1. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Individual Income Taxes 1 Chapter 18 Accounting Periods and Methods

2. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 2 Accounting Periods (slide 1 of 3) Taxable year –The tax year may be shorter but is usually not longer than 12 months –Taxpayer elects a tax year by the timely filing of the initial return –Permission to change taxable years must be obtained from the IRS

3. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 3 Accounting Periods (slide 2 of 3) Types of taxable years –Calendar year: January 1 – December 31 –Fiscal year: must start on the first day of a month and end the last day of a month, other than December, 12 months later Example: July 1 – June 30

4. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 4 Accounting Periods (slide 3 of 3) Types of taxable years –52/53 week year: ends on same day of week that is either closest to its normal monthly year-end or occurs last in its year Example: year-end is always the last Saturday in April

5. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 5 Accounting Periods— Partnerships Tax year-end must be that of (in descending order) –Majority interest partners Own a > 50% interest in partnership capital & profits –Principal partners Partner with a 5% or more interest in partnership capital or profits –Least aggregate deferral of income

6. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 6 Accounting Periods— S Corps and PSCs Generally, these entities must have a calendar year –Other tax years may be available if certain requirements can be met

7. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 7 Accounting Periods—Other Allowable Year-Ends Partnerships, S corps, and PSCs can elect to have other fiscal year-ends if any of the following are met: –A valid business purpose can be shown –§444 election is made and year-end results in no more than a 3-month deferral Requires certain payments –§444 election was made to retain the same year as was used for the fiscal year ending in 1987 Requires certain payments

8. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 8 Accounting Periods—Valid Business Purpose IRS acknowledges only one valid business purpose for using a fiscal year-end –Conforming the tax year to the entity’s natural business year (seasonal businesses) Example: a September 30 year-end may be a natural business year-end for a swim suit manufacturer

9. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 9 Accounting Periods—§444 Deferral and Required Tax Payments Partnerships and S corporations (not their owners) must make tax payments at the highest individual rate plus 1% (e.g., 36%) on estimated deferral period income –The amount due is reduced by the amount of required tax payments for the previous year

10. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10 Accounting Periods—§444 Deferral and Required Salary Payments PSCs must pay shareholder-employees salaries during the deferral period that are at least proportionate to their salaries for the preceding fiscal year –Failure to make required salary payments reduces PSCs deduction for salaries paid to shareholder- employees

11. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 11 Example of §444 Deferral and Required Salary Payments PSC has October 31 year-end and cannot satisfy the business purpose test for a fiscal year –Provides 2 month deferral –Has one shareholder-employee with $60,000 in salary for prior fiscal year –PSC should pay shareholder-employee at least $10,000 in salary during the deferral period $60,000 × 2/12 = $10,000

12. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 12 Change in Accounting Period Must obtain IRS consent before changing tax year IRS will not consent to a change unless taxpayer demonstrates a substantial business purpose for change, such as changing to natural business year

13. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 13 Change in Accounting Period— Natural Business Year Objective test: At least 25% of entity’s gross receipts are realized in the final 2 months of the desired tax year for 3 consecutive years IRS usually establishes certain conditions that the taxpayer must accept if approval for change is to be granted – In particular, if the taxpayer has a net operating loss (NOL) for the short period, the IRS requires that the loss be carried forward The loss cannot be carried back to prior years

14. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 14 Accounting Periods— Short Taxable Year A short taxable year is a period of less than 12 calendar months –Can occur in the first taxable year, the last taxable year, or when there is a change in the taxable year If the short-period year is caused by a change in taxable year, the short-year income must be annualized –Necessary due to the progressive tax rate structure

15. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 15 Mitigation of the Annual Accounting Period Concept (slide 1 of 2) Several Code provisions provide relief from harsh results produced by the combined effects of an arbitrary accounting period & a progressive rate structure, for example –NOL carryover rules A loss in one year can be carried back 2 years & carried forward for 20 years –Special relief is provided for casualty losses pursuant to a disaster and for reporting insurance proceeds from destruction of crops

16. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 16 Mitigation of the Annual Accounting Period Concept (slide 2 of 2) Farmers and fishermen –Often subject to wide fluctuations in income Allowed to use an averaging system that helps avoid higher marginal tax rates associated with a large amount of income received in one year Crop insurance proceeds may be received in a year before the income from the crop would have been realized –Allowed to defer reporting the income until the year following the disaster Section 451(e) provides similar relief when livestock must be sold on account of drought or other weather-related conditions

17. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 17 Accounting Methods (slide 1 of 10) There are 3 generally permissible overall methods of accounting –Cash receipts and disbursements method –Accrual method –Hybrid method Generally, any of the three methods of accounting may be used –Must be consistently employed and clearly reflect income In most cases the taxpayer is required to use the accrual method for sales and costs of goods sold if inventories are an income-producing factor

18. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 18 Accounting Methods (slide 2 of 10) Cash receipts and disbursements method –Income is recognized when it is actually or constructively received –Expenses are deductible when they are paid Most courts have applied the “one year rule” for prepaid expenses –Requires that prepaid expenses whose benefits extend beyond the end of the following tax year must be capitalized

19. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 19 Accounting Methods (slide 3 of 10) Cash receipts and disbursements method - Restrictions on use –Cash method cannot be used by corporations, partnerships with a corporate partner, and tax shelters Exceptions: –Farming business –Qualified PSC –An entity that is not a tax shelter whose average annual gross receipts for most recent three-year period are $5 million or less

20. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 20 Accounting Methods (slide 4 of 10) Restrictions on use of cash method (cont’d) –As an administrative convenience, the IRS permits the following entities to use the cash method Entities with $1 million or less average annual gross receipts during last three-year period (even if buying and selling inventory), and Certain entities with average annual gross receipts of greater than $1 million but not more than $10 million during last three-year period with the following restrictions –Inventory on hand at the end of the tax year cannot be deducted until the inventory is sold (i.e., must be capitalized) –Not eligible are entities whose principal business activity is selling goods, manufacturing, mining, and certain publishing activities

21. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 21 Accounting Methods (slide 5 of 10) Special Rules for Small Farmers –Although inventories are material to farming operations, the IRS allows small farmers to use the cash method of accounting Applies to unincorporated farms and closely held farming corps with gross receipts < $25 million –Must still capitalize costs of raising trees with preproduction period > two years

22. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 22 Accounting Methods (slide 6 of 10) Special Rules for Small Farmers (cont’d) –Farmers producing crops that take > 1 year from planting to harvesting can elect to use the crop method to report income Under the crop method, costs of raising crops are capitalized and then deducted in year income from crop is realized –Cash basis farmers must capitalize the purchase price of animals, whether acquired for sale or breeding The costs of raising the animal can be expensed

23. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 23 Accounting Methods (slide 7 of 10) Accrual method: Income –Income is recognized when it is earned Income is earned when all events have occurred to fix the taxpayer’s rights to the income, and The amount can be determined with reasonable accuracy

24. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 24 Accounting Methods (slide 8 of 10) Accrual method: Deductions –Expenses are deductible when they meet the all events test and the economic performance test –Economic performance test is waived for certain recurring items

25. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 25 Accounting Methods (slide 9 of 10) Hybrid method involves the use of more than one method –e.g., A combination of cash and accrual methods –Generally used when inventory is a material factor e.g., Accrual accounting used for determining gross profit from inventory & cash accounting used to report other income & expenses

26. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 26 Accounting Methods (slide 10 of 10) Change in accounting method –Taxpayer elects accounting method for subsequent years by filing the initial return –Must obtain permission from IRS to change accounting methods Adjustments may be required to prevent distortion of taxable income –Correction of error is not a change in accounting method

27. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 27 Disposition Of Net Adjustment From Change in Accounting Method (slide 1 of 2) Required changes in accounting methods are the result of an IRS examination –IRS will not require a change unless the net adjustment is positive Adjustment generally must be included in gross income for the year of the change Additional tax and interest on the tax will be due –If adjustment is > $3,000, the taxpayer can elect to calculate tax by spreading adjustment over one or more previous years

28. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 28 Disposition of Net Adjustment from Change in Accounting Method (slide 2 of 2) For voluntarily changes from incorrect methods and to facilitate changes from one correct method to another –IRS generally allows the taxpayer to spread a positive adjustment into future years 1/4th of the adjustment is applied to the year of change, and 1/4th of the adjustment is applied to each of the next 3 taxable years A negative adjustment can be deducted in the year of the change

29. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 29 Installment Method (slide 1 of 11) Installment method of reporting gain allows the taxpayer to recognize gain as payments on the sale are received

30. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 30 Installment Method (slide 2 of 11) To qualify for installment treatment, the taxpayer must receive at least one payment after the year of sale May elect out of installment treatment

31. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 31 Installment Method (slide 3 of 11) Installment treatment is not allowed for the following: –Gains on property held for sale in the ordinary course of business –Depreciation recapture under §1245 and §1250 –Sale of securities traded on established markets As an exception to the first item (above), the installment method may be used to report gains from sales of the following –Time-share units (e.g., the right to use real property for two weeks each year) –Residential lots (if the seller is not to make any improvements) –Any property used or produced in the trade or business of farming

32. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 32 Installment Method (slide 4 of 11) Computing the gain recognized: –Gain recognized each year is dependent on the payments received during the year –Recognized Gain = Total gain × Payments Received Contract Price

33. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 33 Installment Method (slide 5 of 11) Definitions –Total gain = selling price less selling expenses less adjusted basis of property –Contract price = Sales price less liabilities assumed by buyer Generally is equal to amount (other than interest) seller will receive from purchaser

34. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 34 Installment Method (slide 6 of 11) If liabilities assumed by buyer exceed the seller’s basis and selling expenses –The difference must be added to the contract price and to payments received in year of sale

35. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 35 Installment Method (slide 7 of 11) Depreciation recapture under §1245 & §1250 –Depreciation recapture is ineligible for installment treatment All recapture must be recognized in year of sale –Because most, if not all, of the gain on the sale of tangible property is §1245 recapture, benefit of installment treatment is generally limited to sales of real property

36. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 36 Installment Method (slide 8 of 11) Imputed interest –Deferred payment contracts where the sales price exceeds $3,000 Reasonable rate of interest (at least the applicable Federal rate) must be charged by taxpayer on the outstanding balance Failure to charge adequate interest will result in imputed interest at Federal rate

37. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 37 Installment Method (slide 9 of 11) Related party installment sales –Limitations on the use of the installment method Nondepreciable property: disposition of property by related purchaser generally accelerates recognition of gain on installment obligation for related seller Depreciable property: installment method is not available on sale to controlled entity (i.e., more than 50% interest) unless it can be demonstrated that tax avoidance was not a principal purpose

38. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 38 Installment Method (slide 10 of 11) Disposition of obligation –Generally, disposition of an installment obligation triggers recognition of remaining deferred gain The gift or cancellation of an installment note is treated as a taxable disposition by the donor –The amount realized from the cancellation is the face amount of the note if the parties (obligor and obligee) are related to each other Exceptions are provided for the following transfers –Tax-free incorporations under § 351 –Contributions of capital to a partnership –Certain corporate liquidations –Transfers due to the taxpayer’s death, and –Transfers between spouses or incident to divorce In such situations, the deferred profit is shifted to the transferee –Transferee is responsible for payment of tax on subsequent collections

39. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 39 Installment Method (slide 11 of 11) Interest on deferred taxes –Required to pay interest on the deferred taxes related to the excess obligation amount (excess of $5 million) when Installment obligation is from sale of property for more than $150,000, and Sum of such obligations outstanding at year-end exceeds $5 million

40. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 40 Long-Term Contracts (slide 1 of 5) Long-term contract defined –A building, installation, construction, or manufacturing contract that is not completed within the same taxable year in which it began A manufacturing contract is long-term only if a contract to manufacture: –A unique item not normally carried in finished goods inventory, or –Items that normally require more than 12 months to complete

41. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 41 Long-Term Contracts (slide 2 of 5) Methods of accounting for long-term contracts –Completed contract: Home construction and certain other real estate construction contracts if The contract is expected to be completed within the two-year period beginning on the commencement date of the contract The contract is performed by a taxpayer whose average annual gross receipts for the 3 preceding taxable years do not exceed $10 million –Percentage of completion: All other contracts

42. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 42 Long-Term Contracts (slide 3 of 5) Completed contract method –Income recognition occurs when the contract is completed and accepted

43. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 43 Long-Term Contracts (slide 4 of 5) Percentage of completion –A portion of the gross contract price is included in income each year as the work progresses –Amount of revenue accrued: (Costs incurred in tax year/total estimated costs) × contract price = revenue accrued in tax year –Current year costs are deductible

44. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 44 Long-Term Contracts (slide 5 of 5) Percentage of completion lookback provisions –In the year that the contract is completed, the profit and related taxes must be recalculated If taxpayer overpaid taxes, interest on the overpayment is paid to taxpayer If taxpayer underpaid taxes, interest on the underpayment is due from taxpayer

45. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 45 Inventories (slide 1 of 4) Generally, tax accounting and financial accounting for inventories are much the same –Inventories are necessary to clearly reflect the income of businesses engaged in the production and/or sale of goods –Inventories should include all finished goods, goods in process, and raw materials and supplies –Inventory rules must give effect to the best accounting practices, consistently followed from year to year –All items included in inventory should be valued at either cost or the lower of cost or market value

46. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 46 Inventories (slide 2 of 4) Determining Inventory Cost –For merchandise purchased, cost is the invoice price less trade discounts plus freight and other handling charges Cash discounts approximating a fair interest rate can be deducted or capitalized providing the method used is consistently applied Uniform Capitalization rules under Section 263A –Provide that for inventory and property produced by the taxpayer, the following must be capitalized The direct cost of such property, and Such property’s share of those indirect costs (including taxes) part or all of which are allocable to such property

47. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 47 Inventories (slide 3 of 4) Lower of Cost or Market –Except for those taxpayers who use the LIFO method, inventories may be valued at the lower of cost or market (replacement cost) Taxpayers using LIFO must value inventory at cost

48. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 48 Inventories (slide 4 of 4) A taxpayer may use any of the following methods, provided the method is consistently applied –Specific Identification –First in, first out (FIFO) –Last in, first out (LIFO) –Average cost method Farmers who do not use the cash method may elect to use the farm price method or the unit-livestock-price method rather than one of the inventory methods above

49. © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 49 If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA trippedr@oneonta.edu SUNY Oneonta