Chapter 9: Business Income, Deductions, and Accounting Methods

Small Business Definition (IRS)

Gross receipts under $31 million; this is the threshold for many tax simplification provisions

Three Requirements for Business Deductions

1. Directly connected to business activity

2. Ordinary and necessary

3. Reasonable in amount

Ordinary and Necessary Definition

Ordinary: Common and accepted in the industry
Necessary: Appropriate and helpful for the business (conducive to profit generation)

Prohibited Business Expenses

Fines and penalties, bribes, lobbying expenses, political contributions (Congress doesn't want to subsidize illegal or policy-violating behavior)

Capital Expenditure Rule

Expenditures that create future benefits must be capitalized, not immediately deducted; recovered through depreciation over time

12-Month Rule for Prepaid Expenses

Can deduct prepaid expense if: benefit period ≤ 12 months AND benefits don't extend beyond end of next tax year (does NOT apply to interest)

12-Month Rule Example

December 1, Year 1: Pay $12,000 for 12 months of insurance (Dec 1 - Nov 30 Year 2) = Can deduct full $12,000 in Year 1

Primary Motive Test

Used for business travel; must be primarily business (>50% business days); if yes, deduct transportation; if no, deduct only hotel/meals for business days

Meal Deduction Limitation

Business meals are 50% deductible; entertainment is 0% deductible (NOT allowed post-TCJA)

100% Deductible Meals

Employee recreational events (holiday party, picnic) and meals provided for employer's convenience

C Corporation Tax Treatment

Separate taxable entity, files Form 1120, pays 21% flat corporate tax rate, double taxation (corporation pays tax, shareholders pay tax on dividends)

Flow-Through Entities

Income "flows through" to owners' personal returns; includes sole proprietorship, partnership, S corporation, and LLC

Sole Proprietorship Reporting

Reports on Schedule C (Form 1040); owner pays self-employment tax; not a separate legal entity

Partnership Tax Treatment

Files Form 1065 (informational return); issues Schedule K-1 to each partner; partners report on personal returns

S Corporation Tax Treatment

Files Form 1120-S (informational); issues Schedule K-1 to shareholders; NO self-employment tax on distributions

LLC Tax Treatment

Single-member LLC: Schedule C (like sole proprietorship); Multi-member LLC: Partnership (Form 1065); can elect C-corp or S-corp treatment

Cash Method - Income Recognition

Recognize when actually or constructively received (income available without substantial restriction)

Cash Method - Expense Recognition

Deduct when paid

Constructive Receipt

Income available without substantial restriction; Example: Check arrives Dec 31 but not cashed until Jan = income in December

Cash Method Advantages

Flexible (can time income/expenses), simple (easy to track), inexpensive (less accounting costs), tax planning (control timing)

Cash Method Disadvantages

Poor matching (income and expenses in different years), less accurate (doesn't reflect true economic performance)

Who Can Use Cash Method

Individuals, small businesses meeting gross receipts test (≤ $31 million average for prior 3 years); Exception: must use accrual if large corporation or business with inventory

Accrual Method - Income Recognition

Recognize when earned or received (whichever is earlier); all-events test: all events have occurred that fix right to receive income AND amount determinable

Accrual Method - Expense Recognition

Recognize when: all-events test satisfied AND economic performance occurred

All-Events Test for Income

All events have occurred that fix the right to receive income AND amount can be determined with reasonable accuracy

All-Events Test for Expenses

All events have occurred to establish liability AND amount determinable with reasonable accuracy (reserves for future liabilities NOT allowed)

Economic Performance - Services Provided

Taxpayer provides goods/services: as taxpayer provides them

Economic Performance - Services Received

Taxpayer receives goods/services: as provided to taxpayer OR when paid (if expected within 3.5 months)

Economic Performance - Payment Liabilities

When paid

Economic Performance - Interest and Rent

Ratably over time (Increase over time)

Economic Performance Example

Ben signed contract for $7,500 repairs, paid $1,500 deposit, repairs start next year; Can deduct $7,500 next year when repairs performed (economic performance not yet satisfied)

Advance Payment Deferral Rule

Can defer advance payments for goods/services up to 1 year until earlier of: when earned OR end of next tax year (does NOT apply to rent, interest, insurance)

Advance Payment Example

Received $2,400 for 2-year contract Sept 30, Year 1; Accrual method: Year 1 recognize $300 (3 months earned), Year 2 recognize $2,100 (remaining), Year 3 nothing

Inventory Requirement

Must use accrual method for inventory if sales of goods is an income-producing factor (creates hybrid method for cash-basis taxpayers)

Small Business Inventory Exception

If meet $31 million test, can: 1. Treat inventory as non-incidental materials (deduct when used/sold) OR 2. Use same method as financial statements

FIFO Inventory Method

First-In, First-Out; assumes oldest inventory sold first; ending inventory = most recent purchases

LIFO Inventory Method

Last-In, First-Out; assumes newest inventory sold first; ending inventory = oldest purchases; book-tax conformity required; generates lowest taxable income during inflation

Specific Identification Method

Track actual specific items sold; used for unique items (cars, jewelry, art)

Cost of Goods Sold Formula

Beginning Inventory + Purchases - Ending Inventory = COGS

Gross Profit Formula

Sales - COGS = Gross Profit

Adoption of Accounting Methods

Permissible method: adopted by using for 1 year; Impermissible method: adopted by using for 2 years

Changing Accounting Methods

General rule: requires IRS permission (Form 3115); Exceptions: some specific changes qualify for automatic consent (still must file Form 3115)

Schedule C Components

Part I: Income (gross receipts, COGS)

Part II: Expenses

Part III: COGS detail

Part IV: Vehicle info

Part V: Other expenses

Schedule C Net Profit Calculation

Gross Receipts - Returns/Allowances - COGS = Gross Profit + Other Income - Business Expenses = Net Profit (Loss)

Schedule C Net Profit Flow

Flows to Form 1040, Line 3 (Schedule 1); also subject to self-employment tax (Schedule SE)

Self-Employment Tax Rate

15.3% total: 12.4% Social Security (on earnings up to $168,600 for 2024) + 2.9% Medicare (no limit) + 0.9% Additional Medicare Tax (over $200K single/$250K MFJ)

SE Tax Calculation Step 1

Schedule C Net Profit × 92.35% = Net SE Income

Why 92.35% for SE Tax

Employees don't pay FICA on employer's portion; this adjustment approximates employer portion deduction

SE Tax Calculation Step 2

Net SE Income × 15.3% = SE Tax

SE Tax Deduction

SE Tax × 50% = Deduction (above-the-line); approximates employer portion that's deductible

SE Tax Complete Example

Schedule C Net Profit $100,000 × 0.9235 = $92,350 × 0.153 = $14,130 SE tax; $14,130 × 0.50 = $7,065 deduction for AGI

Sole Proprietorship Advantages

Simple formation, easy tax reporting (Schedule C), flow-through taxation (no double tax), losses offset other income, flexibility, low cost, full control

Sole Proprietorship Disadvantages

Unlimited personal liability, self-employment tax (15.3%), difficult to raise capital (can't issue stock), limited life, harder to transfer, benefits not deductible, all income subject to SE tax

Home Office Requirements

Regular and exclusive use for business AND principal place of business OR place to meet clients/customers

Home Office Simplified Method

$5 per square foot, maximum 300 square feet, maximum deduction $1,500

Home Office Actual Method

Calculate actual expenses (mortgage interest, property tax, insurance, utilities, repairs) × business percentage (business sq ft / total sq ft)

Home Office Deduction Limit

Cannot create a loss; limited to business income

Standard Mileage Rate

2024 rate: $0.67 per business mile plus parking and tolls; simple to track

Auto Actual Expense Method

Gas, oil, repairs, insurance, license, registration, depreciation × business use percentage; more record-keeping required

What Can Be Depreciated

Property with useful life > 1 year, used in business or for production of income, property that wears out/decays/becomes obsolete

Section 179 Expensing

Immediate deduction (up to $1,220,000 for 2024); phased out for high asset purchases

Bonus Depreciation

60% immediate deduction (2024); being phased out (was 100% through 2022)

Related Party Loss Disallowance

Losses on sales to related parties NOT deductible by seller; buyer can use loss to offset future gains

Related Party Expense Accrual Rule

Cannot deduct expense accrued to related cash-basis taxpayer until paid (matching rule)

Related Parties Include

Family members (siblings, spouse, ancestors, descendants), corporation and >50% shareholder, partnerships and partners, two corporations with common ownership >50%

Business Bad Debts

Fully deductible as ordinary loss; must have been included in income (accrual method); must be worthless

Nonbusiness Bad Debts

Treated as short-term capital loss; limited to $3,000 per year deduction

Start-Up Costs Treatment

First $5,000 can be deducted immediately; remainder amortized over 180 months (15 years); $5,000 reduced dollar-for-dollar if costs > $50,000

Start-Up Costs Examples

Investigation costs, market research, employee training before opening, legal/accounting fees to establish business

Gross Receipts Test Benefits

Can use cash method, simplified inventory rules, exempt from UNICAP rules, simplified accounting for long-term contracts

Travel Expense Documentation

Business purpose, date, location, amount spent, people involved

Casualty Loss Limitation

Limited to lesser of: decline in FMV (repair cost) OR adjusted basis; complete destruction: loss = adjusted basis

Key Employee Life Insurance

Company is beneficiary, death benefits are tax-exempt, therefore premiums are NOT deductible

Municipal Bond Interest Expense

Interest on loan to buy municipal bonds NOT deductible (municipal bond interest is tax-exempt, can't deduct interest to earn tax-exempt income)

Client Gift Limitation

Limited to $25 per person per year

Parking Ticket Deduction

NOT deductible (fine/penalty against public policy)

Hybrid Accounting Method

Cash-basis taxpayer with inventory must use accrual for sales/purchases, cash for other income/expenses

Required Tax Year - Proprietorships

Must use same year-end as owner (calendar year for individuals)

Required Tax Year - C Corporations

Can choose fiscal year or calendar year; choice made on first tax return; must be consistent with book accounting

Required Tax Year - Flow-Through Entities

Generally must match owners' tax year; for partnerships with multiple owners: complex rules to determine required year

De Minimis Safe Harbor

Allows immediate deduction for low-cost items (typically under $2,500) rather than capitalizing and depreciating

Adjusted Basis Definition

Amount originally paid for property, plus improvements, minus depreciation

MACRS

Modified Accelerated Cost Recovery System; most common depreciation method; IRS assigns recovery periods

UNICAP Rules

Uniform Capitalization rules; require certain businesses to capitalize indirect costs; exemption for small businesses meeting $31M test