2013 cch basic principles ch13

Chapter 13

Tax Accounting

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CCH Federal Taxation Basic Principles 2 of 88

Chapter 13 Exhibits

Chapter 13, Exhibit Contents A

1. Computation of Taxable Income

2. Net Tax Liability

3. Accounting Periods

4. Election of the Tax Year

5. Partnerships

6. Partnership Accounting Period—Examples

7. Corporations, Estates, and Trusts

8. Change of Accounting Periods

9. IRS Permission or Consent

10. Exceptions to Permission Requirements

11. Short Tax Years

12. Short-Period Tax

13. Alternative Method

14. Short-Period Example


Chapter 13 Exhibits

Chapter 13, Exhibit Contents B

15. Accounting Methods

16. Cash Method

17. Constructive Receipt

18. Cash Basis Taxpayer Examples

19. Deductibility of Expenses

20. Limitations on Use of Cash Method

21. Accrual Method

22. Accrual Basis Taxpayer Examples

23. Prepaid Income and Expenses

24. Separate Sources of Income

25. Hybrid Methods

26. Change of Accounting Methods

27. Adjustment—Voluntary/Required Change

28. Change in Accounting Method Example


Chapter 13 Exhibits

Chapter 13, Exhibit Contents C

29. Inventories

30. Valuation of Inventory

31. Cost Methods

32. Uniform Capitalization Rules (UNICAP)

33. Cost Allocation Procedures

34. Simplified Retail Method

35. Inventory and UNICAP

36. Simplified Production Method

37. Lower-of-Cost-or-Market (LCM) Method

38. LCM Example

39. Valuation of Inventory Items

40. Inventory Valuation Example

41. Inventory Valuation Example—FIFO

42. Inventory Valuation Example—LIFO


Chapter 13 Exhibits

Chapter 13, Exhibit Contents D

43. Inventory Valuation Example—Weighted Average Cost

44. Dollar-Value LIFO Method

45. Double Extension Method

46. Dollar Value LIFO Example

47. Dollar Value LIFO Example—2009



50. Simplified Dollar-Value LIFO Method

51. Simplified Dollar-Value LIFO Example

52. Estimates of Inventory Shrinkage

53. Long-term Contracts

54. Capitalization of Expenses

55. Percentage-of-Completion Method

56. Modified Percentage-of-Completion Method


Chapter 13 Exhibits

Chapter 13, Exhibit Contents E

57. Completed Contract Methods

58. Long-term Contracts Example

59. Installment Sales

60. Computation of Gain

61. Installment Sale Example

62. Dispositions of Installment Obligations

63. Disposition of Installment Obligation—Example

64. Repossessions of Personal Property

65. Repossessions of Real Property

66. Personal Property Repossessions—Example

67. Real Property Repossessions—Example

68. Advantages and Disadvantages of Installment Method


Computation of Taxable Income

IndividualsIncome Broadly ConceivedLess: ExclusionsGross IncomeLess: Deductions for Adjusted Gross IncomeAdjusted Gross IncomeLess: Deductions from Adjusted Gross Income

Taxable Income C CorporationsIncome Broadly ConceivedLess: ExclusionsGross IncomeLess: Deductions Routine SpecialTaxable Income

S CorporationsIncome Broadly ConceivedLess: ExclusionsGross IncomeLess: DeductionsOrdinary Income Estates and TrustsIncome Broadly ConceivedLess: ExclusionsGross IncomeLess: DeductionsTaxable Income

Chapter 13, Exhibit 1


Net Tax Liability

Individuals, C Corporations, and Estates and Trusts

Gross Tax Liability

Less: Credits

Net Tax Liability

Less: Prepayments

Net Tax or Refund Due

Chapter 13, Exhibit 2a


Net Tax Liability

Many of the income, deductions, and credit concepts you have learned in first 12 chapters apply to all entities

However, there are numerous and substantial differences

Chapter 13, Exhibit 2b


Accounting Periods

Tax year - calendar year or fiscal year on the basis of which taxable income is determined May not exceed 12 months

Calendar year - ends on December 31 Fiscal year - ends on last day of any month other than

December Taxpayer must correlate accounting, financial, and

business practices with the fiscal year used for tax returns

Tax return is required for a fractional part of a year Known as a short tax year



Election of the Tax Year

New taxpayer may adopt any tax year without obtaining prior approval of IRS in first year. First tax year must be adopted on or before time for

filing the initial return Taxpayers who do not have books must use the

calendar year Sole proprietors

Must use same period for business tax reporting purposes that they use for their personal books



Partnerships

Must use same tax year as that of its partners who have a majority interest

If partners owning a majority interest have different tax years Partnership must adopt same tax year as that of its principal

partners Principal partner - a partner having ≥5 percent interest in

partnership profits or capital When neither condition is met

Partnership must use a year that results in least aggregate deferral of income to partners

Partnership income is considered to be earned by partners on the last day of partnership’s tax year



Partnership Accounting Period Examples

1. X and Y form XY Partnership. X owns 60% of XY, so XY must use X’s tax year.

2. A, B and C form ABC Partnership. They are equal owners. A and B are calendar taxpayers and C is a 5/31 year-end taxpayer. ABC must use the calendar year.



Partnership Accounting Period Examples

M (40%), N (40%) and O (20%) form MNO Partnership. They have the following tax year ends:M: December 31N: April 30O: June 30MNO must use a 12/31 year end based as follows:

Possible Tax Year Ends 4/30 6/30 12/31 Months Months Months

Partner Interest Partner Year End Deferred Total Deferred Total Deferred Total M 40% 12/31 8 3.2 6 2.4 0 0.0N 40% 4/30 0 0.0 10 4.0 4 1.6O 20% 6/30 2 0.4 0 0.0 6 1.2

3.6 6.4 2.8December 31 year end has the least aggregate deferral.



Corporations, Estates, and Trusts

Newly organized C corporation may select any tax year May differ from that of the shareholders

S corporation generally required to be a calendar year Estate may adopt any tax year Trusts must use calendar year



Change of Accounting Periods

In general, prior approval must be obtained Usually obtained if there are substantial business

reasons for change Usually involves a short-period tax year



IRS Permission or Consent

Taxpayer must file an application on Form 1128 On or before the 15th day of third calendar month

following the end of short year Should show that there is a substantial business

purpose for change and that any tax cost to IRS is insignificant

To prevent substantial distortion of income, an agreement between taxpayer and IRS is required

If approval is granted, taxpayer must file an income tax return for short period



Exceptions to Permission Requirements

An individual whose income is derived solely from wages, salaries, interest, dividends, capital gains, pensions and annuities, or rents and royalties May change from the fiscal year to calendar year

Newly married individual May adopt accounting period of other spouse without prior

approval All partnerships, S corporations, and personal service

corporations that conform their tax years to their owners’ tax year

Other corporations have more restrictions to their annual accounting period without prior approval



Short Tax Years

Separate return is filed for short period beginning with day following the close of old tax year and ending with day preceding first day of new tax year

The procedures are as follows:

1. Annualize short-period income

2. Determine tax on the annualized income

3. Determine short-period tax



Short-Period Tax

Determine annualized income (AI) for short-period income (SPI):

AI = SPI x (12/# months in short period) Determine tax (T) on annualized income:

From rate schedules Determine short-period tax (SPT):

SPT = T x (# months in short period/12)



Alternative Method

Annualization may result in inequities to taxpayer An exception to general rule may result in less tax:

Determine taxable income for the 12-month period beginning on the first day of the short period

Determine the tax on the taxable income for this 12-month period

Alternative short-period tax ASPT) = Tax on 12-month period × [ Taxable income for short period/Taxable income for 12-month period]

Short-period tax computed in Step 3 cannot be less than it would have been if it had been computed on short-period taxable income without placing it on an annualized basis



Short-Period Example

X Corporation uses a calendar yearIn 2012 it changed its accounting period to one ending on 4/30 Taxable income for 1/1/12-12/31/12 is $50,000Taxable income for 1/1 – 4/30 is $24,000AI = $24,000 x (12/4) = $72,000T = $13,500SPT = $13,500 x (4/12) = $4,500Does alternative apply? Yes, as follows.1. TI = $50,0002. Tax = $7,5003. ASPT = $7,500 x ($24,000/$50,000) = $3,6004. (Tax on SPTI not annualized = $3,600), so ASPT = $3,600

So X Corporation’s short-period tax = Lesser of $4,500 or $3,600 = $3,600



Accounting Methods

Must clearly reflect income. Income should be reflected with as much accuracy as

standard methods of accounting practice permit If method does not clearly reflect income

Tax computation is to be made under a method that IRS agrees will clearly reflect income

The two most commonly used overall methods:(1) Cash method and (2) Accrual method

Special treatment is accorded various types of revenue (e.g., installment sales) and many types of expenses (e.g., bad debts)



Cash Method

Vast majority of individuals and many businesses use it Income recognized in tax year when cash and/or cash

equivalents are actually or constructively received Expenses generally deductible in tax year paid unless

they are attributable to more than one year Cash equivalents may take many different forms



Constructive Receipt

Income constructively received in tax year in which: It is credited to the taxpayer’s account, Set apart for the taxpayer, or Made available to the taxpayer to draw upon If the taxpayer’s control of its receipt is not subject to

substantial limitations or restrictions The payer must:

Have ability to pay, Set aside funds for payments, and Not place substantial restrictions on taxpayer’s ability to access

funds (or property) If these conditions are met, then taxpayer cannot deliberately turn

back on income and thus select year of reporting



Cash Basis Taxpayer Examples

1. X received a $1,000 check on 12/28/2011 but did not cash it until 1/2/2012. X has constructive receipt on 12/28/2011.

2. On 12/15/2012, Y completed a job for Z, Z gave Y a $9,000 check. Y returned the check and asked Z to give it to him on 1/3/2013. Y has constructive receipt on 12/15/2012.

3. A performs a service for B. B gives a 100 shares of stock worth $6,000. A has income of $6,000 at time of receipt. The stock’s FMV is a cash equivalent.



Deductibility of Expenses

Does not coincide with the recognition of income under cash method

Expenses are recognized in year they are paid Some expenditures are recognized as an expense

over the asset’s life May be “paid” in cash or in property

Not by note of the taxpayer even if secured by collateral



Limitations on Use of Cash Method

Three types of taxpayers cannot use cash method of accounting for tax purposes:1. C corporations2. Partnerships which have a C corporation as a partner3. Tax shelters

Small businesses can use cash method of accounting if have Average annual gross receipts of $5 million or less over the past three years The three-year period does not include current tax year in which

determination is being made Gross receipts:

Deduct sales returns and allowances from gross receipts Exclude dividends, interest, gross rents, other income, and net gains and

losses from sales of capital and business assets Qualified personal service corporation may use the cash method of accounting



Accrual Method

Income recognized in year: All events that determine right to receive income have occurred Amount can be determined with reasonable accuracy

Expenses recognized in year: Legal obligation to make payments comes into existence All events that determine fact of the liability have occurred Amount can be determined with reasonable accuracy

All events test not met until economic performance with respect to item has occurred Economic performance occurs if liability arises because a

service or property is provided to taxpayer Taxpayer must keep adequate books



Accrual Method

Income recognized when: Unconditional right to receive it Amount is determinable with reasonable accuracy Amount is collectible

If taxpayer’s right to receive is dependent upon future events Postpone income recognition until those contingencies occur or

lapse If real doubt and uncertainty exist as to whether amount due will

ever be collected Postpone income recognition



Accrual Basis Taxpayer Examples

1. Joe performed accounting work for Jerry. The agreed upon price was $20,000 and payment was due 30 days after completion. Joe finished the work on 7/8/12. Joe recognizes $20,000 on 7/8/12.

2. Assume the same as #1 except Jerry contests the quality of the work performed and has indicated that he will not pay any amount. Since the amount is not determinable, Joe does not recognize income on 7/8/12. Joe will recognize income when his claim against Jerry is reasonably determinable.

3. Jen performs legal work for ABC Company. In return, she receives rights to buy 10,000 shares of ABC Company if it goes public (currently it is not in the process of making an initial public offering). Jen does not recognize income when she receives the rights because the rights are contingent on ABC Company going public and there is no indication that this will happen.



Accrual Basis Taxpayer Examples

4. On 10/9/11, Ed signs a contract to perform legal services for Z Co. and receives $30,000 payment. The contract requires that Ed be available for 30 hours of consulting over the next three years. Under the claim of right doctrine, Ed must recognize $30,000 on 10/9/11.

5. Assume the same facts as #4 except the contract period ends on 10/9/12. Ed may use his accrual method and recognize income as he performs the services.



Prepaid Income and Expenses

Generally taxable in year received Accrual-basis taxpayers may elect to recognize prepaid subscription income

over subscription period Applicable to all prepaid subscription income

Membership organization that receives prepaid dues may elect to recognize income over time period it has a liability to render these services unless income relates to a liability that extends for more than 36 months

Accrual-basis taxpayers can deduct interest only in period in which use of the money occurs

Accrual-basis taxpayers may include prepayment for services in gross income in year of receipt If certain conditions are met, the income may be spread over year of

receipt and/or the following year (prepaid service income method) To qualify for prepaid service income method, taxpayer must perform all

services under an agreement by end of tax year following year of receipt



Separate Sources of Income

Taxpayer with two or more separate and distinct businesses Different accounting method may be used for each

business Must maintain separate books and records May not shift profits and losses between businesses

via inventory adjustments, sales, purchases, or expenses



Hybrid Methods

Many combinations of permissible accounting methods may be used

But a taxpayer’s choice is not unlimited If cash method is used for income, it must also be

used for expenses If accrual method is used for expenses, it must also

be used for income Accrual method is required if inventories are an

income-producing factor



Change of Accounting Methods

IRS permission must be obtained Major changes in accounting method include:

1. Change to or from cash-basis method2. Change in method of valuing inventory3. Change from accrual method to a long-term contract method or vice

versa4. Change involving the adoption, use, or discontinuance of any other

specialized method of computing income, such as the crop method by farmers

5. Certain changes in computing depreciation or amortization6. Change for which the Code or Regulations specifically require consent

If taxpayer’s method does not clearly reflect income, then IRS may prescribe a method which does

Change in method does not include correction of mathematical and posting errors, or of errors in the computation of tax liability



Adjustment – Voluntary/Required Change

Adjustments must be made in year of change to prevent items from being duplicated or entirely omitted

Net adjustment = sum of positive and negative adjustments Adjustment period for taxpayer-initiated changes that result in a

positive adjustment is four years Tax year of change is first year If adjustment is less than $25,000, may elect a one-year

adjustment period Adjustment period is one year for negative adjustments A positive adjustment due to a change initiated by IRS generally

is recognized over the four-year period as noted above However, IRS can require that it be recognized over a shorter

time period



Change in Accounting Method Example

Kim Co. is a cash basis, calendar year taxpayer. It changed to the accrual method in 2012 and determined its net income as follows:

Sales $800,000Cost of goods sold 500,000Gross profit 300,000Expenses 100,000Net Income $200,000On 12/31/2011, it had $30,000 in inventory, accounts receivable of $23,000 and $29,000 in accounts

payable.Kim Co.s net adjustment to Net income is $24,000, based as follows:

Positive adjustment for ending inventory $30,000Positive adjustment for ending accounts receivable 23,000Negative adjustment for ending accounts payable (29,000)Net adjustment $24,000

Thus, it can add $6,000 ($24,000/4) to income in 2012, 2013, 2014, and 2015 or add $24,000 to the $200,000 in 2012.



Inventories

Must use the accrual method of accounting if inventories are an income-producing factor

Cost of goods sold: Recognized when inventory sold Equals:

Opening inventory+ Inventory purchased or produced - Ending inventory

Value of ending inventory a function of: (1) What costs are included (2) Cost flow assumptions made



Valuation of Inventory

Two fundamental requirements for valuation of inventory: 1. must conform as nearly as possible to best

accounting practice in the trade or business 2. must clearly reflect income

Inventory may be valued at cost or lower-of-cost-or-market

If LIFO method used, then the taxpayer cannot use lower-of-cost-or-market

Lower-of-cost-or-market must be applied to each item in inventory



Cost Methods

Cost of merchandise purchased equals:Invoice prices- Trade discounts+ Incidental costs incurred to acquire the goods

Cost of merchandise produced includes the cost of direct materials, direct labor, and indirect costs Manufacturers must use absorption costing (full costing) to

value inventories Indirect costs that must be capitalized include repairs,

maintenance, utilities, rent, and indirect labor and materials. §263A expands definition of includible costs by requiring

most entities (especially manufacturers) to use uniform capitalization (UNICAP) rules



Uniform Capitalization Rules (UNICAP)

Generally applies to: Real or personal property produced by taxpayer Real or personal property acquired by taxpayer for resale

Under UNICAP, indirect costs include:1. Factory repairs and maintenance; utilities; rent; depreciation,

amortization, and depletion; small tools; and insurance2. Indirect labor and production supervisory labor; administrative costs;

indirect materials and supplies; rework, scrap, and spoilage; storage and warehousing costs; purchasing costs; handling, processing, assembly, repacking costs; and quality control and inspection costs

3. Taxes (other than income taxes)4. Deductible contributions to pension, profit-sharing, stock bonus, or

annuity plans 5. Interest, but only for real property, long-lived property, or property

requiring more than two years to produce



Cost Allocation Procedures

Once total additional §263A costs are identified, next step in costing inventory is to allocate these costs

Direct capitalized costs: Associated with specific production activities and products and

allocated to them accordingly Taxpayer may use any method which reasonably allocates such costs

Indirect costs allocated to activities and products using one of three methods:

a) Specific identification (costs are specifically identified with activities or products that directly benefit from the costs)

b) Standard costing (costs are allocated to products based upon established standards)

c) Burden rates (costs are allocated based on direct labor hours, direct labor costs, and similar expenses)



Simplified Retail Method

May elect to use to allocate costs under §263A Fully capitalize costs for: 1. Off-site storage and warehousing

2. Purchasing3. Handling, processing, assembly

Amount of mixed service costs (general and administrative costs) allocated requires two steps:1. Determine amount of mixed service costs that are

additional §263A costs2. Allocate this amount to ending inventory



Simplified Retail Method

Amount of mixed service costs included under §263A is determined by multiplying such costs by ratio of:1.Total labor costs included in off-site, storage,

purchasing, and handling cost to2.Total labor costs incurred in taxpayer’s business,

excluding the labor included in the mixed service costs Once amount is determined, then allocated to ending

inventory by multiplying amount in ending inventory that was purchased during year by the ratio of1.Total additional §263A costs to2.Taxpayer’s total purchases during year



Inventory and UNICAP X Co. uses FIFO for its inventory. During the year it incurred:

Storage costs = $200,000,Purchasing costs = $300,000, andHandling and processing costs = $100,000Labor costs included in amounts above = $180,000 Mixed service costs = $250,000 Total labor costs, excluding amounts included in mixed service costs = $2,000,000

• X’s beginning inventory (excluding additional Code Sec. 263A costs) = $1,000,000 • Total purchases = $7,000,000 • Ending inventory = $1,500,000 (excluding additional Code Sec. 263A costs) • Since X Co. uses the FIFO method, the full $1,500,000 of ending inventory is considered purchased during the year

X Co.’s ending inventory i= $1,633,350, consisting of :Original cost of $1,500,000+ Capitalized additional Code Sec. 263A resale costs of $133,350 (determined below)

• First, determine mixed service costs considered additional Code Sec. 263A costs using the labor ratios: Labor ratio = $180,000/$2,000,000 = 9% Mixed service costs considered additional Code 263A costs = 9% × $250,000 = $22,500

• Next, determine total additional Code Sec. 263A and allocate to ending inventory (using the additional Code Sec. 263A costs to purchases ratio)

Costs to purchase ratio = $622,500/$7,000,000 = 8.89% Additional Code Sec. 263A costs allocated to ending inventory = 8.89% × $1,500,000 = $133,350



Simplified Production Method

Taxpayers may elect to use simplified production method to allocate capitalized costs for property produced

Cannot be used for property acquired for resale and for property produced by taxpayer for use in its business

Additional §263A costs allocated based on an absorption ratio and the allocation requires two steps

First, compute the absorption ratio -- this is the ratio of:1. Total additional §263A costs incurred during the year to2. Total §471 costs incurred during the year

Second – additional §263A costs capitalized equals:Absorption ratio x amount of §471 costs incurred during the year which areincluded in the taxpayer’s ending inventory If taxpayer uses FIFO, then absorption ratio is applied to §471 costs included

in ending inventory If taxpayer uses LIFO, then absorption ratio is applied to §471 costs included

in this year’s increase in inventory (the incremental layer)



Lower-of-Cost-or-Market (LCM) Method

Ending inventory may be written down to a lower market value unless taxpayer is using LIFO

Lower cost or market must be applied to each item of inventory



LCM Example

Tom Co. uses LCM for inventory purposes

Cost and market information follows:

Item Cost Market LCM

A $10,000 $5,000 $5,000

B 14,000 18,000 14,000

C 6,000 4,000 4,000

Total $30,000 $27,000 $23,000

Its ending inventory is written down from $30,000 to $23,000



Valuation of Inventory Items

May use one of four cost flow assumptions to value their inventories: Specific identification First-in, first-out (FIFO) Last-in, first-out (LIFO) Weighted average

Does not have to agree with actual physical flow of goods Must receive IRS approval to use LIFO If LIFO is used for tax purposes then also must be used for

financial reporting purposes



Inventory Valuation Example

Tati Co. sells widgets. Following is a review of its inventory and purchases for the year

1/1: 2,000 units in beginning inventory @ $20

5/6: 1,000 units purchased @ $22

7/10: 1,500 units @ $24

11/15: 500 units @ $23

Tati Co. sold 4,000 units during the year for $200,000

What is Tati Co.’s gross profit under FIFO, LIFO and weighted average inventory valuation systems?



Inventory Valuation Example - FIFO

Sales $200,000

Inventory 1/1 $40,000

Purchases 69,500

Available for sale $109,500

Ending inventory

500@ $24 $12,000

500@ $23 11,500 23,500

Cost of goods sold 86,000

Gross profit $114,000



Inventory Valuation Example - LIFO

Sales $200,000


Purchases 69,500


Ending inventory

1,000@ $20 20,000





Inventory Valuation Example—Weighted Average Cost

Sales $200,000


Purchases 69,500


Ending inventory

$109,500/5,000 = $21.90

1,000@ $21.90 21,900





Dollar-Value LIFO Method

Increase in LIFO value is determined by: Comparing the total dollar value of beginning and

ending inventories at base-year (first LIFO year) prices Then converting any dollar-value increase to current

prices by means of an index Allowed to determine base-year dollars through the use of

government indexes Several price index methods are permitted Double extension method is used most frequently



Double Extension Method

1. Determine opening inventory at base-year prices (the prices in effect when LIFO was adopted)

2. Determine ending inventory at base-year prices3. Compute the difference

The result is either an increase (increment) or a decrease (decrement)

4. Determine a price index to value increment, if any Index equals ending inventory at current prices/ending

inventory at base-year prices5. Adjust inventory “layers” for any increment or decrement

Every increment represents a new layer Any decrement uses up most recently added layer or layers

first



Dollar Value LIFO Example

Jenn Co started business in 2011 and uses the LIFO method. Inventory information follows:

1/1/2011: inventory = $10,000 (base period, index = 1.0)

inventory (actual prices) inventory (base-year prices)

12/31/2011 $26,000 $21,000

12/31/2012 $30,000 $16,000

12/31/2013 $40,000 $29,000

What amount did Jenn Co. use to value its ending inventory in 2011, 2012, and 2013?



Dollar Value LIFO Example - 2011

1/1/2011 Index 12/31/2011

1/1/2011 inventory $10,000 1.0 $10,000

2011 increase 11,000 1.2381 13,619

Ending LIFO inventory$21,000 $23,619

Keeping prices constant, the increment in inventory = $11,000 ($21,000 - $10,000)

Index = $26,000/$21,000 = 1.2381

Thus, Jenn Co. valued its ending inventory on 12/31/2011 at $23,619




1/1/2012 Index 12/31/2012

1/1/2011 base inventory $10,000 1.0 $10,000

Remaining 2011 increase 6, 000 1.2381 7,429


Keeping prices constant, the increment in base inventory = $6,000 ($16,000 - $10,000)





1/1/2013 Index 12/31/2013

1/1/2011 base inventory $10,000 1.0 $10,000

Remaining 2011 increase 6, 000 1.2381 7,429

2013 increase 13,000 1.3793 17,931


Keeping prices constant, the increment in base inventory = $6,000 ($16,000 - $10,000)

Index = $40,000/$29,000 = 1.3793




Simplified Dollar-Value LIFO Method

May elect to use simplified dollar-value LIFO method, but then must be used to value all LIFO inventories May elect for any year in which average annual gross receipts

for preceding three years do not exceed $5 million Taxpayer groups inventory into pools for each major category in

the applicable government price index provided by Bureau of Labor Statistics

Each pool is separately adjusted using appropriate government index

Do not compute base period prices Use year-end inventory values and determine an assumed base

period value by applying the government price index If resulting base period value exceeds opening inventory value at

base period prices, then increment is valued using same index



Simplified Dollar-Value LIFO Example

Andy Inc. uses the simplified dollar-value LIFO method.Relevant inventory information follows:

CPI2012: 1.102013: 1.14

Inventory – base year prices2012: $420,0002013: $500,000

What ending inventory value will Andy Inc. use for 2013?



Simplified Dollar-Value LIFO Example

2012 inventory value $420,000

2013 increase in inventory 64,727*

2013 year-end inventory value $484,727

*2013 increase in inventory:Ending inventory at assumed base-year prices = $500,000 x (1.1/1.14) = $482,456

Increase at 2012 base prices = $482,456 - $420,000 = $62,456

Increase at 2013 base prices = $62,456 x (1.14/1.1) = $64,727



Estimates of Inventory Shrinkage

Permits a business to determine its year-end closing inventory by using estimates for shrinkage (e.g., loss due to theft)

Year-end physical count not necessary if: Normally take a physical count of inventories at each

business location on a regular and consistent basis and Make proper adjustments to inventories and to

estimating methods to extent estimates differ from actual shrinkage.



Long-Term Contracts

Any contract for manufacture, building, installation, or construction of property if such property is not completed within the taxable year into which contract is entered

Two alternatives: (1) Percentage-of-completion method (or modified percentage-of-completion method in some cases), and (2) Completed-contract method (in limited circumstances)

Method selected must be used for all long-term contracts in same trade or business

All cost associated with contract are capitalized and deducted as profits are recognized



Capitalization of Expenses

The following expenses must be capitalized:

1. Cost recovery of assets employed for work on specific contracts

2. Pension costs representing current service costs

3. General and administrative expenses relating to specific contracts

4. R&D expenses with respect to specific contracts

5. Scrap and spoilage costs



Percentage-of-Completion Method

Report income under the contract annually based on estimated progress Percentage of completion =

allocated costs to the contract and direct costs incurred by the close of the year/estimated total contract costs

Income reported for year = Total contract price x Percentage Must use a look-back method in year contract is completed

Compare the actual completion level to the claimed level Redetermine taxable income and tax liability accordingly Interest is charged on any underpayment and is received for any overpayment

Long-term contracts completed within two years of contract commencement are exempt from look-back method if gross contract price does not exceed lesser of $1,000,000 or 1 percent of taxpayer’s average gross receipts for the previous three years

Many elect not to apply the look-back method for long-term contracts completed during year and in all subsequent years if actual contract taxable income is within 10 percent of estimated taxable income under percentage-of-completion method (using estimated contract price and costs)



Modified Percentage-of-Completion Method

Available for contracts less than 10 percent complete at end of year

May elect to defer reporting any income from contract until at least 10 percent of work is completed



Completed Contract Methods

No income until final completion of contract All costs are accumulated and recognized at

completion Only small construction contractors and home

construction contractors can use Those whose average gross receipts for three

preceding tax years do not exceed $10,000,000



Long-Term Contracts Example

James Co. is a small construction contractor. In 2012 it entered into a two-year building contract with Dan Co. Contract price is $4,000,000 and expected costs are $3,000,000.2012 actual costs: $1,500,0002013 actual costs: $1,200,000

What gross profit will James Co. report in 2012 and 2013 under the percentage-of-completion method and the completed-contract method?




Percentage-of-completion method 2012 2013

Gross revenue* $2,000,000 $2,000,000

Actual costs 1,500,000 1,200,000

Gross profit $500,000 $800,000

*2012: ($1,500,000/$3,000,000) x $4,000,000 = $2,000,000

2013: $4,000,000 - $2,000,000 = $2,000,000




Completed-contract method2012 2013

Gross revenue $0 $4,000,000

Actual costs 0 2,700,000

Gross profit $0 $1,300,000

Chapter 13, Exhibit 58c


Installment Sales

Disposition of property where at least one payment is received after the close of tax year in which disposition occurs

May be used by cash-basis taxpayers as a means to defer gain recognition or to spread gain recognition over several tax periods

May not be used if property is disposed of at a loss Does not change character of gain (capital or ordinary) Any depreciation recapture under §1245 and §1250 recognized in year

of sale Not available to all taxpayers Must use installment method for tax purposes if taxpayer disposes

property under an installment contract and disposition qualifies for installment method May make an irrevocable election not to use installment method



Computation of Gain

Step 1. Determine gross profit from the saleStep 2. Determine contract price

Generally equals amount seller will receive Can never be less than gross profit

Step 3. Compute gross profit percentage Gross profit percentage = Gross profit/Contract

price

Step 4. Determine gain recognized in year of sale Equals: Payments received × Gross profit

percentage



Installment Sale Example

Susan sold property (capital asset) for $500,000 (after all transaction costs) in 2012

She acquired the property five years ago for $200,000 There is a $50,000 liability on the property The buyer assumes the liability Susan will receive $300,000 in 2012 and $150,000 in

2013 What income (gain) will Susan report in 2012 and

2013?




Gain on sale: $500,000 - $200,000 = $300,000

Contract price: $500,000 - $50,000 = $450,000

Gross profit percentage: $300,000/$450,000 = 66.67%

2012 income: $300,000 x 66.67% = $200,000 LTCG

2013 income: $150,000 x 66.67% = $100,000 LTCG

Total income recognized: $300,000 LTCG




Susan sold property for $500,000 (after all transaction costs) in 2012

She acquired the property five years ago for $200,000 Total depreciation subject to §1245 recapture taken was

$30,000 There is a $50,000 liability on the property The buyer assumes the liability Susan will receive $300,000 in 2012 and $150,000 in 2013 What income (gain) will Susan report in 2012 and 2013?

Chapter 13, Exhibit 61c



Gain on sale: $500,000 - $200,000 = $300,000

Contract price: $500,000 - $50,000 = $450,000

§1245 gain recognized on sale: $30,000

Gross profit percentage: ($300,000-$30,000)/$450,000 = 60%

2012 income: $300,000 x 60% = $180,000 §1231 gain (and $30,000 §1245 gain)

2013 income: $150,000 x 60% = $90,000 §1231 gain

Total income recognized: $300,000

Chapter 13, Exhibit 61d


Dispositions of Installment Obligations

Must determine obligation’s AB and gain or loss on disposition

AB of installment obligation equals Face amount of obligation in excess of income that

would have been reported if obligation had been paid in full

Gain/loss = amount realized if obligation is sold (or obligation’s FMV if it is disposed of other than by sale) - AB

Character of gain/loss is based on property sold under installment method



Disposition of Installment Obligation—Example

Tom sold land (§1231 asset) in 2011 for $100,000His basis in the land was $30,000He received $25,000 in 2011 and $35,000 in 2012He sold the installment obligation in 2013 for $23,000 What is Tom’s gain (loss) on the sale of the installment

obligation in 2013?



2011:

Realized gain: $100,000 - $30,000 = $70,000

Gross profit percentage: $70,000/$100,000 = 70%

Income reported in 2011: $25,000 x .7 = $17,500 §1231 gain

-----------

2012:

Income reported: $35,000 x .7 = $24,500 §1231 gain

-----------

2013:

Adjusted basis of installment obligation: $40,000 - $28,000 = $12,000

Income reported from sale of installment obligation: $23,000 - $12,000 = $11,000 §1231 gain


Disposition of Installment Obligation—Example


Repossessions of Personal Property

A taxable event. Gain or loss equals:

Difference between FMV of property repossessed and AB of installment obligation

Any costs incurred during repossession increase AB of installment obligation.

Character of gain or loss recognized is same as character of gain or loss recognized on original sale

Basis of repossessed property is its FMV



Repossessions of Real Property

Loss is not recognized Gain recognized is lesser of:

(1) Cash and FMV of property received from buyer in excess of gain previously recognized by holder of installment obligation or

(2) Gain not yet recognized by holder of installment obligation (deferred gross profit), reduced by repossession costs

Character of gain is same as that recognized under original sale of property

Basis of repossessed real property AB of installment obligation, increased by repossession costs

and by any gain recognized from repossession



Personal Property Repossessions—Example

Kim sold a painting in 2011 for $80,000 She acquired the painting in 2004 for $20,000Kim received $20,000 in 2011 and the remainder was due

in 2012Kim was unable to collect the $60,000, and repossessed

the painting in 2013 when it was worth $50,000She incurred $1,000 in repossession feesWhat are the tax consequences of the repossession?



Personal Property Repossessions—Example

2011:

Realized gain: $80,000 - $20,000 = $60,000

Gross profit percentage: $60,000/$80,000 = 75%

Income reported in 2011: $20,000 x .75 = $15,000 LTCG

----------

2012:

Nothing reported

----------

2013:

Adjusted basis of installment obligation: $60,000 - $45,000 = $15,000

Adjusted basis for repossession purposes = $15,000 + $1,000 = $16,000

Income reported from repossession: $50,000 - $16,000 = $34,000 LTCG

Kim’s basis in the painting = $50,000



Real Property Repossessions—Example

Gary sold land in 2011 for $200,000He bought the land in 2005 for $60,000He received $50,000 in 2011 and the balance was due in

2012Gary was unable to collect the $150,000, and in 2013 he

repossessed the land when it was worth $190,000Repossession fees were $5,000What are the tax consequences of the repossession?



Real Property Repossessions—Example

2011:Realized gain: $200,000 - $60,000 = $140,000Gross profit percentage: $140,000/$200,000 = 70%Income reported in 2011: $50,000 x .70 = $35,000 LTCG----------2012:Nothing reported----------2013:Adjusted basis of installment obligation: $150,000 - $105,000 = $45,000(1) Excess of payments received – gain reported in previous years: $50,000 - $35,000 =

$15,000(2) Gain not yet reported: $150,000 x .7 = $105,000Income reported from repossession: lesser of [(1) or (2)] – repossession fees= lesser of $15,000 or ($105,000 - $5,000) = $15,000 LTCGGary’s basis in the painting = $45,000 + $5,000 + $15,000 = $65,000



Advantages and Disadvantages of Installment Method

Advantages1. Tax liabilities deferred until

proceeds are available2. Marginal tax rates may decline in

future years3. Interest income, to some extent,

may be converted to capital gains by charging a lower interest rate and a higher price (but the imputed interest rules affect this)

4. Since the seller finances the purchase, sales are more easily made

Disadvantages 1. Default risk and potential

collection costs2. In periods of inflation - loss of

purchasing power3. Taxes deferred but so are

collections4. Marginal tax rates may increase

during collection years5. Although the holding period in the

year of sale determines whether the transaction is short-term or long-term, the character of the gain is determined in the year of collection

6. Depreciation recapture takes place in the year of sale


2013 cch basic principles ch13

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