Tax Accounting Methods

Question 1

Partnership tax year

Answer 1

Must use same tax year as majority (greater than 50%) of income & capital; if not, then the partnership must use tax year of its prinicpal partners (those with more than 5% interest in the partnership); if not, then must use taxable year that results in least aggregate deferral of income to the partners (exception would be business purpose approved by IRS)

Question 2

S Corporations and Personal Service Corporations tax year

Answer 2

Calendar year unless corporations has a business purpose. If ending on a certain day, then period may vary between 52-53 weeks

Question 3

Required payments and fiscal years

Answer 3

• (Maximum tax rate for individuals + 1%) x previous year’s taxable income x deferral ratio
• Deferral ratio= #months in deferral period / # months in taxable year
  -Adjustment is made for deductible amounts distributed to owners during the year (no need to pay if <$500)

Question 4

Changes in accounting periods

Answer 4

IRS usually only approves changes to accounting periods if taxpayer can prove substantial business purpose for change eg natural business year (at least 25% of revenues bust occur during last two months of the year)
-Don’t need approval if: newly married and want to conform within 1st/2nd yr of marriage
-Change to 52-53 week year that ends with reference to the same calendar month in which the former tax year ended
-Taxpayer who filed erroneously /different to books/no change in last 10 yrs, resulting year does not have net operating loss, taxable income is at least 90% of previous yr, and if there’s no change in the corporation status
-if partners with majority interest have same tax year, or if all principal partners change
-Corporation: no change in accounting period in last 10 years, resulting yr does not have NO, taxable income is at least 90% of previous year, no change in corporation status

Question 5

How to change an accounting period

Answer 5

1) Determine initial accounting period
2) Establish substantial business purpose for change
3) Apply on form 1128 to Commissioner of the IRS in DC
4) IRS reviews and approves/establishes conditions that must be met

Question 6

When would returns for periods be less than 12 months?

Answer 6

• 1st/final return (no need to annualize)
• change in accounting periods (need to annualize)

Question 7

How to annualize income

Answer 7

• Determine Modified Taxable income (itemize deductions)
• Multiply Modified Taxable income(x 12/number of months in short period)
• Compute tax on resulting taxable income (use appropriate tax rate schedule to compute tax)
• Multiply resulting tax (x # of months in short period/12)

Question 8

Permissible accounting methods

Answer 8

Must clearly reflect income:
-Cash receipts & disbursements
- Accrual
- Hybrid

Question 9

Cash Method

Answer 9

Used by most individuals and small businesses:
When income is received, not earned: accounts receivable do not have value.
Since prepaid income is taxed when received, there is a mismatch in income and expenses

Question 10

Constructive receipt

Answer 10

determined by availability of income even if taxpayer chooses not to use it later

Question 11

Cash method exceptions

Answer 11

-Interest on Series E & EE Savings bond don’t need to be reported until maturity date (can be deferred even later if exchanged with HH Savings bonds within one year)
- farmers and ranchers may report proceeds in the year following receipt if normally would have been sold in the following year (to prevent bunching income in one year)

Question 12

Capitalization requirements for cash method taxpayers

Answer 12

• Must capitalize fixed assets
  -Recover cost through depreciation/amortization if the life of the asset extends substantially beyond the end of the tax year
  Exception:
  -deduction for prepaid interest must be capitalized

Question 13

Accrual method

Answer 13

Income is reported the year it is earned. C corporations and partnerships with corporate partners, tax shelters, and certain trusts are required to use this method. Qualified personal service corporations, certain types of farms, and entities with average gross receipts under $29 million (2023) are exempt from the requirement.

Question 14

Exceptions to Accrual method

Answer 14

Prepaid income: payments received in advance for goods/services is taxable the year it is received, with these two exceptions:
-Advance payment for goods/service that will be delivered in a future tax year
- Advance payments for goods/inventory to be rendered only if method of accounting must match tax and financial accounting

Question 15

All events test

Answer 15

• Income is reported once all events have occurred that allow taxpayer to receive income and the amount can be determined with accuracy.
• Expense is deductible when all events have occurred that establish the liability and amount can be determined and economic performance has taken place

Question 16

Economic performance test

Answer 16

when property or services are provided by the other party

Question 17

Economic performance test waived if

Answer 17

• all events test without regard to economic performance is satisfied
• Economic performance occurs within a reasonable period (but not > than 8 1/2 months) after the close of the tax year.
  -The item is recurring, and the taxpayer consistently treats items of the same type as incurred in the tax year in which the all-events test is met.
  -taxpayer isn’t a tax shelter.
• Either amount in immaterial or the earlier accrual results in a better matching of income and expense

Question 18

Hybrid method

Answer 18

Taxpayer uses accrual method for purchase and sales of good; and the cash method for income and expenses; since income is reported even if not received, sometimes tax is paid even though they haven’t received the income

Question 19

Long-term contracts

Answer 19

• building, installation, construction, or manufacturing contracts that are not completed in the same tax year in which they began
• manufacture of either a unique item not carried in finished goods inventory or items that require more than 12 calendar months to complete

Contracts for services do not qualify

Question 20

Completed contract method

Answer 20

Labor, materials and overhead costs are capitalized and deducted from revenue the year the contract is completed; however interest must be capitalized if the property being produced is real property, long-lived property, or property that requires more than two years to produce (one year in the case of property costing more than $1 million).

Can be used by smaller companies (ave gross receipts for 3 preceding years of <=$10MM) for constructions contracts that are expected to take 2 years or less to complete
Can be used for home construction contracts

Cannot be used by larger companies for manufacturing/other LT contracts other than home construction /construction contracts>2 yrs

Question 21

Percentage of completion method

Answer 21

Current year cost/ Expected total cost= Percentage of completion

Question 22

Modified percentage of completion method

Answer 22

Since it is difficult to estimate total cost, taxpayer may elect to defer reporting of any income until at least 10% of estimated total cost has incurred

Question 23

Lookback interest

Answer 23

Interest on potential tax due/owed when comparing actual cost to estimated cost; only applicable if contract price >=1% of taxpayer’s average gross receipts for the 3 taxable years previous, or $1MM. May elect 10% de minimis exception to avoid interest computation if within 10% of recomputed “look-back income”

Question 24

Installment sale

Answer 24

Disposition of property where at least one payment is received after the close of the taxable year in which the disposition occurs- not applicable to sales of:
- Inventory
-Personal property by dealer
- marketable securities

Note:
-Gains recaptured as ordinary income must be recognized in the year of the sale and is not eligible for installment sale treatment
- if property is sold to a related party who sells within 2 years, the deferred gain must be fully recognized at that time by the original seller
-Gross Profit Percentage (GPP) is used to calculate gain and is applied to the down payment as well as the principal portion of the loan payments, which is made of P&I

Question 25

Calculate installment sale

Answer 25

1) Calculate GPP= (Gross profit /sale amount)
2) Calculate down payment
3) Calculate loan payments, then using amortization function, calculate P&I received the first year
4)Interest (from P&I) taxed as ordinary income
5) sum of down payment and the principal (from P&I)x the GPP is the reported gain

Return of basis=down payment+payment principal-cap gain income)

Question 26

A taxpayer must use the same accounting method on a personal tax return as the taxpayer’s business. (T/F)

Answer 26

F: An overall accounting method used in one business does not have to be the same method used in another business or for non-business income and deductions.

Question 27

Which type of taxpayers must use the accrual method of accounting

Answer 27

Taxpayers with inventories if they are an income producing factor of the business

Question 28

Inventory cost

Answer 28

may be valued at cost, market value, or the lower of the two

Question 29

Uniform Capitalization Rules (UNICAP)

Answer 29

Allocation of Purchasing costs (e.g., salaries of purchasing agents), warehousing costs, packaging, and administrative costs be to inventory, applicable to taxpayers whose ave gross receipts for the three preceding years >$29MM

Includes direct labor and materials along with manufacturing overhead in the case of goods manufactured by taxpayer, interest if the property is real property, long-lived ore requiring more than 2 yrs to produce; but non-manufacturing costs such as advertising, selling and research are not required to be included in inventory.

Question 30

LIFO method

Answer 30

Lowest taxable income since the most recent cost of inventory is usually the highest especially with inflation; therefore lowest profits and value of inventory. Can not be used with the lower of cost or market method. More complex, so not usually used by small businesses.

Question 31

FIFO method

Answer 31

may produce lower inventory values in the case of electronics

Question 32

Change in accounting methods adjustments

Answer 32

A positive adjustment when a change in accounting method occurs is added to income, where as a negative adjustment is subtracted from income. A large positive adjustment may push taxpayer into a higher tax bracket

Question 33

Reporting amount of change due to change in accounting method

Answer 33

If voluntary, then can be spread out over four years, taken in one year if <$25,000; if changing from incorrect to correct, then no penalty

Question 34

Accounting periods

Answer 34

Consideration to adopt a tax year for the initial reporting period that ends before the amount of taxable income exceeds the amount that is taxed at the lowest tax rates

Question 35

Procedures for changing to LIFO

Answer 35

-Fill application Form970 along with tax return, must include analysis of beginning and ending inventories, with beginning inventory for LIFO purposes the same as previous method.

-If former inventory is valued on the lower of cost or market, an adjustment is required to restate beginning inventory to cost since LCM can’t be used with LIFO. Adjustment can be spread over year of change and next 2 yrs.

Question 36

Why is LIFO inventory recommended during inflationary periods?

Answer 36

it tends to reduce inventory values and increase the cost of goods sold. This will reduce taxable income

Question 37

DEF Partnership begins operations on May 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 $250,000.

Calculate DEF Partnership’s required payment.

Answer 37

DEF must make a required payment of $39,583 ($250,000 x 38% x 5/12) on or before April 15, 2024.

Question 38

The installment method is NOT applicable to sales of:

Answer 38

Inventory,
Personal property by a dealer, or
Marketable securities.

Question 39

installment sale

Answer 39

any disposition of property where at least one payment is received after the close of the taxable year in which the disposition occurs:
Gains recaptured as ordinary income under IRC sections 1245 and 1250, must be recognized in the year of the sale (regardless of when the first payment is to be received), and are not eligible for installment sale treatment. Only section 1231 gain is eligible for installment.
If property is sold to a related party, and the related party sells property within 2 years from the date of the original sale, the deferred gain must be fully recognized at that time by the original seller.
The Gross Profit Percentage (GPP) is used to calculate the gain and is applied to the down payment as well as the principal portion of the loan payments, which are comprised of principal and interest (P&I).

Question 40

Application for permission to change accounting periods is made on _________

Answer 40

Form 1128. The application must be sent to the Commissioner of the IRS, Washington, D.C.