Advanced Individual Income Tax

Accounting 811: Spring, 1998

Week 13: Timing

 Outline (c) 1997-98 Robert H. Daniels

 Control Panel

 1. Key issues: year of inclusion or deduction

Code Secs. 441, 446, 448, 451, 461, 1341, 172
Shows that lawyers don’t understand accounting

Reasons timing matters

Different rates in different years
Different brackets in different years
Present value of $$: tax delayed is tax avoided
Statute of limitations

 

2. The tax year: Sec. 441

Normally 12 months, chosen implicitly on initial return

Closes on month end, or 52-53 week year (441(f))

Can be short years: sometimes need to prorate

Sec. 443 change of year, or if Tp is corp formed during year

Pass thru entities are limited in choice of year

mandatory synchronization, to prevent rolling deferral

Change of year requires IRS approval: Sec. 442

In practice, TO calendar is OK. To fiscal is questionable

 

3. Accounting methods

Method: consistent set of principles for determining timing

GAAP is only one method

used because of "scientific matching"
other methods: like non euclidian geometries
other methods may be easier to use, or better gauge ability to pay

Example: Installment Sales

Timing of gain on non-inventory, non-recapture property sales

Code Sect. 453: applies to Purchase money financing

generally, makes seller's tax correspond with receipt of $$

Mechanics: gain (t) = pmts (t) x GPR

Timing of Income

Sec. 451(a): on receipt of item
  unless method of accounting makes a different year proper

Timing of Expense: 461

 proper taxable year under the method of accounting

The Regs under these two sections explain it

Note that 461(h) creates a new method
(economic performance accrual)
and promptly carves out the 8 & 1/2 month exception

 

4. Choice of Method: Sec. 446

Method used in keeping books. 446(a)

Has been interpreted to allow cash for tax w/ "reconciling entries" for accrual type shareholder reports

 If no method, or if method not clearly reflect income

then IRS chooses method to clearly reflect. 446(b)

Clear reflection of Y:

IRS has lots of acctg method power

471: IRS decides if inventories needed: Accrual: 1.446-1(c)(2)

446(c ): subject to above, Tp can use cash, accrual or hybrid

448: entities (C corps and p’ships w/ C corps) must accrue, unless farming, pers service, under $5mm

 

5. Cash method: Sec. 446(c)(1)

Can the cash method ever "clearly reflect" income?

Implies that matching not always needed for "clear reflection"

Not just scientific matching concerns
administerability and wherewithall to pay

Advantages of cash method for Tp

control over timing of billing payment

Year-end payment manipulation
The "mailbox rule"

Consider the effect of accrual inventories: like a permanent speedup.

 if items are part of closing inventory, then no current deduction
  cr cash dr closing inventory

note that if firm has inv. forever, then in effect,
  deduction for cost of goods not yet sold is forever deferred

Consider timing of tax on a business with receivables greater than payables.

Meaning of "cash method": Per Regs. 1.446-1(c)(1):

Y included in year when actually or constructively received

regardless of form of receipt cash, goods, services, etc.

Expense for the year in which actually made

Depreciation, however, still required

Constructive receipt and Hornung v. Commissioner

Facts:

Football player is voted MVP of championship game on 12/31.
Announced winner of car: picked up on 1/3

Issue: was car constructively received when awarded in 1961?

Reason: Tp trying to bar w/ limitations

Held: no

Reasoning

Sec. 451 Regs on what "receipt" means"
  available to be drawn upon without restriction

Doctrine invented by IRS, but can be used by Tp

Tp lacked control on 12/31: no keys, no title, couldn't get to NY, car not set aside for Tp

Critique:

IRS fuzzed its own doctrine: eg. Davis v. CIR case (retired RR employee)

How Much Prepayment is Too Much: Boylston Market Ass'n v. CIR

Facts:

cash method taxpayer prepaid insurance for 3 yrs
deducted only prorated amount for each year

Issue: is Tp limited to the amount paid

Note bigger issue: what are the limits of cash?

Held: no

Reasoning

Like prepaid rentals, Tp has purchased an asset
Useful life extending beyond end of year
And is thus limited to depreciation or amortization of that asset

Full deduction in the year of payment would distort Y

Critique

note circularity: an "asset" is just a cost that is waiting to be matched with future revenue.

Saying" purchased an asset" is just shorthand for "cost that can't be taken as an expense now"

Also: how much prepayment is too much?
Zaninovich in 9th Cir: beyond end of year 2.

 

6. Accrual Method

Y when all events fix the right, determined w/ reasonable accuracy.

North American Oil Co. case

Facts:

1916 dispute w/ gov't over oil land ownership
"receiver" 2/16. $ paid to co 1917
Co booked Y in 1916.

Procedure:

$ not on original 1916 return.
on amended return filed in 1918
IRS audited 1917
in 1927, IRS amended to add this as 1917 item
BTA held was receiver Y in 1916, regardless of method
Ct App said 1917 Y regardless of method

Issue: who is taxed (receiver or co)? and 1916 or 1917 (or 1922, when underlying dispute finally ended)?

Held: 1917

Reasoning

Not receiver Y under law then: only a partial receivership
Not 1916 Y, because co might never get the $$
Not 1922 Y, because held under CLAIM OF RIGHT in 1917 w/o restriction as to disposition

Artnell Co. (p. 616)

Background: IRS victory on prepaid items in the AAA cases and in Schlude

Facts

T acquired Chicago White Sox, Inc

Acquisition produced a short year
CWSI had received cash during short year for season tickets etc.,
  for games played after the short year end

Issue: is the income that of CWSI or of Artnell in the following year.

Held: Artnell the following year

Reasoning

question is availability in tax accounting of a deferred income liability
Analyzed Sup Ct cases as involving uncertain timing of performance of services
Here, deferral so clearly reflects income that CIR doesn’t have discretion to reject it

Now for services: RP 70-21: 1 year postponement OK

For goods, Reg. 451-5: limited deferral

Expense when all events fix liability and reasonable accuracy

 and if applicable, Sec. 461 "economic performance" has occurred

 Schuessler case

Furnaces sold with lighting service for 5 years

Cost of service was reserved (dr income cr service contract reserve)

Held: acceptable, because more clearly reflects income

Now: economic performance test

the Mooney bond problem

When does a casino accrue a progressive jackpot?
 Hughes Properties (Sup .Ct. 1986)

 

7. Inventories

gross receipts - COGS equals income

COGS = opening inventory - purchases plus closing inventory

so GR - purchases - opening inv + closing inv = income

i.e. an increase in inventory is taxable income currently

eg. Buy 10 for 10. Sell 5 for 20. Use the $ to pay for more goods

        income is 50 even though no cashflow / no "ability to pay"

  inventory methods: specific identification or FIFO for tax

LIFO allowed, can be very helpful but complicated

eg. year 2 bot 10 more for 15. Sell 10 for 25
are you selling year 1 costs or year 2 costs?

simplified LIFO: dollar value single pool

take FIFO "physical" inventory
deflate inventory to opening prices (as of start of LIFO)
calculate change in inventory in opening year prices
inflate the change to current year prices

Example:

Uniform Capitalization cost accounting for taxes

mfg and for wholesale and retail 10mm

Significance: what costs belong to goods sold *and not yet sold* (deferred)
  as opposed to sales, general and administrative overhead

 allocation issues

 division of costs between MG&A and goods
 step-down of overheads
 allocation of overhead costs to classes of inventory
 allocation of costs to current sales or ending inventory

in general: capitalize

Direct materials and labor
plus fixed and variable indirect production costs
repairs, utilities, rent, indirect labor and supervision
tools, equipment, quality control
taxes, depreciation, scrap, pensions, etc.
tax depreciation over financial St depreciation
employee benefits and pensions
direct administration, officer salaries, insurance
interest for certain self-constructed property

  Administrative issues

problem for smaller manufacturing business
jobs not specialized; record-keeping burden

 problem: cost accounting not tax oriented

tax has no management relevance criterion

 

8. Changes of method:

Per 446, IRS can require a change.

446(e) Tp needs permission to change
446(f) change without permission isn’t a defense to penalties

481 adjustments required by method change

book the otherwise duplicated or omitted items to income

eg change from cash to accrual.

The excess of AR over AP at the start of the year is added to income

in some cases a backward spread is allowed (reconstruct earlier years) or a forward spread

Depends on whether its change between acceptable methods or from unacceptable to acceptable

And on whether TP or IRS catches it 1st

 

9. "Integrity" of the taxable year

Claim of right and Sec. 1341

Applies to reversing items: allows calculation of  tax based on earlier year

Van Cleave case

a savings clause in an employement contract
compensation found unreasonable, TP pays back

Tax benefit rule - Sec 111

A refund is income if and only if the item refunded was a deduction that affected tax liability

 

10. Carryovers and Carrybacks

  1. Individual

  2. Corporate

  1. General Business

  2. Foreign Tax Credit