Business Taxation: Deductible Expenses and Inventory Costs - Prof. Charles F. Kelliher, Study notes of Business Taxation and Tax Management

Download Business Taxation: Deductible Expenses and Inventory Costs - Prof. Charles F. Kelliher and more Study notes Business Taxation and Tax Management in PDF only on Docsity! 1 TAX 6845 – Tax Planning & Consulting (September 22) Topic: Operating a business: Business expenses, inventory and the “manufacturer’s” deduction updated: September 14, 2009 I. Deductible expenses – to be deductible in the current period an expense must be: A. ordinary • normal, usual, or customary in the type of business run by taxpayer • NOT capital in nature • based on common and accepted business practice • an expense need not be recurring to be deductible B. necessary • a prudent businessperson would incur the same expense • the expense is expected to be appropriate and helpful in the business (not synonymous with “indispensable”) C. reasonable in amount • while the Code refers solely to salary & other compensation, the Courts have expanded the scope to include all other business expenses • not excessive in the specific circumstances • expenses in excess of reasonable amounts are NOT deductible • the taxpayer has the burden of proof for substantiating expenses and must retain adequate records; otherwise, IRS can disallow any deductions (especially with respect to travel, meals & entertainment, business gifts, and transportation (car expenses)) D. In addition, the expense must be: • incurred in connection with either a trade or business or with the production of income (in one sense this is a business purpose test) • incurred by the taxpayer (e.g., a father cannot deduct his son's interest) • possess substance 2 E. A current deduction is not allowed: • for capital expenditures (adds to the value or useful life of the property or adapts property to new or different use) • for most personal expenditures (food, clothing, or hobby) • expenses related to the production of tax exempt income • expenses contrary to public policy • for expenses covered by some specific rule (political contributions, related party, wash sale, at-risk, passive loss, vacation home, etc.) Note: Some deductions are specifically allowed and hence do not have to pass all of the tests. Examples include alimony, medical, and casualty losses, etc. Some deductions are exempt from some of criteria. Thus, home mortgage interest expense is not a trade or business expense and definitely is a personal expense. Similarly, a swimming pool may be a capital expenditure but still can qualify as a medical expense (but, not necessarily all of the expenditure is deductible). 5 III. Components of the domestic production activities deduction A. The qualified production activities deduction (DPAD) is computed by multiplying 3-6-9% times the lesser of: 1. qualified production activities income (QPAI), or 2. taxable income (without regard to the DPAD, but adjusted for any NOL carryforward). 3. However, the DPAD is subject to an overall W-2 wage limitation (50% of employer’s W-2 wages). This includes only wages properly allocable to domestic production gross receipts (DPGR). This allocation may be made using any reasonable method. There are now two safe harbor methods for computing the W-2 amount: • With a wage-expense method – W-2 wages are multiplied by the ratio of wage expense used to determine QPAI to the total wage expenses used to determine taxable income for the year. • Under the small business simplified overall method – W-2 wages are charged against DPGR in the same proportion as DPGR bears to total gross receipts. Originally, the wage limitation included all wages paid to all workers (for the first two years 2005/2006). Note1: The W-2 wage limit could be a problem for smaller sole proprietorships and partnerships because the owner/partners are not considered employees. Note2: For pass-through entities each partner or shareholder is treated as having W-2 wages for the tax year equal to his allocable share of the partnership’s or S corporation’s W-2 wages. Note3: If the deduction cannot be used in the current year because of the taxable income or W-2 wage limitation it is lost forever. 6 B. Qualified production activities income (QPAI) = domestic production gross receipts (DPGR) less allocable expenses (QPAI is determined on an item-by- item basis; no grouping is permitted). 1. domestic production gross receipts (DPGR) includes but is not limited to gross receipts from: a. lease, license, sale, or other disposition of qualified production property (QPP) that was manufactured, produced, grown, or extracted (MPGE) by the taxpayer in whole or significant part within the U.S. b. qualified films largely created in the U.S. c. production of electricity, natural gas, or potable water d. construction projects (real property) located in the U.S. (but not self-construction) e. engineering & architectural services for domestic construction Note1: DPGR does not include gross receipts from the sale of food and beverages prepared at a retail business, services, or sales between related parties (i.e., between controlled business and affiliated groups) Note2: Must apportion gross receipts that qualify from those that don’t qualify. Must use a “reasonable method” that is “satisfactory” to the IRS. For example, from products produced in the U.S. from those produced outside the U.S. Also, must apportion gross receipts for products with an “embedded service” component (e.g., a product warranty, training, or maintenance agreement). Note3: There are several de minimis safe harbor tests. (1) No apportionment necessary if less than 5% of total gross receipts are from nonqualified activities. (2) No apportionment necessary if embedded service element in a contract is less than 5% of the selling price. 7 2. less: allocable expenses a. cost of goods sold – in accordance with the general principals of Section 263A. In a typical scenario, this would include direct materials, direct labor, factory overhead, and a portion of its “mixed service costs”. b. other deductions, expenses, and losses directly allocable to those receipts (selling & marketing expenses) c. a ratable portion of other deductions, expenses, and losses not directly allocable to those receipts (general & administrative expenses) Note1: The second and third categories may be allocated by one of three methods (see item V, page 9) 10 VI. Tax planning opportunities A. Identify what activities qualify for the DPAD. B. Put in place processes for gathering the data to calculate QPAI. C. Develop methods for data analysis. D. Accumulate appropriate information to substantiate amount deducted. 11 VII. Inventories – in general A. Manufacturing & merchandising companies are required to use the accrual method for purchases & sales of goods. B. The method used: 1. must conform to generally accepted accounting principles from similar businesses & must be considered the “best practice” for the industry, and 2. must clearly reflect income. C. Once adopted the method cannot normally be changed without approval (consent) of the IRS. D. Items included in inventory: 1. merchandise 2. raw materials 3. work in process 4. finished products 5. supplies that physically become part of the item intended for sale Note: The Uniform Capitalization Rules (UNICAP) (Sec 263A) define what amounts must be included in inventory and what amounts must be capitalized in the cost of long-term contracts. However, the UNICAP rules: • Do not apply to merchandising businesses if gross receipts for the preceding three years do not exceed < $10M. • There are no size exceptions for manufacturing businesses. 12 E. Valuing inventory – four methods: 1. specific identification method 2. first-in, first-out method (FIFO) – two methods • cost method • lower-of-cost-or-market method 3. last-in, first-out (LIFO) – if LIFO is adopted for tax purposes it must be used for financial reporting purposes (Sec. 472(c) – the LIFO conformity rule). Note: Internationally, there is little support for LIFO. If LIFO was eliminated in the U.S. the revenue pick-up from the LIFO reserves is estimated to be $100 billion. 4. retail method VIII. Cost method A. For merchandising companies, cost includes: 1. invoice price 2. minus: trade discount (based on volume or quantity purchases) 3. plus: transportation and other handling charges 4. plus: off-site storage (warehousing), purchasing (salary of purchasing agent), and handling, processing, assembling and repackaging cost must be included in inventory, but only if average gross receipts during the previous three years exceed $10 million. Note1: The items in #4 are capitalized and allocated between inventory and cost of goods sold because of the uniform capitalization rules (UNICAP rules of Sec. 263A). These amounts are expensed under GAAP creating another book-tax difference. Note2: Any cash discount may be deducted from inventory cost or included in gross income (but it must be treated in the same manner from year to year). 15 E. Allocation of indirect costs to ending inventory under Sec 263A – using the preferred “direct to total labor hours burden rate” method under Regulation 1.263A-1(f)(3)(i). (See Sec 263A worksheet on web page.) E. There is also a “simplified method” – These additional costs may be allocated to inventory in a manner similar to an overhead application rate. For example, if these costs are equal to 20% of other manufacturing costs, then the inventory value can simply be increased by 20%. In the case of LIFO users, the adjustment is made only to the current LIFO layer which means no addition is made in years when the ending inventory is lower than the beginning inventory. 16 IX. Lower-of-cost-or-market method A. Compare the market value (replacement cost) of each item on hand on the inventory date with its cost and use the lower value as its inventory value. This method applies to the following: 1. goods purchased and on hand 2. the basic elements of cost (direct materials, direct labor, and an allocable share of indirect costs) of goods being manufactured and finished goods on hand B. Market value (replacement cost) = the usual bid price on the date of inventory, based on the volume of merchandise you usually buy (it is not selling price). C. For tax purposes the LCM method must be applied to each separate inventory item (GAAP allows an aggregate or group approach) D. Cannot be used in conjunction with the LIFO inventory. E. Obsolete or other slow moving inventory cannot be written down below replacement cost unless (based on the Thor Power Tool case): 1. the selling price is also reduced, or 2. the inventory is destroyed or otherwise disposed of 17 X. LIFO pools or “dollar-value” LIFO A. Two problems with LIFO 1. recordkeeping under LIFO can often be cumbersome, even with computer software & bar codes (most systems track units and sales revenue, not old base layer costs). The method is applied to individual units of inventory. 2. LIFO liquidation may occur if the number of units on hand decreases during the year. The old-out-of-date costs imbedded in the existing LIFO layers (often referred to as LIFO reserves) are charged to cost of goods sold in the current period, and the “paper” profits deferred from prior years are recognized in the current period (and the related tax is due). B. The solution: “Dollar-value LIFO” inventory pools (DVL) 1. DVL keeps track of inventories by grouping inventory units into pools based on the same cost change pressures (not necessarily physical similarity) 2. tax requires you to have more than one pool 3. inventory is viewed as a quantity of value instead of a physical quantity of goods 4. the focus is on inventory value not inventory units 5. the new replacement units must be “substantially” identical to the units sold 6. price indices (either a government index or an internally generated index) are used to determine if any increase/decrease in inventory is due to: a. an increase/decrease in the quantity of inventory, or b. an increase/decrease in prices