Income Tax Fundamentals 2010 Gerald E. Whittenburg & Martha Altus-Buller Student Copy 2010 Cengage Learning

 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 2010 Cengage Learning

 A Personal Service Corporation (PSC) is a corporation with shareholder-employee(s) whom 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 2010 Cengage Learning See next slide

 If taxpayer has a short year (other than first/last year of operation), tax is calculated based on following example: °In 2009, Flo-Mex changes from a calendar year to tax year ending 9/30. For the short period 1/1/09 – 9/30/09, Flo-Mex’s taxable income = $20,000. Calculate tax for the short period Annualize TI $20,000 x 12/9 = 26,667 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 *Chapter 1, page Cengage Learning

must use same method for tax & books  There are three acceptable accounting methods for reporting taxable income (TI) ◦ 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 2010 Cengage Learning

 Accrual method ◦ Recognize income when earned and can be reasonably estimated ◦ Recognize deductions when incurred and can be reasonably estimated  Hybrid method ◦ An example of a hybrid taxpayer is one that utilizes cash method for receipts and disbursements, but accrual for cost of products sold 2010 Cengage Learning

 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 2010 Cengage Learning

 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 & property with no ADR life * See Table 1 for Asset Depreciation Ranges (ADR) for all classes of assets 2010 Cengage Learning

 Depreciation is determined using IRS tables ◦ Table 2 ◦ Salvage value not used in MACRS ◦ Tables based on half-year convention  That 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  Must use either MACRS or straight-line for all property in a given class placed in service during that year 2010 Cengage Learning

 Mid-quarter convention is required if taxpayer purchases 40% or more 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) 2010 Cengage Learning

Reinstated for two years only ( )  Additional depreciation is available for assets purchased in  Available for 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 2010 Cengage Learning

 Real assets depreciated based on a recovery period depending on type of property ◦ Real assets are depreciated using the straight-line method with a mid-month convention  Mid-month convention assumes all  Used for real estate acquired after 1986  27.5 years Residential rental  39 years Nonresidential 2010 Cengage Learning

 §179 allows immediate expensing of qualifying property ◦ For 2009, the annual amount allowed is $250,000 ◦ 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 > $800,000, then reduce §179 expense dollar for dollar  For example, if assets purchased in current year = $900,000 taxpayer must reduce §179 by $100,000. Therefore, election to expense is limited to = $150,000 ($250,000 – 100,000). The remaining $750,000 of basis is depreciated over assets’ useful lives. ◦ Cannot take §179 expense in excess of taxable income 2010 Cengage Learning

 When using with regular MACRS, take §179 first, then reduce basis to calculate MACRS  For example ◦ In 2009, NanoPaint Inc.’s taxable income = $1.25 million. They placed a 7-year piece of property into service costing $342,000 – it was their only asset purchase in What is total depreciation, including election to expense? ◦ Assuming bonus depreciation not claimed – first take $250,000 deduction under §179, reduce basis to $92,000, then multiply by.1429 from MACRS tables  Total depreciation expense = $263,147 ($250,000) + ($92,000 x.1429) 2010 Cengage Learning