governmental unit, can deduct other fines and penalties), congress don't want to subsidize illegal activity and frustrate public policy, illegal business may still deduct COGS and ordinary and necessary business expenses in conducting their activities
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political contributions and lobbying costs
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congress doesn't want to subsidize TP efforts to influence politics so political contributions and lobbying costs aren't deductible even if incurred as a business activity, certain lobbying costs may deducted if they are reasonable lobbying costs incurred in conjunction with the submission of statements to a local council with respect to proposed legislation of direct interest to the TP
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capital expenditures
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(for both cash and accrual method accounting) business must capitalize expenditures for tangible assets such as buildings, machinery and equipment, furniture and fixtures, and similar property that have useful lives of more than one year, businesses then recovery the cost of these assets (other than land) through cost recovery (depreciation), businesses also capitalize the cost to create or acquire intangible assets such as patents, goodwill, start-up costs, and organizational expenditures and then recover these costs with amortization cost recovery or upon disposition, prepaid expenses may be capitalized
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personal expenditures
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these are usually not deducted however when otherwise personal items are specially adapted to business use TP may deduct the cost with limitations (example: cost of uniforms or special clothing they purchase for use in their business can be deducted, if the clothing isn't appropriate to be worn as ordinary clothing outside of business), educational expenditures may be deductible for a business if education: (1) maintains or improves (not qualifies) skills required by the individual in his employment or other trade or business or (2) meets the express requirements of the individuals employer or requirements of applicable law or regulations, imposed as a condition to the retention by the individual of an established employment relationship, status, or rate of compensation
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expenses associated with the production of tax exempt income
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these expenses are not allowed to be deducted (examples: interest expense on a loan whose proceeds were used to purchase a municipal bond, premium expense on a life insurance policy for employees that compensate the business as well as death benefits for family) because benefits and income at aren't taxable shouldn't have expenses incurred in generating said income deducted
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mixed motive expenditures
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business owners may make expenditures that are motivated by both business and personal concerns that are closely monitored and restricted by the IRS, includes: meals and entertainment, travel, transportation, and property use (for these expenses TP must maintain specific, written, contemporaneous records)
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business meals
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TP may only deduct 50% of actual business meals that: (1) are in reasonable amount (expense) under the circumstance, (2) have the TP (or employee) present when the meal is furnished, and (3) are directly associated with the active conduct of the TP business (need records)
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business entertainment
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TP may only deduct 50% of allowable business entertainment as business expense, entertain deductions allowable if: (1) business associated are entertained, (2) the amounts paid are reasonable in amount, and (3) the entertainment is either "directly related" or "associated with" the active conduct of business (need records)
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"business associates" for entertainment deduction
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these are individuals with whom the TP reasonable expects to do business, such as customers, suppliers, employees, or advisors
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entertainment directly related to business
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entertainment in which there is an active discussion aimed at generating revenues or fees or the discussion occurs in a clear business setting (conference room)
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entertainment associated with business
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entertainment that occurs in a setting with little possibility of conducting a business discussion yet directly follows or precedes a substantial business discussion qualifies
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transportation
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includes the direct cost of transporting the TP to and from business sites (not cost of commuting between home and regular business), costs of operating a vehicle (if TP uses one) plus any depreciation on the vehicles tax basis (or standard mileage rate), transportation for vehicle must be for primarily business motives to deduct these costs (majority)
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standard mileage rate for transportation
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(56 cents/mile) TP can deduct actual costs of operating vehicle for business and depreciation or this, which represents the per mile cost of operating an automobile (including depreciation, insurance, registration, repairs, and lease payment/ doesn't include: tolls, car loan interest, or taxes), when using this option calculate standard mileage and then add (pro rata based on miles) items not included in the standard calculation, this option is only available for vehicles not previously depreciated, vehicles previously depreciated using the straight line method, or for leased vehicles where this method has been used throughout the term of the lease
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travel
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these are only deductible if the TP is away from home overnight (=TP has left their primary place of business on a trip of sufficient duration to require sleep or rest) while traveling, TP may deduct: cost of transportation, M+E (50%), lodging, and incidental expenses, when a TP travels solely for business purposes then all of the costs associated with the travel are deductible (different rules when there is a personal aspect but this depends on the fact and circumstances of the travel)
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domestic primary business travel
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transportation costs are fully deductible but all other related travel expenses are limited to those incurred during the business portion of the trip
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domestic primary personal travel
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TP may not deduct any transportation costs related to the travel (can deduct transportation during the trip for business) but may deduct other expenses incurred during the business portion of the trip
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abroad primarily personal travel
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only expenses directly associated with business activities are deductible and TP cannot deduct days spend traveling (the same as domestic travel)
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abroad primarily business travel
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a portion of the round-trip transportation costs is deductible (business days/total trip) and days spend traveling to the site are considered business days for this calculation, other expenses have same rules as domestic travel
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property use
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several types of property may be used for both business and personal purposes (listed property, weird depreciation rules), TP must allocate the expenses between the business and personal use portions because expenses are only deductible to the extent they're used in business, related costs of these assets are deductible based on the proportion that asset was used in business during the year
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specific business deductions
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specific business items may be deducted (even if not ordinary, necessary, in reasonable amount, or for profit), including: domestic production activities deduction (don't need to know how to calculate), losses on disposition of business property (discussed in chapter 10), business casualty losses, start up costs and organizational expenditures, and bad debt expense
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business casualty losses
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businesses may deduct these in the year that it occurs or in the year it is discovered, the amount of the loss deduction depends on whether the asset is: completely destroyed/stolen or only partially destroyed, loss is deducted as a for AGI deduction (casualty losses associated with the production of income (investment) or personal assets is an itemized deduction, see exhibit 8-2)
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casualties
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losses incurred due to assets being stolen, damaged, or completely destroyed by unexpected forces outside the control of the business
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casualty loss for completely destroyed asset
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the business calculates the amount of the loss as though it sold the asset for the insurance proceeds (if any) so the loss = adjusted tax basis of destroyed asset - insurance reimbursements
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casualty loss for partially destroyed asset
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the amount of the loss for the asset = (the lesser of: ((1) assets tax basis or (2) the decline in value due to the casualty)) - (insurance reimbursements),
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start up costs and organizational expenditures
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expenditures to create, establish, or organize new trades or businesses up to 5K may be expensed (proportional phase out beginning at 50K of start up cost and organizational expenditures for the year so if TP has 55K of these costs then no deduction can be taken)
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bad debt expense deduction (explained later)
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deductible only when debt become worthless/uncollectible (this only matters for accrual basis TP)
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accounting periods/tax year
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this affects when TP determine their income and deductions because TP report their activities over a fixed time period (this), period can be a full tax year (12 months, never more) or short tax year, there are three types of this, which a TP chooses with their first return (except 52/53) and must receive permission from IRS to change: calendar year, fiscal year, or 52/53 week year
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short tax year
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an accounting period/tax year with a time period of less than 12 months, these may be used in the year of the businesses creation or disposition, this tax year is treated the same as a full tax year (however special rules apply when this is due to changing owners causing a change in type of tax year so might not be treated as full year), depreciation will be calculated as a full year (with conventions) no matter what
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calendar year
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this tax year starts on 1/1 and ends on 12/31 (always), used by all sole proprietorship's, some flow-through (partnership and S-corp's who have owners who use this type of tax year), and some C-corporations (can choose any three)
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fiscal year
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any 12 month period (unless short tax year) that ends on the last day of any month other than december, used by some flow-through (partnership and S-corp's who have owners who use this type of tax year) and and some C-corporations (can choose any 3)
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52/53 week year
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any 12 month period (unless short tax year) that ends on the same day of the week every year based on month (last friday of july or friday closest to the end of july), used by some flow-through (partnership and S-corp's who have owners who use this type of tax year) and and some C-corporations (can choose any 3), TP chooses this tax year with a special election with the IRS
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accounting methods
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once a business adopts a tax year, it must determine this affects which items of income and deductions to recognize during a particular tax year, this affects the timing of when a TP reports income and deductions within a specific time period, TP should choose method that clearly reflects economic income and method should be applied consistently (reporting and tax), the two primary methods are: cash and accrual method (or hybrid of both)
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financial (reporting) vs tax accounting methods
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reporting (for certain businesses): make financial statements that want to accelerate income, defer deductions (expenses) so they look more profitable (under GAAP) vs tax: for returns defer income and accelerate deductions to maximize tax benefit, generally businesses must use the same accounting methods for tax and reporting purposes and choose a method that will clearly reflect economic income, however sometimes the tax law requires businesses to use different (more appropriate) methods for tax purposes
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cash method of accounting
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(all individuals use this) TP or business using this method recognizes revenue when property or services are actually or constructively received (doesn't matter when the good or service are sold) and recognize noncash payments, recognize deductions when expenses are paid or disbursed (timing of liability relating to expense is irrelevant)
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exception to cash method expense deduction
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a business expending cash on ordinary and necessary business expenses may not be allowed to currently deduct the expense at the time of the payment, cash method TP (and accrual) are never allowed to deduct prepaid interest expense and cannot usually deduct prepaid expenses or payments that create a (in)tangible asset, however tax law provides for 12 month rule for prepaid expenses creating (in)tangible assets
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12 month rule
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this applies to both cash and accrual TP except more limitations with accrual TP (helps determine if TP should capitalize or immediately expense prepaid expenditures that create benefits for regularly short periods of time, such as: insurance, security, rent, and warranty service contracts) TP can immediately deduct prepaid expenses (not capitalize them) if: (1) the contract period doesn't last more than a year and (2) the contract period doesn't extend beyond the end of the taxable year following the tax year in which the TP makes the payment, if the expense doesn't meet the aforementioned criteria: capitalize prepaid expense and amortize it over the life of the expressed contract (for both cash and accrual)
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accrual method of accounting
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businesses using this to determine taxable income when said income satisfies the all-events test, limitations exists for unearned income, UNICAP rules affect inventory sale, expense deductions must meet the all events and economic performance tests, certain rules affect bad debt expense and related parties
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accrual method vs GAAP
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TP using the accrual method follow similar rules to GAAP with two basic differences: (1) requirements for recognizing taxable income tend to be structured to recognize income earlier than recognition rules for reporting and (2) requirements for accruing tax deductions tend to be structured to recognize less accrued expenses than the recognition rules for reporting purposes
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objective of financial reporting
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provide useful information to stakeholders (creditors, potential investors, and shareholders), system designed to guard against businesses overstating profitability (bias against overstating income) so push businesses to recognize income later and expenses sooner, which is a conservative outlook to best reflect economic income
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objective of tax accounting
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goal is to collect revenues thus tax law for accrual method TP tend to be bias against understating income (income sooner, expenses later), which is a liberal outlook
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all events test for accrual income
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requires that businesses recognize income when: (1) all events have occurred that determine or fix the businesses right to receive the income (most important) and (2) the amount of the income can be determined with reasonable accuracy, if these conditions are met businesses this test (recognize the revenues) on the earliest of: (1) when they complete the task required to earn the income (as services are provided or title passes for sold property to buyer), which reflects GAAPs outlook, (2) when the payment for the task is due from the customer, or (3) when the business receives payment for the task (wherewithal to pay)
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taxation of advance payments of income (unearned revenue) for accrual method
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businesses may receive income payments before they actually earn income (prepayment), when the business recognizes this income depends on the type of income: unearned rents and interest, unearned service revenue, advance payment for goods
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unearned rent and interest revenue for accrual method
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rule for this income is relatively strict, businesses must recognize this income immediately upon receipt (income is recognized before it is earned) businesses are not required to recognize security deposits received from rental customers because they incur a liability to return the deposits when they receive the payments
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unearned service revenue for accrual method
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for tax: all events test generally requires businesses receiving advance payments for services to recognize the income when they receive the payment (rather than when service is performed), for financial: business doesn't immediately recognize income on payments it receives for services to be provided in the future (then recognizes as service is performed)
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exception for unearned service revenue
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businesses receiving advance payments for services may defer recognizing the prepayment as income until the tax year following the year they receive the payment (1 year deferral), this one year deferral doesn't apply if: (1) (or the extent to which) the income is actually earned by the end of the year of receipt, (2) the prepayment was included in financial reporting income, or (3) the prepayment was for interest or rent
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unearned revenue on goods sold for accrual method
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when an accrual business receives an advance payment for goods it will provide to customers in the future, the business may account for the prepayment (taxwise) under the: full inclusion method or deferral method (deferral doesn't apply to goods held for sale in the ordinary course of business/inventory)
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the full inclusion method
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business will immediately recognize an advance payment for goods as income
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the deferral method
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(like unearned service revenue) business will recognize advance payments for goods by the earlier of: (1) when the business would recognize the income for tax purposes if it had not received the advance payment or (2) when it recognizes the income for financial reporting purposes (so can defer for as long as deferred on financial statements->more than a year)
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inventories for accrual
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many businesses generate income by selling products they acquire for resale or products they manufacture, when selling this is a material income-producing factor, a business generally must account for gross profit (sales - COGS) using the accrual method (even if they are cash method TP) with exceptions, businesses must determine their inventory costs to accurately compute taxable income: compute raw materials, work in process, and ending inventory, purchase price of raw materials (minus discounts, returns, allowances), any indirect costs to the inventory under UNICAP rules, and inventory cost methods
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exception to inventory rules
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a cash method business is allowed to use the cash method to account for gross profit of inventory sales if: the average annual gross receipts for the three year period prior to the current year do not exceed 10 million, the primary business activity is to provide services to customers and the sale of products is secondary or small part of their services, a business is not allowed to deduct the cost of the inventory to the extent it has the product at the end of the year (this allows businesses to defer revenue until they receive it in payments)
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uniform cost capitalization (UNICAP) rules
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(applies to manufacturers and large retailers, not resellers of personal property that report average annual gross receipts of 10 million or less over the three year period ending with the taxable year prior to the current year) law requires businesses to capitalize certain direct and indirect costs associated with inventories (because: (1) accelerate tax revenues for the government by deferring deductions for the capitalized costs until the business sells the associated inventory so one year lag between capitalization and deduction and (2) to reduce variation in the costs businesses include in inventory), businesses will capitalize more costs to inventory under tax than reporting (reporting: costs within production facility), these rules require businesses to allocate (capitalize the portion allocated) to inventory the costs they incur inside the production facility and the costs they incur outside the production facility to support production (or inventory acquisition) activities that would be deducted as period costs for reporting purposes (except: selling, advertising, and research costs aren't required to be capitalized at all)
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inventory cost-flow methods
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once a business determines the cost of its inventory, it must use this to determine its cost of goods sold, three primary methods: specific identification, FIFO, and LIFO, FIFO and LIFO should be used when businesses sell similar, relatively low-cost, high-volume products (simplify inventory accounting because the business need not track the individual cost of each item it sells, businesses that sell distinct, relatively high cost, low volume products should use specific identification, when costs are increasing a business using FIFO will report higher profits than LIFO, tax law requires business can use LIFO for tax purposes only if it also uses LIFO for reporting purposes
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accrual deductions
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generally when a business incurs a liability relating to a business expense or pays for a business expense they must meet: (1) an all events test and (2) an economic performance test with respect to the liability/expense
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all events test for accrual deductions
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(similar for recognizing income) for a business to recognize a deduction, all events that establish its liability giving rise to the deduction must have occurred and the business must be able to determine the amount of the liability with reasonable accuracy
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economic performance test for accrual deductions
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(in place because some TP claimed current deductions and delayed paying the expense for years) business must clear this in addition to the all events test to recognize business deductions, requirement specifies businesses may not recognize a deduction for an expense until the underlying activity generating the associated liability has occurred, this test is deemed to have been satisfied if the expense meets the recurring item exception, this test differs based on whether the liability arose from: receiving goods or services from another party, use of property, providing goods or services to another party, and certain activities creating payment liabilities
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receipt of goods and/or services from another party
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when a business agrees to pay another party for goods or services the other party will provide, the business deducts the expense associated with the liability as the other party provides the goods or services (assuming all events test is also met), exception: when a business hires another party to provide goods/services and the business actually pays the liability before the other party provides the goods or services, actual payment may be deducted (pass economic performance test) as long as the business reasonable expects the other party to provide the goods or all of the services within 3.5 months after the payment
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renting/leasing (use) of property from another party
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when a business enters into an agreement to rent/lease property from another party, economic performance occurs over the rental period, business can deduct the rental expense over the expressed period of the lease
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providing goods/services to another party
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businesses liable for providing goods/services to other parties meet the economic performance test as they satisfy the liability or as business incurs costs in providing said goods/services (example: wages and salary)
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payment liabilities
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certain activities create this, economic performance occurs for certain liabilities only when the business actually pays the liability, thus accrual method businesses incurring these are essentially on the cash method for deducting the associated expenses, accrual method TP that prepay business expenses for these (examples: insurance contracts, warranties, and product service contracts provided to the TP) are allowed to immediately deduct the prepayments subject to the 12-month rule for prepaid expenses
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recurring item exception
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one of the most common exceptions to economic performance is this exception which is designed to minimize the cost of applying economic performance to relatively small expenses that occur on a regular basis, accrual method TP can deduct certain accrued expenses even if economic performance has not occurred by year end, a recurring item is a liability that is expected to persist in future years, and is either not material in amount or deducting the expense currently matches with revenue, the all events test still needs to be satisfied at year end and actual economic performance must occur within: a reasonable time or 8.5 months of year end, this exception doesn't apply to workers compensation or tort liabilities
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bad debt expense
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when accrual businesses sell a product/service on credit sometimes they don't collect all the revenues and incur this which is when a customer owes a business a debt that the customer will not pay, business determine which debts are uncollectible and write them off (direct write off method) for tax purposes instead of the allowance method which can be used for reporting purposes, a cash method TP just would never record the income because it was never received, so TP deducts this in the year actually written off when debt is worthless
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limitations on accruals to related parties (accrual)
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to prevent businesses and related parties from working together to defer taxes, business isn't allowed to accrue or deduct any and all expenses for a liability owed to a related party using the cash method until the related party (cash basis) recognizes the income associated with the payment
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related parties
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include: family members (parents, siblings, spouses), shareholders and C corporations when the shareholder owns more than 50% of the corporations stock, and owners of partnerships and S corporations no matter the ownership percentage
