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Chapter 7Chapter 7Accounting Periods and Accounting Periods and
Methods Methods and Depreciationand Depreciation
Income Tax Fundamentals 2011
Gerald E. Whittenburg &Martha Altus-Buller
2011 Cengage Learning
Learning ObjectivesLearning ObjectivesDetermine different accounting
periods and methods for tax periodsCalculate depreciation using MACRS
tables Identify when §179 election to
expense may be appliedApply listed property and luxury
automobile limitationsUnderstand tax treatment of
intangiblesDetermine whether parties are
considered related and how to treat related party transactions
2011 Cengage Learning
Accounting PeriodsAccounting Periods
Rarely, a taxpayer’s tax year will differ from the calendar year
However, in partnership 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 2011 Cengage Learning
Accounting PeriodsAccounting Periods
Partnerships/S-Corporations may elect to adopt a different fiscal tax year from the one prescribed on previous slide, but only
° If entity can demonstrate that natural business cycle easily conforms to fiscal year other than calendar year
Such as golf course (natural cycle in Denver ends in October)
Note: S-Corporations don’t pay tax as an entity
2011 Cengage Learning
Required Tax PaymentRequired 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
2011 Cengage Learning
Required Tax Payment ExampleRequired Tax Payment Example
Example
San Juan River Expeditions Inc., an S-Corp, has taxable income of $360,000 for the year ended 9/30/10 with a three-month deferral period. The company made a $15,000 payment last year. What’s their current required tax payment?
2011 Cengage Learning
SolutionSolutionExampleSan Juan River Expeditions Inc., an S-Corp, has taxable
income of $360,000 for the year ended 9/30/10 with a three-month deferral period. The company made a $15,000 payment last year. What’s their current required tax payment?
SolutionThe 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
2011 Cengage Learning
Tax Year for Tax Year for Personal Service CorporationPersonal 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 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
2011 Cengage Learning
See next slide
PSC Limit on PSC Limit on Salaries DeductionSalaries 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
2011 Cengage Learning
Short Period Taxable Income Short Period Taxable Income (TI)(TI)
If taxpayer has a short year (other than first or last year of operation), tax is calculated based on following example:
° In 2010, Flo-Mex changes from a calendar year to tax year ending 9/30. For the short period 1/1/10 – 9/30/10, Flo-Mex’ 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
2011 Cengage Learning
must use same method for tax & books
Accounting MethodsAccounting Methods There are three acceptable accounting
methods for reporting taxable income
◦ Cash
◦ Hybrid
◦ 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
2011 Cengage Learning
Accounting MethodsAccounting 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 trusts with unrelated business
income Doesn’t apply to certain organizations
2011 Cengage Learning
Accounting Methods Accounting Methods (continued)(continued)
Accrual method◦Recognize income when earned and can
be reasonably estimated◦Recognize deductions when incurred and
can be reasonably estimatedHybrid method
◦An example of a hybrid taxpayer is one that utilizes cash method for receipts and disbursements, but accrual for cost of products sold
2011 Cengage Learning
DepreciationDepreciation
Depreciation is 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
Complete Form 4562 to reflect depreciation
2011 Cengage Learning
Depreciation MethodsDepreciation Methods
Straight-line depreciation is easiest, for accounting purposes, and is calculated as (Cost of asset – salvage value)/Years in estimated
lifeModified 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
2011 Cengage Learning
Personal Property Recovery Personal Property Recovery PeriodsPeriods
With MACRS, 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 & certain equipment
◦ 7 year Mostly business furniture & 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
2011 Cengage Learning
Calculating Depreciation Calculating Depreciation for Personal Propertyfor 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
2011 Cengage Learning
Using Tables -Personal Using Tables -Personal PropertyProperty
2011 Cengage Learning
Example 1: On March 15, Zumiz 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, 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
Mid-Quarter ConventionMid-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)
2011 Cengage Learning
50% Bonus Depreciation 50% Bonus Depreciation Reinstated for 2008-2010
Additional depreciation immediately available Applies to assets with recovery period of twenty
years or less plus computer software, leasehold improvements and water utility property
Amount = 50% of adjusted basis Take 50% bonus first, then regular MACRS
depreciation on remaining basis May elect out of bonus if anticipate need for
higher depreciation in future years
2011 Cengage Learning
Personal Property Personal Property Depreciation ExampleDepreciation ExampleExampleNicole purchases a cherry desk and executive
chair for use in her engineering firm on July 16, 2010 for $8,150. What is her depreciation for 2010 using half-year convention and MACRS tables? 2011? (Assume Nicole didn’t take bonus depreciation as she anticipates higher income in subsequent years).
How would 2010 depreciation change if she had taken 50% bonus depreciation?
2011 Cengage Learning
SolutionSolutionExample
Nicole purchases a cherry desk and executive chair for use in her engineering firm on July 16, 2010 for $8,150. What is her depreciation for 2010 using half-year convention and MACRS tables? 2011? (Assume Nicole didn’t take bonus depreciation as she assumes higher income in subsequent years).
How would 2010 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
2010 depreciation = $1,165 ($8,150 x .1429)
2011 depreciation = $1,996 ($8,150 x .2449)
If bonus depreciation were taken:
2010 depreciation = 50% bonus depreciation + MACRS % to remaining basis
$8,150 x 50% = $4,075 bonus depreciation
$4,075 x .1429 = $582 MACRS depreciation
Total depreciation = $4,657 ($4,075 + $582)2011 Cengage Learning
Real EstateReal Estate
Real assets depreciated based on a recovery period – 2 types of real propertyo 27.5 years Residential real estateo 39 years Nonresidential real estateo 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
2011 Cengage Learning
Real Estate ExampleReal Estate Example
ExampleGwen purchased a residential triplex on
8/1/10 for $290,000 (including land cost of $50,000). What is her depreciation for 2010? 2011?
2011 Cengage Learning
SolutionSolutionExample
Gwen purchased a residential triplex on 8/1/10 for $290,000 (including land cost of $50,000). What is her depreciation for 2010? 2011?
Solution
Since land is not depreciable, only $240,000 may be multiplied by percentages from Table 7.4 (27.5-year residential real property). The purchase occurred in the eighth month; therefore, depreciation equals
2010 $240,000 x 1.364% = $3,274
2011 $240,000 x 3.636% = $8,726
2011 Cengage Learning
Election to Expense - §179Election to Expense - §179
§179 allows immediate expensing of qualifying property◦ For 2010, the annual amount allowed is $500,000
◦ Qualifying property is tangible personal property used in a business But not real estate or property used in residential real estate
rental business
§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
2011 Cengage Learning
Election to Expense - Election to Expense - §§179179 When using with regular MACRS, take §179 first,
then reduce basis to calculate bonus depreciation, then reduce basis to calculate MACRS
For example◦ In 2010, 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 2010. What is total depreciation, including election to expense?
◦ Assuming bonus depreciation will be claimed – first take $500,000 deduction under §179, reduce basis to $342,000, then multiply by 50% to get bonus depreciation and then remaining basis ($171,000) by .1429 from MACRS tables
Total depreciation and Section 179 = $695,436 ($500,000 + 171,000 + *24,436) = $695,436
*(remaining basis of $171,000 x .1429)2011 Cengage Learning
§§179 Example179 Example
2011 Cengage Learning
Example
On 7/11/10, O’Neill Machinery LLC purchases a 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? Assume bonus depreciation.
SolutionSolutionExample
On 7/11/10, O’Neill Machinery LLC purchases a 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? Assume bonus depreciation.
Solution
Asset purchases didn’t exceed $2,000,000, so no reduction in §179 required:
Cost $659,000§179 expense ( 500,000)Adjusted depreciable basis
$159,000x 50% bonus depreciation ( 79,500)Remaining Basis $ 79,500x Table % .1429
MACRS $ 11,361
Total depreciation= $590,861 $500,000 + $79,500 + $11,3612011 Cengage Learning
Listed PropertyListed 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 use falls to 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
2011 Cengage Learning
Luxury Auto LimitationsLuxury 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 2010 2010 - $3,060 (or $11,060 if taking bonus
depreciation*) 2011 - $4,900 2012 - $2,950 2013 and subsequent years - $1,775
*Only allowed if used more than 50% in business and purchased new during 2010
2011 CengaLearning
Exception to Exception to Luxury Auto LimitationsLuxury Auto Limitations Definition of 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, can ‘only’ expense $25,000
and then depreciate remainder using five year MACRS percentages These SUVs will qualify for 50% bonus
depreciation in 2010 as well
2011 Cengage Learning
Luxury Auto ExampleLuxury Auto Example
Example
On 3/15/10, 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 does use the bonus depreciation?
2011 Cengage Learning
SolutionSolutionExample On 3/15/10, 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?
SolutionRegular depreciation ($50,000 x 20%*) 10,000Times business use percentage 60% X .60Possible depreciation 6,000
“Luxury auto” limitation (60% of $3,060) $ 1,836
If Jim elects bonus depreciation, gets
Bonus depreciation ($50,000 x 50%) 25,000
MACRS-remaining basis ($25,000 x 20%) 6,250
Subtotal 31,250
Business Use % 60%
Depreciation limited to business use % 18,750
But ultimately limited to luxury auto x business use % (60% of $11,060) = $6,636
*From MACRS tables, cars are 5-year assets2011 Cengage Learning
Intangible AssetsIntangible Assets
§197 intangible 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
2011 Cengage Learning
Amortization ExampleAmortization Example
Example
FionaWear Inc. purchased a small textile company in May 2010 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 2010?
2011 Cengage Learning
SolutionSolution
Example
FionaWear Inc. purchased a small textile company in May 2010 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 2010?
Solution
$54,000/15 years = $3,600/12 months = $300 per month
§197 amortization $300 x 8 months = $2,400
2011 Cengage Learning
Related Party Transactions Related Party Transactions §267§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
2011 Cengage Learning
Related Party Transactions Related Party Transactions §267§267
Losses disallowed between related parties◦ When property sold later to an unrelated party, all
previously disallowed losses may be taken against gain
May not avoid tax when one taxpayer uses cash method for expenses and interest and the other taxpayer uses accrual method
2011 Cengage Learning
The End!The End!
2011 Cengage Learning
My head hurts!