2. #5-1 McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter 5 Taxable Income from Business Operations

3. #5-2 Objectives Describe how taxable year relates to operating cycle Identify tax methods of accounting Explain why tax policy affects the computation of taxes Apply the cash method to compute taxable income GAAP conservatism versus tax conservatism Book-tax permanent and temporary income differences Explain the difference between tax expense per books and tax payable Accrual basis exceptions for prepaid income and accrued expenses Net Operating Losses (NOLs)

4. #5-3 Taxable Income Taxable income = gross income less allowable deductions Gross income “means all income from whatever source derived” Deductions are allowed through legislative grace, and include “all ordinary and necessary expenses … in carrying on any trade or business”

5. #5-4 Taxable Income Good rule of thumb: Receipts are taxable UNLESS you can find a law that says the receipt is excluded Expenses are deductible ONLY if you can find a law that says the expense is deductible

6. #5-5 Taxable Year A taxable year is generally a 12-month period which corresponds to a firm’s fiscal year Individual taxpayers must generally choose a calendar year Firms generally choose a year = end of an annual operating cycle

7. #5-6 Taxable Year Examples Discuss the choice of a taxable year for the following businesses: Retail plant and garden center French bakery Chimney cleaning business Moving and transport business Software consulting business

8. #5-7 A new business establishes it’s taxable year by filing an initial tax return based on such a year Changing tax years requires permission of the IRS Because of the change, the first return may reflect a short period of less than 12 months The taxable income reported on the short-period return must be annualized – mathematically inflated to reflect 12 months of business operations Taxable Year

9. #5-8 Taxable Year Example: Acme had a fiscal year ending on June 30. It changed to a year ending September 30. For the three months ended 9/30 Acme has income of $25,000 Annualized income = $100,000 [($25,000 / 3) * 12] Tax on $100,000 = $22,250 Tax for 3-month short period = 5,563 [($22,250/12) * 3]

10. #5-9 Tax Methods of Accounting A tax method is an overall method by which taxpayers determine their income, deductions and credits, as well as the time realized and recognized. The Internal Revenue Code (IRC) permits firms to use the following methods: Cash Accrual Combined (hybrid)

11. #5-10 Tax Methods of Accounting Section 482 grants IRS broad powers to “distribute, apportion, or allocate income” among businesses to CLEARLY REFLECT income of each This is a BIG issue in multi-jurisdictional taxation More discussion in Ch. 12

12. #5-11 Taxable Methods of Accounting - Other policy objectives Public policy No deduction for fines, political contributions Why? Congress does not want to subsidize bad behavior with a tax deduction or finance the lobbying efforts of special interest groups Limits on meal and entertainment expenses; only 50% deductible Why? Lavish meals and entertainment involve more pleasure than business and should not be subsidized with federal tax dollars

13. #5-12 Taxable Methods of Accounting - Other policy objectives Economic incentives State and local bond interest income is exempt (Likewise, related expenses are nondeductible) Why? To help local governments raise funds by lowering the effective cost of debt Businesses can write-off equipment faster for tax purposes than GAAP useful life Why? To encourage firms to replace equipment often which helps businesses maintain a competitive edge

14. #5-13 Cash Method Under the cash method, gross income includes cash or property actually RECEIVED during the tax year – regardless of when the sale occurred or services were provided Deductions are usually taken in the year cash or property is PAID – regardless of when the expense was incurred

15. #5-14 Cash Method A taxpayer receives “free” automobile repair work in exchange for preparing the mechanic’s tax return Does income need to be recognized if the taxpayer uses the accrual method of tax accounting? Yes – services have been provided and income has been earned What if the taxpayer uses the cash method of accounting? Yes – cash method income includes the receipt of non- cash goods

16. #5-15 Cash Method Income Constructive receipt of income Occurs when taxpayer has unrestricted access to and control of the income – even if not in the taxpayer’s actual possession NO constructive receipt exists if the amount is available only on surrender of a valuable right, or if there are substantial limits on the right to receive it

17. #5-16 Cash Method Income A calendar-year, cash-basis firm would like to defer income from the current year to the following year. Can it defer recognizing income this year if: The company holds the checks received from its customers in December in its vault and does not cash them until January? No – the income has been constructively received

18. #5-17 Cash Method Deductions Cash method - deduct expenses when PAID. A check is payment when mailed When does it make sense for a cash basis firm to pay an expense early? When the tax savings from the deduction are greater than the opportunity cost of the early payment

19. #5-18 Cash Method Deductions – Capital Assets If an expenditure results in a benefit that extends beyond 12 months, a capital asset exists The cost of the asset may be recovered over the asset life (e.g. through depreciation or cost of goods sold) Major repairs may result in a dispute with the IRS regarding taking a current year deduction versus capitalization

20. #5-19 Cash Method Deductions - Inventory Inventory must be accounted for on the accrual method, even for cash basis taxpayers This is called a hybrid method of accounting Under this method, purchases and sales of inventories are accounted for under the accrual method and all other transactions under the cash method

21. #5-20 Cash Method Deductions - Prepaid Expenses Generally when an expense is prepaid, the total payment is considered to be income to the recipient in the year it is received More on this later…

22. #5-21 Limitations on Corporations Using Cash Method Corporations that average more than $5 million in annual gross receipts cannot use the cash method Service firms can have up to $10 million of average annual gross receipts before they must use accrual method However, personal service corporations (professional services like medical, legal, accounting) of any size may still use the cash method

23. #5-22 Accrual Method of Tax Accounting Under the accrual method, taxpayers generally recognize (report) income when the right to the income and the amount of the income can be determined with reasonable accuracy (i.e., when realization occurs) Under special tax rules discussed later, recognition and realization may not occur at the same time In addition, expenses are matched against revenues. Expenses are deducted when ALL EVENTS have occurred that determine the existence of the liability and the amount of the liability can be determined with reasonable accuracy

24. #5-23 Book-Tax Differences Financial Accounting and Tax Accounting exhibit contrasting principles of conservatism GAAP seeks to protect shareholders and creditors: Don’t overstate book income Tax law seeks to protect government revenues: Don’t understate taxable income However, a contrasting result may arise due to economic incentives - e.g. accelerated depreciation

25. #5-24 Book-Tax Permanent Differences Permanent differences do not reverse in future time periods Temporary differences reverse over the life of the firm Examples of permanent non-deductible expenses 50% meals and entertainment Political contributions Fines and penalties Interest expense to generate tax-exempt municipal bond income Premiums on life insurance

26. #5-25 Temporary Book-Tax Differences Temporary differences occur when an item of income or expense is taken into account in a different year (or years) for book purposes than for tax purposes. Examples of temporary differences: Depreciation Timing of accruals Capital losses Bad debts (allowance vs. direct write-off) Cash versus accrual accounting

27. #5-26 GAAP Tax Expense Versus Tax Payable GAAP current tax expense = tax on taxable income GAAP deferred tax expense = the tax effect of temporary differences reversing in the future Total tax expense per books (SFAS109) = current +/- deferred tax expense In simple situations (APB11) Pre-tax book income + / - permanent differences = adjusted book income x tax rate; less credits = Total tax expense per books (same # as SFAS 109)

28. #5-27 Book – Tax Differences ABC Company earns $100,000 in operating income during the year and it receives $2,000 in municipal bond interest. ABC Company buys an asset for $20,000 which it completely expenses under the tax law but which it straight-line depreciates for four years under GAAP. Assume a stable 35% tax rate. What is the total tax expense per the books per SFAS 109?

29. #5-28 GAAP Tax Expense Versus Tax Payable GAAP current tax expense = $100,000 operating income less $20,000 Section 179 expense = $80,000 taxable income x.35 = $28,000 GAAP deferred tax expense = ($5,000 annual depreciation x 3 years) = $15,000 x.35 = $5,250 Total tax expense per books (SFAS 109) = $28,000 + $5,250 = $33,250 Or Pre-tax book income ($100,000 + 2,000 – 5,000) – permanent difference ($2,000) = $95,000 x.35 = $33,250 (APB11)

30. #5-29 Temporary Differences: Prepaid Income and Expenses Prepaid income is taxed when received under the Claim of Right Doctrine The government has the right to tax income when the taxpayer has the unrestricted right to use such income amounts When a prepaid expense (e.g., rent or insurance) covers more than the following tax year, the deduction must be spread over the tax years to which the expense applies

31. #5-30 Prepaid Income and Expenses Example Cheryl rents office space on December 1 st. She pays $650 for December’s rent and an additional $650 for last month’s rent on a two-year lease How much income will the landlord recognize in the current year? $1,300 for December and last month’s rents How much rent may Cheryl deduct? $650 for December’s rent, under the cash or accrual method If the lease was only for one year, Cheryl would be able to deduct $1,300 this year under the cash method

32. #5-31 Temporary Differences: Prepaid Services Advance payments received for services to be performed must be reported by an accrual basis taxpayer in the year received Exception: A taxpayer can elect to defer advance payments over the period services are performed if they are received under an agreement requiring all the services to be performed by the end of the following tax year

33. #5-32 Accrued Expenses, All Events Test The tax law allows a deduction for an accrued expense only if it meets the All Events Test: 1) All events that establish the liability have already occurred, and 2) The amount must be determinable with reasonable accuracy If an accrued expense meets these two requirements and is a recurring item that the firm treats in a consistent manner every year, the expense is deductible in the current year

34. #5-33 Accrued Expenses – Economic Performance For certain items, economic performance must occur before a deduction is allowed The economic performance requirement delays the deduction until payment is made (like the cash basis) for: Legal settlements (tort, contract breach, violating law) Customer rebates/refunds Awards, prizes State income taxes

35. #5-34 Accrued Expenses ABC Company has two accruals at year end: December’s utility bill to be paid in 30 days Customer rebate checks to be issued during the 1 st quarter of the new year Which accrual(s) can be deducted on the current year tax return? Only the accrual for utilities

36. #5-35 Accrual Expenses Exceptions Related Party Accruals The paying party cannot deduct an expense until the year that a receiving party recognizes the income This rule prevents accrual basis taxpayers from accruing an expense but delaying payment Bad Debts GAAP requires the allowance method For tax purposes, the direct write-off method is required The taxpayer will record income if the account is repaid later

37. #5-36 Summary: Cash vs Accrual Summary:

38. #5-37 Net Operating Losses (NOL) If operations result in an excess of deductible expenses over gross income, a NOL results A problem exists as excess deductions yield no current tax savings. This problem arises due to artificial time divisions (years)

39. #5-38 Net Operating Losses (NOL) The Solution: carryback the NOL 2 years, carryforward 20 years If the NOL is carried back to prior years, the taxpayer enjoys the tax savings immediately in the form of a cash refund If carried forward, the NOL deduction becomes less valuable the longer the time period over which it is deducted

40. #5-39 Net Operating Losses (NOL) GAAP now allows firms to record a tax benefit for the expected value of future NOL deductions as a deferred tax asset The taxpayer may elect to FOREGO CARRYBACK and carryforward only This might increase the net present value of the tax benefit if the taxpayer expects a sufficiently higher tax rate in the future

41. #5-40