#11518 - Methods Of Accounting - U.S. Income Tax Law

METHODS OF ACCOUNTING

1. Annual Accounting Method

   1. Whichever method, tax is always due on 15^th day of fourth month following the close of the tax year (§6072).

   2. The method used by the TP will generally be acceptable if it accords with GAAP (Reg 1.446-1(c)(1)(ii)(C)).

   3. Choosing the Taxable Year (§441(b))

      1. Calendar Year (441(b)(2))

         • Required for any taxpayer who keeps no books, or does not have an annual accounting period, or one that doesn’t end on last day of month.

      2. Fiscal Year: (441(b)(1)) Must end on the last day of a month other than Dec.

         • Required for any taxpayer (usually a business) that keeps its books on a non-calendar year basis.

         • §441 limits ability to game system by selecting fiscal year right after you get a big gain

   4. Net Operating Loss Carryovers (§172)

      1. Can be used to offset net income in two years preceding loss year and 20 years following loss year.

      2. NOL is carried to the earliest possible year first, and then any remaining amount is carried forward to later years.

         • But remember, if company is failing, won’t be able to take advantage of the carry forward unless acquired

   5. §441 has special rules for partnerships, S Corps, personal service corps.

2. Claim of Right (§1341)

   1. Basic idea: you pay taxes in year one/two based on income to which you have claim of right and are entitled to. But if it turns out in a later year that that claim of right never materialized, you’re allowed to a deduction and don’t have to go through amending prior year’s return. This comes from United States v Lewis (US 1951, p 180 squib). If same tax bracket in the two years, you don’t even need §1341, just Lewis.

      1. Ex: Insurance salesman pays tax on $10K income for commission on policy sale in year 1, but then year 2 customer cancels policy and he has to repay commission.

   2. Really only a problem when you have different rates in different years. When this is the case, and the item exceeds $3K, §1341 works in favor of taxpayer. TP has choice to just deduct the amount in year two, or to subtract from tax liability the amount by which he overpaid in year 1 (does this if in lower bracket in year 2).

   3. §1341 conditions:

      1. Amount exceeds $3K

      2. TP must have included the item in a previous tax year

      3. Has to have had “unrestricted right” to the income in the previous year

      4. In a later year, the TP had to pay the item back (turns out he did not have the unrestricted right) (Lewis—p 179)

3. Tax Benefit Rule (Hillsboro)—Inverse of Claim of Right

   1. Basically, you pay tax in a subsequent year to offset a tax benefit in an earlier year when it becomes clear that that benefit was granted based on a mistaken assumption.

   2. Hillsboro—a bank paid property tax and the tax was later declared unconstitutional and refunded.

      1. Court says bank has to report as income the recovery to the extent that it took a deduction for the property taxes to reduce its federal income tax liability in a previous year.

      2. Unlike §1341, don’t account for different rates across years. Just deduct it in later year, regardless of what your marginal tax rate is there.

   3. Note—this concept is different from simply making a mistake based on facts known or knowable in the earlier year, and having to simply amend the return to correct it.

4. Cash Method Accounting

   1. All individuals must use cash method.

   2. Income

      1. Basic: Amount is includible when actually or constructively received (cite §451, also in 1.451-1).

      2. Constructive Receipt: Taxpayer has to report income in this period if the payment is credited to the TP, set apart for the TP, or otherwise made available for the TP during the period. (Reg §1.451-2(a)).

         • Checks for recipient are treated as cash, with very few exceptions. So if I write a check to you now, but you don’t cash it for a year, you pay tax now as soon as you receive the check.

         • But, taxpayer has to know about the receipt in order for there to be constructive receipt (Davis)

         • Substantial Restrictions: (Reg §1.451-2(a)): No constructive receipt if there are substantial restrictions on receipt or if payment is not yet vested.

   3. Deductions:

      1. Basic: For TP on cash method, deductions should be taken into account for the taxable year in which paid (Reg §1.461-1(a)).

         • NO Constructive Payment; Vander Poel v Commissioner (TC 1947, Unit VB supp)—there is no doctrine of constructive payment. Employer put money into employees’ accounts, from which they could draw. But they never did. Employer tried to deduct it in year in which paid in, using corollary of constructive receipt. Court says even though logic would support this, the code does not.

           • Deductions are “legislative grace,” and you can’t make any assumptions to allow for any new or stretch any existing deductions.

         • Checks for payor: Mailing of a check is considered delivery of payment if the check clears in the ordinary course of business.

         • IOUs: Deduction is taken on actual payment (Rev Ruling 76-135)

         • Credit Cards: Even though you’re borrowing from a bank, it is considered to be payment when you swipe the card and its processed (Rev Rul 78-38).

           • But note: if it’s a two party card, that’s just an account with that particular merchant, then its not deductible until paid. These things are treated differently from credit cards.

5. Accrual Method Accounting—mandatory for businesses that involve inventory (e.g., retail)

   1. Income: Under accrual method, income is includible when all the events have occurred which fix the right to receive such income and the amount thereof can be determined with reasonable accuracy.” (Reg §1.451-1(a))

      1. All Events Test: All events occur upon earliest (disjunctive) of when amount are:

         • Paid

         • Due, or

         • Earned

      2. For TP on accrual method, amounts attributable only to his death do not count as income for that year.

   2. Deductions

      1. Basic: (Reg §1.461-1(a)(2)): Under accrual method, a liability is incurred and is taken into account in the taxable year in which all the events have occurred that (i) establish the fact of the liability, the amount of the liability can be (ii) determined w/ reasonable accuracy, and (iii) economic performance has occurred w/r/t the liability.

      2. Economic Performance Test:

         • For certain types of liabilities, all events test will not be treated as having been met until economic performance has occurred.

           • Includes property and services provided to TP, workers comp and tort liabilities,

         • Economic performance occurs when services or property are actually provided, or in case of rent, when they are used (§461(h)(2))

         • Prevents arbitrage of buyer and seller agreeing to pay long in advance (so that buyer can take huge deduction now w/o actually paying until inflation makes the cost much less, but seller not pay tax until received, if on cash basis).

         • See hypo of Mooney selling a plane along with a 30-year $1K bond, and trying to deduct the cost of the bond now even though they wont pay it out for 30 years.

      3. Partial deduction: If it is too early to calculate the exact amount of the liability, TP can account for that portion of the liability which can be computed w/ reasonable accuracy w/in the taxable year (Reg 1.461-1(b)(ii))

         • But if we’re uncertain of what something will cost, but we know it will cost at least $1,000, Blank says its an unclear area of the law whether we should accrue the $1K immediately and then report the rest later, or alternatively just wait and take it all when we can determine the exact amount with reasonable accuracy. But he says the tendency is to keep the transaction together, not split it apart like that.

      4. Errors: should be addressed by amending the prior year’s tax return, not by just adding the deduction into the current year (similar to other code sections) (1.461(b)(3)).

      5. Special Cases

         • Jackpots: If Google promises to pay $3 billion jackpot 100 years from now, its not deductible until actually paid. Focus on economic performance in the regs is on when payment is actually made.

         • Escrow, trusts, other third parties: when payor pays through third party like escrow, economic performance occurs when the third party pays to the ultimate payee (1.461-4(g)(1)).

         • Torts or contract liability: §461h)(2)(C) and Reg §1.461-4(g)(2) specifically says that these amounts are deductible when actually paid. Can cite to either. Same thing.

6. Original Issue Discount (§1272(a) is general rule)

   1. Basically imputes annual interest for zero-coupon debt. Because of compounding, OID rises over time. Gains to bondholder should mirror deductions for issuer.

   2. Requires taxpayer to include OID as ordinary income calculated on a pro rata daily basis for each year (§163(e)) and issuer and bondholder take reciprocal/symmetrical income and deductions—they include income and deductions at same time and in same amount.

   3. Interest Periods: Unless otherwise specified, accrual periods will be 6-month periods, the last one ending on the maturity date (§1272(a)(5)).

      1. The more compounding periods you have, more interest you earn, ceteris paribus. For same amount at maturity, you need lower interest rate the more compounding periods you have.

   4. Formulae

      1. Discounting: Present value = Fut Val / (1+i)ⁿ

      2. Compounding: Principal (1+i)ⁿ = Future Value

   5. Terms

      1. Issue Price: Price you pay for the bond (1.1273-2(e))

      2. Stated Redemption Price at Maturity (SRPM) (§1273(a)(2)): Principal...