ACCTG 321 [Class 5 - Midterm]

Class 5: 1-32 Class 6: 33-

The General Rule

the Internal Revenue Code states that “all income, from whatever source derived” is taxable UNLESS an exclusion or deduction exists

1. Trade or business (expenses & losses are generally deductible)

   1. Ex: salary, depreciation, rent, COGS, R&D

2. Investment (expenses & losses are generally deductible)

3. Personal ((expenses & losses are generally NOT deductible, there are some exceptions)

Legislative grace for expenses & losses varies based on what 3 general categories?

ordinary, necessary

IRC 162 authorizes a deduction for “all the ___ and ___ expenses paid or incurred during the taxable year in carrying on any trade or business

Ordinary

customary for the type of trade or business & is commonly or frequently incurred (ex: rent, employee wages, advertising, insurance)

Necessary

Appropriate and helpful for the development of the business or generation of revenue

• campaign expenses

• fines or penalties

• club dues

• lobbying expenses

• political contributions

• …and anything that is not specifically listed as a deduction

Items that are NEVER deductible (6)

Net Operating Loss

when taxable income is negative because deductions (generally limited to business deductions) exceed income

They can be carried forward and used to reduce positive taxable income in later years

wages and salaries

What is considered business income?

interest and dividend income (they are investment income)

what is not considered business income?

• itemized deductions (individuals)

• educational interest expense (individuals)

What are examples of non-business deductions?

deferred tax asset

What are NOLs reported on the balance sheet as?

valuation allowance

Deferred tax asset is offset by __ when the prospect of deducting the NOL in the future is uncertain

NOLs incurred after 12/31/2017 can be carries forward indefinitely BUT when they are utilized they can only offset 80% of the current year taxable income

(Before: corporations could carry the NOL back 2 years and/or forward 20 years to offset any amount of income in those years

What happened as a result of the CARES Act?

FIFO

pre-TCJA NOLs

post TCJA NOLs

NOLs must be used on a ____ basis, so ___ are utilized BEFORE ___.

the amount of capital gains they have in a given year

Corporations can only deduct capital losses up to what amount?

3 years back, 5 years forward

How long back and/or forward can corporate capital losses go?

No they do not get any special rate

Do corporations get any special capital gains rate?

Double taxation only applies to the distributed portion of corporate income

Impact is never actually double, because any distribution would be reduced by corporate taxes

Is there a double taxation in Corporate taxes?

1. pay a salary (has to be considered ordinary & necessary)

2. Debt vs equity

3. rental agreements

4. corporate shareholders - dividend received deduction

Ways to reduce double taxation (4)

Dividend-received deduction

When a corporation receives dividends from another domestic corporation, the recipient corporation must recognize gross income in the amount of the dividend AND a deduction is often allowed to the recipient as well

21%, there is no preferential rate for corporations

What rate are dividends taxed at to corporations?

Dividend-received deduction chart

% of stock owned DRD

<20% 50%
20% - 79.99% 65%

>80% 100%

1. dividend

2. Basis reduction

3. Capital Gain

What are the 3 tax treatment of shareholders?

(1/3) Dividend

A distribution from a corporation to a shareholder is a __ to the extent of a corporation’s earnings and profits (E&P)

(2/3) Reduction of basis

After E&P are depleted, the distribution reduces the recipient shareholder’s basis in the stock (nontaxable to the shareholder)

(3/3) Capital Gain

Excess over shareholder business is a __ to the shareholder and is taxable

Accumulated E&P

the sum of ALL PRIOR YEARS’ undistributed E&P as of the beginning of the first day of the tax year

Distributions first come out of Current E&P

Any remaining distributions come out of Accumulated E&P.

(A corporation can have a dividend even if Accumulated E&P + Current E&P is negative, as the distribution is deemed to come out of Current E&P first)

What is the distribution ordering of current and accumulated E&P?

Dividend based on current E&P, accumulated E&P is ignored

Positive current E&P, negative accumulated E&P

net deficit against accumulated E&P

Negative current E&P, positive accumulated E&P

distributions from current E&P, any remainings come out from accumulated E&P

Positive current E&P, positive accumulated E&P

multiply the # of current E&P * the % of ownership in the company, same with accumulated E&P

when calculating how much of distributions go to dividends, reduction of basis, capital gains, how do we calculate how much goes into dividends?

current year

If you have an expenditure in business, would you rather deduct that expense for tax purposes in the current year or future?

recovery of cost

the ability to deduct the cost of an asset for tax purposes, which gives rise to tax savings equal to the deduction amount multiplied by the taxpayer’s tax rate

immediately expensing (currently deducting)

tax savings are maximized if the cost is deductible in the year incurred

Capitalization

results in ___ if an expenditure is not eligible for immediate expensing but its cost may be recovered at some point in the future. The cost is __ as an asset on the balance sheet

General rule for capitalization of costs

costs are capitalized unless there is a specific provision that allows for immediate expensing / current deduction

• costs attributable to the purchase

• creation or enhancement of an asset that has longer than one-year useful life

• costs that result in a significant long-term benefit of the business

What are things that must be capitalized?

If they are ordinary and necessary and paid or incurred during the tax year

What is the one exception that the IRC allows business to currently deduct expenses?

repairs & maintenance

expenditures are currently deductible is they are regular, recurring in nature and do not increase the value or the useful life of an asset

improvements

substantially prolong the life of an asset or increase its value are capitalized

repairs and maintenance so they can immediately expense it

Do business want things to be repairs & maintenance or improvements?

Tax basis

when a taxpayer purchases an asset or capitalizes an expenditure, the cost of the asset or the amount of the expenditure becomes this for that asset

• FMV of property given up

• FMV of services rendered in exchange for the asset (includes an acquisition indebtedness)

What costs are included in the tax basis of an asset?

any additional expenditures incurred to acquire the asset

what is also CAPITALIZED into the cost basis of the asset which are included as the starting point for tax basis?

1. a taxpayer sells the asset (the gain is taxed)

2. through a series of future tax deductions

   1. deducting the useful life of the $1000 computer for 6 yrs

   2. $200, $320, $192, $115, $115, $58

Recovery of basis occurs when … (2)

1. the asset’s tax basis is reduced by the deduction (aka assets adjusted basis)

2. the deduction generates tax savings that reduce the after-tax cost of the asset

this is how you get a “tax write off” for the cost of the asset

What are the 2 consequences when a taxpayer deducts a portion of the capitalized cost of an asset for tax purposes?

capital additions

expenditures that add to the value or prolong the life of the asset

capital recoveries

depreciation, amortization, depletion

Initial cost basis
+ capital additions
- capital recoveries (depreciation)
____________________________

adjusted basis

Tax basis formula

1. you must own the property

2. the property must be used in your business

3. the property must have a determinable useful life

4. the property must be expected to last more than one year

Note: This means that the cost of the asset is capitalized. Creates tax basis in the asset and the cost is NOT currently deductible

to be depreciable, property must meet what 4 requirements?

No only if you’re in trade or business

can any taxpayer depreciate any asset with more than a one-year useful life?

1. 179 expensing

2. Bonus depreciation

3. Regular depreciation (MACRS)

Note: 1 and 2 only applies in the INITIAL year the asset is in place

What are the 3 common methods to recover capitalized basis?

Yes, as both book and tax fully depreciate

Tax rules differs from depreciation under financial accounting rules, is this difference temporary?

§179 Expensing rules

• only applies to personalty (T/B assets that are NOT land or building), not real estate

• can’t exceed taxable income from the trade or business

  • excess amounts can be carried forward indefinitely (as long as you have sufficient taxable income)

• MAX expense deduction is $2,560,000 in 2026

• The $2.56m is reduced $1 for $1 by the amount of qualified personal property placed into service in a given year to the extent it exceeds $4,090,000

  • any amount limited due to excess personal property placed into service can’t be carried forward

Bonus Depreciation

Allows taxpayers to depreciate a very large percentage of certain assets in the first year that the assets are placed in service

• 1/20/25 & Beyond: 100%

1. taxpayers may not take bonus depreciation on real property

2. bonus depreciation applies after 179 expensing and before MCARS depreciation

3. not all states adopt the federal bonus depreciation rules

Exception / Special rules to Bonus Depreciation (3)

1. recovery period

2. placed in service date

3. purchase price

4. §179 & bonus depreciation amount

to calculate depreciation, the taxpayer must first gather what 4 information?

the property is ready for use (this doesn’t need to align with the date that the property is actually first used)

Tax depreciation begins on the date that ….?

convention

determines how much depreciation is eligible for the year the asset is placed into service and the year the asset is disposed of

Mid-month convention (MM)

• Used for all real property (buildings)

• All property placed in service during a month is treated as placed in service at the midpoint of that month

• A half-month of depreciation is allowed (when property is placed in service or disposed of in that month)

Half-year convention (HY)

• Used for personalty if the mid-quarter convention doesn’t apply

• treats all property as placed in service or disposed of at the midpoint of the year

• half a year of depreciation is allowed for the year the property is placed in serice or disposed of

Mid-quarter convention (MQ)

• For all personal property (must use MQ or HY)

• Use this if: the total cost of PERSONALTY placed in service in Q4 of the tax year exceeds 40% of the total cost of all PERSONALTY placed in service during the entire year

• All property placed in service during any quarter of the tax year as placed in service at the midpoint of that quarter

Steps for calculating MACRS Depreciation

1. Calculate depreciable basis

   1. Depreciable basis = initial cost basis - 179 depreciation - BONUS depreciation (only used to calculate MACRS depreciation w/table)

2. Determine convention (ie: mid-month, mid-quarter, half-year)

3. Determine recovery period

4. Find appropriate MACRS table

5. Multiple depreciable basis by % listed in the table for that assets recover period and service year.

• Disposal Year: The taxpayer must multiple the % listed on the table by the % of depreciation they are eligible for in the disposal year (based on the asset’s convention)

• Depreciable Basis: Depreciable basis is NOT adjusted each year. This is different from the adjusted basis of the asset. Depreciable basis is only used to determine the amount of MACRS depreciation that is deductible for the given tax year.