Ch. 6 - Taxable Income from Business Operations

Question 1

What is the base for the federal income tax?

Answer 1

Taxable income

Question 2

Taxable income

Answer 2

Gross income minus allowable deductions

Question 3

Gross income

Answer 3

“all income from whatever source derived”

Question 4

What is does gross income consist of (in a business context)?

Answer 4

-Revenues from the sales of goods or services or performance of services in the regular course of business

Gross income from the sale of tangible goods by manufacturer, wholesaler, or retailer equals gross receipts less COGS

Gross income from from the performance of services includes all charges, fees, commissions, and bonuses received as compensation

Gross income also includes rents received for occupancy of real estate or the use of tangible personalty, royalties received for the use of intellectual properties, and interest and dividends received as a return on invested capital.

Question 5

True or false: there are certain limitations imposed by the federal courses on the definition of “from whatever source derived”

Answer 5

False—the courts have consistently ruled that phrase is broad enough to include any accession to wealth or increase in net worth

Question 6

True of false: firms can only derive gross income from events or transactions occurring within the course of their routine commercial activities

Answer 6

False—it can be from outside their normal course of business as well.

Question 7

What does the IRC allow deductions for (in a general sense)?

Answer 7

“All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.”

Question 8

What makes an expense ordinary (and therefore deductible)?

Answer 8

If it is customary for a particular type of trade or business and is commonly or frequently incurred.

Question 9

What makes an expense necessary (and therefore deductible)?

Answer 9

It is necessary if it is appropriate and helpful for the development of the business and the generation of revenue.

Question 10

True or false: firms can deduct the various state, local, and foreign taxes incurred in carrying out their business activities.

Answer 10

True!

Question 11

The federal income tax is imposed on ______ rather than _______?

Answer 11

It is imposed on the net profit rather than gross receipts (because of deductions)

Question 12

A firm’s taxable year generally corresponds to its _________?

Answer 12

annual accounting period for financial statement purposes

Question 13

Calendar year

Answer 13

The 12 month period from January 1 through December 31

Question 14

Fiscal year

Answer 14

Any twelve month period ending on the last day of any month except December

Question 15

The choice of a calendar or fiscal year is usually dictated by __________

Answer 15

The firm’s operating cycle

Question 16

How does a new business entity establish its taxable year?

Answer 16

By filing an initial return on the basis of such year

Question 17

How does a firm change their calendar year?

Answer 17

They must receive express permission from the IRS

Question 18

Short period return

Answer 18

A tax return for the taxable year consisting on less than 12 months

Question 19

Method of accounting

Answer 19

A consistent system methodfor determining the point in time at which items of income and deduction are recognized for tax purposes

Question 20

The IRC permits firms to use which accounting methods?

Answer 20

-The cash method
-The accural method
-A hybrid of both

Question 21

True or false: a taxpayer with multiple business must use the same method of accounting for all businesses

Answer 21

False—they can use different ones for different businesses.

Question 22

Recognition

Answer 22

Inclusion of an item of item of income or deduction in the computation of taxable income

Question 23

What is Section 482 pertain to?

Answer 23

Section 482 of the IRC states that in the case of two or more businesses under common ownership or control, the IRS may “distribute, apportion, or allocate gross income, deduction, credits, or allowances” among the businesses to clearly reflect the income of each.

Section 482 is typically invoked by the IRS when a method of accounting results in the beneficial shift of income between related parties.

Question 24

True of false: a company can change it’s method of accounting when it has reason to

Answer 24

It can, but it must seek and receive permission from the IRS

Question 25

What are some of the objectives of tax policy?

Answer 25

-Accurate measurement of income

—Congress also wants laws to be consistent with public policy and political concerns
—For example, contribution to political parties or candidates for public office and lobbying expenses are not deductible, nnot are fines, bribes, penalties, and kickbacks paid to any government for a violation of law

Question 26

Explain how deductions for business meals work

Answer 26

Congress allows firms to deduct 50% of most business meals (with exceptions)

Question 27

True or false: business entertainment expenses are nondeductible

Answer 27

True! (as of 2018)

Question 28

True or false: interest paid on debt is not deductible

Answer 28

False—it is deductible

Question 29

True or false: payments to equity holders are not deductible

Answer 29

True!

Question 30

Business interest limitation

Answer 30

Business net interest in excess of 30% of adjusted taxable income is not deductible

From the IRS website:
the amount of deductible business interest expense in a taxable year cannot exceed the sum of:

-the taxpayer’s business interest income for the taxable year;
-30% of the taxpayer’s adjusted taxable income (ATI) for the taxable year; and
-the taxpayer’s floor plan financing interest expense for the taxable year.

Question 31

Net interest expense

Answer 31

Business interest expense in excess of business interest income

Question 32

What happens to interest not deductible as a result of the business interest limitation?

Answer 32

It can be carried forward to succeeding taxable years as business interest

Question 33

The interest expense limitation applies only to ___________

Answer 33

Taxpayers with average gross receipts of $29 million or more over the three preceding tax years

Question 34

True or false: interest paid on state and local local debt obligations are exempt from federal income tax

Answer 34

True! (aka it is recorded on the books as revenue but not recognized as gross income for tax purposes).

Question 35

Key-person life insurance policies

Answer 35

Insurance purchased by a firm on the life of a high level employee. The firm is the beneficiary of the policy.

When a key person dies and the firm received payment from the insurance company, the payment is recorded as revenue but not included in gross income

Question 36

True or false: expenses related to income from municipal bond interest and key-person life insurance policies are nondeductible.

Answer 36

(so you do not include the income from these sources in gross income, and the expenses are related to them cannot be deducted).

So, a firm can’t deduct interest paid on a debt if the borrowed funds were used to purchase or carry tax-exempt bonds.

Question 37

What does Section 199A refer to?

Answer 37

Qualified business income (QBI)

Question 38

Qualified business income (QBI) deduction.

Answer 38

Active trade or business income from non-service businesses eligible for the Section 199A deduction.

This section provides taxpayers other than corporations a 20% deduction against QBI

Aka if you earn 100,000 of QBI, you deduct 20% of that so you will only pay taxes on $80,000 of business profit

Question 39

Cash method of accounting

Answer 39

Firms record revenue from the sale of goods or the performance of services in the year the payment is received, regardless of when the sale occurred or the services were performed.

Firms record expenses in the year the expense is paid, regardless of when the liability for the expense was incurred

Question 40

True or false: net income computed under the cash method doesn’t equate to net cash flows.

Answer 40

True, because you can have income for a period but not record the money for it

Question 41

Doctrine of constructive receipt

Answer 41

The point at which a taxpayers has unrestricted access to and control of income, even if the item is not in the taxpayers actual possession.

The courts have generally concluded that constructive receipt occurred if no substantial barrier to the firms control and possession of the income exist.

In other words, a calendar year, cash basis firm can’t defer income from one year to the next by holding the checks received from its customers in December and cashing the checks the following January.

Question 42

Any business expenditure creating a benefit with a useful life extending substantially beyond the close of the year is _______ and must be ________

Answer 42

Is not deductible and must be capitalized and amortized over its useful life

Question 43

Explain the tax law for the “12 month rule” for determining whether an expense is currently deductible or must be capitalized to an intangible asset account

Answer 43

If the expenditure results in a benefit with a duration of 12 months or less and that benefit doesn’t extend beyond the end of the taxable year following the year of payment, the expenditure is deductible in the year of the payment. If teh expenditure results in a benefit with a duration of more than 12 months, it must be capitalized.

Question 44

True: cash basis taxpayers must capitalize and deduct interest in future years for which the interest is actually charged

Answer 44

True (even for cash basis taxpayers)

Question 45

True or false: firms that sell merchandise to their customers may use either the accrual or cash method to account for purchases and the sale of the merchandise.

Answer 45

False—even cash basis taxpayers must use the accrual method. Aka they must capitalize the cost of merchandise as an inventory asset and can expense only the cost of inventory sold during the year.

Question 46

True or false: all business must account for inventory using the accrual method.

Answer 46

False—typically this is right, by TCJA exempted taxpayers with an average annual gross receipts of $29 million or less so they can either:
1) Treat inventories as non-incidental materials and supplies or
2) Conform to their financial accounting treatment of inventory.

Question 47

Who is allowed to use the cash method?

Answer 47

Corporations that average more than $29 million annual gross receipts (2023 threshold amount) can’t use the cash method for tax purposes.

This also includes partnerships with corporate partners

But it does NOT apply to personal service corporations.

Question 48

Personal service corporations

Answer 48

Corporations that offer professional services (medical, legal, accounting, etc) performed by individuals shareholders or employees for the corporate client.