Chapter 6 - Taxable Income from Business Operations

Chapter 6
Questions and Problems for Discussion 1. a. The annual business cycle for a plant and garden center might end in the late autumn indicating an October 31 or November 30 fiscal year end. b. A bakery has no obvious annual business cycle to suggest a particular taxable year. c. The annual cycle for a chimney cleaning business might end in late spring indicating an April 30 fiscal year end, or the cycle might end in early autumn indicating a September 30 fiscal year end.

d. The annual cycle for a moving and transport business might end in late summer indicating an August 31 fiscal year end. e. A software consulting business has no obvious annual cycle to suggest a particular taxable year. 2. 3. 4. Corporation DB can elect a different overall method of accounting for each of its three business ventures. This lucky event increased Firm LKs net worth by $72,000 and, therefore, resulted in $72,000 realized income to the firm. If the two corporations have different marginal tax rates, an intercompany transaction could result in a shift of income from the high tax entity to the low tax entity or a shift of a deduction from the low tax entity to the high tax entity. A method of accounting that accomplishes such a shift and does not reflect an arms length transaction price between the related corporations is highly vulnerable to IRS challenge. Firms that provide audited financial statements to external users (investors, creditors, regulatory agencies, etc.) must prepare the statements in accordance with GAAP. The SEC requires publicly held corporations to follow GAAP in the preparation of financial statements. No, the cash method does not require that the taxpayer receive currency. The receipt of property (such as the case of wine) triggers income recognition based on the value of the property. Evidently, the increase in the after-tax cost of business lunches reduced KJ Inc.s demand for the service provided by Als Steak House. To the extent that the restaurants profitability declined because of the aggregate reduction in demand by the business community, the restaurants owners bear the incidence of the indirect tax increase. The death benefits received by a corporate beneficiary under its key-person life Insurance policies are nontaxable. Therefore, the cost associated with the nontaxable income (the annual premiums on the policies) is nondeductible by the corporation. In contrast, if other parties (the officers spouse and children) are named as beneficiaries, the premiums paid by the corporation represent additional officers compensation, which is a deductible business expense. Under GAAP, income is not realized until earned. If a firm receives payment for goods or services to be provided in a future year, the prepayment is recorded in a liability account as unearned revenue. Under the tax law, many prepayments of income must be included in taxable 6-1

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Chapter 6 - Taxable Income from Business Operations

income, even if the income has not yet been earned. The GAAP treatment is conservative because it prevents an overstatement of book income. The tax treatment is conservative because it prevents an understatement of taxable income (financial ability to pay).

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10. a. Taxable income exceeds book income by $55 (disallowed 50 percent of meal expense). b. Book income exceeds taxable income by $700 ($3,500 tax-exempt interest $2,800 nondeductible interest expense). c. Taxable income exceeds book income by $17,400 ($7,400 nondeductible lobbying expenses + $10,000 nondeductible political contribution).

11. Under the cash method, income from the provision of goods and services is not recognized until payment for the goods and services is received, an event that usually occurs after the income is earned under the accrual method. Thus, the cash method results in deferral from the year income is earned until the year payment is received. In a growing business, this on-going deferral results in a continuous deferral of tax. Therefore, in NPV terms, the tax cost associated with the cash method is less than the tax cost associated with the accrual method, even though each method results in the same total income recognition over the life of the business. 12. A deferred tax asset is similar to a prepaid tax resulting from an excess of taxable income over book income. The asset creates no independent value for the firm. A deferred tax liability is similar to a deferred tax resulting from an excess of book income over taxable income. The liability has no independent cost to the firm. 13. A net operating loss suggests that a business is losing money. Most unprofitable business ventures dont last for 20 years. 14. A tax preference may take the form of (1) an income item reported for financial statement purposes but never included in gross income, or (2) a tax deduction that is not based on an expense or loss reported for financial statement purposes. The resulting book/tax differences are permanent differences, which are more valuable than temporary differences in NPV terms. Application Problems 1. a. Nello must recognize the $8,400 excess of the account payable over the settlement payment ($23,400 - $15,000) as discharge-of-debt income. Nellos tax cost of the income is $2,940 ($8,400 35%), and its net cash outflow is $17,940 ($15,000 cash paid + $2,940 tax cost). b. Bonview can deduct the $8,400 excess of the account receivable over the settlement payment ($23,400 - $15,000) as a bad debt. Nellos tax savings from the deduction is $2,520 ($8,400 30%), and its net cash inflow is $17,520 ($15,000 cash received + $2,520 tax savings). 2. a. PTs tax on $92,000 income is $19,530 ($13,750 + 34%[$17,000 excess income over $75,000]). b. In this case, PT must annualize the $92,000 income reported on the short-period return. $92,000 short-period income (12 months 4 months) = $276,000 annualized income. The tax on $276,000 annualized income is $90,890 ($22,250 + 39%[$176,000 income over $100,000]). This tax must be deflated to reflect the four months of operations in the short period. $90,890 (4 months 12 months) = $30,297

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3. a. Because the property and casualty insurance premium is deductible, the after-tax cost is $3,640 ($5,600 [$5,600 35%]). b. Because the fine is nondeductible, the after-tax cost is $1,200. c. Because the life insurance premium is nondeductible, the after-tax cost is $3,700. d. Because the political contribution is nondeductible, the after-tax cost is $50,000. e. Because only 50 percent of the entertainment expense is deductible, the after-tax cost is $6,435 ($7,800 [$3,900 35%]). 4. Northwest Company is allowed a domestic production activities deduction equal to 6% of net income generated by the Portland plant. Consequently, its taxable income is computed as follows. Net income from Portland plant $3,100,000 Net income from Vancouver plant 4,800,000 Domestic production activities deduction (6% $3,100,000) (186,000) Taxable income $7,714,000 a. $22 taxable income. Although Firm B received $522 cash, the $500 principal repayment was a nontaxable return of investment. Only the $22 interest is income. b. No taxable income. Although Firm B received $600 cash, the receipt created a liability for repayment of the deposit and did not increase net worth. c. No taxable income. Although Firm B received $10,000 cash, the receipt created a liability for repayment of the loan and did not increase net worth.

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d. $888 taxable income. Although Firm B earned only $180 of the prepaid rent this year, (15 days in December $12), the income is recognized in the year payment is received. 6. a. The recording of the account receivable had no effect on Firm Fs taxable income. b. The write-off of the account receivable had no effect on Firm Fs taxable income. 7. 8. Although Firm Q is a cash basis taxpayer and received only $10,000 cash, it recognizes the $23,400 total value of the cash and noncash payment as taxable income. a. As a cash basis taxpayer, RTY recognizes no income for the services performed and $4,000 prepaid rent income. b. As an accrual basis taxpayer, RTY recognizes $17,800 income for the services performed and $4,000 of prepaid rent income. 9. a. No deduction. The $50,000 results in a benefit extending beyond the following taxable year and must be capitalized. b. No deduction. Brillo must use the accrual method to account for purchases of inventory. Thus, the $79,000 is capitalized to inventory. c. No deduction. The $1,800 cost of the refrigerator is capitalized to an asset account. d. $4,800 deduction. e. $22,300 deduction.

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Chapter 6 - Taxable Income from Business Operations

10. a. Even though NC adopted the cash method as its overall method of accounting, it must use the accrual method to account for inventory purchases. Therefore, its cost of goods sold for its first taxable year is $254,400 ($319,000 purchases $64,600 inventory on hand at yearend), and it is using a hybrid method of accounting. b. $254,400 (no difference) 11. a. LSG can deduct the entire $9,450 expenditure in 2007, the year of payment, because the expenditure results in a benefit with a duration of less than 12 months and the benefit does not extend beyond 2008. b. LSG must capitalize the $9,450 expenditure because it results in a benefit with a duration of more than 12 months. LSG can amortize the capitalized expenditure at a rate of $525 per month ($9,450 18 months), and can amortize and deduct $1,050 in 2007 ($525 2 months). 12. a. Even as a cash basis taxpayer, Firm F can deduct only $4,720 of the interest payment (the interest relating to the four-month period from September 1 through December 31). b. $4,720 (no difference) 13. a. Under the cash method of accounting, Wahoo must recognize the entire $36,000 prepayment as 2007 income. b. Even as an accrual basis taxpayer, Wahoo must recognize the entire $36,000 prepayment as 2007 income. 14. a. GreenUp should report $20,000 revenue in 2007, $65,000 revenue in 2008, and $15,000 revenue in 2009 for financial statement purposes. b. Under the one-year deferral method, GreenUp must recognize $20,000 taxable income in 2007 and $80,000 taxable income in 2008. 15. Cornish cannot deduct an accrued expense that fails the all-events test. Cornishs liability for the accrued expense is fixed because it has a binding contract with the construction company. However, the amount of the liability is simply an estimate. Consequently, Cornish can deduct only the $7,200 portion of the accrued expense for which economic performance (i.e. payment) has occurred. 16. a. If KLP uses the cash method of accounting, it can deduct $100,000 in the year of payment. b. For financial statement purposes, KLP must accrue a $100,000 expense in the year the winner was selected and its liability to pay the prize became fixed. However, because of the economic performance requirement, KLP is not allowed a tax deduction until the year of payment. 17. a. Deduction for accrued expense in 2006 Tax rate 2006 tax savings NPV of 2008 payment ($180,000 .873 discount factor at 7%) After-tax cost b. After-tax cost in 2008 $180,000 .35 $63,000 (157,140) $(94,140)

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($180,000 payment $63,000 tax savings) NPV ($117,000 .873 discount factor at 7%) $(117,000) $(102,141)

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Chapter 6 - Taxable Income from Business Operations

18. a. Company N can deduct the $7,740 interest payment in 2008, the year in which related party Creditor K recognized the payment as income. b. Company N can deduct the $7,740 interest expense in 2007. Even though Creditor K is a related party, it recognized the payment as income in 2007 under its accrual method of accounting. c. 19. a Company N can deduct the $7,740 interest expense in 2007 because Company N and Creditor K are unrelated. If Mrs. T owns no Acme stock, she and Acme are not related parties. Thus, Acme can deduct the $20,000 bonus in 2007, the year in which the expense was accrued.

b. If Mrs. T owns 63 percent of Acmes stock, she and Acme are related parties. Thus, Acme must wait to deduct the $20,000 bonus until 2008, the year in which Mrs. T includes the payment in income. 20. a. GKs bad debt expense for financial statement purposes is $90,000, which is the addition to the allowance for bad debts. b. GKs tax deduction for bad debts is $77,300, the amount of actual write-offs of accounts receivable. 21. a. For financial statement purposes, the $65,000 write-off was charged against the allowance for bad debts and did not reduce financial statement income. For tax purposes, the $65,000 write-off was deducted in the computation of taxable income. b. For financial statement purposes, the $65,000 recovery was credited to the allowance for bad debts and did not increase financial statement income. For tax purposes, the $65,000 recovery was included in taxable income under the tax benefit rule. 22. EFGs net book income before tax Bad debt expense per books Bad debt deduction (write-offs) Nondeductible fine Nondeductible contingent liability EFGs taxable income $500,000 $12,500 (13,800) (1,300) 17,500 50,000 $566,200

23. a. 35% $31,000 excess of book income over taxable income = $10,850 deferred tax liability b. No deferred tax asset or liability from permanent book/tax difference. c. 35% $55,000 excess of taxable income over book income = $17,500 deferred tax asset

24. a. GTs tax expense is $238,000 (34% $700,000 book income). b. GTs tax payable is $275,400 (34% $810,000 taxable income). c. The excess of tax payable over tax expense is a $37,400 net increase in deferred tax assets.

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25. a. Net income before tax Permanent book/tax differences Tax rate Corporation Hs tax expense b. Taxable income Tax rate Corporation Hs tax payable c. Tax expense Tax payable Net increase in deferred tax liabilities $600,000 15,000 $615,000 .34 $209,100 $539,000 .34 $183,260 $209,100 (183,260) $25,840 $378,200 (33,500) $344,700 .34 $117,198 $457,100 .34 $155,414 $155,414 (117,198) $38,216 $505,100 (19,176) 40,000 (21,400) $504,524

26. a. Net income before tax Permanent book/tax differences Tax rate Corporation Hs tax expense b. Taxable income Tax rate Corporation Hs tax payable c. Tax payable Tax expense Net increase in deferred tax assets

27. Micros net book income before tax Domestic production activities deduction (6% $319,600) Prepaid royalty income NOL carryforward deduction Micros taxable income

28. TRWs taxable income for the eight-year period is computed as follows:
2001 Tax. income before NOL deduction NOL deduction Taxable income 20,000 20,000 2002 158,000 (158,000) -02003 81,000 (81,000) -02004 (741,000) NA 2005 21,000 (21,000) -02006 398,000 (398,000) -02007 687,000 (83,000) 604,000 2008 905,000 905,000

29. a. 34% $90,000 unfavorable temporary difference = $30,600 deferred tax asset b. 34% $710,000 NOL carryforward = $241,400 deferred tax asset c. Negative tax expense $272,000 ($30,600 + $241,400). Negative tax expense can also be computed by multiplying Ronys $800,000 book loss by its 34 percent tax rate.

30. a. Ronys tax expense is $408,000 (34% $1,200,000 book income). b. Ronys tax payable is $136,000 (34% $400,000 taxable income). c. Ronys reduction in its deferred tax assets is $272,000.

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Issue Recognition Problems 1. 2. Must Corporation DS recognize the $15,000 discharged debt as income, even though the cancellation did not increase the insolvent corporations net worth? Is the discovery of the underlying painting a realization event that triggers $249,700 income for the theater company? Did the discovery of the underlying painting merely increase the value of the asset purchased for $300, an increase that does not represent realized income? Is BL Inc. required to request permission from the IRS to change from an incorrect to a correct method of accounting? In which year (2007 or 2008) does Company A recognize the $160,000 income from the consulting engagement? Because Company A used the cash method in 2007 (when the consulting engagement was completed) and the accrual method in 2008 (when the cash was received), does the $160,000 income from the consulting engagement escape taxation entirely? Was Mr. RJ in constructive receipt of the $3,500 income in the earlier year because he could have picked up the check from the clients receptionist if he had checked his phone messages during the holidays?

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6. Can Masterson Inc. accrue a $119,200 state income tax expense on December 31, 2006, and deduct the accrued expense on its 2006 federal income tax return? In which taxable year (2006 or 2007) can Masterson deduct the $119,200 state income tax payment in the computation of federal taxable income? 7. Is $75,000 an arms length price for the advertising provided by HT to LT? Did HT undercharge for the service rendered to LT to shift income to a related party with a zero marginal tax rate?

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Chapter 6 - Taxable Income from Business Operations

8. 9. Does the $18,000 property tax refund represent either financial statement income or taxable income to Firm K? Should Firm G have recognized $200,000 or only $150,000 income in 2005? If Firm G recognized $200,000 income in 2005, can it deduct the $30,000 settlement paid in 2007? If Firm G recognized $200,000 income in 2005, can it request a $11,700 refund ($30,000 39 percent), or must it be content with a $10,200 tax savings from a 2007 deduction ($30,000 34 percent)?

10. Can a taxpayer choose the carryback year in which an NOL is deducted or must an NOL carryback be deducted in chronological order? 11. Can BL deduct TMs NOL carryforwards? If a taxpayer purchases a business that generated NOL carryforwards, does the purchaser acquire the carryforwards along with all the other business properties?

Research Problems 1. Section 458 provides a special method of accounting available to publishers and distributors of magazines, paperback books, and musical records, tapes, and discs. According to Section 458(a), accrual basis taxpayers can exclude the income realized on sales of these items that are returned before the close of the merchandise return period. According to Section 458(b)(7), the merchandise return period for magazines is the two-month and 15-day period after the close of the taxable year. According to Section 458(b)(6), the income excluded is limited to the refund paid by the taxpayer for the returned items. Based on these rules, Bontaine Inc. can exclude $82,717 (refund paid in January 2008 for December 2007 sales) from its 2007 taxable income. 2. In CharlesSchwab Corp. v. Commissioner, 107 T.C. 282 (1996), affd, 161 F.3d 1231 (CA-9, 1998), cert. denied (1999), the Tax Court and the Ninth Circuit Court of Appeals held that discount brokerage houses must accrue commission income on the earlier trade date instead of the later settlement date. Based on this decision, CheapTrade should recognize $1,712,400 commission income in 2007. 3. The answer to this research problem depends on whether Moleri has made an election under Section 461(c) and Reg. Sec. 1.461-1(c) to accrue real property tax ratably over the twelve months of the calendar year to which the tax relates. If this election is in effect, Moleri deducts $17,395 (7 months [$29,820 12 months] of the 2007 tax on its return for the fiscal year ending July 31, 2007. It also deducts the 5 months of its 2006 property tax payment relating to August through December 2006. If this election is not in effect, Moleri deducts the entire 2007 tax because it paid the tax (i.e. economic performance occurred) during the year. Reg. Sec. 1.461-4(g)(6)(iii)(A). 4. This case is based on U.S. Freightways Corp. v. Commissioner, 270 F. 3d 1137 (CA-7, 2001), revg 113 TC 329 (1999). The accrual basis freight company deducted its entire annual payment for permits and licenses, even when the annual term of the permit or license extended into the following year. The company based this accounting treatment on the regulatory rule allowing a deduction for prepaid expenses providing a benefit that does not extend substantially beyond the end of the year following the year of payment. The IRS argued that this 12-month rule applied only to cash basis taxpayers. Although the Tax Court agreed with the IRS, the Seventh Circuit reversed the Tax Court and allowed the deduction. This decision paved the way for new Reg. Sec. 1.263(a)-4, which clarifies that the 12-month rule applies to both cash and accrual basis taxpayers. Under the new regulation, Jetex Inc. can deduct $1,119,200 in 2007. 6-10

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Tax Planning Cases 1. The net income deferred from 2007 until 2008 through use of the cash method is computed as follows. Accrual method: Income from billings Expense incurred Net income in 2007 Cash method: $3,500,000 (800,000) $2,700,000

Cash received $2,900,000 Expenses paid (670,000) Net income in 2007 Income deferred until 2008 under cash method The value of this deferral is computed as follows. Tax on income deferred one year ($470,000 34%) NPV of deferred tax ($159,800 .935 discount factor at 7%) Decrease in tax cost from cash method 2.

(2,230,000) $470,000

$159,800 (149,413) $10,387

a. Yes. VBs positive taxable income in 2005 indicates that the corporation either carried back its 2004 NOL or claimed it as a carryforward deduction in 2005. b. VBs carryback of $170,000 of the 2007 NOL would generate the following refund. Tax paid in 2005 Tax after $60,000 NOL carryback Refund Tax paid in 2006 Tax after $110,000 NOL carryback Refund Total refund received NOL carryforward deduction Projected 2009 marginal tax rate Projected tax savings from deduction NPV of tax savings ($61,200 .873 discount factor at 7%) $10,000 -0$10,000 $26,150 -026,150 $36,150 $180,000 .34 $61,200

The NPV of VBs remaining $180,000 NOL carryforward into 2009 is computed as follows.

$53,428

The total value of the 2007 NOL is $89,578 ($36,150 + $53,428). c. The NPV of a $350,000 NOL carryforward into 2009 is computed as follows. NOL carryforward deduction Projected 2009 marginal tax rate Projected tax savings from deduction NPV of tax savings ($119,000 .873 discount factor at 7%) $350,000 .34 $119,000

$103,887

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To maximize the value of the NOL deduction, VB should give up the carryback and carry the 2007 NOL forward as a deduction to 2009.

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