Bryant - Course 4. Tax Planning. 13. Tax Accounting Methods Flashcards
Module Introduction
Federal income tax is the dominant form of taxation in the United States. In addition to federal income tax, most states, and some cities and counties, also impose an income tax to which corporations and individuals are subject. The calculation of income for these taxes often depends on accounting principles. In order to understand and calculate taxable income, a planner must consider the taxpayer’s method of tax accounting. The term “method of tax accounting” is used to include the overall methods of tax accounting and the accounting treatment of specific items.
The Tax Accounting Methods module will explain the different accounting periods, changes in accounting periods and accounting methods, and inventory costs and their impact on taxation.
Upon completion of this module you should be able to:
* List the rules for adopting and changing an accounting period,
* Explain the differences between cash, accrual, and hybrid accounting,
* Determine the tax treatments in case of duplications and omissions that may result due to changes in accounting methods, and
* List the methods used for inventory costs.
Module Overview
In order to have a clear understanding of tax accounting methods, you must keep in mind that taxable income is computed on the basis of the taxpayer’s annual accounting period, which is ordinarily 12 months (i.e., either a calendar year or a fiscal year). A fiscal year is a 12-month period that ends on the last day of any month other than December.
The tax year must coincide with the year used to keep the taxpayer’s books and records. Taxpayers who do not have books, such as an individual with wage income, must use the calendar year. The year in which income is taxed depends on the taxpayer’s accounting method. The three primary overall accounting methods are the cash receipts and disbursements method, the accrual method, and the hybrid method.
Finally, a change in accounting methods usually results in duplications or omissions of items of income or expense. When this happens the net amount of the change must be taken into account. There are different methods for reporting the amount of change. But, in general, once an accounting method is chosen, it cannot be changed without IRS approval. There are, however, a few exceptions to the rule.
There will be a discussion on inventories, which may be valued at either cost or at the lower of cost or market value. The costs that must be included in inventory are found in IRC Section 263A and are referred to as the Uniform Capitalization Rules (UNICAP). The specifics of these rules are beyond the scope of this course and are not usually part of the financial planner’s role.
To ensure that you have an understanding of tax accounting methods, the following lessons will be covered in this module:
* Accounting Periods
* Accounting Methods
* Inventories Overview
* Changes in Accounting Methods
Accounting Periods
The taxpayer’s annual period on the basis of which taxable income is computed is called an accounting period. An accounting period is either a calendar year or fiscal year typically consisting of 12 months. The tax year must coincide with the taxpayer’s books and records. Taxpayers who do not have books, such as an individual with wage income, must use the calendar year. The tax year is elected on the first tax return that is filed by a taxpayer and cannot be changed without consent from the IRS.
A taxpayer with a seasonal business may find a fiscal year to be advantageous. During the slow season, inventories may be lower and employees are available to take inventory and perform other accounting duties associated with the year-end.
To ensure that you have an understanding of accounting periods, the following topics will be covered in this lesson:
* Partnerships
* S Corporations and Personal Service Corporations
* Required Payments and Fiscal years
* Changes in Accounting Periods
Returns for Periods of Less Than 12 Months
Upon completion of this lesson, you should be able to:
* List the different kinds of accounting periods
* Explain the purpose of having stringent guidelines to govern accounting periods
* Impact of tax rules on accounting periods, and
* Exceptions in the rules governing accounting periods.
What tax year must a partnership use?
A partnership must use the same tax year of the partners who own the majority (greater than 50%) of partnership income and capital. If a majority of partners do not have the same year, the partnership must use the tax year of its principal partners (those with more than a 5% interest in the partnership). If the principal partners do not have the same tax year, the partnership must use the taxable year that results in the least aggregate deferral of income to the partners. An exception is made for partnerships that can establish to the satisfaction of the IRS a business purpose for having a different year.
The purpose of the strict rules for selecting accounting periods is to prevent partners from deferring partnership income by choosing a different tax year for the partnership. For example, calendar-year partners might select a partnership year that ends on January 31. Because Partnership income is considered to be earned by the partners on the last day of the partnership’s tax year, reporting the profits would thus be deferred 11 months because the partnership tax year ends after the partner’s year. Consequently, the income of the partnership earned in 2023 would be deemed earned by the partner in 2024 and not taxed until that year.
If a majority of the partners do not have the same tax year, they should use the __ ____??____ __ tax year.
* principal partners’
* limited partners’
principal partners’
If a majority of partners do not have the same year, the partnership must use the tax year of its principal partners (those with more than a 5% interest in the partnership).
S Corporations and Personal Service Corporations
What tax year are S corporations and personal service corporations required to adopt?
Generally, S corporations and personal service corporations are required to adopt a calendar year unless the corporation has a business purpose for electing a fiscal year. Taxpayers willing to make certain required payments or distributions may choose a fiscal year.
An improper election to use a fiscal year automatically places the taxpayer on the calendar year. Thus, if the first return is filed late because of oversight, the option to choose a fiscal year is lost.
Establishing a Corporate Tax Period Example:
Eagle Corporation has adopted a 52-53-week year. Eagle’s tax year begins on December 29, 2023. Assume that a new tax rate schedule applies to tax years beginning after December 31, 2022. The new tax rate schedule is applicable to Eagle because, in the absence of the 52-53-week year, its tax period would have started on January 1, 2023.
While most tax years end on the last day of a month, the tax law allows taxpayers to use a tax year that always ends on the same day of the week, such as the last Friday in October. This means that the tax years will vary in length between 52 and 53 weeks. Taxpayers who regularly keep their books over a period that varies from 52 to 53 weeks may elect the same period for tax purposes. A 52-53-week taxable year must end either the last time a particular day occurs during a calendar month (e.g., the last Friday in October) or the occurrence of the particular day that is closest to the end of a calendar month (e.g., the Saturday closest to the end of November). Under the first alternative, the year may end as many as six days before the end of the month but must end within the month. Under the second alternative, the year may end as many as three days before or after the end of the month.
Although the 52-53-week year may actually end on a day other than the last day of the month, it is treated as ending on the last day of the calendar month for “effective date” changes in the tax law that would otherwise coincide with the year-end.
If Partnerships and S corporations make the Section 444 election, what are they required to do?
Virtually all C corporations (other than personal service corporations) have flexibility in choosing an accounting period. Other taxpayers, such as partnerships and S corporations, may use a fiscal year if they have an acceptable business purpose. However, most of these businesses are unable to meet the rather rigid business purpose requirements outlined by the IRS. As a result, these businesses end up using the calendar year and have to concentrate most tax work in the early months of the year. Concern over this problem led Congress to enact IRC Section 444, which allows partnerships, S corporations, and personal service corporations (such as incorporated medical practices) to elect a taxable year that results in a tax deferral of three months or less. For example, a partnership with calendar-year partners may elect a September 30 year-end.
Partnerships and S corporations making the Section 444 election, however, must make annual required payments by April 15 of the following year. The purpose of the required payment is to offset the tax deferral advantage obtained when fiscal years are used.
How do you calculate the required payment?
The amount of the required payment is determined by multiplying the maximum tax rate for individuals plus 1% (38% in 2023) times the previous year’s taxable income times a deferral ratio. The deferral ratio is equal to the number of months in the deferral period divided by the number of months in the taxable year. An adjustment is made for deductible amounts distributed to the owners during the year. If the deductible amount due is $500 or less, no payment is required. If a business elects something other than a calendar year-end, it will have to make tax payments for the time value of money benefit it gets for the tax deferral on reporting the income. The business can deduct the amount distributed to the business owners during the year (as they will be reporting this income on their return). However, they will have to pay income taxes on any amount above $500.
Required Payments & Fiscal Year Example:
ABC Partnership begins operations on October 1, 2023, and elects a September 30 year-end under Section 444. The partnership’s net income for the fiscal year ended September 30, 2023, is $100,000.
* What is ABC’s required payment?
* When is it due?
ABC must make a required payment of $9,500 ($100,000 x 38% x 3/12) on or before April 15, 2024.
What must personal service corporations do to elect a fiscal year-end?
Personal service corporations may elect a fiscal year-end if they make minimum distributions to shareholders during the deferral period. Personal service corporations are incorporated medical practices and other similar businesses owned by individuals who provide their services through the corporation. In general, the rules prevent a distribution pattern that creates a tax deferral. This is achieved by requiring that the deductible payments made to owners during the deferral period be at a rate no lower than during the previous fiscal year.
When is a change in Accounting periods allowed?
Once adopted, an accounting period cannot normally be changed without the approval of the IRS. The IRS will usually approve a change only if the taxpayer can establish a substantial business purpose for the change (e.g., changing to a natural business year). A natural business year ends at or soon after the peak income-earning period (e.g., the natural business year for a department store that has a seasonal holiday business may end on January 31). A business without a peak income period may not be able to establish a natural business year and may, therefore, be precluded from changing its tax year. In general, at least 25% of revenues must occur during the last two months of the year in order to qualify as a natural business year.
What are the instances for which IRS approval is not required to change to another accounting period?
- A newly married person may change tax years to conform to that of his or her spouse so that a joint return may be filed. However, the election must be made in either the first or second year after the marriage date.
- A change to a 52-53-week year that ends with reference to the same calendar month in which the former tax year ended.
- A taxpayer who erroneously files tax returns using an accounting period other than that on which his or her books are kept is not required to obtain permission to file returns for later years based on the way the books are kept. Corporations under the following specified conditions may switch to another accounting period even without IRS approval: There has been no change in its accounting period within the past ten calendar years; the resulting year does not have a net operating loss (NOL); the taxable income for the resulting short tax year when annualized is at least 90% of the taxable income for the preceding full tax year; and if there is no change in status of the corporation (such as an S corporation election).
- An existing partnership can change its tax year without prior approval if the partners with a majority interest have the same tax year to which the partnership changes or if all principal partners who do not have such a tax year concurrently change to such a tax year.
- A corporation meeting the following specified conditions may change without IRS approval: (1) There has been no change in its accounting period within the past ten calendar years. (2) the resulting year does not have a net operating loss (NOL), (3) the taxable income for the resulting short tax year when annualized is at least 90% of the taxable income for the preceding full tax year, and (4) there is no change in status of the corporation (such as an S corporation election). A statement should be attached to the return indicating that each condition is met.
When is a change in tax years required?
There is one instance, however, when a change in tax years is required: A subsidiary corporation filing a consolidated return with its parent corporation must change its accounting period to conform to its parent’s tax year. Application for permission to change accounting periods is made on Form 1128 (Application to Adopt, Change or Retain an Accounting Period), on or before the due date of the return including extensions. The application must be sent to the Commissioner of the IRS, Washington, D.C. The IRS may establish certain conditions for the taxpayer to meet before it approves the change to a new tax year.
What are the 4 steps in changing an Accounting Period?
- Step 1
Accounting Period - An initial accounting period is determined by the corporation. - Step 2
Purpose for Change - The taxpayer must establish a substantial business purpose for the change. - Step 3
Form 1128 - Application for permission to change accounting periods is made on Form 1128. The application must be sent to the Commissioner of the IRS, Washington, D.C. - Step 4
IRS Approval - The IRS reviews Form 1128 and either approves the change in the accounting period or establishes conditions that must be met in order for the change to be approved.
What are the 2 occasions that a taxpayer’s accounting period may be less than 12 months duration?
- The first instance is when the taxpayer’s first or final return is filed and the second one occurs if the taxpayer changes accounting periods.
- Taxpayers filing an initial tax return, executors filing a taxpayer’s final return, or corporations filing their last return are not required to annualize the year’s income. There are no provisions for personal exemptions or tax credits to be prorated. These returns are prepared and filed, and taxes are paid as though they are returns for a 12-month period ending on the last day of the short period. An exception permits the final return of a decedent to be filed as though the decedent lived throughout the entire tax year.
Taxpayers who change from one accounting period to another must annualize their income for the resulting short period. This prevents income earned during the resulting short period from being taxed at lower rates.
What are the 4 Steps to Annualize Income?
Step 1
Determine Modified Taxable Income - Individuals must compute their taxable income for the short period by itemizing their deductions.
Step 2
Multiply Modified Taxable Income - Modified Taxable Income is multiplied by (12 ÷ # of months in short period).
Step 3
Compute the Tax on the Resulting Taxable Income - Use the appropriate tax rate schedule to compute the tax.
Step 4
Multiply the Resulting Tax - Multiply the tax result by (# of months in short period ÷ 12).
Section One Summary
The tax year is elected on the first tax return that is filed by a taxpayer and cannot be changed without consent from the IRS. The taxable income of any taxpayer is computed on the basis of the taxpayer’s annual accounting period which is usually 12 months. The IRS will usually approve of a change only if the taxpayer can establish a substantial business purpose for the change.
Most income tax returns cover an accounting period of 12 months. However, on two occasions, a taxpayer’s accounting period may be less than 12 months: When the taxpayer’s first or final return is filed, or when the taxpayer changes accounting periods.
In this lesson, we have covered the following:
* Partnerships: Generally must use the tax year of the majority owners of the partnership. If the majority of partners do not have the same tax year, they are required to use the tax year of the principal partners who have more than 5% ownership.
* S Corporations and Personal Service Corporations are generally required to adopt a calendar year for their accounting period unless they have a business purpose for electing a fiscal year.
- Required payments and fiscal years: Almost all C Corporations have flexibility in choosing an accounting period. However, most other forms of business such as partnerships, S Corporations, and personal service corporations are unable to meet the rigid business purpose requirements outlined by the IRS, so these businesses are allowed to use a fiscal year provided they make certain required payments to the IRS to eliminate the tax benefit of deferring the taxability of income due to the fiscal year election.
- Changes in the accounting period cannot be changed without consent from the IRS. The IRS approves of a change only if the taxpayer is able to establish a substantial business purpose for the change. There are also a few instances where IRS approval is not required to change an accounting period such as a newly married person changing tax years to match his or her spouse so that a joint return may be filed.
- Returns for periods less than 12 months are acceptable for the following two reasons: When the taxpayer’s first or final return is filed, or when the taxpayer changes accounting periods.
The tax year must coincide with the year used to keep the taxpayer’s books and records.
* False
* True
True
The tax year must coincide with the year used to keep the taxpayer’s books and records. Taxpayers who do not have books must use a calendar year.
All of the following are acceptable accounting tax years EXCEPT?
* A corporate tax year ending on February 15th.
* A corporate tax year ending on the last Friday in April.
* A partnership tax year ending on December 31 with three equal tax partners whose tax year ends on September 30, October 31, and November 30.
* An S corporation’s tax year ending on December 31.
A corporate tax year ending on February 15th.
A tax year must fall at the end of the month or be specified as a specific day at the end of the month such as the last Friday in April.
When preparing a tax return for a short period, the taxpayer should annualize the income if the short return:
* Is the last return for a decedent who died on November 23.
* Is the first return for a corporation created on June 12.
* Is a return for June 1 to December 31, for a corporation changing from a fiscal year to a calendar year.
* Is the last return for a partnership, which is terminated on October 12.
Is a return for June 1 to December 31, for a corporation changing from a fiscal year to a calendar year.
Taxpayers who change from one accounting period to another must annualize their income for the resulting short period. This prevents income earned during the resulting short period from being taxed at lower rates.
Section 2 - Accounting Methods
A taxpayer’s method of accounting determines the year in which income is reported and expenses are deducted. Taxable income must be computed using the method of accounting regularly used by the taxpayer in keeping his or her books if that method clearly reflects income. Permissible overall accounting methods are:
* Cash receipts and disbursements method (often called the “cash method of accounting”)
* Accrual method
* A combination of the first two methods often called the hybrid method
Individual taxpayers and small businesses use the cash receipts and disbursements method of accounting. Taxpayers using the accrual method of accounting generally report income in the year it is earned. The hybrid method of accounting really is a combination of the cash and accrual methods. Under the hybrid method, some items of income or expense are reported under the cash basis and others are reported under the accrual method.
While taxpayers have the right to choose a method of accounting, the chosen method still must clearly reflect income as determined by the IRS. The IRS has the power to change the accounting method used by a taxpayer if, in the opinion of the IRS, the method being used does not clearly reflect income.
In order to have an understanding of accounting methods, the following topics will be covered in this lesson:
* Cash Method
* Accrual Method
* Hybrid Method
* Long-term Contract
* Installment Sales
Upon completion of this lesson, you should be able to:
* List the different accounting methods,
* Explain the purpose of having different methods to compute tax,
* Explain the differences among these methods, and
* Determine the taxable ramifications of an installment sale.
Cash Method of Accounting Example:
In December of the current year, Troy, who owns an apartment building, collects the first and last months’ rent from the tenant. Troy must report two months’ rent in the current year. The actual expenses associated with the last month’s rental are not incurred until the last month. However, Troy must report two months’ income this year, but may only deduct one month’s expenses.
Reporting prepaid income can have harsh results because it is not offset by related deductions. If the income is taxed before the expenses are incurred, the taxpayer may not have enough cash to pay the expenses when they are incurred.
Most individual taxpayers and most small businesses use the cash receipts and disbursements method of accounting. Under this method, income is reported in the year the taxpayer actually or constructively receives the income rather than in the year the income is earned. The income can be received by the taxpayer or the taxpayer’s agent and be in the form of cash, other property, or services. When received as property or services, the amount included in income is the value of the property or services.
Accounts receivable or other unsupported promises to pay are considered to have no value under the cash method and, as a result, no income is recognized until the receivable is collected. The fact that prepaid income is taxed when received and not when earned often results in mismatching of income and expenses.
What is Constructive Receipt?
A cash-basis taxpayer must report income in the year in which it is actually or constructively received. Constructive receipt means that the income is made available to the taxpayer so that it may be drawn upon it at any time. However, income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions. This rule prevents taxpayers from deferring income that is otherwise available by merely “turning their backs” on it. A taxpayer cannot defer income recognition by refusing to accept payment until a later taxable year.
What are instances of constructive receipt where taxpayers are required to report taxable income even though no cash is actually received include?
Instances of constructive receipt where taxpayers are required to report taxable income even though no cash is actually received include:
* A check received after banking hours
* Interest credited to a bank savings account
* Bond interest coupons that have matured but have not been redeemed
* Salary available to an employee who does not accept payment
When is an amount is not constructively received?
An amount is not constructively received if:
* It is subject to substantial limitations or restrictions.
* The payer does not have the funds necessary to make the payment.
* The amount is unavailable to the taxpayer.
Constructive Receipt Example:
Beth owns an ordinary life insurance policy with a cash surrender value. She need not report any income as the cash surrender value increases, because the requirement that she cancel the policy in order to collect the cash surrender value constitutes a substantial restriction. If she cancels the policy, she reports as income the difference between the cash surrender value collected and net premiums paid.
Exam Tip:
Getting to know the CFP Board-provided tax tables and limits is essential to achieving exam success. Listen in to this audio guide to find out tax table-related best practices for your studies & exam preparation.
Constructive Receipt - income is recognized and taxes are paid
* Good question to ask to determine: Are there any strings attached still attached to the receipient’s ability to have access to the funds?
- If there’s no strings attached, it is constructive receipt
- Common to see on test: Non-qualified deferred compensation - strings attached (period of time, accomplishment of goals). Until that time, there’s substanial risk of forfeiture. So, no constructive receipt until it’s released.
The term ‘constructive receipt’ means the taxpayer has access to the income at any time.
* False
* True
True.
Constructive receipt means that the income is made available to the taxpayer so that (s)he may draw upon it any time. However, income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.
What is one of the exceptions to the basic rule that cash-basis taxpayers report income when it is actually or constructively received?
- The interest on Series E and Series EE U.S. savings bonds need not be reported until the final maturity date, which varies but may be as long as forty years after the date of issue, and can be deferred even longer if the bonds are exchanged within one year of the final maturity date for Series HH U.S. savings bonds.
Many taxpayers purchase bonds with a maturity date that occurs after retirement when the taxpayers expect to be in a lower tax bracket.
For example, Tenisha purchased a Series EE U.S. savings bond in the current year for $2,500 that matures in 10 years. The bond will not pay any interest until it matures; at maturity, the bond will be worth $5,000. Tenisha is not required to report any interest income for tax purposes until the bond matures. At maturity, when Tenisha receives the $5,000, she will report $2,500 of interest income. If she desires to defer the interest further and avoid paying tax on the interest income, she could exchange her Series EE bond for a Series HH bond within one year.
What is the other exception to the basic rule that cash-basis taxpayers report income when it is actually or constructively received?
Special rules also apply to farmers and ranchers. Farmers may report crop insurance proceeds in the year following receipt if the crop would have ordinarily been sold in the following year. Ranchers who sell livestock may, on account of drought, flood, or other weather-related conditions delay reporting income until the following year if they can establish that the livestock sale would otherwise have taken place in a later tax year. These rules help taxpayers avoid bunching income into one year.
What are taxpayers who use cash receipts and disbursement methods required to do with fixed assets?
Taxpayers who use cash receipts and disbursement methods are required to capitalize fixed assets. They must also recover the cost through depreciation or amortization. The regulations state that pre-paid expenses must be capitalized and deducted over the life of the asset if the life of the asset extends substantially beyond the end of the tax year. Typically, capitalization is required only if the life of the asset extends beyond the close of the tax year following the year of payment.
Capitalization Example:
On July 1, 2023, Acme Corporation, a cash-basis, calendar-year taxpayer, pays an insurance premium of $3,000 for a policy that is effective from July 1, 2023, to June 30, 2024. The full $3,000 is deductible in 2023.
What is one notable exception to the one-year rule?
One notable exception to the one-year rule denies a deduction for prepaid interest. Cash-method taxpayers must capitalize such amounts and allocate interest over the prepayment period. A special rule allows homeowners to deduct points paid on a mortgage used to buy or improve a personal residence. The payment must be an established business practice in the area and not exceed amounts generally charged for such home loans.
Who is required to use the accrual method of accounting, according to IRC Section 448?
Who is exempt from this requirement?
Taxpayers using the accrual method of accounting generally report income in the year it is earned. Income is earned when all the events that fix the right to receive the income have occurred and the amount of income can be easily determined. In the case of a sale of property, income normally accrues when the title passes to the buyer. Income from services accrues as the services are performed.
IRC Section 448 requires C corporations and partnerships with corporate partners, tax shelters, and certain trusts to use the accrual method of accounting.
Qualified personal service corporations, certain types of farms, and entities with average gross receipts under $29 million (2023) are exempt from the requirement.
What is a major exception to the normal operation of the accrual method?
A major exception to the normal operation of the accrual method is the rule applicable to the receipt of prepaid income. Prepaid income is generally taxable in the year of receipt. For example, if a lender receives interest for January in the preceding December, it is taxable in the year received, whether the lender uses the cash or accrual method. This treatment, of course, differs from financial accounting, where the interest would be reported as it accrues.
Two important exceptions to the general rule are:
* Accrual-basis taxpayers may defer recognizing income in the case of certain advance payments for goods and in the case of certain advance payments for services to be rendered.
* A taxpayer may defer advance payments for goods (inventory) if the taxpayer’s method of accounting for the sale is the same for tax and financial accounting purposes.
A taxpayer may defer advance payments for services if the payments are for services to be performed before the end of the tax year following the year of receipt. Such payments may be reported as the services are performed. For example, the taxpayer may allocate the payment received over the current and succeeding years. The rule is not applicable if a payment covers a time period that extends beyond the end of the tax year following the year of receipt. This rule can be applied to a variety of services such as dance lessons, maintenance contracts (but not to warranties included in the sales price of a product), and rent (if services are associated with the rent, as with a hotel or motel).
What is the all events test?
An accrual-method taxpayer reports an item of income when all events have occurred that fix the taxpayer’s right to receive the item of income and the amount can be determined with reasonable accuracy. Similarly, an expense is deductible when all events have occurred that establish the fact of the liability and the amount of the expense can be determined with reasonable accuracy. For deductions, the all-events test is not satisfied until the economic performance has taken place.
