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Chapter 8

Business Income, Deductions, and Accounting Methods

Learning Objectives1) 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.

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.

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Business income and deductions

Schedule C – Trade or business income Includes revenue from services and sales activities. Gross profit from sales - cost of goods is a return of

capital. Business income does not include excluded and deferred

income. Deductions must be directly connected to business

activity. Ordinary and necessary means conducive to profit

generation. Reasonable in amount means not extravagant.

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Reasonableness example

Rick owns a business that employs his brother, Ben. Ben is paid $45,000 per year by Rick’s business. In comparison, other employees with Ben’s responsibilities are only paid $30,000 per year.

What is Rick’s business deduction for employing Ben?

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Reasonableness solution

A reasonable amount for compensating Ben is $30,000 rather than $45,000.

Hence, Rick can only deduct $30,000.

The extra $15,000 ($45,000 paid minus $30,000 deduction) is a gift from Rick to Ben.

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Statutory limits on business expense deductions

1. Expenses against public policy No deduction for fines, bribes, lobby

expenditures, or political contributions

2. Expenses relating 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.

3. Capital expenditures4. Personal expenses

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Capital expenditures

Does the expenditure provide future benefit (beyond this year)? If so, capitalize rather than deduct.

12-month rule for prepaid expenses: Deduct if benefit < 12 months and

Benefits do not extend beyond end of next tax year.

Does not apply to interest.

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12-month rule example

Ben, a cash basis taxpayer, makes the following payments on June 30 of this year: $10,000 for the next 10 months of utilities. $12,000 for insurance over the next 24 months. $9,600 for the next 8 months of interest on a

business loan.

What amounts are deductible this year?

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12-month rule solution

Ben can deduct all $10,000 for the utilities because:

the benefit is not more than 12 months and

the benefit ends prior to the end of next year.

Ben can deduct $3,000 for insurance because:

the payment is more than 12 months. Hence, Ben can only deduct 6 months ($500 per month).

Ben can deduct $7,200 for interest because:

the 12-month rule does not apply to interest.

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Special business deductions

Start-up and organizational expenditures Expense up to $5,000 and capitalize/amortize the rest.

Bad debts Accrual taxpayers can only use direct write-off method.

Losses on disposition of business assets Recognized losses are deductible

Casualty losses are limited to lesser of decline in value (repair cost) or basis.

Basis is amount of loss if business asset is completely destroyed.

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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 percentage (9 percent) of the lesser of qualified production activities income (QPAI) or modified AGI.

Formula: QPAI = domestic production gross receipts less expenses

attributed to domestic production. Deduction is ultimately limited to 50% of wages allocated

to qualified activities.

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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.

What is Brian’s domestic production activities deduction?

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DPAD solution Calculate QPAI:

QDGR (receipts) $100,000expenses - 55,000QPAI (qualifying income) $ 45,000

QPAI cannot exceed modified AGI:Modified AGI is $47,000 so no limit

Calculate DPADQPAI $ 45,0002010 percent x 9%DPAD $ 4,050

Limit DPAD to 50% of wages50% of wages is $6,000 DPAD =$4,050

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Business expenses with personal benefits

No deduction for purely personal expenditures unless otherwise allowable – e.g. charity, medical, etc.

Mixed motive? Primary motive for some expenditures (all or nothing).

Business travel (away from home overnight). Otherwise, allocate deduction to business portion.

Arbitrary percentage (50% meals and entertainment).Basis for allocation (mileage or time).

Recordkeeping Document business purpose.

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Travel example

Ben paid the following to attend a business meeting in Chicago:

Airfare (first class) - $ 1,200Hotel (three nights) - $ 750Meals (three days) - $ 270

1. What amounts are deductible if Ben spent two days in meetings (primarily business)?

2. What amounts are deductible if Ben spent one day in a meeting (primarily personal)?

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Travel solution

Ben can deduct the following amounts:

2 days 1 daybusiness

personalAir fare (all or none) $ 1,200 $ 0

Hotel ($250 per day) 500 250

Meals ($90 per day x 50%) 90 45

Total Travel Deduction $ 1,790 $ 295

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Accounting for taxable income

We’ve learned to identify: Business gross income and

Deductible expenses

Now we need to match income and deductions to a specific period. Accounting methods match income and expense

to a specific period.

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Accounting periods

Annual period Full tax year is 12 months long. Short tax year is < 12 months.

Year ends Calendar year ends 12/31. Fiscal year end depends upon choice:

Last day of a month (not December).52/53 week year end is the same day of a specific

month.

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Choosing an accounting period

Proprietorships – same as proprietor.

“C” corporations and individuals – choice made on first tax return and is consistent with book accounting period.

Flow-thru entities – a “required” tax year. Match to owners’ period (multiple owners for

partnerships so this can be complicated).

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Accounting methods

Comparison of financial and tax methods Financial accounting is “conservative”

GAAP is slow to recognize income, but quick to recognize losses or expenses.

Objective is to avoid misleading investors & creditors.

Tax accounting is much less conservative.Quick to recognize income but likely to defer

deductions. Objective of Congress is to maximize tax revenues.

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Accounting methods

Permissible “overall” methods: Cash – recognize income when received.

Accrual – recognize income when earned or received (whichever is first generally).

Hybrid – mix of accrual and cash depending upon accounts (e.g. sales on accrual).

Methods are adopted with first tax return.

Large corporations must use accrual.

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Cash method

Income recognized when actually or constructively received.

Expenses recognized when paid. Pros and cons:

Flexible. Simple and relatively inexpensive. Not GAAP – poor matching of income and expense. Not available for some business organizations (large C

corporations typically).

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Accrual income

Income is recognized when earned or received. All-events test – recognize income when all the events

have occurred which fix the right to receive such income and

the amount can be determined with reasonable accuracy

Earliest of these dates: Complete service or sale

Payment is due

Payment is received

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Accrual questionBen provides consulting services and bills Ace for $12,000. Ace disputes the amount claiming that $8,000 is the proper amount.

How much income should Ben recognize under the accrual method this year?

$ ________

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Accrual – prepaid income

Advance payments for services: Allowed to defer recognition for one year unless income is

earned or recognized for financial records.

Not applicable to payments relating to rent or interest income.

Advance payments for goods: Elect one of two methods of recognition.

Full inclusion method – recognize prepayments as income.

Deferral method – include in period earned for tax or financial purposes.

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Advance payment example

Ben provides dancing lessons. On September 30th of this year he received $2,400 full payment for a 2-year service contract.

What amount of income must Ben recognize:

(1) if he is on the cash method?

(2) if he is on the accrual method?

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Advance payment solution

1. If Ben uses the cash method, he must recognize income as received - $2,400 this year.

2. If Ben uses the accrual method, then he can elect to defer advances for services for a year.

This year Ben would recognize $300 - the income earned from September 30 (3/24 x $2,400).

Next year Ben would recognize the remaining $2,100 - income can only be deferred one year.

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Inventories

Inventories must be accounted for under the accrual method if sales of goods constitute a “material” income producing factor. Purchases accrued with accounts payable. Sales accrued with accounts receivable.

Cash method taxpayers may use cash method for other (non-inventory) accounts. Technique is called the “hybrid” method.

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UNICAP

Inventory (purchased or produced) must be accounted for using tax version of “full absorption” rules.

Indirect costs are allocated to inventories (not expensed).

Costs of selling, advertising, and research need not be capitalized.

Exception for “small” businesses (average annual gross receipts < $10 million).

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Inventory flow assumptions

First-in, First-out (FIFO)

Last-in, Last-out (LIFO) Same method for financial and tax records “Book-tax conformity” requirement Generates lowest taxable income in time of

inflation.

Specific identification

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Accruing business expenses

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.

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Economic performance

Applies to accrual method taxpayers only Taxpayer provides goods or services:

Performance occurs as taxpayer provides goods or services.

Taxpayer using property or goods: Performance occurs as goods are provided or economic performance is otherwise expected within 3 ½

months of payment.

Payment liabilities are performed only when paid.

Interest and rent occurs ratably.8-32

Economic performance example

Ben has signed a binding contract for Peter to provide Ben with repair services. Ben paid $1,500 to Peter and owes an additional $6,000 on the contract. The repairs will commence late next year.

When can Ben claim the deduction if he uses the accrual method?

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Economic Performance solution

Although the all events test is satisfied, Ben can only deduct $7,500 next year because that is when economic performance occurs (taxpayer liable for performing service).

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Liability and economic

performance(IRC §461)

Capitalize(IRC §263(a)

or §471)

Deduct(IRC §162)12-month rule

DisallowMeals & Entertainment

Spousal TravelClub DuesLobbying

Etc.

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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.

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Chapter Summary

LO1: we learned how to identify common business deductions.

LO2: we applied various statutory limitations to determine deductible amounts.

LO3: we reviewed the special deductions specifically allowed for businesses.

LO4: we reviewed the accounting periods available for calculating business income.

LO5: we summarized and compared the accrual and cash methods of accounting for income and deductions.

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