Chapter 1 Business Income and Deductions Flashcards
List the 6 business deductions
- business deductions must be ordinary and necessary
- business deductions must be reasonable in amount
- business deductions must be arm’s length (e.g. unrelated persons)
- business deductions are not allowed for penalties or fines
- business deductions are not allowed for political contributions or lobbying expenses.
- business expenditures for tangible property with a life greater than one-year must be capitalized.
Why must business expenditures for tangible property with a life greater than one-year be capitalized?
Business expenditures for tangible property with a life greater than one year must be capitalized because they provide future economic benefits that extend beyond the current tax year. Here are the key reasons for capitalization:
Matching Principle: According to accounting principles, expenses should be matched with the revenues they help to generate. Tangible property with a useful life greater than one year contributes to revenue over multiple periods. Capitalizing these expenditures ensures that the cost is allocated over the periods in which the property is used, matching expenses to the revenue they help generate.
Accurate Financial Reporting: Capitalization ensures that the financial statements accurately reflect a company’s financial position. By capitalizing long-term assets, businesses avoid overstating expenses in the year of purchase and provide a clearer picture of their asset base and profitability over time.
Tax Compliance: For tax purposes, the IRS requires capitalization of expenditures on tangible property that is expected to last more than one year. This rule prevents businesses from deducting large capital expenditures in a single year, which could otherwise distort taxable income. Instead, the cost is recovered through depreciation over the asset’s useful life.
Reflecting Asset Value: Capitalization adds the cost of the tangible property to the balance sheet as an asset, reflecting its value to the business. This approach aligns with how businesses use these assets over time and demonstrates the company’s investment in its productive capacity.
In summary, capitalization of long-lived tangible property ensures compliance with accounting standards, tax regulations, and presents a more accurate depiction of a business’s financial health and operational results.
Cash Method
A business that recognizes revenue when property or services are actually or constructively received.
Businesses must have average annual revenue of less than $30,000,000 for the three prior taxable periods (e.g., 2021, 2022, and 2023) to be able to use the Cash Method.
Accrual Method
Businesses recognize income when they meet the “All Events” Test. Deductions must meet the “All Events” Test and the “Economic Performance” Test.
All Events Test for Income
The All Events Test for Income is a principle in U.S. federal tax law that determines when a taxpayer must recognize income for tax purposes.
This test is applied to determine when income is “fixed and determinable” and therefore must be reported.
All events test for income (accrual basis tax payers).
Earliest of the following three dates:
- When the business completes the service for the customer, or passes title for goods to the customer.
-When they complete the task required to earn the income. Businesses earn income for services as they provide the services, and they generally earn income from selling property when the title of the property passes the buyer.
- When payment for the task is due from the customer.
3.) When the payment is received.
What does All-Events Test is met on the earliest of these three dates mean?
This means that a business must recognize income for tax purposes as soon as the first of the following three events occurs:
What is a Gross Receipt Test
A business meets the gross receipt test for 2024 if its average annual gross receipts for the three prior taxable years does not exceed $30 million.
Gross Receipt Test determines if a business qualifies as a “small” business under an annual gross receipts test if its average annual gross receipts for the three prior taxable years does not exceed a threshold.
Gross Receipts Test for Identifying Small Businesses
A.) For purposes of the test, gross receipts include total sales (net of returns and allowances but not cost of good sold), amounts received for services, and income from investments (including tax-exempt interest).
Gross Receipts Test for Identifying Small Businesses
B.) When the business has not been in existence for three prior tax year, the test is conducted for the years that it was in existence.
Gross Receipts Test for Identifying Small Businesses
C.) In the case of a taxable year of less than 12 months (a short year), the amount of gross receipts must be Annualized by Multiplying the gross receipts for the short year by 12 and Dividing the result by the number of months in the short year.
Business Deductions: Ordinary and Necessary
Business expenditures must be BOTH Ordinary and Necessary to be deductible.
Business Deductions: Reasonable in Amount
An expenditure is reasonable when the amount paid is neither extravagant nor exorbitant. Ordinary and necessary business expenses are deductible only to the extent they are reasonable in amount.
Business Deductions: Arm’s-length amount
Is the price that two independent people or businesses agree on when they buy or sell something. It means they are both looking out for their own best interest, and neither side has an unfair advantage over the other.
Limitations on Business Deductions: Political Contributions and Lobbying Costs
Tax law prohibit deductions for political contributions and most lobbying expenses.
Capital (Business) Expenditures
Whether a business uses the cash or accrual method of accounting, it must Capitalize Expenditures for Tangible assets such as buildings, machinery and equipment, furniture, and fixtures, and similar property that have useful lives of more than on year (12 months).
For tax purposes, businesses recover the cost of capitalized tangible assets (other than land) either by immediate expensing (when allowed by law) or through deprecation.
Businesses also capitalize the cost to create or acquire Intangible assets such as patents, purchased goodwill, start-up cost, and organizational expenditures. They recover the costs of capitalized intangible assets either through Amortization (when the tax laws allow them to do so) or upon disposition of the assets. Prepaid expenses are also subject to capitalization, but there is a special exception that we discuss under accounting methods later in this chapter.
Business Income and Deductions: Business Casualty Losses
Businesses can also incur deductible losses when their assets are stolen, damaged, or destroyed by a force outside of the control of the business. These events are called casualties.
Businesses deduct casualty losses in the year the casualty occurs or in the case of theft, the year the theft is discovered.
The amount of the loss deduction depends on whether the asset is Completely destroyed (or stolen), the business calculates the loss by substituting the insurance proceeds if amy for the amount realized.
Total Loss
Loss deduction for AGI = Insurance Proceeds - Tax Basis
If the asset is damaged but not completely destroyed, the amount of the loss is the amount of the insurance proceeds minus Lesser of 1) the asset;s adjusted tax basis or 2) the decline in the value of the asset due to the casualty
Partial Loss
Loss deduction for AGI = Insurance Proceeds - Lesser of asset’s adjusted basis or decline in the value of the asset due to the casualty.
** Tax Basis = Original Cost + Any Improvements - Tax Depreciation
ACCRUAL Deductions: To claim a tax deduction for an accrued expense, the expense must meet two tests: 1) an all events-test and 2) an economic performance test
