Depreciation

Accounting Periods & Methods and Depreciation

Copyright ©2005 by South-Western, a division of Thomson Learning. All rights reserved.

Objective

Identify different accounting periods and methods allowed

Tax Year for Individuals

Individuals must use a calendar year as their tax year

Businesses must use a calendar year as their tax year unless they can show a different

“natural business year”

Tax Years for Partnerships

Partnerships don’t pay tax as an entity must file an informational tax return

1065

Tax year must be the same tax year as 50% of partners if partners’ tax years are different, use tax year of

principal owners principal is 5% or more owner

otherwise use calendar year may use fiscal year if it results in a deferral period of

no more than three months

Tax Year for S Corporations S-Corporations don’t pay tax as an entity

must file an informational tax return 1120S

Must use a calendar year or may elect a fiscal year

if the S corporation can demonstrate a business purpose, or

fiscal year results in a deferral period of less than 3 months and S corporation agrees to make annual “required tax payment”

deferral period is period of time from fiscal year-end to December 31

required tax payment also applies to fiscal year-end partnerships

Deferral Example

S-Corp has taxable income of $360,000 for the year ended 5/30 and last year’s required tax payment = $15,000

CalculationThe required tax payment = (Cash flow in deferral period x 36%) - prior year’s tax payment

Deferral period is 7 months $360,000/12 x 7 months = $210,000 cash flow ($210,000 x 36%) - $15,000 = $60,600 deposit

Tax Year for Personal Service Corporation

A Personal Service Corporation (PSC) is a corporation with shareholder-employees who provide a personal service for example, an architect or dentist

Generally must adopt calendar year Can adopt a fiscal year if

can prove business purpose, or shareholders’ salaries for deferral period are

proportionate to salaries received during rest of the period and corporation limits its deduction

purpose is to keep the PSC from deducting one year’s salary in beginning nine months

if salaries don’t remain constant, the PSC can only deduct pro rata amount

Short Tax Periods

Occur when taxpayer changes from fiscal year-end to calendar year-end or visa versa

Taxpayer must annualize income see example on p. 7-4, calculate tax, then allocate it to the short period

At top of tax return must complete: “For Short Tax Year from _____ to _____”

must use same method for tax & books

Accounting MethodsThere are three acceptable

accounting methods Cash Hybrid Accrual

Must use one method consistently make an election on your first return by filing

using a particular method file Form 3115 within first 6 months after initial

election this requests permission from IRS to change

accounting methods

Accounting Methods (continued)

Cash basis taxpayers can’t deduct prepaid rent or interest can’t use cash basis if taxpayer is a

trust with UBI (unrelated business income), or partnership with a corporation as a partner, or C corporation

PSCs and farms may use cash basis, and entities with gross receipts $5,000,000 or less

Accrual basis taxpayers must report prepaid interest or rent as income when

received Hybrid basis taxpayers

cash method but must use accrual for COGS

Objective

Describe the concept of depreciation and be able to

calculate depreciation expense using MACRS tables

Depreciation (Form 4562)

Depreciation is a process of allocating the cost of assets to expense over their useful lives land is not depreciated

Rules for depreciation have changed over the years pre-1980: straight line (SL) method 1980-1986: use ACRS tables Post-1986: use MACRS tables

Personal Property

Each asset is depreciated according to an IRS-specified recovery period 3 year Race horses, tractors units 5 year Computer, cars and light

trucks, R&D equipment 7 year Office furniture, machinery,

property with no life 10 year Barges, vessels 15 year Land Improvements 20 year Utility plants, sewers

Personal Property (continued)

Depreciation is determined using IRS tables (Table 2 in text) percentages from tables are based on

double-declining balance salvage value not used in MACRS tables based on half year convention

1/2 year depreciation taken in year of acquisition

1/2 year depreciation taken in final year May elect to use tables based on

straight line instead

Personal Property (continued)

Always use the half-year convention unless mid-quarter convention applies

Mid-quarter convention is required if taxpayer purchases 40% or more of total assets (except real estate) in last quarter of tax year applies to every asset purchased in the year excluding real property and §179 property must use special mid-quarter tables

Example 1: On March 15 purchased furniture for $180,000; furniture is a 7-year asset (use ½ yr convention)

Using tables Year 1: $180,000 x .1429 = $25,722Year 2: $180,000 x .2449 = $44,082

Example 2: On November 3, purchased computer for $12,000; it is a 5-year asset.

Using tablesYear 1: $12,000 x .20 = $2,400Year 2: $12,000 x .32 = $3,840

Personal Property Example

30% Bonus Depreciation

Additional depreciation is available for assets purchased between 9/11/01 and 12/31/04

Amount = 30% of adjusted basis only for new personal property with recovery

period < 20 years Take 30% bonus first, then regular MACRS

depreciation on remaining basis May elect out of bonus if anticipate need for

higher depreciation in future years

50% Bonus Depreciation

Additional depreciation is available for assets purchased between 5/5/03 and 12/31/04

Amount = 50% of adjusted basis only for new personal property with recovery

period < 20 years Take 50% bonus first, then regular MACRS

depreciation on remaining basis May elect out of bonus if anticipate need

for higher depreciation in future years

Real Property

Real assets depreciated based on a recovery period depending on use 27.5 year: Residential rental 39 year: Nonresidential

Real assets are depreciated using the straight-line method with a mid-month convention (Table 4) treats all acquisitions/dispositions as occurring mid-

month no mid-quarter convention for real estate

Objective

Identify when an election to expense the cost of an asset may

be used and calculate amount

Election to Expense - Section 179 §179 allows immediate expensing of qualifying

property in 2004, the annual amount allowed is $102,000 qualifying property is tangible personal property used in

a business §179 limited:

if cost of qualifying property placed in service in a year > $410,000, reduce §179 expense $ for $

cannot take §179 expense in excess of taxable income may carry forward any unused amount

If using bonus depreciation, take §179 first then 30% or 50% bonus depreciation then MACRS depreciation

Example: On 7/11/04, purchase a tooling machine (7-year asset) for $139,000. The taxable income from business is $245,500 and total asset acquisitions for year are $182,453.

Answer: Cost $139,000§179 expense (102,000)Adjusted depreciable basis 37,000Less 50% bonus ( 18,500)Remaining depr. basis 18,500 x Table % 0.1429

MACRS 2,644

Total depreciation: 102,000 §179 18,500 50% bonus depreciation 2,644 MACRS

$123,144

Section 179 Example

Objective

Define listed property and luxury automobiles; describe the

limitations placed on depreciation of these items

Listed Property

Special rules exist to limit deductions on assets used both in a business and personally cars cell phones computers (unless used exclusively at business) entertainment equipment

Limitation depends on amount of business use if asset used > 50% for business, can use MACRS if asset used < 50% for business, must use straight line

Separate section on page 2 of Form 4562

Luxury Autos Limits

Maximum allowed amount is luxury auto limits x business use % depreciation on automobiles is also limited

based on business use (5-year MACRS amount x business use %)

Luxury auto limits are quite low: depreciation on autos placed into service in

2004 is: 2004 - $2,960 2005 - $4,800 2006 - $2,850 2007 and subsequent years - $1,675

Special First-Year Depreciation for Automobiles

Extra depreciation is allowed on autos used more than 50% business maximum of 50% up to $7,650

then multiply by business use % new autos purchased before 12/31/04 may elect ‘out of’ special first year

depreciation

Luxury Auto Example

Example: On 3/15/04, Jim purchased a new automobile for $50,000. The automobile was used 60% for business and Jim wants to maximize the special first-year depreciation.

Answer:50% Bonus depreciation (50,000 X .5) $25,000Regular depreciation (50,000 - 25,000) x .2* 5,000Total 30,000Times business use percentage 60% X .60Possible depreciation 18,000

Luxury limitation {60% of ($2960 + $7650)} $ 6,366

Total allowable depreciation: $6,366

*From MACRS tables – cars are 5-year assets

Hybrid/Electric Cars

May qualify for up to $2000 deduction for AGI if purchase hybrid vehicle Such as the Toyota Prius/Honda Insight vehicle may be used 100% personal

Objective

Describe the tax treatment for goodwill and certain other

intangible assets

Intangible Assets §197 intangible assets are acquired by

purchase amortized over 15-years beginning in month

acquired goodwill going-concern covenant not to compete see complete list in text, p. 7-21

Many intangible assets are excluded from Section 197 provisions may not amortize internally-generated assets like

patents and copyrights Report in separate section of Form 4562

Objective

Determine whether parties are classified as ‘related’ for tax

purposes and identify tax treatment of related party transactions

Related Party Transactions

Related parties are: a corporation and > 50% owner brother/sister corporations parent/subsidiary corporations family members

spouses, lineal descendants, siblings also used for purposes of calculating ownership in

corporations §267 disallows losses on sales between related

parties when property sold later to an unrelated party, all

previously disallowed losses may be taken against gain

The End!My head hurts!