Tax Accounting Issues Chapter 8 pp. 263 - 300 2015 National Income Tax Workbook™

Tax Accounting IssuesChapter 8 pp. 263 - 300

2015 National IncomeTax Workbook™

Tax Accounting Issues p. 263

Issue 1: Cash & Accrual Methods Issue 2: Choosing a Tax Accounting

Method Issue 3: Book-Tax Conformity Issue 4: Inventories Issue 5: UNICAP Rules Issue 6: Cost of Goods Sold Issue 7: Installment Sale Method

Tax Accounting Issues p. 263

Issue 8: Accounting for Soil & Water Conservation Expenses

Issue 9: Accounting and Reporting Rules for Tips

Issue 10: Changing a Tax Accounting Method

Issue 11: Correcting Depreciation Errors

Issue 1: Cash and Accrual p. 264

The two most commonly used tax accounting methods.

Taxpayers filing their first tax return can adopt any permissible method of tax accounting.

Once a method has been adopted, changes typically require IRS consent.

Cash Method - Income p. 264

Include income when it is actually or constructively received.

Under constructive receipt doctrine, income may be included before it is actually received if it is credited to the taxpayer’s account, set apart for the taxpayer, or otherwise made available to the taxpayer.

Income is not constructively received if there is a substantial limitation or restriction on the taxpayer’s receipt of the income.

Cash Method - Expenses p. 265

Cash method taxpayers typically claim deductions when they pay expenses.

However, cash method taxpayers may not be able to claim a current deduction for expenses paid for a future accounting period.

An expense paid by a cash method taxpayer in advance is deductible only in the year the service or property that was purchased is used or consumed.

Capitalized Prepaid Expenses p. 265

Prepaid expenses must be capitalized. If the expense qualifies under the 12-month rule, a

taxpayer is not required to capitalize prepaid expenses (although the taxpayer can elect to capitalize such expenses).

The 12-month rule applies to: ▪ Amounts paid to create rights or benefits for the

taxpayer that do not extend beyond the earlier of 12 months after the right or benefit begins, OR

▪ The end of the tax year after the tax year in which payment is made

Application of the 12 Month Rule (PRACTIONER NOTE) p. 265

The 12-month rule is used to determine whether a prepaid expense can be deducted in the year the expense is paid.

It does not affect:▪ Either the determination of when a liability

has accrued under the accrual method, ▪ OR ▪ The determination of whether the economic

performance test has been met.

Accrual Method - Incomep. 265 - 266

Accrual method taxpayers include income when earned.

Income is considered earned, and included in gross income, when:▪ All the events have occurred that fix the

right to receive the income, ▪ AND ▪ The amount of income can be determined

with reasonable accuracy.

Accrual: When not to Include Income?p. 265 - 266

Income is not considered earned, and included in gross income, when:▪ The amount owed can’t be estimated

accurately, ▪ OR▪ If there is reasonable certainty that amounts

owed won’t be collected.

Accrual Method: All Events Testp. 266

Accrual method taxpayers claim a liability in the tax year in which:

1. All the events have occurred that establish the fact of the liability,

2. The amount of the liability can be determined with reasonable accuracy, and

3. Economic performance has occurred with respect to the liability.

Economic Performancep. 266

3 Scenarios that determine Economic Performance of when liability arises for a taxpayer:

1. If the taxpayer receives services from another person, economic performance occurs when the services or property is provided.

2. If the taxpayer uses property, economic performance occurs ratably over the period of time the taxpayer is entitled to the use of the property.

3. If the taxpayer provides services or property to another person, economic performance occurs as the taxpayer incurs costs to satisfy the liability.

Recurring Items Exceptionp. 266 - 267

Normally, recurring items are treated as incurred during the year, even though economic performance has not yet occurred.

However, the exception applies if all the following occur:▪ 1. The all events test is met ▪ 2. Economic performance occurs on or before the earlier of the

fifteenth day of the ninth calendar month after the close of that tax year, or the date of a timely filed return (including extensions) – thus the 9 month, 15 day deadline

▪ 3. The liability is recurring▪ 4. Either the amount of the liability is not material, or accruing

the liability in the year in which the all events test is met results in a better match against income than accruing the liability in the year of economic performance.

Issue 2: Choosing a Tax Accounting Method

p. 267 Some taxpayers are:▪ Prohibited from using the cash method, ▪ AND▪ Required to use the accrual method.

This section reviews the requirements for selecting a permissible tax accounting method.

Taxpayers who Cannot use the Cash Method

p. 267

I.R.C. § 448(a) prohibits the following from using the cash method:▪ C corporations, ▪ Partnerships with a C corporation as a

partner, and▪ Tax shelters

This prohibition includes any hybrid method that includes the cash method.

Taxpayers who cannot use the Cash Method

p. 267

Three exceptions in I.R.C allow use of the cash method by:▪ 1. Certain farming businesses▪ 2. Qualified personal service corporations▪ 3. Taxpayers with average gross receipts

not exceeding $5,000,000.• “Definition of Small Business per

Chapter 13, p. 562”

Farming Businessp. 267 - 268

Prohibition on use of the cash method by does not apply to a farming business.

Broad exceptions to allow farming businesses to use cash method in the following scenarios:▪ Operating as S corporations▪ Farming corporations that meet a gross

receipts test (under $1,000,000).▪ Family farming corporations that meet a

gross receipts test (under $25,000,000).

Qualified Personal Service Corporations (QPSC)

p. 268 Qualified personal service corporations can use the

cash method of tax accounting, even if they are C corporations or partnerships with a C corporation partner.

A qualified personal service corporation must meet:

1. A function test AND 2. An ownership test

QPSC– Function Testp. 268

Substantially (95% or more) all of the activities of the personal service corporation must involve the performance of services in a qualifying field.

Qualifying fields are the following:▪ 1. Health▪ 2. Law▪ 3. Engineering▪ 4. Architecture▪ 5. Accounting▪ 6. Actuarial science▪ 7. Performing arts▪ 8. Consulting

QPSC– Ownership Testp. 269

Substantially all (95% or more) of the stock of the personal service corporation must be owned directly by employees performing services for the corporation in a qualifying field.

Ownership call also be indirect through one or more partnerships, S corporations, or qualified personal service corporations that are not tax shelters or partnerships with a C corporation as a partner.

The ownership test will also be met if the stock is owned by retired employees who had formerly performed services for the corporation in a qualifying field.

QPSC– Ownership After Death of Employee (PRACTIONER NOTE)

p. 269 The ownership test will still be met if substantially all of the

stock is owned by:▪ The estate of an employee or retired employee, ▪ OR▪ By a person who acquired the stock by reason of the death

of the employee or retired employee ▪ NOTE: The employee or retired employee must have

performed services for the corporation in a qualifying field.

This exception applies only to the 2-year period beginning on the date of the death of the employee.

QPSC– Ownership After Death of Employee (PRACTIONER NOTE)

p. 269 The ownership test will still be met if substantially all of the

stock is owned by:▪ The estate of an employee or retired employee, ▪ OR▪ By a person who acquired the stock by reason of the death

of the employee or retired employee ▪ NOTE: The employee or retired employee must have

performed services for the corporation in a qualifying field.

This exception applies only to the 2-year period beginning on the date of the death of the employee.

Entities with Gross Receipts of Not More than $5,000,000

p. 269 C corporations and partnerships with a C corporation partner

can use the cash method of tax accounting if the average annual gross receipts of the entity for the 3 previous tax years does not exceed $5,000,000.

If an entity has not been in existence for the preceding 3-year period, the gross receipts test is applied for the time that the entity (or trade or business) has been in existence.

Other Restrictions on Method on Accounting

p. 269 - 270 Special Rule for Inventories

▪ Taxpayers are required to use the accrual method for sales and purchases of merchandise if it is necessary to use an inventory.

▪ It is necessary to use an inventory if the production, purchase, or sale of merchandise of any kind is an income-producing factor.

Clear Reflection of Income▪ The taxpayer’s choice of tax accounting method must be a

permissible method, and it also has to clearly reflect income. ▪ An accounting method clearly reflects income if it is consistent. ▪ Consistency includes both use of the same method from year

to year and use of the same method for income and expenses.

Issue 3: Book-Tax Conformityp. 270

This section explains whether a taxpayer has to use the same methods of accounting for calculating taxes and for managing its business.

IRC (Internal Revenue Code) 466 requires use of the same accounting methods for tax reporting and for bookkeeping (book-tax conformity).

HOWEVER,

Courts and IRS administrative guidance have frequently held that tax reporting methods can differ from financial accounting methods.


Courts have considered the objectives of financial and tax accounting, which are very different.

A primary goal of financial accounting is to provide useful information to management, shareholders, creditors, and other interested persons.

A primary goal of tax accounting is the equitable collection of revenue.


Differences in book and tax accounting methods have been allowed if a taxpayer’s books contain records and data that allow reconciliation of the differences between a taxpayer’s return and its books.

EXAMPLE:▪ IRS held that a corporation that maintained its books on the

accrual method could file income tax returns on the cash method.

▪ Book-tax conformity was not required because the taxpayer’s books and records clearly showed the adjustments made to convert its books to the cash method.

Accounting Methods Must Clearly Reflect Income (PRACTIONER NOTE)

p. 270

Variations between tax reporting and financial accounting methods have been allowed only if the taxpayer’s method of tax accounting clearly reflects income.

All items of income and expense have to be treated the same every year.

A combination of tax accounting methods is allowed if it is used consistently.

Electronic Records (PRACTIONER NOTE)

p. 271

In an examination the IRS may request a copy of the taxpayer’s electronic files, including files created by accounting software and the accompanying metadata.

If those records are prepared on the accrual basis, and the taxpayer uses the cash method for federal income tax purposes, the taxpayer must be able to reconcile the two methods.

The taxpayer may also have to reconcile book income with tax income on Form 1120, U.S Corporation Income Tax Return, Schedule M-1 Reconciliation of Income (Loss) per Books With Income Per Return.

Issue 4: Inventoriesp. 271

This section describes:

1. When taxpayers are required to keep inventories.

2. Whether those taxpayers are required to use the accrual method.

3. How to identify and value inventory.

Issue 4: Inventoriesp. 271

If a taxpayer produces, purchases, or sells merchandise in its business, the taxpayer must keep an inventory.

The taxpayer must use the accrual method for purchases and sales of merchandise.

Rev Procedure 2001-10 – Qualifying Taxpayer

p. 271

A qualifying taxpayer can use the cash method even if the taxpayer produces, purchases, or sells merchandise.

A taxpayer must meet 2 requirements:

▪ 1. Average annual gross receipts must be $1,000,000 or less.▪ 2. The taxpayer cannot be a tax shelter.

Treatment of Inventoryp. 271

Qualifying taxpayers that do not want to keep an inventory must treat inventoriable items in the same manner as materials and supplies that are not incidental.

Examples of inventoriable items are: ▪ Merchandise purchased for resale.▪ Raw materials purchased for use in

producing finished goods.

Qualifying Small Business Taxpayerp. 271 - 272

A qualifying small business taxpayer can use the cash method of accounting even if the taxpayer produces, purchases, or sells merchandise, and is required to keep inventories.

A qualifying small business taxpayer must meet three requirements:▪ 1. Average annual gross receipts cannot be more than

$10,000,000.▪ 2. The taxpayer cannot be prohibited from using the cash

method under I.R.C. § 448.▪ 3. The taxpayer’s principal business activity has to be an

eligible business (see next slide for list of ineligible principal business activities.)

Ineligible Principal Business Activitiesp. 272

1. Mining Activities (Code 21) 2. Manufacturing Activities (Codes 31 –

33) 3. Wholesale Trade (Code 42) 4. Retail Trade (Codes 44 – 45) 5. Information Industries (Code 51)

Identification of Inventoryp. 272 - 273

FIFO (First in, First Out) Method▪ The items purchased or produced first are the first items

sold, consumed, or otherwise disposed of. ▪ The items in inventory at the end of the tax year are

matched with the costs of similar items that were most recently purchased or produced.

LIFO (Last In, First Out) Method▪ Items of inventory purchased or produced last are the

first items sold, consumed, or otherwise disposed of. ▪ Items included in closing inventory are considered to be

from the opening inventory in the order of acquisition and from those acquired during the tax year.

Valuation of Inventoryp. 273

Cost Method Includes all direct and indirect costs associated with the

inventory item. Cost means the invoice price minus any trade or other

discounts. (Transportation is added to the invoice price.) Includes: Raw Materials & Supplies, Direct Labor & Indirect

production costs. Lower of Cost or Market Compares the market value of each inventory item with its

cost and uses the lower of the two as the inventory value. Market value: Market price of each of the costs allocable to

the goods being valued.

Inventory and Uniform Capitalization Rules

p. 273 Treas. Reg. § 1.263A-7 requires a taxpayer using inventories

to adopt the Uniform Capitalization (UNICAP) rules.

In the first year of adoption, the UNICAP rules are applied to revalue all inventory costs accumulated in prior years.

I.R.C. § 481(a) requires an adjustment equal to the difference between the original value of the inventory and the revalued inventory.

Issue 5: UNICAP Rulesp. 274

This section reviews:

1. The activities that are subject to the UNICAP rules.

2. The costs that have to be capitalized under the UNICAP rules.

3. How those costs are allocated.


UNICAP rules require capitalization of the direct costs and a portion of indirect costs to produce:

▪ To produce certain real property or tangible personal property,

▪ AND

▪ To acquire certain property for resale.


For property that is inventory, capitalize means that the costs are included in inventory costs.

For self-constructed assets capitalize means that the cost is added to basis.

The activities that are subject to the UNICAP rules.

p. 274

The UNICAP rules apply to real property and tangible personal property that is:

Property produced by a taxpayer,

AND

To the acquisition of property that is inventory or other property held primarily for sale to customers.


p. 274

Examples of tangible personal property: 1. Films 2. Sound recordings 3. Videotapes 4. Books 5. Artwork 6. Photographs 7. Similar property containing words, ideas, concepts,

images, or sounds


p. 274 Tangible personal property does not include property that is

representative or evidence of value.

Examples of these types of tangible personal property:

1. Stock and securities 2. Debt instruments 3. Mortgages or loans

Activities that are not subject to the UNICAP rules.

p. 274 - 275

There are a number of activities that are excluded from the application of the UNICAP rules.

Pages 274 to 275 of the 2015 Tax Workbook lists 14 examples of excluded activities to the UNICAP rules.

Capitalize Direct Costsp. 275

The taxpayer is required to capitalize all direct costs incurred to produce or acquire real or tangible personal property.

Direct costs are the direct costs of materials and labor.

For a taxpayer who acquires property for resale, the direct costs are the acquisition costs of the property.

Capitalize Indirect Costsp. 275 - 276

Indirect costs are all costs other than direct material costs and direct labor costs (in the case of property produced) or acquisition costs (in the case of property acquired for resale).

Taxpayers must capitalize all indirect costs that are allocable to property produced or property acquired for resale.

See Figure 8.3 on page 276 for a list of several common indirect expenses.

Indirect Service Costsp. 275 - 277

Capitalizable indirect service costs are those that directly benefit or are incurred by reason of the performance of the production or resale activities of the taxpayer.

A portion of these costs has to be capitalized. See page 277 for a list of capitalizable indirect service

costs. Mixed Service Costs: Indirect service costs that are

partially allocable to production or resale activities and partially allocable to nonproduction or non-resale activities.▪ Mixed service costs are allocated separately from other

costs.

UNICAP Rules for Farmingp. 277 - 279

UNICAP rules apply to property produced in a farming business, and the taxpayer is required to capitalize direct costs and a portion of indirect costs incurred in the raising or growing of plants and animals.

UNICAP does not apply to some farming businesses.

See pages 277 to 279 for an in depth review of the UNICAP rules regarding Farming Businesses.

Allocation of Costsp. 279

After costs have been identified, they have to be allocated.

Once the cost attributable to production and resale activities has been determined, that cost must be allocated between cost of goods sold (the cost of inventory sold during the year) and ending inventory.

Change in Allocation Method(PRACTIONER NOTE) p. 280

A change in the method or base used to allocate service costs or a change in the taxpayer’s determination of what functions or departments of the taxpayer are to be allocated, is a change in method of accounting.

The taxpayer has to obtain IRS consent to the change!

Allocate to Ending Inventoryp. 280

If the taxpayer keeps an inventory:▪ The direct and indirect costs of property

produced or property acquired for resale have to be further allocated between:

• Cost of Goods Sold (COGS)• AND• Ending Inventory.

Issue 6: Cost of Goods Sold (COGS)p. 281

Cost of Goods Sold (COGS) represents:▪ The cost to produce or acquire inventory that

has been sold to customers.▪ In Addition,▪ Manufacturers and merchants calculate cost

of goods sold to offset receipts from the sale of those goods.

Issue 6: Cost of Goods Sold (COGS)p. 281

COGS is calculated as:

Beginning inventory PLUS Production and acquisition costs incurred

during the year MINUS The closing inventory.

Calculate Beginning Inventory for COGS

p. 281

Merchant:▪ Beginning inventory is the cost of

merchandise on hand at the beginning of the year.

Manufacturer or Producer:▪ Beginning inventory is the cost of raw

materials and supplies, work in process, and finished goods on hand at the beginning of the year.

Add Purchases to COGSp. 281

Merchant:▪ Add the cost of all merchandise they bought

for sale during the year Manufacturer or Producer:▪ Add the cost of all raw materials or parts

purchased for manufacture into a finished product.

COGS: Additional Manufacturing Costs

p. 281 - 282 Labor:▪ Both the direct and indirect labor used in

fabricating raw materials into a finished product. Materials & Supplies:▪ Directly and indirectly used in manufacturing goods

Other Costs:▪ If they are direct and necessary expenses of the

resale, manufacturing, or mining operation.

Subtract Inventory at End of Yearp. 282

Merchant, Manufacturer or Producer:▪ Subtract the value of inventory on hand at the end

of the year

▪ This includes the portion of the cost that have been allocated to ending inventory of:• Raw materials and supplies, • Labor,• Overhead expenses.

No Limit on Cost of Good Sold(PRACTIONER NOTE) p. 282

Cost of Goods Sold (COGS) is an adjustment, not a deduction, and therefore it is not subject to the limitations on deductions found in I.R.C. § 162.

Issue 7: Installment Sale Methodp. 282

This section explains:▪ When the installment method can be

used▪ How income is calculated under the

installment sale method, ▪ The special rules for dispositions to

related parties▪ The dispositions of depreciable property.

Issue 7: Installment Sale Methodp. 282

The IRC 453 provides a special reporting method for installment sales.

An installment sale:▪ A disposition of property in which at least one

payment is to be received after the close of the tax year in which the disposition occurs.

The installment sale method defers recognition of gain to the tax year when payment is received.

Dealer Dispositionsp. 282 - 283

The installment sale method cannot be used for dealer

dispositions. Dealer Dispositions means:▪ Any disposition of personal property by a person who

regularly sells or otherwise disposes of personal property of the same type on the installment plan

▪ Any disposition of real property that is held by the taxpayer for sale to customers in the ordinary course of the taxpayer’s trade or business

Dealer Dispositions does not include:▪ A disposition on the installment plan of any property used or

produced in the trade or business of farming.

Sales of Inventory(PLANNING POINTER) p. 283

The installment sale method cannot be used for sales of inventory.

So, when selling a business, the taxpayer should make sure that the sale agreement separately allocates a value to inventory.

If the taxpayer does not allocate a value to inventory, the IRS can allocate a portion of the sale price to inventory and disallow the installment sale method for that portion of the sale price allocated to inventory.

Use IRS Form 8594, Asset Acquisition Statement, to allocate a portion of the sale price to inventory.

Calculation of Income under the Installment Method

p. 283

Income is recognized as amounts are paid.

Income recognized in a tax year is a proportionate share of income realized or to be realized on the total contract price.

Electing Out of the Installment Method

p. 283 Installment sale method automatically applies unless the

taxpayer elects out of the installment method.

If the taxpayer elects out of the installment method, all gain on the disposition is taxed in the year of sale, even for cash method taxpayers.

The election is made by reporting the entire amount of gain in the year of sale.

The election must be made on or before the due date (including extensions) for filing the taxpayer’s tax return for the tax year in which the disposition occurs.

Disposition to Related Personsp. 283 - 284

1st Disposition: A person disposes of property to a related person.

BUT Before the person making the 1st disposition receives all

payments owed on the 1st disposition, The related person disposes of the property (the 2nd

disposition), then the amount realized on the 2nd disposition is treated as received at the time of the 2nd disposition by the person making the 1st disposition.

The rule doesn’t apply if the 2nd disposition is more than 2 years after the date of the 1st disposition.

Exceptions apply to transfers of stock to the issuing corporation, compulsory or involuntary conversions, and transfers on death.

Sale of Depreciable Property to a Related Person

p. 284 If a taxpayer sells depreciable property to related persons,

the installment method does not apply. Instead, all payments to be received are considered received

in the year of sale. There is an exception for a sale of depreciable property to a

related person if no significant tax deferral benefit is derived from the sale.

To qualify for the exception, the taxpayer must show that avoidance of federal income tax was not one of the principal purposes of the sale.

Sale of Depreciable Property to a Related Person

p. 284 A related person includes the following:▪ 1. A person and all controlled entities with respect to that

person.▪ 2. A taxpayer and any trust in which such taxpayer (or his

or her spouse) is a beneficiary, unless that beneficiary’s interest in the trust is a remote contingent interest.

▪ 3. Except in the case of a sale or exchange in satisfaction of a pecuniary bequest, an executor of an estate and a beneficiary of that estate.

▪ 4. Two or more partnerships in which the same person owns, directly or indirectly, more than 50% of the capital interests or the profits interests.

Individuals are not Related Partiesp. 284

The I.R.C. § 1239(c) definition of related parties does not include individuals.

Therefore, family members are not related parties for purposes of the rule that prohibits installment reporting for the sale of depreciable assets.

EXAMPLE: Parents can use the installment method to report gain from the sale of depreciable livestock to their children.

Recapture Incomep. 284

Recapture income has to be fully recognized in the year of the disposition

IN ADDITION,

Gain in excess of the recapture income can be taken into account under the installment method.

Issue 8: Accounting for Soil & Water Conservation Expenses

p. 285 - 286

I.R.C. § 175 allows a deduction for soil and water conservation expenses.

Provides farmers a deduction for soil or water conservation expenditures that do not give rise to a deduction for depreciation, and that are not otherwise deductible.

The amount of the deduction is limited to 25% of the taxpayer’s gross annual income from farming.


p. 286

This section explains how to:▪ Distinguish between tips and service

charges.

▪ AND

▪ Discusses the withholding and reporting rules for tips and service charges.


p. 286 Direct and indirect cash tips totaling less than

$20 in a calendar month are excluded from the definition of wages for FICA purposes.

Noncash tips from customers are also not wages for FICA tax purposes. ▪ Examples: Tips received by an employee in a

medium other than cash, such as passes, tickets, or other goods or commodities.


p. 286 But all direct and indirect cash tips (regardless of

the amount), and all noncash tips, are:

▪ Included in an employee’s gross income,

▪ AND

▪ Subject to federal income taxes.


p. 286 Employees who receive $20 or more direct and

indirect cash tips in a calendar month must:

▪ Report all direct and indirect cash tips for the month to their employer,

▪ AND

▪ Those tips are subject to FICA and federal income tax withholding.


p. 286 Direct Tips: Cash tips received from customers and

tips paid electronically.▪ Examples: Waiters, waitresses, bartenders, and

hairstylists

Indirect Tips: Cash tips received from other employees through a tip-pool, tip-splitting, or other tip-sharing arrangement.▪ Examples: Bussers, bartenders, cooks, and salon

shampooers.

Tip or Service Chargep. 286

Service charges paid to an employee are non-tip wages. ▪ Automatic gratuities are service charges.▪ These non-tip wages are subject to social security

tax, Medicare tax, and federal income tax withholding.

Tips are discretionary (optional or extra) payments, and the amount of a tip is determined by the customer.

Employer Accounting & Reporting Obligations with Tips

p. 287 Tips received by an employee in the course of the

employee’s employment are:

▪ Considered remuneration for that employment

▪ AND

▪ Are deemed to have been paid by the employer for purposes of calculating the employer’s share of social security and Medicare tax owed.

Employer Accounting & Reporting Obligations with Tips

p. 287 The IRC requires the employer to pay:▪ Social security tax on the cash tips received by

the employee, up to and including the contribution and benefit base,

▪ AND

▪ Medicare tax on all cash tips received by the employee.

Employer Liability on Unreported Tips (PRACTIONER NOTE)

p. 287 - 288 Employers are not liable to withhold and pay the employee’s

share of FICA taxes on unreported tips. The employer is not required to pay the employer’s share

of FICA taxes on the unreported amount……….. UNTIL……….. The employer receives notice and demand from the IRS.▪ The IRS must send the employer a pre-notice Letter 3264

at least 30 days prior to issuing the section 3121(q) notice and demand.

▪ The pre-notice: Intended to notify the employer of the FICA tax liability & to allow the employer adequate time to gather the necessary funds and make a timely tax deposit.

Employee Accounting & Reporting Obligation for Tips

p. 288 The employee must report tips in a written statement

furnished to the employer on or before the tenth day of the month following the month in which the tips were received.

If the employer does not have a specific form, the employee can use Form 4070, Employee’s Report of Tips to Employer.

If an employee fails to report tips to his or her employer, the employee is liable for the employee’s share of FICA taxes on the unreported tips.

The IRC imposes a penalty for failure to report tips to the employer: ▪ The penalty is up to 50% of the employee’s share of FICA

taxes on the unreported tips.

Tips and Independent Contractors(PRACTIONER NOTE) p. 288

Independent contractors report their tips as gross income.

Example: Hair salon booth renters

Reporting Service Chargesp. 289

Employers report service charges as non-tip wages paid to the employee.

Some employers keep a portion of the service charges.

Only the amounts distributed to employees are non-tip wages.

The employer must withhold taxes on the service charges that are distributed to employees and treat the service charge the same as regular wages for tax-filing requirements.

Large Food & Beverage Establishments (PRACTIONER NOTE) p. 289

Special withholding and reporting rules apply to employers who operate large food and beverage establishments (more than 10 employees).

These employers must allocate tips among their tipped employees who report tips that are less than a specified percentage of sales.

Issue 10: Changing a Tax Accounting Methodp. 289

This section examines:▪ What changes constitute a change in accounting

method.

▪ What approval is necessary to change a method of accounting.

▪ What adjustments that may be required by a change in method of accounting.

Issue 10: Changing a Tax Accounting Methodp. 289

Taxpayers choose a method of tax accounting when they first file a return.

Subsequent changes in method of accounting typically require IRS approval.

Although a taxpayer generally cannot retroactively adopt a new method of accounting by filing an amended return, if the taxpayer’s first return used an improper method, the IRS allows the taxpayer to change to a proper method prior to filing the next year’s return.

What Constitutes a Change in Tax Accounting Method? p. 289

1. A change from the cash method to the accrual method, or vice versa.

2. A change involving the method or basis used to value or identify inventories.

3. A change from the cash or accrual method to a long-term contract method, or vice versa.

4. Certain changes in computing depreciation or amortization

5. A change involving the adoption, use, or discontinuance of any other specialized method of computing taxable income

Automatic Consent or Advance Consentp. 290

There are two procedures to obtain IRS approval of a change in method of accounting and both procedures require filing IRS Form 3115, Application for Change in Accounting Method.

1. Automatic consent procedure▪ Filing fee? NO▪ IRS Review of Form 3115 Before Consent granted? NO

2. Advance consent procedure (Non-Automatic)▪ Filing fee? YES▪ IRS Review of Form 3115 Before Consent granted? YES▪ NOTE: IRS reviews Form 3115 and issues a consent letter.

Revenue Procedure (Rev Proc) 2015-20p. 290 - 292

Permits small business taxpayers to make certain changes in methods of accounting using the cutoff method, and without filing Form 3115.

Unless it is extended, the waiver of the requirement to file Form 3115 applies only to the first tax year beginning on or after January 1, 2014.

See page 291 of the 2015 Tax Workbook for an extensive detailing of the changes allowed in tax accounting from Rev Proc 2015-20.

Audit Protection(PLANNING POINTER) p. 292

Most changes in methods of accounting made by filing Form 3115 are granted with audit protection.

The taxpayer is not required to change an improper method of accounting for the same item in a prior year.

Audit protection for prior years is not provided for changes in accounting methods using the cutoff method under Rev. Proc. 2015- 20.

Therefore, some taxpayers may still want to file Form 3115 to make a change in a method of accounting, and receive audit protection for prior years.

Issue 11: Correcting Depreciation Errorsp. 292 - 294

This section describes the two methods to correct depreciation errors and when they can be used:

1. Amending the Return▪ If you were incorrect in calculating depreciation for only 1

tax year, or failed to claim depreciation for only 1 tax year, you must complete an amended return to correct the error.

2. File Form 3115 (Application for Change in Acc. Method)▪ If you were incorrect in calculating depreciation for 2 or

more years, you must correct it by filing Form 3115.

Closed Tax Year(PRACTIONER NOTE) p. 294

If depreciation deductions were missed in a closed tax year, the return cannot be amended.

BUT

The taxpayer can file Form 3115 and claim the section 481(a) adjustment to get the benefit of the missed depreciation deductions.

Filing Form 3115p. 294

Form 3115 must be filed in duplicate.

The original is filed with the taxpayer’s tax return in the year of the change, and a copy must be filed with the IRS prior to filing the tax return.

The IRS does not send a notice of acceptance of an automatic change request.

Generally, a separate Form 3115 must be filed for each accounting method change.

Depreciation Corrections: Q&Ap. 300

Question 1 I failed to take a depreciation deduction on an asset I am

selling this year. Can I correct this mistake?


Question 1 I failed to take a depreciation deduction on an asset I am

selling this year. Can I correct this mistake? Answer 1: YES If you owned the asset for more than 1 tax year, you must file

Form 3115 to change your method of accounting. If the missed deduction was for only 1 tax year, file an

amended return for last year. NOTE: If you do not correct this error in the year of the sale or

before, you cannot file Form 3115 to correct this mistake in the future.


Question 2 I made a math error in calculating my depreciation for the last

4 tax years. How do I correct this error?


Question 2 I made a math error in calculating my depreciation for the last

4 tax years. How do I correct this error? Answer 2 This is not a change of accounting method, so you must

amend all open tax years. Assuming the last 3 years are still open, you can correct those

years by amending the returns, BUT You will not be able to correct the return filed 4 years ago.


Question 3 For the last 5 years I depreciated the same asset twice on my depreciation

schedule. How do I correct this error?


Question 3 For the last 5 years I depreciated the same asset twice on my depreciation

schedule. How do I correct this error? Answer 3 Because this error affects more than 1 tax year, you must file Form 3115

and make a positive adjustment to income. NOTE:

▪ If the adjustment is under $50,000:• You can make the entire adjustment in the year of the change or

spread the adjustment over 4 years, beginning with the year of change.

▪ If the adjustment is $50,000 or more:• You must spread the adjustment over 4 years.

Tax Accounting Issues – Chapter 8

Thank you

Documents

Tax Accounting Issues Chapter 8 pp. 263 - 300 2015 National Income Tax Workbook™