Acc 331 Chapter 4 Notes

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an accounting provision (a non-deductible expense) instead of a write-off in 2014?

3. Year of Inclusion – When is income recognized

A. Why would a taxpayer care about when income is recognized?

One of the tax planning strategies we discussed was shifting income from one period to another:

1) Defer payment of taxes to a later year

2) Take advantage of differences in tax rates between years

A taxpayer can earn income on Jan 1, X1 and wait until April 15, X2 to pay the associated taxes (with limitations).

Income taxes are computed based on tax years, the most common being the tax years based on the calendar year Jan -Dec. Several provisions of the Code require computations using the taxpayer’s income for the year. E.g., as we will see in the next chapter, for corporate taxpayers, charitable contribution deduction is limited to 10 percent of taxable income for that year.

B. Taxable year

Individuals and sole proprietorships use a calendar year to report taxable income

C-corporations may select a calendar year-end or fiscal year-end

Flow-through entities must adopt tax years consistent with the owners’ tax years

C. Accounting methods

There are three primary methods of accounting used for tax purposes:

1) Cash-basis method – recognize income (deductions) when they are received (paid).

2) Accrual-basis method – similar to financial accounting, income (deductions) are recognized as they are earned (incurred).

3) Hybrid method – a combination of cash and accrual basis, generally, inventory is accounted for under the accrual-basis while other income items and deductions are recognized under the cash-basis.

Tax Regulations required the accrual method for determining sales and purchases when inventory is a significant source of income.

Other accounting methods allowed by the tax code:

Installment method – taxpayer may choose to spread the gain from sale of property over the collection period.

Long-term Contracts – taxpayer can recognize profits from long-term contracts using either:

1) Percentage completion method – profits recognized as the work progresses, or

2) Completed contract method – defer all profits until the year in which the project is completed

Let’s take a closer look at the cash-basis and accrual-basis methods

I. Cash-basis

Income recognized in the year of actual or constructive receipt

i. Receipt may be by taxpayer or agent

ii. Property or services received must have a measurable fair market value

EXAMPLE 5:

Cooper & Smith Partners, a law firm, uses the cash method of accounting. In 2015, the firm provides legal services to Tools LLP and bills the client for $20,000. They also provide legal services to ABC Corporation in the amount of $35,000. Tools LLP sends a check post-dated Jan 15, 2016 in settlement of their bill. ABC Corp sends a negotiable promissory note which matures in February 2016. The fair market value of the note is $28,000. Both bills are paid in full in 2016. What amount should Cooper & Smith report as income in 2015 and 2016?

Certain taxpayers are not allowed to use cash-basis method

i. Corporations (other than S-Corporations or qualified personal service corporation e.g., a law, accounting or engineering firm)

ii. Partnerships with a C-corporation partner

Constructive receipt doctrine (judicial concept) – Income should be recognized once it is available, not necessarily when it is collected. Income is constructively received if:

1) Payment is made readily available to taxpayer

2) Use of funds is not subject to substantial limitations or restrictions

Rationale, if income is available, taxpayer should not be allowed to unilaterally postpone income recognition by delaying collection

The doctrine does not apply to situations where the taxpayer could have contracted to receive income earlier but is not yet entitled to receive payment. E.g., if the taxpayer chooses to forgo collection of a prepayment.

EXAMPLE 6:

Hornung v. Comm’r 47 T.C. 428 (1967)

Paul Hornung was a star football player for the Green Bay Packers. Hornung was named the outstanding player in the NFL Championship game played on Sunday, December 31, 1961 in Green Bay, WI by Sports Magazine and was awarded a 1962 Corvette. On December 31, the Corvette was in New York City. The magazine editor did not have the title or keys with him in Green Bay on December 31. Hornung received the car on January 3, 1962 at an awards lunch in New York. Hornung sold the vehicle in 1962 and reported the sale on his 1962 tax return. He did not include the fair market value of the car in his tax return for 1962 or any other tax year.

a) Was the Corvette income?

b) If so, in what year should it be recognized?

II. Accrual-basis method

Income recognized in the year earned

All events test - All events have occurred to entitle taxpayer to receive payment

1) Title/Ownership to property passes to buyer

2) Services performed for customer/client

Amount