Chapter 3 Outline

300 Introduction – pg. 87
Tax accounting – the official reporting of income and expenses so a taxpayer’s taxable income for a particular period can be determined
- The rules for determining when a business must recognize income and when it may deduct expense are referred to as the taxpayers method of accounting
301 Tax Accounting Distinguished from Financial Accounting
- two sets of books because two different governing bodies
Financial accounting – intended to provide useful information about a business so that management, owners, potential investors, creditors and other interested parties can make well informed investment, credit and other decisions
- must prepare according to GAAP
- accrual method – events reported in the accounting period in which they are earned or incurred rather than when its paid or received
Tax accounting records – focuses on items of income and expense that are important for determining taxable income
For external (financial) reporting – GAAP allows a business to choose among various acceptable accounting methods
- management interested in making business look successful and thriving
Tax accounting – goal is to pay least amount of taxes as legally possible
Accounting Periods – pg. 89
- tax year – period of time taxpayers use to calculate taxable income o may or may not be the same as the annual accounting period used for financial reporting purposes o no constitutional requirement that income be calculated on an annual basis
305 Permissible Methods of Accounting – pg. 97
- a business can usually adopt any method of accounting if it clearly reflects its income and the business regularly uses the method in keeping its books o Two most common methods
 Cash receipts and disbursements – actively or constructively receives it and deduct when actually paid
 Accrual – Required by GAAP – an item of income must be included in gross income when:
• All events have occurred that fix the right to receive the item and its amount can be determined with reasonable accuracy
• An event can be deducted when: o All events have occurred that determine the liability o The amount of the liability can be determined with reasonable accuracy o Economic performance has occurred with respect to the liability
 Hybrid method – combines elements of cash and accrual accounting methods – see pg. 97 o A taxpayer that engages in more than one trade or business may use a different method of accounting for each trade or business o Can use one method of accounting for the taxpayers business and a different method of accounting to compute income and deductions not connected with the business
305.01 Limitations on the Use of the Cash Method
- Cash method is not in accordance with GAAP because can produce mismatch of income and deductions
- Businesses required to maintain inventory – pg. 98 – must use accrual method to account for purchases and sales of inventory o Can use the cash method for its other items of income and expense o IRS exempts certain qualifying small businesses from the requirement to use the accrual method for inventories
 Applies to businesses whose average annual gross receipts over the previous three years do not exceed 10 million
 3 conditions for a qualifying small business to use the cash method for all of its trade or business (see pg 98)
- C corps and partnerships with a C corporation partner – most cannot use the cash method if their annual average gross receipts exceed 5 million o Qualified personal service corporations exempt from rule restricting the use of the cash method
 Pg. 100 – QPSC definition – a C corporation in which 95% of more of its employees’ time is devoted to the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performance arts or consulting
 AND 95% or more of the value of its stock must be directly or indirectly held by:
• 1. Employees performing services in a qualifying field
• 2. retired employees who performed such services for the corporation or estate
• 3. Acquired stock o Special Methods of Accounting – pg. 100 (more notes on this further down)
 Installment sales
 Long-term contracts
 Research and experimental expenditures
 Crops and soil and water conservation expenditures o Special rules for corporations/partnerships in farming – pg. 99
 Partnerships engaged in farming that have a C corp as a partner must use the accrual method
 Any C corp engaged in farming with gross receipts greater than 1 million for any tax year
 “Family corporation” – 50% or more of total voting power and 50% or more of other classes of stock are family owned
307 Accrual Method of Accounting – pg. 105
.01 Accounting for Income
- All – events test - Taxpayers include income on their tax returns for the tax year during which all events have occurred to fix their right to receive the income and its reasonably accurate to determine o Not the actual or constructive receipt of income but the right to receive income – this rule governs the timing of when income must be included in gross income o The all events test is satisfied when all events have occurred to establish the existence of the liability and the amount of the liability can be determined with reasonable accuracy o Taxpayers have a fixed right to receive income when any one of the following events occurs:
 Required performance is completed
 Payment of the income becomes due
 Or payment is received
- Advance receipt of payments for services – pg. 106 o Generally included in gross income for accrual method for the year received o But, may defer all or a portion of an advance payment for services if they include advance payments for services in whole or in part in their revenues for a subsequent tax year for financial statement purposes o See page 106 for examples about the deferral method of advance payments
- Advance receipt of payments for sales of goods – pg. 107 o An accrual method taxpayer can wait to recognize income from advance payments from the sale of goods if it accounts for the sale using the same method for financial and tax accounting purposes
 Under this alternative method, an advance payment is included in a taxpayer’s gross receipt on the earlier of :
• The tax year in which the payments are included in gross income under the accrual method or
• The tax year in which the taxpayer includes any portion of the advance payments in income for financial reporting purposes
- Contested Amounts – pg. 107 – recognize when received
.02 Accounting for Expenses -pg. 102 o Economic performance
 Interest – occurs as the interest economically accrues daily, not as the payments are made
 Taxpayers liability arises from another party providing property or services – occurs as the property or services are provided
 Taxpayer’s liability arises out of the use of property by the taxpayer – economic performance occurs ratably over the period of time the taxpayer is entitled to use the property o Recurring Item Exception – pg 108 – a business can treat a liability as incurred for a tax year if the all-events test is met and the following requirements are satisfied:
 Economic performance
 The liability is recurring in nature and similar liabilities are treated the same
• A liability is recurring if it can generally be expected to be incurred from one tax year to the next
 Either the amount of the liability is not material or accruing the liability for that tax year would result in a better matching of the liability with the income to which it relates o Certain liabilities CANNOT quality for the recurring item exception –pg. 109 o Prepaid Expenses – must be capitalized and amortized over the period covered by the payment unless the 12 month rule applies
 If 12 month rule applies – a business deducts the amount of prepaid expenses in the year paid
• 12 month rule applies if: the amount paid creates any right or benefit for the taxpayer that does not extend beyond the EARLIER of: o 12 months after the first date on which the taxpayer realizes the right or benefit or o The end of the tax year following the tax year in which the payment is made
 Expenses owed to a related party – need to ensure that the amount reported in income and the deduction taken by related parties are accounted for at the same time – SO – the tax laws require that the accrual method taxpayer postpone the timing of the deduction until the cash method recipient includes the amount in income
• See page 110, figure 3-1 regarding related party relationships
 Contested liabilities – can take a deduction for a contested liability when it is paid – pg. 111
309 Special Accounting Methods
.01 Installment Method – taxpayer recognized gain as the payments are received rather than at the time the sale occurs
- Based on the premise that the taxpayers’ ability to pay taxes on income and gain is greatest at the time the cash becomes available
- More closely resembles the cash method of accounting because income is recognized as cash is received
- This method must be used to recognize income from installment sales regardless of what the taxpayer’s overall accounting method is o Taxpayer can elect not to use installment method – in this case the entire gain is recognized in the year of the sale (like accrual)
.02 Long-term Contracts – can use completed contract or % complete method (PCM)
- Pg 113 A long term contract has 3 requirements: o Contract for the manufacture, building, installation or construction of property o Will not be completed in the contracting year o If it’s for the manufacture of property, must involve personal property that is a unique item not normally carried in the taxpayer’s inventory or would usually take more than 12 months to complete
- Percentage of completion – taxpayers include in their gross income each year a portion of the total contract price that corresponds to the portion of the total estimated contract costs actually incurred during the year o Amount determined by multiplying the total contract price by the percentage of the total estimated contract costs that the taxpayer incurs during the year o Can elect to wait until they have incurred at least 10% of the estimated total contract costs before they include anything in gross income o After the contract is complete – the taxpayer must go back and reapply the PCM using its actual contract price and costs
- Completed contract method – no income or expenses related to the contract are recognized until the contract is completed o Types of contracts not required to use PCM include:
 exempt construction contracts – home construction or other to be completed within 2 years – (see pg. 115 for other info)
 residential construction contracts – home construction contract and the building(s) constructed contain more than 4 dwelling units
.03 Research and Experimental Expenditures – pg. 115
- Option to: o Capitalize o Capitalize and amortize over 60 months o Deduct entirely in current year
.04 Crop method of accounting – pg. 116 – the cost of producing the crop cannot be deducted until the year that the farmer realizes the gross income from the crop
.05 Soil and Water – pg. 116 – treat expenses as capital expenditures
312 Claim of Right Doctrine – a rule that requires taxpayers that receive money or other property under a claim of right without restriction to include the amount received in gross income for the year of receipt, regardless of the taxpayer’s method of accounting
- “claim of right” – treats the property as its own
- The amount of money of FMV of the property received must be included in gross income even though the business may not be entitled to keep the money or property and will be required to refund the money or property in a subsequent year – pg. 117 o 4 requirements for the claim of right doctrine to apply
 The business must receive the cash or other property
 Cash or property must constitute income for the business under the method of accounting
 Must have unrestricted control over the use and disposition of the cash or property received
 The business must possess the cash or other property under a claim of right
- Mitigation Rule - Pg. 118 – taxpayers entitled to reduce their tax liability for the year of repayment by the amount of tax attributable to the inclusion of the item in gross income - this rule applies only to deductions that exceed $3,000
313 Tax Benefit Rule – pg. 118
- Tax benefit rule - A tax rule under which an amount recovered must be included in gross income for the year of the recovery if all or a portion of the expense deducted in a prior tax year is recovered in a subsequent tax year and if the deduction resulted in a tax benefit for the taxpayer o The taxpayer must have deducted an amount in a prior year that resulted in a tax benefit to the taxpayer – thus:
 None of the amount recovered is included in a taxpayer’s gross income to the extent the amount did not reduce the taxpayer’s income tax liability in the prior tax year

314 Summary
- Financial accounting – provide useful information for management etc.
- To determine taxable income, need to know their tax year and method of accounting o C Corps have flexibility of using calendar or fiscal year o Personal service corps and flow through entities (S corps or partnerships) generally must have the same tax year as owners to prevent undue deferral of tax o Small businesses generally use the cash method of accounting