Chapter 11: Accounting Periods And Methods Flashcards
How does the choice of accounting method affect taxable income
Determines when income and expenses are reported (not whether they are reported)
Can accelerate or postpone tax payments
Can actually lower taxes by spreading income across multiple periods
Accounting period for taxpayers who do not have “books”
(individuals with wage income)
Required to use calendar year
When does a business choose a tax year
Elected on the first tax return filed and cannot be changed without consent of the IRS
Tax year for partnerships
Must use same tax year as majority partners (who own over 50% of partnership income/capital)
- if majority partners have different tax years must use the tax year of principal partners
- if principal partners have different tax years must use the taxable year resulting in least aggregate deferral of income to partners
Unless partnership can establish to IRS the business purpose of the different year
Principal partners in a partnership
Have more than 5% interest
Accounting period for s corps and personal service corporations
Must use calendar year unless can show business purpose for fiscal year (may use fiscal year if making required payments or distributions)
Consequences of improper use of fiscal tax year
Loss of option to use fiscal tax year: must use calendar year
52-53 week year
Law that allows taxpayers to use a tax year that always ends on the same day of the week - means that the tax year will vary between 52 and 53 weeks
Must end on either the last occurrence of a day in a calendar month (up to six days before EOM) or on the occurrence of the day that is closest to the end of the month (up to 3 days before OR AFTER EOM)
Changes in tax law for companies that use a 52-53 week year
Treated as if tax year ends on the last day of the month for the purpose of determining tax law
Accounting period C corporations
Fiscal year of choice (exception for personal service corps)
Section 444 election
Allows partnerships, s corps, and personal service corps to elect a taxable year that results in a tax deferral of three months or less (from calendar year)
Also grandfathers in businesses that were using fiscal years prior to requirement for calendar year being passed
Requirements if taking section 444 election
-must make required payments by may 15th of following year
- payment = maximum tax rate for individuals + 1% * previous year’s taxable income * deferral ratio
- adjusted for distributions to owners. No payment if amount due is $500 or less
Deferral ratio= # of months in deferral period / # of months in the taxable year
Payment is not a credit for business owners but rather decreases current year’s required payment by previous year’s required payment (negative amount = refund)
Personal service corporation section 444 election
Deductions to shareholder employees may be limited of distributions to such individuals do not exceed a minimum amount
(Deductible payments to owners during the deferral period may not create a tax deferral so must be at a rate no lower than the previous fiscal year)
May use three year average to compute minimum distribution
Natural business year
Ends at or soon after the peak income earning period (at least 25% of incomes occur during the last two months of the year)
Business without a peak income period may not be able to establish a natural business year
When may an accounting period be changed without IRS approval?
- upon marriage if changing to confirm to spousal tax year for joint return purposes (election must be made within first two years of marriage)
- changing to a 52-53 week year that ends in the same month as the previously used tax year
- correction to misfiled returns if bringing tax year into alignment with bookkeeping year
- corporation if: there has been no change of accounting period in last 10 years, resulting year does not have NOL, taxable income for resulting short year is at least 90% of income for proceeding full tax year AND there is no change in the status of the Corp
- partnership if: majority partners have the same tax year or if principal partners change to the tax year
Situation where a business is required to change their tax year
A subsidiary Corp filing a consolidated return with it’s parent must conform to the parents tax year
When may a tax return be for an accounting period of less than 12 months
- filing first or final return (no prorating required. Filed as if for a 12 month period)
- when taxpayer changes accounting periods
Requirements for short period tax filing when changing accounting period
Must ANNUALIZE income for resulting period
How to annualize income
- determine modified taxable income (deductions MUST be itemized)
- multiply result by 12/number of months in short period
- compute tax on resulting taxable income
- multiply the resulting tax by: number of months in short period / 12
When GAAP conflicts with tax regulations
For tax purposes the tax regulations must be followed
GAAP used if regulations don’t specify or if there are multiple options for treatment
Writing down obsolete or slow moving inventory
Per IRS regulation cost can only be reduced when price is reduced (so it clearly reflects income)
Items not salable at normal price (damaged, obsolete, shop worn) may be valued at a bona fide selling price reduced by the direct cost of disposal
UNICAP
Uniform capitalization rules
Options for valuing inventory
May be valued at cost or at the lower of cost or market value (unless taxpayer uses LIFO then may not use LCM)
Inventory cost of merchandise
Invoice price less trade discounts plus freight and handling charges
Treatment of purchasing, warehousing, packaging, and administrative costs
Must be allocated between CoGS and inventory per UNICAP
Required for taxpayers whose average gross receipts for the preceding three years exceed $26M (2021)
UNICAP rules for goods manufactured by the taxpayer
Essentially expanded full absorption method. Direct labor, materials, and overhead must be included in value of inventory
Overhead items manufacturing co. Must include in inventory cost
- factory repairs and maintenance, utilities, rent, insurance, small tools, all depreciation
- factory admin and officer’s salaries related to production
- tax other than income tax
- quality control and inspection
- rework, scrap, and spoilage
- current and past service costs of pensions and profit sharing plans
- service support costs (purchasing, payroll, warehousing)
Basically anything that directly supports manufacturing (so not marketing, selling, R&E)
When must interest be inventoried
Real property
Long-lived property
Property requiring more than two years (or one year if costs >$1M) to produce
Service support costs included in inventory
Must be allocated between manufacturing and non manufacturing and the manufacturing costs included in inventory
When may a manufacturer use standard costs to value inventory
If any significant variance is reallocate pro rata to ending inventory and CoGS
Allowable inventory costing method
FIFO, LIFO, average cost, specific identification
Why do taxpayers use LIFO
During inflationary periods (rising prices) LIFO results in the lowest inventory value/highest CoGS and so the lowest taxable income
Tax requirements if using LIFO for tax purposes
Must also use LIFO for financial accounting (though may disclose what income would be under FIFO etc)
How do taxpayers adopt LIFO for tax purposes
Form 970 or other statement accepted by IRS attached to return for tax year where LIFO first used
Record keeping for LIFO & dollar-value lifo
- use of dollar-value pools and government price indexes (like CPI or Producer price index)
Inventory divided into pools
If a particular pool is depleted the taxpayer loses the right to use the lower prices associated with past layers
Simplified LIFO method
May be used by taxpayers with average annual gross receipts of $5M or less for current and two preceding years
Uses a single LIFO pool
Calculating inventory cost under simplified LIFO method
Base year price index/current year index * current year ending inventory = current year ending inventory in base year prices
Subtract last year ending inventory to find current layer and multiply that by current year/base year index to return to current year price
Add current year layer to base year (and any previous) layer to get ending inventory
Lower of cost or market
Option available unless taxpayer is using LIFO
Inventory is valued at the lower of original cost or current replacement cost on the date of valuation
Must be applied to each item in inventory individually
(Obsolete or slow moving inventory can be written down only if selling price has been reduced)
Market value for LCM
Price at which taxpayer can REPLACE the goods in question (not selling price)
Cycle inventory valuation
Per Congress a taxpayer may count inventory on a cycle (rather than annually) and then adjust quantities for estimated shrinkage at year end based on past experience
Allowed specifically when “the taxpayer makes proper adjustment to such inventories and its estimation method for actual shrinkage”
Long term contracts
Building, installation, construction, or manufacturing contracts that are not completed within the same year in which they began.
Only counts if item is not normally carried in finished goods inventory or normally requires more than 12 months to complete
Contracts for services do not count
Accounting methods available for long-term contracts
- percentage completion method
- modified percentage completion method
- completed contract method (limited circumstances only)
- any other accounting method that clearly reflects income
Whichever used must be used for all long term contracts in same trade or business and cannot be changed without permission
Percentage of completion long term contract accounting method
Taxpayer reports a percentage of gross income from the contract based on the portion of the work that has been completed
Revenue for year = contract price x % complete
% determined by dividing costs to date by expected costs
Completed contract long term contract accounting method
Income from a project recognized & taxable when project completed no matter when price is collected.
Costs capitalized (accumulated in work-in-progress account) and deducted from revenue in year project complete
Concept of completion may vary (total completion and acceptance vs substantial completion)
Defers tax on revenue but may result in overall higher tax rates
Which costs are subject to long-term contract rules
- direct contract costs
- labor, materials, overhead (allocated)
- admin costs (allocated, for percentage and modified percentage methods only)
- interest (costs directly attributable and those that could have been avoided without the contract(
When may the completed contract method be used
- by smaller companies (whose average gross receipts from the preceding three tax years is $26M or less) on construct project expected to take two years or less
- for home construction contracts
Modified percentage of completion method
Taxpayer defers estimating total costs of project/reporting income from a contract until they have incurred at least 10% of total costs
If less than 10% of costs are incurred in first year of construction they included in the second year when costs are more accurately estimated
Look-back interest
Once a contract is complete (under percentage of completion or modified method) must determine if tax paid each year during the contract is more or less than tax that would have been paid the the actual cost had been used instead of estimated cost
If actual tax paid was less, interest is paid on the additional
If tax paid was more taxpayer receives interest on the additional
When must look-back interest be calculated?
- contracts completed more than two years after the commencement date
AND - only if the contract price equals or exceeds either 1% of the taxpayer’s average gross receipts for the three preceding taxable years before the tax year in which the contract was entered OR $1M
De-minimis exception to look back interest computation
If income reported each year on a contract is within 10% of recomputed look-back income then no interest computation is made for the contract
If elected applies to all contracts completed within a year. Must be determined separately for each completed contract that year. Can only revoke election with IRS approval
Installment sales method
Gain from installment sales may be spread over collection period unless taxpayer elects not to use it
Applicable only to gains.
Not applicable to sales of inventory or marketable securities
May be used by cash or accrual method taxpayers
Installment sales
Any disposition of property where at least one payment is received after the close of the taxable year in which the disposition occurs
Contract price
Greater of the gross profit (selling price minus basis, expenses and depreciation recapture) or the selling price reduced by any existing mortgage assumed or acquired by the purchaser
Gross profit percentage
Gross profit / contract price
Computing income under installment sales method
1) selling price less basis, expenses, depreciation recapture = gross profit
2) contract price = greater of gross profit or selling price reduced by existing mortgage assumed by purchaser
3) gross profit/ contract price = gross profit percentage
4) net gain recognized in year of sale = (collections of principal + excess mortgage)* gross profit percentage
Plus depreciation recapture = gain reported in year of sale
4) gain reported in subsequent year =collection of principal x gross profit percentage
Excess mortgage
= mortgage - basis - selling expense - depreciation recapture
When to report depreciation recapture
In year of sale even if no payment received that year
Installment method if purchase price of disposed of property was deducted in year or purchase under sec. 179
Gain on sale covered by section 1245 and must be reported in the year of sale even if the full amount is not received
Makes installment method not helpful
Why is installment method often used for real estate
The cost of real estate cannot be deducted in the year of purchase under sec. 179
What if seller holding an installment obligation does not hold it to it’s full maturity
Holder must determine adjusted basis of obligation in order to compute gain or loss on obligation
Gain or loss = selling price - adjusted basis of installment
Adjusted basis of an installment obligation
= Face amount of the obligation - gross profit that would have been realized if face amount collected
AKA
= Face amount * (100% - gross profit percentage)
Gift of an installment obligation
Donor must recognize gain or loss if the difference between the face value of an obligation and it’s adjusted basis
Cases where donor of installment obligation is not taxed but rather recipients report income when installments collected
- transfers of installments to controlled corporations under section 351
- certain corporate reorganizations and liquidations
- transfers on the death of a taxpayer
- transfers incident to divorce
- distruction by partnerships
- contributions of capital to partnerships
Repossession of property sold in an installment basis
Taxable event
Gain or loss = difference between value of repossessed property (reduced by any costs incurred in repossession) and adjusted basis of remaining installment obligation
New basis is FMV at time of repossession
Gain or loss has same character as gain or loss on original sale
Limitation on gain from repossession of real property
Limited to the lesser of:
- gross profit in remaining installments reduced by costs incurred in repossession, or
- cash and FMV of other property received from the buyer in excess of the gain previously recognized
Rules for installment sales for more than $150,000
- if taxpayer borrows funds with installment obligation as security the amount borrowed = payment on installment obligation
- it installment method is used interest must be paid to government on deferred tax (for deferred principal payments over $5M)
Do not apply to sales of personal-use property, trade or business property, or sales of timeshares or residential lots
Installment sales between related person when property is resold by related purchaser
- first seller must treat amounts received by related person as personally received (gain reported in year(s) in which proceeds received by second seller
- applicable if resale takes place within two years of initial sale
If installment sale method is not applicable or if taxpayer elects out
Accrual method: amount receivable from buyer is part of amount realized (entire gain or loss reported in year of sale)
Cash method: FMV of installment obligation treated as part of amount realized in year of sale (amount realized cannot be less than FMV of property sold less consideration received
If value of obligations received cannot be determined
Said to have indeterminate market value
Value assumed to be no lower than the value of property sold less the value of property received
If have value of property sold: gain = value less basis
Contingent payment sale
A sale or other disposition of property in which the aggregate selling price cannot be determined by the close of the tax year in which the sale took place
When is imputed interest used
In a deferred payment contract where no interest rate or a low interest rate is provided
Tax consequences of imputed interest rules
Sellers must reallocate payment received between interest (fully taxable) and principal (only gains taxable)
May increase income reported in early years and decrease in later years
Also applies to buyer for interest deduction
Transactions exempt from imputed interest rules
- debt subject to original issue discount provisions
- sales of property for $3,000 or less
- sales where all payments are due within six months
- sales of patents to the extent the payment is contingent on the use of disposition of the patent
- certain carrying charges for personal property or educational services covered by section 163(b) where interest charge cannot be ascertained
- charges for the purchase of personal use property (purchaser may not use imputed interest)
Applicable federal rate
Interest rate determined monthly, based on the rate paid by the federal government on borrowed funds. Varies with term of loans:
Short term (< 3 yrs)
Mid term (3 yrs> but <9yrs)
Long term (9 yrs+)
What interest rate must be used to avoid imputed interest
At least 100% of applicable federal rate
(110% for sale-lease back arrangements)
When are interest rates below the applicable federal rate allowable?
- it stated principal amount for qualified debt obligations issued in exchange for property under sec 1274A does not exceed $2.8M: interest limited to 9% compounded semiannually
- sale of land between related individuals for under $500,000: interest limited to 6% compounded semiannually
When to report imputed interest
Generally when it is accrued
When may a borrower and the lender jointly elect not to accrue interest
If stated principal does not exceed $2M, and if lender is not an accrual method taxpayer or a dealer this approach cannot be used
Exceptions to requirement of reporting imputed interest when it accrues
- sale of personal residence
- (most) sales of farms for $1M or less
- sales involving aggregate payments of $250,000 or less
- sale of land between related persons (unless price exceeds $500,000)
Interest expense/ income only reported when final payment is made
Other situations where imputed interest applies
- gift loans
- corporate shareholder loans
- compensation-related loans
- tax avoidance loans in general
Tax avoidance loans
Low-interest or interest-free loan that produces tax savings
Tax treatment of imputed interest
- interest (generally determined using applicable federal interest rates) is taxable to the lender
- may be deducted by the borrower (usual guidelines apply)
-lender is treated as returning imputed interest to borrower (if amount large enough could result in gift tax)
Corporation shareholder loans
If corporation makes an interest free loan to a shareholders they must imputed interest and then the interest is treated as being paid back to the Shareholder as a dividend (shareholder must recognizes as income)
Tax consequences of compensation-related loans
- interest imputed is considered compensation paid by employer and received by employee
- taxable to employee and (if reasonable) deductible by the employer
Times when imputed interest is not used or is limited
- gift loans between individuals totalling $10,000 or less (unless borrowed funds used to purchase income-producing property)
- If gift loans between individuals total $100,000 or less imputed interest is limited to the borrower’s net investment income (If less than $1000, not necessary to impute interest)
- compensation-related or corporate shareholder loans of $10,000 or less
UNLESS TAX AVOIDANCE IS PRINCIPAL PURPOSE OF THE LOAN (then imputed interest always applies)
How is an accounting method selected?
Usually simply by applying the selected method when computing income for the initial tax return or the tax return for the first year in which the item occurs
Can taxpayers change accounting methods?
Yes, but generally not without IRS approval
Accounting changes that can be made without IRS approval
Adoption of LIFO inventory method (then cannot switch back without approval)
How are errors in tax returns corrected?
Normally by filing an amended return for the year(s) in which the error occured
Statute of limitations for correcting tax filing errors
Three years
After which tax year is closed and no further changes can be made
How to request to change accounting methods
File form 3115. One copy to IRS on or before return due date and one copy with the tax return
Can request a change of accounting methods when filing an amended return if filing within six months of the due date
Under what circumstances will the IRS automatically approve accounting changes
- form 3115 filed properly
- taxpayer agreed to take into account the section 481(a) adjustment
- taxpayer is not under examination
- accounting method has not been changed within previous four years
Are changes in accounting methods retroactive?
Generally not but may be in case of misstatement or omission of materials facts or changes in applicable authority
How are duplications or omissions of revenues or expenses handled in the case of a change of accounting methods?
Must be accounted for as a net amount either added to or subtracted from income
For amounts of $3000 or less the entire amount is accounted for in the year of the change
Reporting net change from change in accounting methods if over $3000
Voluntary change of accounting method: must report over a period not exceeding four years, divided equally, beginning in the year of change. (Cannot be spread over a period longer than method has been used) If $25,00 or less may elect to include full amount in the current year
If involuntary change: IRS decides method
If changing from computing taxable income differently from book income to computing in the same way
Should not require IRS approval
If a different method of reporting is used for tax vs book records
As long as financial and book income are reconciled the taxpayer may not have to change the methods to be the same
Form for installment sale income
Form 6252
(Installment sales other than inventory)
Separate form for each installment sale
Changing to LIFO inventory method
No filings necessary if using LIFO from start
If switching to LIFO do not need approval but should file form 970 in the year of change
If LCM was used must restate beginning inventory to cost because LCM cannot be used with LIFO but adjustment can be spread over year of change + next two years
