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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
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
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
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