Chapter 9 - Business Income, Deductions, and Accounting Methods

Gross Receipts Test

Determines if a business qualifies as a “small” business under an annual gross receipts test if its average annual gross receipts for the three prior taxable years does not exceed a threshold that is indexed for inflation; for purposes of the test, includes total sales (net of returns and allowances, but not cost of goods sold), amounts received for services, and income from investments (including tax-exempt interest)

Ordinary and Necessary

An expense that is normal or appropriate and that is helpful or conducive to the business activity

Reasonable in Amount

An expenditure is reasonable when the amount paid is neither extravagent nor exorbitant

Arm’s-Length Amount

Price in transactions among unrelated taxpayers, where each transacting party negotiates for their own benefit

Personal Expenses

Expenses incurred for personal motives; these are not deductible for tax purposes

Mixed-Motive Expenditures

Activities that involve a mixture of business and personal objectives

Travel Expenses

Expenditures incurred while “away from home overnight",” including the cost of transportation, meals, lodging, and incidental expenses

Accounting Period / Tax Year

A fixed period in which a business reports income and deductions, generally 12 months

Fiscal Year

A year that ends on the last day of a month other than December

Flow-Through Entities

Legal entities, like partnerships, limited liability companies, and S corporations, that do not pay income tax; income and losses from flow-through entities are allocated to their owners

Accounting Method

The procedure for determining the taxable year in which a business recognizes a particular item of income or deduction, thereby dictating the timing of when a taxpayer reports income and deductions

12-Month Rule

Regulation that allows prepaid business expenses to be currently deducted when the contract does not extend beyond 12 months and the contract period does not extend beyond the end of the tax year following the year of the payment

Uniform Cost Capitalization (UNICAP) Rules

Specify that inventories must be accounted for using full absorption rules to allocate the indirect costs of productive activities to inventory

First-In, First-Out (FIFO) Method

An accounting method that values the cost of assets sold under the assumption that the assets are sold in the same order in which they are purchased (i.e., first purchased, first sold)

Last-In, First-Out (LIFO) Method

An accounting method that values the cost of assets sold under the assumption that assets are sold in the reverse order in which they are purchased (i.e., last purchased, first sold)

Specific Identification Method

An elective method for determining the cost of an asset sold; under this method, the taxpayer specifically chooses the assets that are to be sold

All-Events Test

Requires that income or expenses are recognized when (1) all events have occurred that determine or fix the right to receive the income or liability to make the payments, and (2) the amount of the income or expense can be determined with reasonable accuracy

Economic Performance Test

The requirement that must be met for an accrual method taxpayer to deduct an expense currently; the specific event that satisfies this test varies based on the type of expense

Payment Liabilities

Liabilities of accrual method businesses for which economic performance occurs when the business actually pays the liability for, among others, workers’ compensation, tort, breach of contract or violation of law, rebates and refunds, awards, prizes, and jackpots, insurance, warranties, and service contracts provided to the business, and taxes

Recurring Item

An election under economic performance to currently deduct an accrued liability if the liability is expected to persist in the future and either it is not material or a current deduction better matches revenue

Direct Write-Off Method

Required for deducting bad debts for tax purposes; under this method, businesses deduct bad debt only when the debt becomes wholly or partially worthless

Allowance Method

Method used for financial reporting purposes; under this method, bad debt expense is based on an estimate of the amount of the bad debts in accounts receivable at year-end

Permissible Accounting Method

Accounting method allowed under the tax law; these are adopted the first time a taxpayer uses the method on a tax return

Impermissible Accounting Method

An accounting method prohibited by tax laws

Section 481 Adjustment

A change to taxable income associated with a change in accounting methods