Вы находитесь на странице: 1из 48

Chapter 8

Business Income, Deductions,


and Accounting Methods

2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This
document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Learning Objectives
1)

Describe the general requirements for deducting business


expenses and identify common business deductions.

2)

Apply the limitations on business deductions to distinguish


between deductible and nondeductible business expenses.
Travel and Transportation

3)

Identify and explain special business deductions specifically


permitted under the tax laws.

4)

Explain the concept of an accounting period and describe


accounting periods available to businesses.

5)

Identify and describe accounting methods available to businesses


and apply cash and accrual methods to determine business
income and expense deductions.
8-2

Business Income

Report business income on Schedule C

Sole proprietorship: for self-employed taxpayers,


business income is personal income
Other entities: only business income. Business
owners separately file personal tax return.

Partnership: form 1065


S Corp: form 1120s
C Corp: form 1120

8-3

Business Income
Gross income includes all income from
whatever source derived. (IRC Section 61)
Tax laws specifically include gross income from
business in this definition.
Source of income:

Inventory sales
Services
Renting or leasing

8-4

Business Deductions

General purpose: deduct expense incurred to


generate business income

Expense incurred to meet personal objectives (Hobby


Expense) may not be deductible.

Business expenditure must be both ordinary and


necessary

Ordinary-does not need to be repetitive in nature. E.g.,


lawsuits
Necessary-helpful or conducive to business. E.g.,
catastrophe insurance

8-5

Business Deductions

Ordinary and necessary business expense is


deductible only to the extent that they are
reasonable in amount.

Not extravagant
Compare the amount of expense to a market price or
an arms length amount.

Most likely an issue in related party transactions.

E.g., over charge business services and goods


8-6

Limitations on business expense


deductions
Expenses against public policy
Capital expenditures
Expenses related to tax-exempt income
Personal expenses
Mixed-motive expenditures

Meals and Entertainment


Travel and Transportation

8-7

Limitations on business expense


deductions

Expenses against public policy

No deduction for fines, bribes, lobby expenditures, or


political contributions

Capital expenditures

Tangible assets are capitalized and costs are recovered


through depreciation.
Intangible assets are capitalized and recovered through
either amortization or upon disposition of assets.

8-8

Limitations on business expense


deductions

Expenses related to tax-exempt income

Interest on loan where proceeds invested in municipal bonds.


Key man insurance premiums no deduction if business is
beneficiary of life insurance.

Personal expenses

Not deductible for personal purposes


Education expense is deductible if the education 1) improves skills
in an existing trade of business or 2) meets employers
requirement

8-9

Limitations on business expense


deductions

Mixed-motive expenditures

Motivated by both business and personal concerns.


Generally, expenses are deductible to the extent of
business use.
The key is how to determine the business portion of
expenditures

8-10

Meals and Entertainment

Taxpayers may only deduct 50 percent of actual business


meals.

The amount must be reasonable under the circumstances.


The taxpayer must be present when the meal is furnished.
The meal must be directly associated with the active conduct of the
taxpayers business.

Taxpayers may only deduct 50 percent of allowable business


entertainment.

Business associates (customers, suppliers ,employees and advisors)


must be entertained.
The amounts paid must be reasonable.
The entertainment must be either directly related or associated with the
active conduct of business.
8-11

Travel and Transportation

Transportation expenses include the direct cost


of transporting the taxpayer to and from
business sites.

Does not include the commute between home


and regular workplace.
Actual cost or standard mileage rate (56.5 cents
per mile for 2013).

8-12

Travel and Transportation

Travel expenses are only deductible if the taxpayer is


away from home overnight while traveling.

Deductible amount: transportation, meals (50 percent), lodging,


and incidental expenses.
If travel is solely for business purposes fully deductible.
If business is primary purpose of trip transportation expense is
fully deductible, but meals, lodging and incidentals are only
deductible for the business portion of the trip.

# of days for business > # of days for personal

If primary purpose is personal transportation expense is not


deductible, but meals, lodging and incidentals are deductible for
the business portion of the trip.

# of days for business < # of days for personal


8-13

Travel and Transportation

Foreign travel that includes both business and


personal activities is treated differently.

If travel is primarily personal transportation is


not deductible, and only expenses directly
associated with business activities are deductible.
If travel is primarily business a portion of the
transportation is deductible (business days/total
days), and expenses directly associated with
business activities are deductible.

8-14

Travel and Transportation


Example 8-8
Rick paid a $300 registration fee for a three-day course in landscape
design. The course was held in New York (Rick paid $700 for airfare
to attend). During the trip, Rick paid $150 a night for three nights'
lodging, $50 a day for meals, and $70 a day for a rental car.
1) If he spent four days in New York. He spent the last day
sightseeing What amount of these travel-related expenditures may
Rick deduct as business expenses?
2) If he stayed in New York for ten days, spending three days at the
seminar and seven days sightseeing. What amount could he deduct?
3) If Rick traveled to London for ten days spending six days at the
seminar and four days sightseeing. What amount could he deduct?

8-15

Specific business deductions

Start up costs
Bad debt expense
Domestic Production Activities Deduction (DPAD)

Losses on dispositions of business property

Business casualty losses

8-16

Specific business deductions

Start-up and organizational expenditures

Expense up to $5,000 and capitalize/amortize the rest. (Chapter


9)

Bad debts

Accrual taxpayers can only use direct write-off method.

8-17

Domestic production activities


deduction (DPAD)

An artificial deduction that subsidizes domestic


manufacturing.

Domestic production of tangible products qualifies for subsidy


but income must be allocated between qualifying and
nonqualifying activities.
Subsidy is 9 percent of the lesser of (1) the businesss taxable
income before the deduction (or modified AGI for individuals) or
(2) qualified production activities income (QPAI). The final
deduction is limited to 50% of employee wages allocated to
qualified activities.

Formula:

QPAI = domestic production gross receipts less expenses


attributed to domestic production.

8-18

DPAD example
Brian recorded $100,000 of receipts from a
qualified domestic production activity.
Brian allocated $55,000 of expenses to the
qualified domestic production activity including
$12,000 of wages.
Brian had modified AGI of $47,000 (or the
business has taxable income before the
deduction of $47,000 )
What is Brians domestic production activities
deduction?

8-19

Specific business deductions

Losses on disposition of business assets

Recognized losses are deductible (Chapter 10)

Business casualty losses

Deduct casualty losses in the year the casualty occurs or in the


year the theft of an asset is discovered.

If a business asset is completely destroyed or stolen, the loss is


the amount of insurance proceeds (if any) minus the adjusted
tax basis of the asset.

If a business asset is damaged but not completely destroyed,


the loss is the amount of insurance proceeds minus the lesser of
the (1) the assets tax basis or (2) the decline in the value of the
asset due to the casualty.
8-20

Business casualty losses


Exhibit 8-2

8-21

Business casualty losses


Example 8-12
Suppose Rick acquired a personal-use asset several years
ago for $9,000. Suppose further that a casualty event
destroyed (completely) the asset, and at that time the asset
was worth $1,000 and insured for $250. What is the
amount of Rick's casualty loss (before applying the per
casualty floor and the AGI restriction)?
Suppose instead that Rick's asset was a business-use
asset and Rick had deducted $4,000 of depreciation
expense against the asset. Hence, the asset's tax basis
was $5,000 ($9,000 $4,000). What would be the amount
of his business casualty loss?

8-22

Accounting periods

Businesses must report their income and deductions


over a fixed accounting period or tax year.
Annual period

Full tax year is 12 months long.

Short tax year is < 12 months. (First year of existence, last year
of existence or change in tax year.)

Year ends

A calendar year ends on December 31.


A fiscal year ends on the last day of a month other than
December.
A 52/53 week year ends on the same day of the week every
year.
8-23

Choosing an accounting period

Proprietorships same as proprietor.

Flow-through entities generally must adopt tax


years consistent with the owners tax year.

C corporations generally allowed to select a


calendar, fiscal or 52/53 week year-end.

8-24

Overall accounting methods

There are two overall accounting methods in GAAP and


tax:

Accounting methods affect the timing of when a taxpayer


reports income and deductions.

Cash method
Accrual method

Generally, the law requires taxpayers to use the same


accounting methods for GAAP and tax

Cash and accrual methods in tax can be used differently


from these methods in GAAP

Tax law difference


8-25

Cash method in tax

Cash method is based on cash receipts and


payments.
Recognize income immediately when cash or
noncash (property or services) is received.
Recognize expense immediately when cash is paid

But prepayment for interests and future tangible or


intangible assets is not immediately deductible

Exception: The prepayment for contracts such as


insurance, security rent and warranty service contracts that
meet 12-month rule is immediately deductible.

8-26

The 12-month rule


When a business prepays business expenses, it may
immediately deduct the prepayment if
(1) the contract period does not last more than a year and
(2) the contract period does not extend beyond the end of
the taxable year following the tax year in which the
taxpayer makes the payment

8-27

Cash prepayment
Example 8-14
1) On July 1 of this year, Rick (calendar year end) paid $1,200 for a 12month insurance policy that covers his business property from accidents
and casualties from July 1 of this year, through June 30 of next year.
How much of the $1,200 expenditure may Rick deduct this year if he
uses the cash method of accounting for his business activities?
2) Suppose the insurance policy was for 12 months but the policy ran
from February 1 of next year, through January 31 of the following year.
How much of the expenditure may Rick deduct this year if he uses the
cash method of accounting for his business activities?
3) Suppose Rick had paid $1,200 for an 18-month policy beginning July
1 of this year, and ending December 31 of next year. How much may he
deduct this year if he uses the cash method of accounting for his
business activities?

Accrual income

When do accrual businesses recognize income?

All-events test (1) Recognize income when all the events have
occurred which fix the right to receive such income and (2) the
amount can be determined with reasonable accuracy.

Assuming amount of income can be determined, allevents test is met at the earliest of these dates:

Complete the task to earn income

Payment is due

Payment is received

8-29

Accrual income

Unearned revenue
Rental and interest income
Services provided
Goods sold
Inventories
Uniform capitalization
Cost flow assumptions

8-30

Accrual Unearned income

Unearned rental and interest income

Unearned service revenue

Recognize income immediately upon receipt


May defer recognition for one year unless (1) the income is
actually earned by the end of the year of receipt, or (2) if the
prepayment was included in financial reporting income.

Unearned goods revenue

Full inclusion method recognize income upon receipt

Deferral method generally recognize income when goods are


delivered

8-31

Accrual Unearned income


Example 8-16
In late November 2014, Rick received a $7,200
payment from a client for monthly landscaping
services from December 1, 2014, through
November 30, 2016 ($300 a month for 24
months). Assume Rick does not include the
income in financial statements until 2016, when
must Rick recognize the income from the
advance payment for services (under both cash
and accrual method)?
8-32

Inventories

Uniform cost capitalization rules (UINCAP)

The tax laws require business to capitalize certain


direct and indirect costs associated with inventories.
Inventory costs include the purchase price of raw
materials (minus any discounts), shipping costs, and
any indirect costs it allocates to the inventory
Mostly applicable to large size manufactures and
resalers (sales more than 10 million)

8-33

Inventory cost
Tax

GAAP

Capitalized inventory
cost

costs they incurred inside


the production facility and
the costs incurred outside
the facility to support
production (E.g.,
compensation and SG&A in
purchasing department)

costs incurred within the


production facility

Cost flow
assumptions

FIFO, LIFO and specific


identification

FIFO, LIFO and specific


identification

8-34

Inventory cost
Example 8-18

8-35

Accrual deductions
1. All-events test

All events have occurred to establish the liability


to pay.
The amount is determinable with reasonable
accuracy.

Reserves for future liabilities not allowed.

2. Economic performance has occurred.

8-36

Accrual deductions

Accrual income

All-events test

Accrual deductions

All-events test AND


Economic performance test
May not recognize a deduction for tax until the underlying
activity generating the associated liability has occurred.
This requirement is similar to the first requirement of allevents test

Likely delay the deduction of prepayment

8-37

Accrual deductions
Receiving

goods or services from another

party.
Renting or leasing property from another
party
Payment liabilities
Bad debt expense

Accrual deductions

Receiving goods or services from another party

Generally, the business deducts the expense


associated with the liability as the other party
provides the goods or services.

Exception: when the business pays the liability before


the other party provides the goods or services, the
cash payment is deductible if 1) the amount is
reasonably expected; 2) the goods and services will
be provided within three and one-half months after
payment (ending date).

Accrual deductions
Example 8-20
1) On December 15, 2014, Rick hires Your New Fence LLC (YNF), to
install a concrete wall for one of his clients by paying $1,000 of the cost
as a down payment and agreeing to pay the remaining $7,000 when
YNF finishes the wall. YNF was not going to start building the wall until
early 2015, so as of the end of the year Rick has not billed his client for
the wall. Rick expects YNF to finish the wall by the end of April. What
amount associated with his liability to YNF is Rick allowed to deduct in
2014 and 2015 under the accrual method and cash method?
2) Assume that Rick expected YNF to finish building the wall by the end
of January 2015. What amount associated with this liability to YNF is
Rick allowed to deduct in 2014 and 2015?

Accrual deductions
Renting

or leasing property from another

party

Generally, the business deducts the leasing or


rental expense over the leasing or renting period
(pro-rated)
Note that under cash method, payment for leasing
and renting contracts is deductible if it meets the
12-month rule.

Accrual deductions
Example 8-21
1) On May 1, 2014, Rick paid $7,200 in advance to rent his
shop for 12 months ($600 per month). What amount may
Rick deduct for rent in 2014 if he accounts for his business
activities using the accrual method?
2) Assuming the original facts, what amount of the $7,200
rental payment may Rick deduct in 2014 if he is using the
cash method of accounting for his business?

Accrual deductions
Payment

liabilities

Payment for certain liabilities is deductible when


the business actually pays the liability.
Examples of payment liabilities:

Workers compensation
Taxes

Accrual deductions

Bad debt expense

For GAAP, use allowance method. The business


estimates bad debt expense by analyzing accounts
receivable account.
For tax, use direct write-off method. The business
deducts bad debt expense when accounts become
uncollectible.

Limitations on accruals to related parties

The business is not allowed to deduct compensation


expense owed to a related party until the year in which
the related party includes the compensation in income

Bad debt expense example


At the beginning of the year Bill Hotdog had an
allowance for doubtful accounts with a balance
of $10,000. At the end of the year, Bill recorded
bad debt expense of $20,000 and the balance
of doubtful accounts had increased to $15,000.
What is Bill's deduction for bad debt expense
this year?

Compare accrual and cash


methods
For

GAAP, cash method is not allowed


For tax

Cash method is commonly used by sole


proprietors
Tax laws require large C corps and partnerships
to use accrual method (sales more than 5 million)

Generally,

businesses need to use the same


method for GAAP and tax

Choosing or changing an
accounting method

Accounting methods are generally adopted by use.

A permissible method is adopted by using and reporting


the method for one year.

An impermissible method is adopted by using and


reporting the method for two years.

Generally method changes require IRS permission.

Some changes are automatic.

Permission is necessary to correct the use of an


impermissible method.

8-47

Practice questions
49

(no part d), 50, 57, 60, 61 (no part c and


d), 62 (no part d), 68 (no part d)