1. Chapter 5
Taxable Income
from
Business Operations

2. TAXABLE INCOME FROM BUSINESS OPERATIONS
Business profit as taxable income
The taxable year
Methods of accounting
Book-tax income differences
Accounting method issues in computing taxable income
NOLs

3. Business Profit as Taxable Income
Taxable income = gross income less allowable deductions
Gross income means “all income from whatever source derived.” §61
Includes discharge of debt income.
Expenses are only deductible if specifically allowed by the Code (§61).
Includes all ordinary and necessary expenses … in carrying on any trade or business.” (§162).

4. Discharge of Indebtedness Income (not in book)
A taxpayer must report income when
A creditor cancels the taxpayer’s debt
The amount of income recognized is generally the amount of the debt forgiven
Reduction of debt not income for:
Discharges under Federal bankruptcy law, or
Discharges that occur when the debtor is insolvent.

5. The Taxable Year (1 of 2) 12-month period
Generally same as its financial year.
Individuals use a calendar year.
Business FYE generally the same for financial and tax.
Need IRS permission to change tax year.
Most common reason is merger of firms with different year-ends.

6. The Taxable Year (2 of 2) Short-year return
Only occurs when tax year changed and reporting period is < 12 months.
Short-year tax liability
Compute short-year taxable income
Annualize income
Multiply by (12 mo)/(# of mo in short yr)
Compute tax on annualized income
Compute tax for short year
Multiply annualized tax liability by (# of mo in short yr)/(12 mo)

7. Methods of Accounting Overall method must clearly reflect income.
Establish a method by using it in the first tax return.
Requires IRS permission to change.
Realization and matching principles
Cash and accrual methods

8. Realization and Matching Principles
REALIZATION principle
Earnings process complete.
MATCHING principle
Match expenses with revenues.
Exceptions due to risks of tax evasion, convenience for gov’t or taxpayer, ability to pay, economic incentives.

9. Cash & Accrual Accounting (1 of 2)
CASH method mandatory where taxpayer's records reflect only cash transactions and no inventories.
ACCRUAL method mandatory for:
Purchases and sales where inventories must be used.
C corps and ptrshps w/ C corp partner.
Small corps (avg. annual gross receipts < $5M) may use cash basis.

10. Cash & Accrual Accounting (2 of 2)
HYBRID method
Use accrual for inventories (CGS), but cash for everything else.

11. Book-Tax Income Differences (1 of 2)
GAAP vs. tax conservatism
GAAP - protect s/hs and creditors: don’t overstate book income.
Tax - protect gov’t revenues: don’t understate taxable income.
Contrary result may arise due to economic incentives - e.g. accelerated. depreciation.)
Tax policy effect on measuring inc.
e.g., fines, penalties, lobbying exp.

12. Book-Tax Income Differences (2 of 2)
Temporary vs. permanent differences
Permanent differences do not reverse;
Temporary differences reverse over the life of the entity.
GAAP current tax expense is based on book income.
GAAP deferred tax expense is the tax effect of temporary differences (not permanent) reversing in the future.

13. Permanent Differences (1 of 2)
Examples of permanent non-deductible expenses (deductible for fin stmts)
50% meals and entertainment
Political contributions & lobby expenses
Fines and penalties
Interest expense to generate tax-exempt municipal bond income
Premiums on key employee life insurance paid by corporation.
Goodwill.

14. Permanent Differences (2 of 2)
Examples of permanent tax preferences that make taxable income less than book income:
Tax-exempt municipal bond income
Life insurance proceeds on key employee policies.

15. Meals and Entertainment Expenses
Qualified M&E expenses only 50% deductible.
Must be directly related to (business discussion takes place) or associated with (directly preceding or proceeding a business meeting) a business activity.
Taxpayer must be present at meals.
Expense must not be lavish or extravagant.

16. Temporary Differences
Examples of temporary differences:
Depreciation
Timing of accruals
Capital losses
Corps: only deductible against cap gains
Individuals: up to $3,000/yr deductible against ordinary income
Bad debts (allowance vs. write-off)
Cash versus accrual accounting

17. Tax Expense & Deferred Taxes
GAAP total tax expense (SFAS109)
= current + deferred tax expense
In simple situations, this approximates tax rate on book income + or - permanent differences.

18. Acctg Method Issues in Computing Taxable Income
Cash method issues
Accrual method issues
Summary of cash vs. accrual
Section 482

19. Cash Method Issues (1 of 2)
Constructive receipt of income.
Report when a person has unrestricted access to and control of the income.
NO constructive receipt if the amount is available only on surrender of a valuable right, or if there are substantial limits on the right to receive it.

20. Cash Method Issues (2 of 2)
Prepaid expenses
Use accrual recognition when expense covers more than the following tax year.
Exception: prepaid interest must be capitalized and deducted over the period for which interest is actually charged.

21. Accrual Method Issues Prepaid income
Advanced payments received for merchandise
Advances and deposits
Related party accruals
Bad debts
Accrued expenses

22. Prepaid Income
Prepaid income taxed when received under the Claim of Right Doctrine, not when the services are performed.
Government has the right to tax income when the taxpayer has unrestricted right to use such income amounts.
Examples: Rent, bonuses, services
Use accrual method for service inc. if completed by end of following tax year.

23. Advanced Payments Received for Merchandise
Advance payments received for merchandise or construction
Delay tax until earned (goods delivered).
OK to use accrual method if used for all tax reporting and financial reporting.
Small contractors may use completed contract method instead of % of completion for accounting for long-term contracts.

24. Long-Term Contracts (not in book) (1 of 2)
Completed contract method
Real estate construction contract or home construction contract (≤ 4 units) if
< 2 yrs to complete & gross receipts < $10M.
Deduct expenses when incurred, and recognize income when completed.

25. Long-Term Contracts (not in book) (2 of 2)
Percentage of completion method
Income recognized = (C/T) x P
C = Contract costs incurred during the period
T = Estimated total cost of the contract
P = Contract price

26. Advances and Deposits
A deposit that guarantees the customer's payment of amounts owed to the creditor is an advance payment includible in income. (E.g., apartment last months’ rent?).
True security deposits are not an advance payment and not includable in income. (e.g., apt security damage deposit).

27. Related Party Accruals
The paying party cannot deduct an expense until the receiving party includes the receipt in income.
Prevents accrual basis taxpayers from deducting an expense before related cash basis taxpayer recognizes the income.

28. Bad Debts GAAP - allowance method Tax - direct write-off method.
Record income if account repaid later.
Cash basis taxpayer cannot deduct bad debt unless there was an actual cash loss or if amount was previously included in income.

29. Accrued Expenses All Events Test requires
Liability is fixed.
Amount determined with reasonable accuracy.
Economic Performance test for nonrecurring expenses also requires that all activities to satisfy the liability have occurred - often requires payment.

30. Summary of Cash & Accrual Tax Issues
Income
When received
When earned
EXCEPT
Constructive receipt
Inventory sale
Ppd. Income
Ppd. Services > next year
Expense
When paid
When accrued
Asset purchase
Ppd. Expense > next year
Ppd. Interest
Related party accrual
Write-off bad debts
All events & economic performance

31. Section 482
IRS has authority to “distribute, apportion, or allocate gross income, deduction, credits or allowances” among businesses to CLEARLY REFLECT income of each.
Transfer pricing
Critical for multi-jurisdictional taxation

32. Net Operating Losses When NOLs can be used:
Carryback 2 yrs, carryforward 20 yrs.
Carryback to oldest year first.
Election available to forgo carryback.
NPV tax benefit if taxpayer expects sufficiently higher tax rate in future.
GAAP allows recording tax benefit for EV of future NOL deductions.
New rules only apply temporarily.

33. End of Chapter 5