©2015, College for Financial Planning, all rights reserved.

Session 4Tax Accounting, Sole Proprietorships and Partnerships

CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAMIncome Tax Planning

Session Details

Module 2

Chapter(s)

1 -3

LOs 2-1 Identify characteristics, advantages, and disadvantages of the cash or accrual method of accounting.

2-2 Evaluate a situation to select the most appropriate method of tax accounting to use.

2-3 Identify an advantage or disadvantage of a particular method of inventory valuation.

2-4 Explain characteristics, advantages, or disadvantages of a business form.

4-2

Cash Method of Accounting

• Income recognized when actually received (generally)

• Constructive receipt doctrine• Expenses deducted when actually paid• Allows for greater flexibility in timing

income and expenses• May be allowed when

inventories are used if taxpayer meets “small business exception”

4-3

Accrual Method of Accounting• Generally must be used if inventory is a

material income-producing factor.• Income is recognized when earned—all-

events test must be met.• Expenses deducted when liability is

established—all-events test must be met and, generally, economic performance must have occurred.

4-4

All-Events Test for Accrual Method

Income recognition• All events must have occurred to fix the right

to the income• Must be able to estimate with reasonable

accuracy

Deduction of expenses• All events must have occurred to fix the

obligation to pay• Must be able to estimate with reasonable

accuracy• Economic performance generally must have

occurred4-5

Other Methods of Accounting

Hybrid method of accounting• Combines cash and accrual methods of

accounting to reflect the nature of the business (e.g., inventory and service)

Long-term contract method of accounting• Contract for manufacture of a unique item• Not normally carried in ending inventory• Not completed in tax year contract entered

into• Item usually takes more than 12 months to

complete4-6

Inventory Valuation Last-In, First-Out (LIFO)

4-7

Inventory Valuation First-In, First-Out (FIFO)

4-8

Sole Proprietorship

4-9

General Partnerships• Conduit entity

• Joint and several liability

• Lack of continuity of life

• Limited capital structure

• Income recognition on disproportionate distribution of Section 751 “hot” assets

• Occasional income recognition on formation

• Ability to use special allocations

• Losses deductible only to extent of basis in partnership

• Basis = cash plus adjusted basis of property contributed plus share of debt, plus flow-through of income minus flow-through of losses and distributions

• Partners liable for self-employment tax4-10

Limited Partnerships

4-11

Self-Employed Health Insurance• Above the line deduction• Sole prop, partner, >2% shareholder in S

corp.• No effect on SE income• Health insurance and qualified LTC premiums• Taxpayer, spouse, and children through age

26• Limitations

o No participation in subsidized plano Limited to business earned incomeo Plan must be in business name (unless

sole proprietorship) 4-12

Review Question 1

Which one of the following is not an advantage of the cash basis method of accounting?a. Taxes are not paid until income is

received.b. Taxpayers can keep simple records.c. Taxpayers can control each year’s

receipts and payouts.d. Constructive receipt serves to defer

income.

4-13

Review Question 2

Under which one of the following circumstances may the long-term contract method of accounting be used?a. The manufacture of an item of

inventory, which consistently takes longer than one year to complete.

b. The manufacture of a unique item for which the contract is not completed in the year into which it is entered.

c. The construction of property for which payments will be received over more than one taxable year.

4-14

Review Question 3

Which of the following is a correct statement regarding the FIFO method of accounting for inventory?a. During periods of declining inventory

prices, lower taxable income will result.b. During periods of increasing inventory

prices, the cost of goods sold (COGS) will be higher.

c. During periods of increasing inventory prices, lower taxable income will result.

4-15

Review Question 4

Which one of the following is a correct statement regarding the LIFO method of accounting for inventory?a. During periods of declining inventory

prices, lower taxable income will result.b. During periods of declining inventory

prices, the cost of goods sold (COGS) will be higher.

c. During periods of increasing inventory prices, lower taxable income will result.

4-16

Review Question 5

Which one of the following is a non-tax disadvantage of operating as a sole proprietorship?I. inability to raise capitalII. unlimited liabilityIII. lack of continuity of life

a. I and II onlyb. II and III onlyc. I, II, and III

4-17

Review Question 6

The partner’s tax basis in his or her interest in a partnershipa. remains unchanged unless additional

capital is contributed or distributions are made.

b. is increased by his or her share of income reported by the partnership.

c. remains unchanged until the interest is sold or otherwise disposed.

4-18

©2015, College for Financial Planning, all rights reserved.

Session 4End of Slides

CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAMIncome Tax Planning