Chapter 7

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Chapter 7

Accounting Periods & Methods & Depreciation

Income Tax Fundamentals 2007

Gerald E. Whittenburg & Martha Altus-Buller


Accounting Periods

Problem when taxpayer’s tax year differs from calendar year Partnerships don’t pay tax as an entity

Tax year must be the same tax year as 50% of partners

If majority of partners’ tax years are different, use tax year of principal partners

Principal partner is partner with at least 5% share in profits or capital

If principal partners have different tax years Use accounting period with the least

aggregated deferral


Tax Year for Personal Service Corporation

A Personal Service Corporation (PSC) is a corporation with shareholder-employees whom provide a personal service For example, an architect or dentist

Generally must adopt calendar year Can adopt a fiscal year if

Can prove business purpose or Fiscal year results in a deferral period of less than 3

months and shareholders’ salaries for deferral period are proportionate to salaries received during rest of the period and corporation limits its deduction [see next slide]


Short Period Taxable Income

If taxpayer has a short year [other than first/last year of operation], tax calculated based on following example:

Example: In 2006, Fed-Mex changes from a calendar year to tax year ending 9/30. For the short period 1/1/06 – 9/30/06, Fed-Mex’s TI = $20,000.

Calculate tax for the short period Annualize TI 20,000 x 12/9 = 26,667 Tax on annualized TI 26,667 x 15% = 4,000 Allocate tax to short period 4,000 x 9/12 = $3,000

Individual taxpayers rarely change tax years


Accounting Methods Cash receipts/disbursements method

Recognize income when cash actually/constructively received

Recognize deduction in year of payment - exception: can’t deduct prepaid rent or interest

This method most common for individuals for overall accounting method

Can’t use cash basis if taxpayer is a C corporation, or Partnership with a corporation as a partner, or Trust with UBI (unrelated business income)

Above regulations don’t apply to certain organizations


Accounting Methods [continued]

Accrual method Recognize income when earned and can be

reasonably estimated Recognize deduction when incurred and can

be reasonably estimated Hybrid method

An example of a hybrid taxpayer, is one that utilizes cash method for receipts/disbursements but accrual for cost of products sold


Depreciation [Form 4562]

Depreciation is a process of allocating and deducting the cost of assets over their useful lives Does not mean devaluation of asset Land is not depreciated

Maintenance vs. depreciation Maintenance expenses are incurred to keep

asset in good operating order Depreciation refers to deducting part of the

original cost of the asset


Personal Property Recover Periods

Each asset is depreciated according to an IRS-specified recovery period 3 year 5 year Computer, cars and light

trucks, R&D equipment, certain energy property & certain equipment

7 year Mostly business furniture and equipment and property with no ADR life

10 year Trees and vines 15 year Treatment plants 20 year Sewers


Personal Property

Depreciation is determined using IRS tables (Table 2 on p. 7-9 in text) Salvage value not used in MACRS Tables based on half-year convention

1/2 year depreciation taken in year of acquisition

1/2 year depreciation taken in final year

May elect to use tables based on straight line instead (Table 3 on p. 7-10 in text)


Mid-Quarter Convention

Mid-quarter convention is required if taxpayer purchases 40% or more of total assets (except real estate) in last quarter of tax year Then must apply this convention to every asset

purchased in the year Excluding real property and §179 property Must use special mid-quarter tables

Found at major tax service such as Commerce Clearing House [CCH] or Research Institute of America [RIA]


Real Estate

Real assets depreciated based on a recovery period depending on use Real assets are depreciated using the

straight-line method with a mid-month convention (Table 4); for real estate acquired after 1986 use

27.5 years: Residential rental 39 years: Nonresidential

Treats all acquisitions/dispositions as occurring mid-month [mid-month convention]

No mid-quarter convention for real estate


Election to Expense - §179 §179 allows immediate expensing of qualifying property

For 2006, the annual amount allowed is $108,000 Qualifying property is tangible personal property used in a

business But not real estate or off-the-shelf computer software

§179 election to expense limited If cost of qualifying property placed in service in a year >

$430,000, then reduce §179 expense $ for $ For example, if assets purchased in current year = $500,000,

then $70,000 reduction in §179 capability so limited to $108,000 – 70,000 = $38,000 election to expense and the remaining 462,000 is depreciated over assets’ useful lives.

Cannot take §179 expense in excess of taxable income - may carry forward any unused amount


Election to Expense - §179

When using with regular MACRS Take §179 first, then reduce basis MACRS depreciation calculated on reduced basis

For example In 2006, a seven-year piece of property placed in

service costing $125,000; taxable income = $1.25 million. What is total depreciation including election to expense?

First – claim $108,000 deduction under §179, reduce basis to $17,000, then multiply by 14.29% MACRS rate

[108,000] + [17,000 x 14.29%] = $110,429 total

Chapter 7

Documents

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