5 Accounting Methods and Special Entities Flashcards
How should a person account for revenue from an accounting perspective?
A person must use the method of accounting regularly used to compute income in keeping books and records. The method must clearly reflect income. The cash method and the accrual method are the most common. Specific provisions of the Internal Revenue Code (IRC) may override and require specific treatment of certain items.
Whose consent is required for changes in accounting method?
Generally, IRS consent is required, which include, but are not limited to, change in either the overall system of accounting for gross income or deductions or treatment of any material item used in the system.
When is income reported?
Income is reported when it can be estimated with reasonable accuracy.
When are adjustments to income made?
Adjustments are made in a later year for any differences between the actual amount and the previously reported amounts.
How is the tax year determined?
The accounting method determines the tax year, which is the annual accounting period used to keep the person’s books and records, in which an item is includible or deductible in computing taxable income.
How are federal income taxes imposed?
Federal income tax is imposed on taxable income.
When is the taxable period adopted?
The taxable period is adopted in a person’s first tax year.
What are types of taxable periods?
- calendar year - 12-month period ending on December 31
- fiscal year - any 12-month period ending on the last day of the month
- 52 or 53 week tax year
- a short tax year is allowed for a business not in existence for an entire year (365 or 366 days) - ex - the start-up year or the year at dissolution
- a change of tax year generally requires IRS consent, and a short tax year return is then required
What is the cash method?
A cash-method taxpayer accounts for income when one of the following occurs:
- cash or its equivalent is actually received
- cash or its equivalent is constructively received
How are noncash forms of income, such as property or services, valued?
They are included in gross income at the fair market value - even if the property or service can be converted into cash at an amount lower than face value.
What is a cash equivalent?
Property that is readily convertible into cash and typically has a maturity of 3 months or less. Cash equivalents are so near to maturity that the risk of loss due to a change in value is immaterial.
What are examples of cash equivalents?
- checks (valued at face)
- promissory notes (valued at FMV)
- Property (transferable at current FMV)
If the value of property cannot be determined, how is it valued?
If the value of property received cannot be determined, the value of what was given in exchange for it is treated as the amount of income received.
If the property received and the property given are impossible to value, how is value determined?
The transaction is treated as open, and the consideration is not viewed as income until its value can be ascertained.
What is the doctrine of constructive receipt?
An item is included in gross income when a person has an unqualified right to immediate possession.
When does a person constructively receive income?
A person constructively receives income in the tax year during which it is credited to their account, set apart for them, or otherwise made available so that they may draw upon it at any time.
- it is more than a billing, offer, or promise to pay
- it includes the ability to use on demand, as with escrowed funds subject to a person’s order
- deferring deposit of a check does not defer income. However, dishonor (bounced or returned checks) retroactively negates the income.
How is constructive receipt by an agent treated?
It is treated as if imputed to the principal.
What is the claim-of-right doctrine?
It indicates that a taxpayer receiving payments under a claim of right and without restrictions on its use includes the payment in income in the year received even though the right to retain the payment is not yet fixed or the taxpayer may later be required to return it.
- if the payment is not received, the payment is not included in income.
What is the economic benefit theory?
The economic benefit theory is that when an economic or financial benefit is conferred on an employee or independent contractor the transfer of property is equivalent to cash. This applies even when the taxpayer cannot choose to take the equivalent value of the income in cash.
When are dividends considered to be constructively received for the cash method?
When made subject to the unqualified demand of a shareholder - Ex. - If a corporation declares a dividend in December and pays such that the shareholders receive it in January, the dividend is not treated as received in December.
When bonds are sold between interest payment dates, how is the interest treated for the cash method?
The interest accrued up to the sale date is added to the selling price of the bond. The seller includes the accrued interest in gross income as interest income. The buyer reduces interest income, as a return of capital, by the same amount.
When is prepaid rent included in gross income?
Prepaid rent is included in gross income when received, for both cash-method and accrual-method taxpayers.
When are lease cancellation payments included in gross income for cash-method taxpayers?
Lease cancellations are included when received for cash-method taxpayers
When are tenant improvements, in lieu of rent, included in gross income for cash-method taxpayers?
Tenant improvements, in lieu of rent, are included when received for cash-method taxpayers
When should advance rental payments be deducted by cash-method taxpayers?
The payee must deduct during the tax periods to which the payments apply.
When are tips reportable as gross income?
Tips are gross income when reported. An employee who receives $20 or more in tips per month working for any employer must report the tips to the employer by the 10th day of the following month.
When are a cash-method taxpayer’s deductions included?
Their deductions include expenditures when actually paid, except generally for prepaid expenses.
If a taxpayer uses the cash-method to report income, must they use the cash-method to report expenses?
Yes
How are prepaid expenses deducted for cash-method taxpayers?
For cash-method taxpayers, prepaid expenses are generally not deductible when paid. Instead, prepaid expenses are prorated over the period of the expense.
What is the exception to the prepaid expense rule for cash-basis taxpayers?
The 12-month rule - This allows a cash-basis taxpayer to deduct a prepaid expense in the year of payment if two conditions are met:
- the contract period of the expense cannot exceed 12 months (the taxpayer cannot prepay for 13 months of a service)
- the contract period cannot extend beyond the end of the next taxable year (payment in year 1 cannot be for a benefit in year 3)
Is prepaid interest an allowed deduction under the 12-month rule?
No, prepaid interest is not allowed a deduction until the year to which the interest relates.
When do accrual-method taxpayers account for income?
In the period it is actually earned.
When do taxpayers with applicable financial statements (AFSs) include income?
Generally no later than the inclusion for financial accounting purposes. This AFS rule does not apply to special methods of accounting (ex - long-term contracts, installment agreements) or mortgage servicing contracts.
When do taxpayers without applicable financial statements (AFSs) include income?
They include income when all the events have occurred that fix the right to receive it and the amount can be determined with reasonable accuracy.
Is a right to receive income fixed if it is contingent on a future event?
NO
When are goods shipped on consignment considered to have met the all-events test to fix the right to receive income?
When the goods shipped on consignment are sold
When do accrual-method taxpayers include prepaid income?
Prepaid income must generally be included when received.
When do accrual-method taxpayers include prepayments for merchandise sales in gross income?
When it is reported for accounting purposes, if reported earlier than when earned.
When do accrual-method taxpayers include expenses?
Expenses are deductible in the period in which they accrue.
What are the requirements for an accrual-method taxpayer to claim an allowable deduction?
The accrual-method taxpayer may claim an allowable deduction when both of the following requirements are met:
- all events have occurred that establish the fact of the liability, including that economic performance has occurred.
- the amount can be determined with reasonable accuracy
For accrual-method taxpayers, when does economic performance occur?
Economic performance occurs as services are performed or as property is provided or used.
How are reserves for contingent liabilities determined for accrual-method taxpayers?
Under current case law, reserves for contingent liabilities (such as product warranties) are not determinable in amount with reasonable accuracy. Therefore, only amounts paid are deductible. Both cash-basis and accrual-method taxpayers must use the direct write-off method.
How are tax deductible expenses related to contingent liabilities calculated?
Using the direct write-off method
beginning balance + accrued expense - ending balance = tax deductible expense
How is accrued vacation pay deducted for accrual-method taxpayers?
It is generally deductible by the employer when paid or in the year accrued if paid within 2.5 months of year end.
How are deductions for amounts payable to related parties treated for accrual-method taxpayers?
Deduction of an amount payable to a related party is allowed only when includible in gross income of the related party.
Which taxpayers are required to use the accrual method?
- C corporations
- partnerships with a C corporation as a partner
- charitable trusts with unrelated income
- tax shelters
What are considered tax shelters?
Tax shelters include any arrangement for which the principal purpose is avoidance of tax, any syndicates, and any enterprise in which the interests must be registered as a security.
What entities are not considered tax shelters?
The following taxpayers are exceptions to the general rule and allow the use of the cash method:
- qualified personal service corporations
- entities that meet the gross receipts test by having $27 million or less average gross receipts in the 3 preceding years
- farming or tree-raising businesses
What is the required accounting method for a taxpayer who maintains inventory?
Accrual method, with regard to purchases and sales.
Which taxpayers maintaining inventory are exceptions to the inventory rule (required accrual method)?
Qualifying taxpayers who satisfy the gross receipts test for each test year. The average annual gross receipts (consisting of the test year and the preceding 2 years) for each test year must be $27 million or less.
How does the gross receipts test apply to S corporations regarding the inventory method?
S corporations are not subject to the $27 million limitation, however if inventory sales are a material part of the S corporation’s operations, the accrual method must be used to calculate gross profit.
What is the inventory method?
A taxpayer who maintains inventory must use the accrual method, exceptions to the rule include qualifying taxpayers who satisfy the gross receipts test for each year. The inventory method used must clearly reflect income and conform to GAAP of the trade or business. Inventory may be valued at cost or at the lower of cost or market.
How may inventory be valued?
At cost or the lower of cost or market
What is gross income for the inventory method?
Gross income includes receipts reduced by COGS whether purchased or manufactured
How is the cost of purchased merchandise calculated?
Cost = purchase price - trade discounts + handling charges
What are the uniform capitalization rules?
The uniform capitalization rules require the costs for acquiring property for sale to customers (retail) to be capitalized. These rules do not apply if property is acquired for resale and the company’s annual gross receipts (for the past 3 years) do not exceed $27 million. Both direct and most allocable indirect costs necessary to prepare the inventory for its intended use must be capitalized.
