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Principles of Taxation

Principles of Taxation. Chapter 5 Taxable Income from Business Operations. Objectives. Describe how taxable year relates to operating cycle. Explain realization and matching principles Cash versus accrual methods GAAP versus tax conservatism Book-tax income differences Constructive receipt

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Principles of Taxation

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  1. Principles of Taxation Chapter 5Taxable Income from Business Operations

  2. Objectives • Describe how taxable year relates to operating cycle. • Explain realization and matching principles • Cash versus accrual methods • GAAP versus tax conservatism • Book-tax income differences • Constructive receipt • Accrual basis exceptions • NOLs

  3. Taxable Income • Taxable income = gross income less allowable deductions • Gross income “means all income from whatever source derived.” • Deductions are allowed through legislative grace, and include all ordinary and necessary expenses … in carrying on any trade or business.” • Good rule of thumb: receipts are taxable UNLESS you can find a law that says it is excluded. Expenses are deductible ONLY if you can find a law that says it is deductible.

  4. Taxable year • 12-month period which generally corresponds to its financial year. • Individual taxpayers must generally choose a calendar year. • Firms generally choose a financial and tax year that corresponds to the end of an annual operating cycle. See Q1. • Why does dividing time into periods (like years) create opportunities for deferral? • Changing tax years requires permission - most common reason is merger of firms with different year-ends.

  5. Accounting Methods • Overall method by which taxpayers determine their income, gains, losses, deductions and credits, as well as the time realized and recognized. CLEARLY REFLECTS INCOME • CONSISTENTLY APPLIED • Establish a method by using it in the first tax return. • Requires IRS permission to change. • What kinds of transition rules do you think the IRS has? E.g. a firm with LIFO layer $1,000,000 switches to FIFO

  6. Accounting Methods - General Principles • Like financial accounting, we follow: • REALIZATION principle (earnings process complete) • MATCHING principle (expenses with revenues) • Exceptions generally arise due to risks of tax evasion, convenience for government or taxpayer, ability to pay, economic incentives.

  7. Accounting Methods - General Principles • The CASH method is mandatory where the individual taxpayer's records reflect only cash transactions and there are no inventories. • The ACCRUAL method is mandatory for: • purchases and sales where inventories must be used. • C corporations, and partnerships with a C corporation as a partner, with average annual gross receipts >= $5,000,000. • HYBRID method - Use accrual for inventories (CGS), but cash for everything else.

  8. Cash Method • Under the cash method, gross income includes cash or property actually or RECEIVED during the tax year. • Deductions are usually taken in the year cash or property is PAID. • It doesn't matter when the income was earned, or when the expense was incurred. • Cash method income includes receipt of noncash goods - Examples? See Q5.

  9. Cash Method Income • Constructive receipt of income. • Income not actually received is constructively received and reportable: • IF within the taxpayer's control. • NO constructive receipt if the amount is available only on surrender of a valuable right, or if there are substantial limits on the right to receive it. • Examples?

  10. Cash Method Deductions • Cash method - deduct when PAY. A check is payment when mailed. • An asset must be capitalized. The cost of the asset may be recovered over the asset life (e.g. depreciation, cost of goods sold). Major repairs may result in IRS dispute regarding expense versus capitalization. • Inventory must be accounted for on the accrual method, even for cash basis taxpayers. This is called a HYBRID method of accounting.

  11. Cash Method DeductionsPrepaid expenses • Where an expense (e.g., rent or an insurance premium) covers more than the following tax year, the deduction must be spread over the period to which the expense applies. AP2. • However, prepaid interest must be capitalized and deducted over the period for which interest is actually charged even if prepayment < next tax year. AP5. • Exception - deduct prepaid interest (points) on the purchase of a home. Does not apply to refinancing.

  12. Accrual Method of Accounting • Under the accrual method, income is reported in the tax year in which the right to the income and the amount of the income can be determined with reasonable accuracy. • Deductions are claimed in the period in which ALL EVENTS have occurred that determine the existence of the liability and the amount of the liability can be determined with reasonable accuracy. • Contrast to financial accounting (what are contingent liability rules in GAAP)?

  13. Accrual Income Exceptions - prepaid income • Prepaid income is taxed when received under the Claim of Right Doctrine • Government has the right to tax income when the taxpayer has unrestricted right to use such income amounts. • Examples: rent, royalty, bonuses, advertising, services (except see below). AP3, 4

  14. Accrual Income Exceptions - prepaid services • Advance payments received for services to be performed must be reported by an accrual basis taxpayer in the year received . • exception: a taxpayer can elect to defer advance payments over the period services are performed if they are received under an agreement requiring all the services to be performed by the end of the following tax year.

  15. Accrual Income - goods • Advance payments received for merchandise or construction = delayed taxation. • OK to use accrual method if that method is used for all tax reporting and for credit and financial purposes. • Small contractors may also use the completed contract method to further delay taxation.

  16. Accrual Income Exceptions - advances and deposits. • A deposit that guarantees the customer's payment of amounts owed to the creditor isn't a deposit but an advance payment includible in income. (E.g., apartment last months’ rent?). • Deposit securing someone's property is a true security deposit and not an advance payment. (E.g., apartment security damage deposit).

  17. Accrual Expenses Exceptions • Related Party Accruals • The paying party cannot deduct an expense until the year that a receiving party deducts the expense. • Prevents accrual basis taxpayers from accruing an expense but delaying payment. • AP6, 7

  18. Accrual Expenses • Bad Debts • GAAP - allowance method • Tax- direct write-off method. Record income if account repaid later. • AP8, 9

  19. Accrual Expenses • GAAP accrued liabilities must be probable and estimable under SFAS 5. • Tax • All Events Test requires 1) liability fixed • 2) amount determined with reasonable accuracy. • Economic Performance test for nonrecurring expenses requires that all activities to satisfy the liability have occurred - often requires payment.

  20. Summary Cash vs Accrual • summary:

  21. Section 482 - Broad IRS Powers • IRS has authority to “distribute, apportion, or allocate gross income, deduction, credits or allowances” among businesses to CLEARLY REFLECT income of each. • BIG issue in multi-jurisdictional taxation. See Chapter 12.

  22. Book-Tax Differences • Contrasting principles of conservatism. • GAAP - protect shareholders and creditors: don’t overstate book income. • Tax - protect government revenues: don’t understate taxable income. (contrasting result may arise due to economic incentives - e.g. accelerated depreciation)

  23. Book-Tax Differences • Permanent differences do not reverse; Temporary differences reverse over the life of the firm. • GAAP current tax expense is based on taxable income. • GAAP deferred tax expense is the tax effect of temporary differences reversing in the future.

  24. Book-Tax Differences • Examples of permanent non-deductible expenses (that are still deductible for financial statements) • 50% meals and entertainment • political contributions • fines and penalties • interest expense to generate tax-exempt municipal bond income • premiums on life insurance • See AP10

  25. Book-Tax Differences • Examples of permanent tax preferences that make taxable income less than book income: • Tax-exempt municipal bond income • Life insurance proceeds. • Examples of temporary differences: • Depreciation • Timing of accruals • Capital losses • Bad debts (allowance vs. writeoff) • Cash versus accrual accounting

  26. Book-Tax Differences • GAAP total tax expense (SFAS109) • = current + deferred tax expense • in simple situations, this approximates tax rate on book income + or - permanent differences (old APB11). • Let’s look at a financial statement (see link on Jones Ch 5 web page). • We’ll see this material again in Chapter 10. • AP8, 11, 18.

  27. Net Operating Losses • Problem arises due to artificial time divisions (years). • Solution: carryback 2 years, carryforward 20 years. • GAAP now allows firms to record a tax benefit for expected value of future NOL deductions. • Election available to FOREGO CARRYBACK.

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