Concorde Career College Federal Taxation Questions

CHAPTER 9
QUESTION 1
Melissa recently paid $500 for round-trip airfare to San Francisco to attend a business conference
for three days. Melissa also paid the following expenses:
$250 fee to register for the conference,
$300 per night for three night’s lodging,
$200 for meals provided by a restaurant, and
$150 for cab fare.
What amount of the travel costs can Melissa deduct as business expenses?
QUESTION 2
Kimberly is a self-employed taxpayer. She recently spent $1,000 for airfare to travel to Italy. On
the trip, she spent 7 days on personal activities and 3 days on business activities. What amount of
the airfare is deductible?
QUESTION 3
Kimberly is a self-employed taxpayer. She recently spent $2,000 for airfare to travel to Italy. On
the trip, she spent 3 days on personal activities and 7 days on business activities. What amount of
the airfare is deductible?
QUESTION 4
Renee operates a proprietorship selling collectibles over the web, and last year she purchased a
building for $24 million for her business. This year, Renee’s proprietorship reported revenue of $84
million and incurred total expenses of $77.6 million. Her expenses included cost of goods sold of
$48.5 million, sales commissions paid of $6.9 million, $9.5 million of interest paid on the building
mortgage, and $12.7 million of depreciation. What is the maximum amount of business interest
expense that Renee can deduct this year?
QUESTION 5
Jeremy is a calendar-year taxpayer who sometimes leases his business equipment to local
organizations. He recorded the following receipts this year: $880 from the Ladies’ Club for leasing
the trailer from December of this year through March of next year ($220 per month). How much of
this payment is taxable income to Jeremy this year if Jeremy is a cash-method taxpayer?
QUESTION 6
Jeremy is a calendar-year taxpayer who sometimes leases his business equipment to local
organizations. He recorded the following receipts this year: $400 lease payment received from the
Men’s Club this year for renting Jeremy’s trailer last year. Jeremy billed them last year. How
much of this payment is taxable income to Jeremy this year if Jeremy is an accrual-method
taxpayer?
QUESTION 7
In January of year 0, Justin paid $5,800 for an insurance policy that covers his business property for
accidents and casualties. Justin is a calendar-year taxpayer who uses the cash method of accounting.
The policy covers the business property from April 1 of year 0 through March 31 of year 1. What
amount of the insurance premium may Justin deduct in year 0?
QUESTION 8
In January of year 0, Justin paid $5,800 for an insurance policy that covers his business property for
accidents and casualties. Justin is a calendar-year taxpayer who uses the cash method of accounting.
The policy begins on February 1 of year 1 and extends through January 31 of year 2. What amount
of the insurance premium may Justin deduct in year 0?
QUESTION 9
In January of year 0, Justin paid $8,000 for an insurance policy that covers his business property for
accidents and casualties. Justin is a calendar-year taxpayer who uses the cash method of accounting.
Assume the insurance policy is for a 24-month period from April 1, year 0 through March 31, year
2. What amount of the insurance premium may Justin deduct in year 0?
QUESTION 10
In October of year 0, Janine received a $2,500 payment from a client for 25 months of security services
she will provide starting on November 1 of year 0. This amounts to $100 per month. What amount of
revenue must Janine recognize in year 0 from the $2,500 advance payment for services if she uses
the cash method of accounting?
QUESTION 11
In October of year 0, Janine received a $2,500 payment from a client for 25 months of security
services she will provide starting on November 1 of year 0. This amounts to $100 per month. What
amount of revenue must Janine recognize in year 1 from the $2,500 advance payment for services if
she uses the accrual method of accounting?
QUESTION 12
Suppose that David had the following transactions for his business inventory of widgets (purchase
prices below).
Widget PurchaseDate DirectCost OtherCosts TotalCost
#1
August 15
$ 2,100
$ 100
$2,200
#2
October 30
$ 2,200
$ 150
$2,350
#3
November 1
$ 2,400
$ 100
$ 2,500
In late December, David sold widget #2. What cost of goods sold would David record if he elects to
use the LIFO method this year?
QUESTION 13
Suppose that David had the following transactions for his business inventory of widgets (purchase
prices below).
Widget PurchaseDate DirectCost OtherCosts TotalCost
#1
August 15
$ 2,100
$ 100
$2,200
#2
October 30
$ 2,200
$ 150
$2,350
#3
November 10
$ 2,400
$ 100
$ 2,500
In late December, David sold widget #2. What ending inventory would David record if he elects to
use the FIFO method this year?
QUESTION 14
This year William provided $6,200 of services to a large client on credit. Unfortunately, this client
has recently encountered financial difficulties and has been unable to pay William for the
services. Moreover, William does not expect to collect for his services. William has “written off”
the account and would like to claim a deduction for tax purposes. What amount of deduction for bad
debt expense can William claim this year if he uses the accrual method?
QUESTION 15
This year William provided $6,200 of services to a large client on credit. Unfortunately, this client
has recently encountered financial difficulties and has been unable to pay William for the
services. Moreover, William does not expect to collect for his services. William has “written off”
the account and would like to claim a deduction for tax purposes. What amount of deduction for bad
debt expense can William claim this year if he uses the cash method?
Chapter 10
QUESTION 1
1. Brittany started a law practice as a sole proprietor. She owned a computer, printer, desk, and file cabinet
she purchased during law school (several years ago) that she is planning to use in her business. What is
the depreciable basis that Brittany should use in her business for each asset, given the following
information?
Asset
Computer
Printer
Desk
File cabinet
Purchase Price
$2,500
$300
$1,200
$200
FMV at Time Converted
$600
$150
$900
$225
QUESTION 2
1. Gary inherited a Maine summer cabin on 10 acres from his grandmother. His grandparents originally
purchased the property for $500 in 1950 and built the cabin at a cost of $10,000 in 1965. His
grandfather died in 1980 and when his grandmother recently passed away, the property was
appraised at $550,000 for the land and $750,000 for the cabin. Since Gary doesn’t currently live in
New England, he decided that it would be best to put the property to use as a rental. What is Gary’s
combined basis in both the land and cabin?
QUESTION 3
1. At the beginning of the year, Poplock began a calendar-year dog boarding business called Griff’s
Palace. Poplock bought and placed in service the following assets during the year:
Asset
Date Acquired
Computer equipment
3/23
Dog grooming furniture 5/12
Pickup truck
9/17
Commercial building
10/11
Land (one acre)
10/11
Cost Basis
$6,000
$7,000
$10,000
$260,000
$80,000
Assuming Poplock does not elect §179 expensing or bonus depreciation, what is Poplock’s year 1
depreciation expense for each asset?
QUESTION 4
1. At the beginning of the year, Poplock began a calendar-year dog boarding business called Griff’s
Palace. Poplock bought and placed in service the following assets during the year:
Asset
Date Acquired
Computer equipment
3/23
Dog grooming furniture 5/12
Pickup truck
9/17
Commercial building
10/11
Land (one acre)
10/11
Cost Basis
$6,000
$7,000
$10,000
$260,000
$80,000
Assuming Poplock does not elect §179 expensing or bonus depreciation, what is Poplock’s year 2
depreciation expense for each asset?
QUESTION 5
1. Way Corporation disposed of the following tangible personal property assets in the current
year. Assume that the delivery truck is not a luxury auto. Calculate Way Corporation’s 2022
depreciation expense (ignore §179 expense and bonus depreciation for this problem).
Asset
Furniture (7 year)
Machinery (7 year)
Delivery truck* (5 year)
Machinery (7 year)
Computer (5 year)
Date acquired
5/12/18
3/23/19
9/17/20
10/11/21
10/11/22
Date sold
7/15/22
3/15/22
3/13/22
8/11/22
12/15/22
Convention
HY
MQ
HY
MQ
HY
*Used 100 percent for business.
QUESTION 6
AMP Corporation (calendar year end) has 2022 taxable income of $1,725,000 before the §179 expense.
During 2022, AMP acquired the following assets:
Asset
Machinery
Computer Equipment
Office Building
Total
Placed in
Service
September 12
February 10
April 2
Basis
$1,540,000
365,000
480,000
$2,385,000
What is the maximum amount of §179 expense AMP may deduct for 2022?
QUESTION 7
1. Assume that TDW Corporation (calendar year end) has 2022 taxable income of $650,000 before
the §179 expense, acquired the following assets during 2022:
Asset
Machinery
Computer Equipment
Furniture
Total
Placed
Service
October 12
February 10
April 2
in
Basis
$2,260,000
268,000
880,000
$3,408,000
What is the maximum amount of §179 expense TDW may deduct for 2022?
QUESTION 8
1. Assume that Timberline Corporation has 2022 taxable income of $245,000 before the §179 expense.
Purchase
Asset
Date
Basis
Furniture (7-year)
December 1
$350,000
Computer Equipment (5-year) February 28
90,000
Copier (5-year)
July 15
30,000
Machinery (7-year)
May 22
480,000
Total
$950,000
What is the maximum amount of §179 expense Timberline may deduct for 2022?
Original
Basis
$50,000
$72,000
$20,000
$260,000
$80,000
QUESTION 9
Last Chance Mine (LC) purchased a coal deposit for $780,000. It estimated it would extract 12,000 tons of
coal from the deposit. LC mined the coal and sold it reporting gross receipts of $1 million for year 1. During
year 1, LC reported net income from the coal deposit activity in the amount of $60,000. In year 1, LC
actually extracted 3,000 tons of coal. What is Last Chance’s cost depletion for years 1?
QUESTION 10
Last Chance Mine (LC) purchased a coal deposit for $780,000. It estimated it would extract 12,000 tons of
coal from the deposit. LC mined the coal and sold it reporting gross receipts of $1 million for year 1. During
year 1, LC reported net income from the coal deposit activity in the amount of $60,000. In year 1, LC
actually extracted 3,000 tons of coal. What is Last Chance’s percentage depletion for year 1 (the applicable
percentage for coal is 10 percent)?
Taxation of Individuals
2023 Edition
Chapter 9
Business Income,
Deductions, and
Accounting
Methods
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Learning Objectives
1. Identify common business deductions.
2. Determine the limits on deducting
business expenses.
3. Describe accounting periods available to
businesses.
4. Apply cash and accrual methods to
determine business income and expense
deductions.
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9-2
Gross Receipts Test
• Gross receipts cannot exceed $27 million
for the 3-year period preceding the
current year.
– Businesses without 3 years of data use the
period for which gross receipts are available.
– Gross receipts for short years must be
annualized by multiplying by 12 and dividing
the produce by the number of months in the
short period.
– Tax shelters never qualify under the gross
receipts test.
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9-3
Gross Receipts Question
Blue Corp began business on July 1 last year
and reports gross receipts of $12.5 million.
Can Blue use the cash method this year?
Yes or no?
Why?
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9-4
Business Income and
Deductions
• Deductions must be directly connected to
business activity.
• Business expenditures must be both
ordinary and necessary to be deductible.
– Ordinary and necessary means conducive to profit
generation.
– Reasonable in amount means not extravagant.
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9-5
Reasonableness Example
Rick hired his brother, Tom, on a part-time
basis. Tom performed the same duties as
other part-time employees, but Rick paid
Tom an extra $5 per hour to provide support
for Tom’s education. At year-end, Tom had
worked a total of 100 hours and received
$2,500 from Rick.
What amount can Rick deduct for the
compensation he paid to his part-time
employees?
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9-6
Reasonableness Solution
Rick cannot deduct the extra $5 an hour for
Tom’s compensation because it is
unreasonable in amount. Thus, $500 is not
deductible because it is considered a
personal (non-deductible) gift from Rick to
Tom.
Hence, Rick can deduct $2,000 for
compensation expense this year [$2,500 $500].
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9-7
Statutory Limits on Business
Expense Deductions
• Expenditures against Public Policy
– No deduction for fines, bribes, lobbying, or
political contributions
• Expenses Relating to Tax-Exempt Income
– Interest on loan where proceeds invested in
municipal bonds
– Key employee insurance premiums
• Capital Expenditures
• Personal Expenditures
• Limitation on Business Interest Deductions
• Losses on Dispositions of Business
Property
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9-8
Capital Expenditures
• Does the expenditure provide future
benefit (beyond this year)?
– If so, capitalize rather than deduct.
• 12-month rule for prepaid expenses
– Deduct if benefit < 12 months and benefits do not extend beyond end of next tax year. – Does not apply to interest expense. – Difficult to apply for accrual taxpayers because economic performance is also required. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 9-9 12-Month Rule Example • Ben, a cash-basis taxpayer, makes the following payments on June 30 of this year: – $10,000 for the next 10 months of utilities. – $12,000 for insurance over the next 24 months. – $9,600 for the next eight months of interest on a business loan. What amounts are deductible this year? © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 9-10 12-Month Rule Solution • Ben can deduct all $10,000 for the utilities because: – The benefit does not exceed 12 months and does not extend beyond next year. • Ben can deduct $3,000 for insurance because: – The benefit exceeds 12 months. Hence, Ben can only deduct six months in this year ($500 per month). • Ben can deduct $7,200 for interest because: – The 12-month rule does not apply to interest. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 9-11 Business Expenses with Personal Benefits • No business deduction for purely personal expenditures • Mixed motive? – Primary motive for some expenditures (all or nothing) ▪ Business travel (away from home overnight) – Otherwise, allocate deduction to business portion ▪ Arbitrary percentage (50 percent meals) ▪ Basis for allocation (mileage or time) • Record keeping – Document business purpose © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 9-12 Travel Example • Ben paid the following to attend a business meeting in Chicago: – Airfare (first class)—$1,200 – Hotel (three nights)—$750 – Meals (three days)—$270 What amounts are deductible if Ben spent two days in meetings (primarily business)? What amounts are deductible if Ben spent one day in a meeting (primarily personal)? What amounts are deductible if the meals were provided by a restaurant? © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 9-13 Travel Solution Ben can deduct the following amounts: Primarily business Primarily personal Airfare (all or none) $ 1,200 Hotel ($250 per day) 500 250 Meals ($90 per day × 50%) 90 45 Total Travel Deduction $ 1,790 $ $ 0 295 The cost of the meals would not be subject to the 50 percent limit if provided by a restaurant. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 9-14 Business Interest Limitation • Does not apply to any taxpayer with average annual gross receipts of $27 million or less for the prior three taxable years. • Business interest expense deduction is limited to: – Business interest income plus – 30 percent of the adjusted taxable income • Adjusted taxable income is: – Taxable income allocable to the business computed by: ▪ Subtracting interest income ▪ Adding interest expense ▪ Adding depreciation, amortization, and depletion ▪ Adding net operating loss deduction and 199A deductions © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 9-15 Business Interest Example This year MH Inc. reported $200,000 of taxable income on $30 million of revenue. The revenue included $20,000 of interest income. In calculating the taxable income, MH deducted: $340,000 of depreciation $210,000 of interest expense What is MH’s maximum business interest deduction this year? © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 9-16 Business Interest Solution • Calculate limit on adjusted taxable income Taxable income less interest income plus depreciation plus interest expense Adjusted taxable income Times 30% $ 200,000 − 20,000 + 240,000 + 210,000 $ 630,000 × 30% $ 189,000 Plus interest income + 20,000 Maximum interest deduction $ 209,000 $1,000 of interest expense is disallowed and carried forward. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 9-17 Sales of Business Assets • Losses on Dispositions of Business Property – Recognized losses are deductible. – Losses on sales to related parties are not deductible by the seller. – Casualty losses are limited to lesser of decline in value (repair cost) or basis. – Basis is amount of loss if business asset is completely destroyed. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 9-18 Accounting for Taxable Income • We’ve learned to identify: – Business gross income – Deductible expenses • Now we need to match income and deductions to a specific period. – Accounting methods match income and expense to a specific period. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 9-19 Accounting Periods • Annual period – Full tax year is 12 months long. – Short tax year is < 12 months. • Year-ends – Calendar year ends 12/31. – Fiscal year-end depends upon choice: ▪ Last day of a month (not December) ▪ 52/53-week year-end is the same day of a specific month © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 9-20 Choosing an Accounting Period • Proprietorships—same as proprietor’s year-end • C corporations and individuals—choice made on first tax return and is consistent with book accounting period • Flow-through entities—a “required” tax year – Match to owners’ period (multiple owners for partnerships so this can be complicated) © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 9-21 Accounting Methods (1 of 2) • Financial and Tax Accounting Methods – In reporting financial statement income, businesses have incentives to select accounting methods permissible under GAAP that accelerate income and defer deductions. – In contrast, for tax planning purposes, businesses have incentives to choose accounting methods that defer income and accelerate deductions. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 9-22 Accounting Methods (2 of 2) • Permissible “overall” methods – Cash: recognize income when received – Accrual: recognize income when earned or received (whichever is first generally) • Large corporations and partnerships with corporate partners must use accrual. – Taxpayers that satisfy the gross receipts test can elect the cash method. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 9-23 Cash Method • Income recognized when actually or constructively received. • Expenses recognized when paid. • Pros and cons – Flexible – Simple and relatively inexpensive – Poor matching of income and expense – Can use accrual for some accounts (hybrid) – Can be used by taxpayers who satisfy the gross receipts test © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 9-24 Accrual Income • Income is recognized when earned or received. – All-events test—recognize income when all the events have occurred that fix the right to receive such income and – The amount can be determined with reasonable accuracy • Recognize on the earliest of these dates: – Complete service or sale – Payment is due – Payment is received © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 9-25 Accrual Question Ben provides consulting services and bills Ace for $12,000. Ace disputes the amount, claiming that $8,000 is the proper amount. How much income should Ben recognize under the accrual method this year? $ ________ © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 9-26 Accrual—Prepaid Income • Advance payments for goods and services – Allowed to defer recognition for one year unless income is earned or recognized for financial records. – Not applicable to payments relating to rent or interest income. – This is an accounting method election that cannot be changed without the permission of the IRS. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 9-27 Advance Payment Example Ben provides dancing lessons. On September 30 of this year, he received $2,400 full payment for a two-year service contract. • What amount of income must Ben recognize – if he is on the cash method? – if he is on the accrual method? © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 9-28 Advance Payment Solution • If Ben uses the cash method, he must recognize income as received—$2,400 this year. • If Ben uses the accrual method, then he can elect to defer advances for services for a year. – This year Ben would recognize $300—the income earned from September 30 (3/24 × $2,400). – Next year Ben would recognize the remaining $2,100— income can only be deferred one year. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 9-29 Inventories • Inventories must generally be accounted for under the accrual method if sales of goods constitute an income-producing factor. – Sales and purchases must be recorded using the accrual method. – The “hybrid” method applies to cash method taxpayers with inventory who use accrual for sales and purchases. – Taxpayers that qualify under the gross receipts test can opt to treat purchases of goods for sale as non-incidental materials or use the financial reporting inventory method. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 9-30 UNICAP • Inventory (purchased or produced) must be accounted for using tax version of “full absorption” rules. • Indirect costs are allocated to inventories (not expensed). • Costs of selling, advertising, and research need not be capitalized. • Not required for businesses that qualify under the gross receipts test. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 9-31 Inventory Flow Assumptions • First-in, first-out (FIFO) • Last-in, first-out (LIFO) – Same method for financial and tax records – “Book-tax conformity” requirement – Generates lowest taxable income in time of inflation • Specific identification © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 9-32 Accruing Business Expenses • All-events test – All events have occurred to establish the liability to pay. – The amount is determinable with reasonable accuracy. – Reserves for future liabilities not allowed. • Economic performance has occurred © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 9-33 Economic Performance • Taxpayer provides goods or services – Performance occurs as taxpayer provides goods or services. • Taxpayer receiving goods or services – Performance occurs as goods are provided or – Payment is made and economic performance is otherwise expected within three and a half months of payment. • Payment liabilities are performed when paid. • Interest and rent occur ratably. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 9-34 Economic Performance Example Ben has signed a binding contract for Peter to provide Ben with repair services. Ben paid $1,500 to Peter and owes an additional $6,000 on the contract. The repairs will commence late next year. When can Ben claim the deduction if he uses the accrual method? © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 9-35 Economic Performance Example Solution The all-events test is satisfied- Ben signed the contract and owes $7,500. However, this falls under a service provided to the taxpayer and economic performance as the service is provided. Hence, Ben deducts $7,500 next year. Note 1: the $1,500 is a prepaid expense and does qualify for the 12-month rule because economic performance is not met. Note 2: Ben could deduct $7,500 if he paid the entire amount and expects the repairs to be completed within 3½ months. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 9-36 Choosing or Changing an Accounting Method • Accounting methods are generally adopted by use. – A permissible method is adopted by using and reporting the method for one year. – An impermissible method is adopted by using and reporting the method for two years. • Generally, method changes require IRS permission. – Some changes are automatic. – Permission is necessary to correct the use of an impermissible method. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 9-37 End of Presentation © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 9-38 Chapter 9 MC Quiz Takeaways 1. For purposes of the business interest expense limitation, adjusted taxable income is defined as taxable income allocable to the business computed without regard to interest income, plus depreciation, amortization, or depletion, interest expense, and net operating loss deductions. 2. Under the accrual method, income is earned when the all events test is satisfied on the earlier of the date that the service is provided, the service is billed, or payment is received. 3. The definition of a recurring item is an expenditure that is not material in amount (or better matching), expected to recur in the future, and paid before the earlier of 8½ months or filing the tax return. 4. Economic performance occurs for the rent ratably over time so only $2,000 is per month is accrued. Insurance is a payment liability and accrues only as paid. However, since the payment spans 2 periods (6 months this year and 6 months next year), the portion benefiting the future period would typically be capitalized. In this case the duration of the contract does not exceed 12 months and the payment does not extend beyond the end of next year. So, the 12-month rule allows for the deduction of $18,000. Note that the 12-month rule cannot apply to the rent until economic performance occurs and this only happens ratably. 5. The interest expense can only be deducted ratably so only 4 months is deductible this year. All of the insurance can be deducted under the 12-month rule. 6. Under the accrual method, prepayments for services can be deferred for one year if the payments are also unearned for financial reporting purposes. 7. Since the life insurance proceeds are not included in employer's income (employer is the policy beneficiary), the premiums are classified as an expense associated with the production of tax-exempt income. 8. The investment seminar and entertainment are not deductible, and only 50% of the meals is deductible if the meals were not provided by a restaurant. There is a special COVID recovery rule which allows for a 100% deduction of meals provided by a restaurant in 2021 and 2022. 9. A taxpayer can elect to deduct the taxes accruing this year or he can elect to deduct them as recurring items. If neither election is made, then Joe deducts them in the year paid. 10. Under the FIFO method the taxpayer sold all five tubs from January and one of the tubs from July. Hence, his ending inventory consisted of two tubs from July plus both tubs from November. Note: that taxpayers (other than tax shelters) with average annual gross receipts of $25 million or less over the three prior tax years can elect to use the cash method of accounting for the purchase, production, or sale of merchandise. 11. For purposes of federal income taxes, an accrual basis taxpayer may only claim a bad debt expense using the actual write-off method. In this case, you are given the beginning and ending balances in the allowance account as well as the current year bad debt expense for financial accounting purposes. The actual writeoffs would equal beginning balance plus bad debt expense for financial reporting purposes less ending balance. 12. To deduct the cost of meals, business discussions must be associated with the event and adequate records must be kept. In all events, only half of the expense can be deducted when the meal is not consumed in a restaurant (special 2021 and 2022 rule). Entertainment expenses are no longer deductible. 13. The business casualty loss deduction equals adjusted basis less insurance reimbursement. 14. 15. Employees cannot deduct business expenses. The fine is against public policy. The three-year subscription must be amortized. The uniforms are only deductible if not adaptable to ordinary wear. Taxation of Individuals 2023 Edition Chapter 10 Property Acquisition and Cost Recovery © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. Learning Objectives (1 of 2) 1. Describe the cost recovery methods for recovering the cost of personal property, real property, intangible assets, and natural resources. 2. Determine the applicable cost recovery (depreciation) life, method, and convention for tangible personal and real property and the deduction allowable under basic MACRS. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 10-2 Learning Objectives (2 of 2) 3. Calculate the deduction allowable under the additional special cost recovery rules (§179, bonus, and listed property). 4. Calculate the deduction for amortization. 5. Explain cost recovery of natural resources and the allowable depletion methods. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 10-3 Cost Recovery (1 of 4) • Businesses must capitalize the cost of assets with a useful life of more than one year on the balance sheet rather than expense the cost immediately. • Also known as depreciation, amortization, or depletion—depending upon the underlying nature of asset. • Businesses use these methods to recover cost of assets due to wear, tear, and obsolescence of assets. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 10-4 Cost Recovery (2 of 4) • Different methods to recover the costs of assets – Depreciation: Deducting the cost of tangible personal and real property (other than land) over a specific period of time – Amortization: Deducting the cost of intangible property over a specific period of time – Depletion: Deducting the cost of natural resources over time © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 10-5 Cost Recovery (3 of 4) • Basis for Cost Recovery – Once the use of purchased assets is started, recouping the cost of assets also starts. – Initial basis reduces when cost is recovered through cost recovery deductions, which is called asset’s adjusted basis or tax basis. – Asset’s adjusted tax basis = asset’s initial basis minus accumulated depreciation (amortization or depletion). © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 10-6 Cost Recovery (4 of 4) EXHIBIT 10-1 Assets and Cost Recovery Asset Type Cost Recovery Method Personal property is comprised of tangible assets such as automobiles, equipment, and machinery. Depreciation Real property comprises buildings and land (although land is nondepreciable). Depreciation Intangible assets are nonphysical assets such as goodwill and patents. Amortization Natural resources are commodities that are considered valuable in their natural form, such as oil, coal, timber, and gold. Depletion © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 10-7 Basis Example (1 of 2) • Scrap-Happy Inc., a scrapbooking retail chain, purchased an old office building for $175,000 for use in expanding its current operations. An additional $15,000 was spent painting and remodeling the building in preparation for its opening. • Two years later, a Scrap-Happy employee discovered that several leaks in the roof were causing serious water damage to the store’s inventory; the company spent $50,000 to reroof the building. • Every six months, Scrap-Happy pays $500 to have the carpet professionally cleaned. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 10-8 Basis Example (2 of 2) • What is the initial basis of the building? $175,000 initial cost +15,000 painting and remodeling $190,000 original basis • What effects do the other two transactions have on the initial basis? – $50,000 reroofing expense: Added to basis (Results in a restoration of a major component of the building) – $500 biannual carpet cleaning: No effect on basis (Deducted immediately → routine maintenance) © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 10-9 Depreciation (1 of 22) • The TCJA made many changes to the way taxpayers will recover the cost of their assets for the next several years. – The changes primarily affect the special rules for depreciating personal property (§179 expensing and bonus depreciation). – The special rules (and changes) are covered after the basis depreciation rules. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 10-10 Depreciation (2 of 22) • Since 1986, businesses calculate their tax depreciation using the Modified Accelerated Cost Recovery System (MACRS, which is pronounced “makers” by tax accountants). © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 10-11 Depreciation (3 of 22) • To compute MACRS depreciation for an asset, the following need to be known: – Asset’s initial basis – Date it was placed in service – Applicable depreciation method – Asset’s recovery period (or depreciable “life”) – Applicable depreciation convention (depreciation deductible in the year of acquisition and the year of disposition) © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 10-12 Depreciation (4 of 22) • Personal Property Depreciation – Includes all tangible property such as computers, automobiles, furniture, machinery, and equipment, other than real property – Personal property (not real property) and personal-use property (used for personal purposes) are not the same. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 10-13 Depreciation (5 of 22) • Depreciation Method – Three acceptable methods for depreciating personal property ▪ 200 percent (double) declining balance ▪ 150 percent declining balance ▪ Straight-line © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 10-14 Depreciation (6 of 22) • Depreciation Recovery Period – For financial accounting purposes, an asset’s recovery period (depreciable life) is based on its taxpayer-determined estimated useful life. – For tax purposes, an asset’s recovery period is predetermined by the IRS in Rev. Proc. 87-56, which helps taxpayers categorize each of their assets based upon the property’s description. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 10-15 Depreciation (7 of 22) • Once the business has determined the appropriate categories for its assets, it can use the revenue procedure to identify the recovery period for all assets in a particular category. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 10-16 Depreciation (8 of 22) EXHIBIT 10-3 Excerpt Revenue Procedure 87-56 Description of Assets Included Years Years Years Specific depreciable assets used in all business activities, except as noted: Class Life General Recovery Period Alternative Recovery Period 00.11 Office Furniture, Fixtures, and Equipment: Includes furniture and fixtures that are not a structural component of a building. Includes such assets as desks, files, safes, and communications equipment. Does not include communications equipment that is included in other classes. 10 7 10 00.12 Information Systems: Includes computers and their peripheral equipment used in administering normal business transactions and the maintenance of business records. 6 5 5 00.241 Light General Purpose Trucks: Includes trucks for use over the road (actual unloaded weight less than 13,000 pounds). . . 4 5 5 34.0 Manufacture of Fabricated Metal Products Special Tools: Includes assets used in the production of metal cans, tinware. . . 12 7 12 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 10-17 Depreciation (9 of 22) EXHIBIT 10-4 Recovery Period for Most Common Business Assets Asset Description (Summary of Rev. Proc. 87-56) Recovery Period Cars, light general-purpose trucks, and computers and peripheral equipment 5 years Office furniture, fixtures, and equipment 7 years © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 10-18 Depreciation (10 of 22) • Depreciation Conventions – Half-year convention ▪ One-half of a full year’s depreciation is allowed in first and last year of an asset’s life. ▪ IRS depreciation tables automatically account for the half-year convention in year of purchase and disposition. ▪ If an asset is disposed of before it is fully depreciated, only one-half of the table’s applicable depreciation percentage is allowed in the year of disposition. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 10-19 Depreciation (11 of 22) – Mid-Quarter Convention ▪ Becomes largely irrelevant post-TCJA ▪ Applicable when > 40 percent of qualified property is
placed in service in the last quarter of the business’s
tax year
▪ Separate tables include rates
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10-20
Depreciation (12 of 22)
• Calculating depreciation for personal property
– Determine the appropriate convention (half-year or midquarter).
– Locate the applicable table provided in Rev. Proc. 87-57.
– Select the column that corresponds with the asset’s
recovery period.
– Find the row identifying the year of the asset’s recovery
period.
•
•
•
•
Applying the half-year convention
Half-year convention for year of disposition
Applying the mid-quarter convention
Mid-quarter convention for year of disposition
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10-21
Depreciation (13 of 22)
TABLE 1 MACRS Half-Year Convention
Depreciation Rate for Recovery Period
Year
3-Year
5-Year
7-Year
10-Year
15-Year
20-Year
1
33.33%
20.00%
14.29%
10.00%
5.00%
3.750%
2
44.45
32.00
24.49
18.00
9.50
7.219
3
14.81
19.20
17.49
14.40
8.55
6.677
4
7.41
11.52
12.49
11.52
7.70
6.177
5
11.52
8.93
9.22
6.93
5.713
6
5.76
8.92
7.37
6.23
5.285
7
8.93
6.55
5.90
4.888
8
4.46
6.55
5.90
4.522
9
6.56
5.91
4.462
10
6.55
5.90
4.461
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10-22
Depreciation (14 of 22)
Year
11
3-Year
5-Year
7-Year
10-Year
3.28
15-Year
20-Year
5.91
4.462
12
5.90
4.461
13
5.91
4.462
14
5.90
4.461
15
5.91
4.462
16
2.95
4.461
17
4.462
18
4.461
19
4.462
20
4.461
21
2.231
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10-23
Depreciation (15 of 22)
TABLE 2a–d MACRS Mid-Quarter Convention
Depreciation Rate for Recovery Period
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10-24
Depreciation (16 of 22)
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10-25
Depreciation Example (1 of 2)
• In 2022, Scrap-Happy purchased and placed in
service the following assets:
Asset
Cost
Date placed in service
Di-Cut Machine
$3,500
February 2 (1st Qtr.)
Computer
$1,200
October 25 (4th Qtr.)
• What is the recovery period for each of the
assets?
– Computer = 5 years
– Di-Cut Machine = 7 years
• Which convention should Scrap-Happy use to
determine depreciation for 2022?
– Answer: Half-year
▪
→ $1,200 4th qtr. assets/$4,700 total assets = 25.53% < 40% © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 10-26 Depreciation Example (2 of 2) • Now assume all the same facts, except that the computer was purchased in February and the machine in October, as shown: Asset Cost Date placed in service Recovery Period Computer $1,200 February 2 (1st Qtr.) 5 Years Di-Cut Machine $3,500 October 25 (4th Qtr.) 7 Years • What convention should be used in computing depreciation for the year? – Answer: Mid-quarter ▪ → $3,500 4th qtr. assets/$4,700 total assets = 74.46% >
40%
• How much depreciation can they take for each of the
assets in 2022?
– Computer: $1,200 × 35%* = $420
– Di-Cut Machine: 3,500 × 3.57%* = $125
*See respective mid-quarter MACRS tables for rates
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10-27
Depreciation (17 of 22)
• Real Property
– Uses mid-month convention and depreciated using
straight-line method
EXHIBIT 10-7 Recovery Period for Real Property
Asset Description (Summary from Rev. Proc. 87-57)
Recovery Period
Residential
27.5 years
Nonresidential property placed in service on or after May
13, 1993
39 years
Nonresidential property placed in service before May 13,
1993
31.5 years
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10-28
REAL PROPERTY: Depreciation
Example
• On July 12, Scrap-Happy purchases and places in
service a warehouse and the land it resides on for
$170,000 ($120,000 is allocated to the building
and $50,000 to the land).
• What is the amount of depreciation on the
property for the first year?
– Answer: $120,000 × 1.177% = $1,412
▪
1.177 percent is the rate given in the nonresidential real
property MACRS table under the column for the seventh
month.
– Land is not included in the calculation because it is not
depreciable.
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10-29
Depreciation (18 of 22)
• Immediate Expensing
– This incentive is commonly referred to as §179
expense or immediate expensing election.
– Limits on immediate expensing
▪ Property limitation
▪ Taxable income limitation
– Choosing the assets to immediately expense
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10-30
Depreciation (19 of 22)
• Bonus Depreciation
– To stimulate the economy, policy makers
occasionally implement bonus depreciation.
– Percentage is 100 percent for assets placed in
service between September 27, 2017, and
December 31, 2022.
– Bonus depreciation will be the primary way to
depreciate qualified assets for most businesses.
– Businesses may elect out of bonus
depreciation.
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10-31
Depreciation (20 of 22)
• Listed Property
– Defined: Assets that tend to be used for both
business and personal purposes.
– Depreciation is limited to business use.
▪ If business use is > 50 percent, use normal
depreciation methods.
▪ If business use is ≤ 50 percent, use straight-line
depreciation.
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10-32
Depreciation (21 of 22)
– If business use drops to ≤ 50 percent, taxpayers
must recompute the depreciation expense for all
prior years as if the business had been using the
straight-line depreciation over the ADS recovery
period the entire time
1. Compute depreciation for the year it drops to 50
percent or below using the straight-line method.
2. Compute amount to be deducted if straight-line
method is used over ADS recovery period for all prior
years (limited to business-use percentage).
3. Compute the amount of depreciation taxpayer
deducted on the assets for all prior years.
4. Subtract amount in Step 2 from amount in Step 3.
Difference is prior-year accelerated depreciation in
excess of straight-line depreciation.
5. Subtract amount in Step 4 from Step 1. This is
business’s allowable depreciation expense on the asset
for that year.
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10-33
Depreciation (22 of 22)
• Luxury Automobiles
EXHIBIT 10-10 Automobile Depreciation Limits
Recovery
Year
Year Placed in Service
2022
2021
2020
2019
1
10,200*
10,200*
10,100*
10,100*
2
16,400
16,400
16,100
16,100
3
9,800
9,800
9,700
9,700
4 and after
5,860
5,860
5,760
5,760
*$8,000 additional depreciation is allowed when bonus is claimed.
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10-34
Amortization (1 of 7)
• Businesses recover cost of intangible assets
through amortization.
• Intangible assets in the form of capitalized
expenditures, such as capitalized research and
experimentation (R&E) costs or covenants, do not
have physical characteristics.
• An intangible asset can be placed in one of four
general categories:
– §197 intangibles
– Start-up expenditures and organizational costs
– Research and experimentation costs
– Patents and copyrights
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10-35
Amortization (2 of 7)
• §197 Intangibles
– According to §197, these assets have a
recovery period of 180 months (15 years),
regardless of their actual life.
– Full-month convention allows taxpayers to
deduct an entire month’s worth of amortization
for the month of purchase and all subsequent
months in the year.
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10-36
Amortization (3 of 7)
• Organizational Expenditures and Start-up
Costs
– Organizational expenditures include
expenditures to form and organize a business
in the form of a corporation or a partnership
and are incurred prior to the starting of
business.
– Start-up costs are costs businesses incur to
start up a business.
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10-37
Amortization (4 of 7)
• Research and Experimentation Expenditures
– To stay competitive, businesses often invest in
activities that will generate innovative products or
significantly improve their current products or
processes.
– Businesses capitalize and amortize these costs over
a 5-year period beginning with the midpoint of the
year in which the costs were incurred. Research
and experimentation expenditures attributable to
research conducted outside the United States are
capitalized and amortized ratably over a period of
15 years after December 31, 2021.
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10-38
Amortization (5 of 7)
• Patents and Copyrights
– Manner of amortization depends on whether
the business directly purchases the patent or
copyright or whether it self-creates the
intangibles.
– Businesses directly purchasing patents or
copyrights amortize the cost over the
remaining life of the patents or copyrights.
– Businesses receiving “self-created” patents or
copyrights amortize the cost or basis of the
self-created intangible assets over the shorter
of the legal life or remaining useful life.
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10-39
Amortization (6 of 7)
EXHIBIT 10-14 Summary of Amortizable Assets
Asset
Description
§197 purchased
intangibles,
including goodwill,
trademarks,
patents, and
covenants not to
compete
Organizational
expenditures and
start-up costs that
are required to be
capitalized
Recovery Period
(months)
180
180
Applicable
Convention
Financial
Accounting
Treatment
Straight-line
Full-month
beginning with
month of purchase
ASC 350 tests for
annual impairment
Straight-line
Full-month in
month business
begins
AICPA SOP 98-5
Applicable
Method
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10-40
Amortization (7 of 7)
Asset
Description
Research and
experimentation
costs that are
capitalized
Self-created
patents and
copyrights
Purchased patents
and copyrights
Recovery Period
(months)
Ratably over 5
years
Actual life
Remaining life
Applicable
Method
Applicable
Convention
Financial
Accounting
Treatment
Straight-line
Midpoint of the
tax year in which
the costs are paid
or incurred.
Expensed
Straight-line
Full-month in
month intangible
is obtained
Expensed
Straight-line
Full-month in
month intangible
is obtained
Expensed
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10-41
Depletion (1 of 3)
• A method taxpayers use to recover their
capital investment in natural resources
• Businesses compute annual depletion
expense under both the cost and
percentage depletion methods and they
deduct the larger of the two.
• Taxpayers must estimate or determine the
number of units or reserves that remain at
the beginning of the year and allocate a
pro rata share of that basis to each unit
that is extracted during the year.
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10-42
Depletion (2 of 3)
• Once entire cost is recovered, businesses
are not allowed to use cost depletion to
determine depletion deduction.
• The amount of percentage depletion for a
natural resource business activity is
determined by multiplying the gross
income from the resource extraction
activity by a fixed percentage based on
the type of natural resource as indicated
in Exhibit 10-16.
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10-43
Depletion (3 of 3)
EXHIBIT 10-16 Applicable Percentage Depletion
Rates
Statutory Percentage
Natural Resources (partial list)
5 percent [§613(b)(6)]
Gravel, pumice, and stone
14 percent [§613(b)(3)]
Asphalt rock, clay, and other metals
15 percent [§613(b)(2)]
Gold, copper, oil shale, and silver
15 percent [§613A(c)(1)]
Domestic oil and gas
22 percent [§613(b)(1)]
Platinum, sulfur, uranium, and
titanium
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10-44
Cost Depletion Example
(1 of 2)
• Scrap-Happy purchases a tract of forest
land that it plans to use to harvest trees
to produce scrapbook paper. It is
estimated that the tract contains 30,000
board feet of timber. The original cost of
the property is $75,000, of which $60,000
is allocated to the timber and $15,000 to
the land.
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10-45
Cost Depletion Example
(2 of 2)
• What is the cost depletion per board foot?
– Answer: $60,000 basis/30,000 ft = $2/ft
• If the company uses 10,000 board feet
during the first year, how much will they
expense under the cost depletion method?
– Answer: 10,000 ft. × $2/ft = $20,000
– OR $60,000 basis × 33.33% resource used =
$20,000
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10-46
End of Presentation
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10-47