Ch. 6- Measurement of Taxable Income

Question 1

How is Gross Income calculated? (in order to compute taxable income)

Answer 1

(Sales - COGS) + rent received, royalties, interest, discharge of debt, any access to increased net worth or wealth

Question 2

How is taxable income calculated?

Answer 2

Gross income - deductions = taxable income

Question 3

What are deductions for computing taxable income?

Answer 3

IRS allows deductions for “all ordinary and necessary BUSINESS expenses paid or incurred in the taxable year”

Question 4

Are personal expenses that are paid for by the business allowed as a tax deduction?

Answer 4

No, businesses can incur personal expenses but will not be tax deductible. (Hot dog example)

Question 5

How does the process work for changing taxable years for businesses?

Answer 5

Every business must request the change with the IRS and must get their request approved before changing their taxable year.

They will most likely also have to file a short period return for the year in which they change their taxable year.

Question 6

Are two or more businesses, under common ownership, allowed to distribute income to one entity or the other in order to minimize tax obligations?

Answer 6

No, businesses must report income and incur expenses that clearly reflect the operations of each business.

Question 7

Can companies deduct political campaign contributions?

Answer 7

No, if this was allowed it would subvert the democratic process and allow large companies to have more control over Congress.

Question 8

Can companies deduct fines or penalties?

Answer 8

No, Congress does not want to lessen any enforcement penalty.

Question 9

Can companies deduct bribes or settlement payments in regards to sexual assault or harrassment?

Answer 9

No, Congress does not want to subsidize bad behavior.

Question 10

How are business meals and business entertainment expenses treated under the tax code?

Answer 10

50% of most meals are tax deductible.

As of 2018, NO deduction is allowed for entertainment expenses incurred by a business.

Question 11

How did the Consolidated Appropriations Act of 2021 (CAA) affect the tax treatment of business meals?

Answer 11

If these business meals were provided by a restaurant, the full amount is deductible.

Only for business meals incurred in 2021 and 2022. (In order to stimulate business spending during COVID to help restaurants)

Question 12

What are the deduction limitations for net interest expense and give the formula for net interest expense?

Answer 12

Net interest expense = business interest expense - business interest income

A deduction is not allowed for net interest expense if it is in excess of 30% of the business’s adjusted taxable income. (To stop businesses from taking on too much debt)

Beginning in 2022, the Business interest limitation only applies to companies with average gross receipts (sales) of $27 million ort more over the last 3 years.

Question 13

Tax Preferences that encourage Economic behavior: Do companies that hold municipal debt have to pay taxes on the interest payments of the debt?

Answer 13

No, the taxpayer does not have to pay tax on interest revenue. This encourages companies to invest in the communities they do business in.

CAVEAT: However, the taxpayer cannot deduct interest expenses on debt used to buy local or state bonds.

Question 14

Tax Preferences that encourage Economic behavior: Are proceeds from life insurance policies taxable?

Answer 14

They are not taxable only if they are on key personnel. Example: Steve Jobs for Apple

CAVEAT: Companies cannot deduct expense of the life insurance premiums for tax purposes.

Question 15

What is the corporate tax rate as of 2018? What did the corporate tax rate used to be prior to 2018?

Answer 15

As of 2018, Corporate tax is a flat rate of 21% (on ALL taxable income regardless of size). The tax rate prior to 2018, used to be a progressive system similar to personal income taxes.

Question 16

Noncorporate business entities: Name a few. Do these entities get any special tax treatment?

Answer 16

Examples: Sole proprietorship, partnership, S corps, LLC’s (pass through entities)

For these entities, individuals get a 20% deduction against “qualified business income”

Question 17

Give the definition for the cash method of accounting. What size companies are allowed to use the cash method?

Answer 17

Firms record revenue when payment is received, regardless of when the sale occurred or the services were performed.

Firms record expenses when the payment is made.

Income is received when a person or company has unrestricted access to and control of income (ie: you have the check)

Cash method is only allowed for small companies. (less than or equal to $25 million in average sales)

Question 18

How are companies expected to handle selling inventory for tax purposes? Can smaller companies use a hybrid method?

Answer 18

Firms have to use the accrual method of accounting for inventory purchases and sales. This means that the cost of inventory is capitalized and can only be expensed in the year of sale.

Smaller companies that qualify for the cash method can use a “hybrid” system. They use accrual for inventory purchase and sales. And use the cash method for everything other than inventory.

Question 19

Can large corporations use the cash method of accounting?

Answer 19

No, C-corps with an average of more than $26 million in sales cannot use the cash method for tax purposes.

Size limitations do not apply to pass-through entities or personal service corporations. (Medical, legal, accounting personal practices)

Question 20

Give the definition for the accrual method of accounting.

Answer 20

Revenues are recognized when earnings is complete (ie the firm has shipped the goods or performed the service)

Match the expenses with the revenues that the expenses are generating.

Question 21

Will the accrual method of accounting produce book income to be the same as taxable income?

Answer 21

Not necessarily, GAAP requires companies to use accrual method for book income and even if taxpayer uses accrual for tax purposes: taxable income may still be different from book income. (book to tax differences)

Question 22

Name two permanent book to tax differences.

Answer 22

1. Expense or loss recognized for book purposes, but never recognized for tax purposes. Ex: nondeductible fine/ penalty, campaign contribution, personal expenses.
2. Tax law allows a deduction which never corresponds to a book expense or loss.
   Ex: dividends received deduction

Question 23

Name the two common temporary book to tax differences.

Answer 23

1. Delayed tax when taxable income < book income. Usually early in the life of a depreciable asset. Creates a deferred tax liability
2. Paying more tax, taxable income > book income. Creates a deferred tax asset

Question 24

Illustrations of Temporary book to tax differences (5 total): Explain the rules surrounding prepaid income.

Answer 24

a. Prepaid income that is entirely taxable in the year of receipt: prepaid rent income, insurance premiums, and warrant contracts.
Ex: Landlord receives 2 years of rental payment ($100,000):
Book Income: Taxable Income:
Year 1: $50,000 $100,000
Year 2: $50,000 $0

b. Prepaid income that has a special one-year deferral rule: These include prepaid service income, advance payments related to use of intellectual property, and advanced payments related to the sale, license, and use of computer software.
Rule: In the first year, you have to pay tax on that year of income, but can defer the rest of the prepayment until the second year.

c. Advance payment for sale of inventory can lead to difference in book income compared to tax accounting for sale. Example: Customer pays in Dec. ‘09 but goods aren’t shipped until Jan ‘10.
Taxpayer can include this sale^ as taxable income in 2009 or 2010, they have the choice.
If taxpayer includes the sale in ‘09 then there will be taxable income > book income since GAAP doesn’t recognize sale until goods are shipped.

Question 25

Illustrations of Temporary book to tax differences (5 total): Explain Accrued Expenses and the 3 requirements of the “all events test”.

Answer 25

Accrued expense: an expense recognized on the books before it has been paid.

1st Requirement: The liability is fixed
2nd Requirement: The liability must be determinable with reasonable accuracy
Ex: Company has hired temporary employees who have worked X amount of hours but has yet to receive a bill from employees. (Company knows pay rate and number of hours worked so this passes the first two requirements.)

3rd Requirement: Economic performance test, the seller must have delivered the goods or performed the services. For example, accrued estimates of warranty claims for tax purposes do not satisfy this requirement since the claims have not been serviced.

One exception to the Economic performance test: If an accrued expense happens each year, with year to year accrual under GAAP AND economic performance will occur within 8.5 months after the close of the year, the taxpayer CAN deduct the accrued expense.

Question 26

Illustrations of Temporary book to tax differences (5 total): Explain Compensation Accruals and how they create a book to tax difference?

Answer 26

If an employee earns the income in 2009, as long as the employee is PAID within the first 2.5 months of 2019, the company can deduct the wage expense in 2009. Examples of these types of deductions:
- A bonus for 2009, paid in Jan of 2010
- 2009, accrued vacation pay is paid during 1-1-10 and 3-15-10 (IT MUST BE PAID BY 3-15 to be deductible for the previous year)

Question 27

Illustrations of Temporary book to tax differences (5 total): Explain related party accruals and how that creates a book to tax difference?

Answer 27

Example: CB owns a controlling interest (~20%) in firm AB (smaller firm).

If AB hires CB, AB is not allowed to deduct accrued expense, AB has to defer the deduction until the next tax year, when it is paid, and CB recognizes the income.

Question 28

Illustrations of Temporary book to tax differences (5 total): Explain Business Bad debts and how it is treated for book and tax purposes.

Answer 28

1) Book purposes: Firms should use the allowance method. Basically estimating a contra-asset account called: Allowance for doubtful accounts. This would be an estimate of the number of credit sales that go bankrupt.

2) Tax purposes: Firms must use the direct write-off method. Make a list of every account that defaulted and then deduct the total amount at Y/E. (Total bad debt expense)

Question 29

Explain Net Operating Loss and the Excess Business Loss Limitation. (Includes worked calculation)

Answer 29

Net Operating Losses (NOL) = excess of deductible expenses over gross income.

Solution “NOL deduction”: As of 2021, the taxpayer can carry an NOL forward indefinitely against taxable income in succeeding tax years. However, the amount deductible in such carry forward years is limited to 80% of taxable income before such deduction.

SEE WORKED EXAMPLE PAGE 9 of CH 6 PART 4

Excess Business Loss Limitation: Limitation on deducting NOL’s that applies to only individuals, trusts, and estates.

The limitation represents a “threshold” and only NOL’s over this threshold are carried over into future years to be deducted. For individuals in 2018, the threshold was $500,000 for married filing jointly and $250,000 for single filers. Thresholds have been increasing since inception in 2018 but we only need to know the 2018 figures.

Ex: In 2018, partnership has a current year NOL of $700,000 and assuming married filing then only $200,000 of NOL can be rolled over into future years by Business Loss Limitation

This Limitation is to discourage partnerships and other pass thru entities from being too risky and generating huge NOLs.