Miscellaneous
Miscellaneous taxes that can affect a business include tariffs on imported goods, franchise taxes, and occupational taxes.
expense does not represent a new capital investment.
The method of accounting affects when deductions are taken. With cash accounting, expenses are deductible only when paid. With accrual accounting, expenses are deductible when the obligation is incurred.
The IRS code does have some specific restrictions, but even within those restrictions, some discretion is allowed. In general, an expense will be disallowed if it is incurred in an act contrary to public policy. This means payments of penalties, fines, illegal bribes, or kickbacks.
If you are running an illegal business, you can claim expenses just as if the business were legal, unless you are trafficking in controlled substances. In that case, only the cost of goods sold is a deductible business expense. Fines and bribes would still not be deductible. (An exception to this might be parking tickets: even legitimate businesses can claim a deduction if they can show that tickets are a regular occurrence and thus an ordinary expense in their business.) The requirement for illegal businesses to file and pay tax on income is what permits subsequent prosecution for tax evasion. Few illegal businesses file regularly.
Business Bad Debt
A bad debt deduction is often misapplied. In general, the bad debt must be specifically identified. Some financial institu-
tions can establish a reserve account and use the reserve method.
Accrual method accounting permits an allowance for doubtful
accounts to estimate bad debt losses.The cash basis business does not have bad debt deduction for unpaid receivables, because no cash has changed hands. Deduct the bad debt as an ordinary loss in the year when debt is partially or wholly worthless.
For example,Tom, accrual method, sells inventory on account for
$1,500. Buyer pays $150 down and makes no other payments.Tom has a $1,350 bad debt tax deduction, because he reports $1,500 in income.
Teresa, cash method, performs legal services for $1,500. Client pays
$150 down and makes no other payments.Teresa has no bad debt tax deduction, since only $150 changed hands. She reports the $150 in income and pursues satisfaction in small claims court.
Expenses for lobbying and political purposes generally do not meet the deductibility test. There are exceptions for lobby- ing to influence local legislation and to monitor legislation; those contributions are specifically permitted by law.
Debt vs. Equity Financing
In calculating taxes, corporations may deduct operating expens- es and interest expense but not dividends paid. This creates a tax advantage for using debt financing, as the following exam- ple will demonstrate.
A firm with 100,000 shares outstanding needs to raise an additional $500,000 in capital. It can do so by selling bonds that pay 6% interest or by issuing 10,000 additional shares at
$50/share. The firm pays $3.00 in dividends for each share out- standing.
Debt financing can increase cash flow and EPS and decrease taxes paid. The tax deductibility of interest and other related expenses reduces their actual (after-tax) cost to the profitable firm. The nondeductibility of dividends paid results in double taxation under the corporate form of organization. This relative attractiveness of debt financing can lead corporations to
Debt Financing Equity Financing Net Operating Profit (EBIT)
Less: Interest Expense Earnings Before Taxes Less: Taxes (40%) Earnings After Taxes Shares Outstanding Dividends Paid
Earnings Available to Common Share Holders
Earnings per Share (EPS)
$1,000,000 30,000 970,000 388,000 582,000 100,000 300,000 282,000
$2.82
$1,000,000
1,000,000 400,000 600,000 110,000 330,000 270,000
$2.45
—
Table 9-1. Impact of debt vs. equity financing
acquire high debt loads. If business enters a slump, servicing the debt load may place the company at risk of bankruptcy.
Net Operating Losses (NOL)
While no business eagerly seeks losses, one aspect of the tax code takes the sting out of losses. When a corporation records a net operating loss (NOL) in a business year, it can get some relief through tax loss carrybacks and/or carryforwards. The carryback/carryforward feature lets corporations with NOL carry tax losses back to profitable years and/or forward. The number of years eligible for the carryback provision depends on current tax code. The carryforward eligibility lasts for 20 years or until the NOL is made up.
The law states that losses first be carried back, applying them to the earliest year allowable and progressively moving forward until the loss has been fully recovered or the carryfor- ward period has passed. The business can make an irrevocable decision to carry the losses forward and forgo the carryback provision. This election is usually made when a company suf- fers losses from the start-up phase of operations and has no prior profitable years to fall back on.
Skillful management planning can take advantage of this feature of the tax code.
After a profitable year, management can plan to absorb the expense of expansion or dropping an unprofitable line of busi- ness. Losses from trade or business operations, casualty and theft losses, or losses from foreign government confiscations can create a NOL.
When there are NOLs from two or more years, use them on a FIFO basis. For a carryback NOL, the business must recompute taxable income and the income tax due, if any, on the revised profit figure. Based on the new calculation, the business can choose to have excess tax paid on the old profit figure refunded or applied to future tax obligations.
The recalculation can be involved. For example, limitations and deductions based on adjusted gross income (AGI) and any
tax credits based on taxes paid must be recomputed.
If excess NOL remains after applying the carryback calcula- tion, any remaining NOL is then carried forward. After using the NOL in the initial carryover year, the business must determine how much NOL remains to carry to future years.
Cost Recovery and Depreciation
When a firm buys a business or income-producing asset, the cost has to show up on the books as an expense. A variety of meth- ods have developed to account for this cost recovery. For fixed assets, cost recovery comes through one of the depreciation methods. Intangible assets follow amortization schedules. Natural resource cost recovery falls under depletion tables. Intangible assets and resource depletion are areas for specialized study.
The concept of depreciation reflects the accrual accounting method. This assumes that the economic life of an asset will be consumed over time so a portion of its cost must be charged to each time period. The IRS mandates the use of the modified accelerated cost recovery system (MACRS) in calculating depreciation for tax purposes. A variety of other depreciation methods are often used for financial reporting purposes. These depreciation methods include double declining balance, sum-of- the-years, and straight line.
Under the basic MACRS procedures, the depreciable value of an asset is its full cost, including outlays for installation. There is no adjustment for expected salvage value as there is under some other depreciation methods. MACRS has several property class-
Modified accelerated cost recovery system (MACRS) A depreciation method for writing off over time the value of depreciable property other than real estate, introduced by the Tax Reform Act of 1986. As the name states, MACRS is a series of modifications to the accelerated cost recovery system (ACRS).With MACRS, businesses write off the costs of quali- fied property over predetermined periods, which allows faster recov- ery of costs than straight-line depreciation. MACRS is mandatory for most depreciable assets placed in service after December 31, 1986.
es and life spans. Fit the property to the class and you have the predetermined depreciable life span and annual percentages.
MACRS also has conventions for determining when property was placed in service during a year.
As long as you have positive taxable income, you would always prefer to expense any asset purchase. Remember: a dol- lar saved today is worth more than a dollar saved tomorrow.
The ideal depreciation schedule would be to expense 100% of all asset purchases in the year placed in service. Many small businesses have something like that through the provisions of Section 179 of the tax code.
Under Section 179, a business can elect to immediately expense a specific amount of tangible asset purchases up to a statute limit. That limit changes every year based on inflation and other tax policy considerations. To make certain that the benefit applies only to small business, there is also an upper limit on asset purchases. Above that limit, there is a one-for-one dollar reduction until any Section 179 benefit is exhausted.
Section179 cannot be used to buy real estate or income-pro- ducing property. The deduction cannot exceed taxable income
MACRS Depreciation
Erskine Corporation bought and installed a machine with a five-year MACRS recovery period.The cost was $50,000.
Using the applicable MACRS rates, the depreciation expenses are as shown below.
Year Depreciation
20% $10,000
MACRS Rate 1
2 3 4 5 6 Totals
32%
19%
12%
12%
5%
100%
$16,000
$9,500
$6,000
$6,000
$2,500
$50,000
before Section 179 is applied.
Financial managers are traditionally more concerned with cash flows rather than profits as the basic measure of business health. To adjust the income statement to show cash flows from operations, all noncash charges should be added back to net profit after taxes. By lowering taxable income, depreciation and other noncash expenses create a tax shield and enhance cash flow.
Hybrid Tax Accounting
In the Chapter 2 discussion of GAAP, we went into the cash and accrual methods of accounting. The IRS permits for tax purpos- es a third type of account- ing method, called hybrid.
Hybrid combines cash and accrual methods. When inventory is a material income-producing factor, hybrid offers some tax advantages. It uses the accrual method for calcu- lating gross profit (i.e., sales - cost of goods sold) and the cash method for remaining income and expenses.
Section 179
For the year, assume the Section 179 deduction limit is
$25,000 and the maximum asset purchase amount is
$230,000. If Erskine Corporation purchases assets worth $25,000 dur- ing the year, it can expense the entire amount against income. If Erskine purchases $50,000 in assets, it can expense $25,000 and depreciate $25,000 under MACRS rules for the asset class. If it spends
$250,000 on fixed assets, its Section 179 deduction is limited to
$5,000 ($250,000 - $230,000 = $20,000, $25,000 – $20,000 = $5,000).
If Erskine spends $1 more than $255,000, no Section 179 deduction is allowed. Cost recovery will then be straight MACRS depreciation.
Hybrid method An accounting method allowed by the IRS for tax purpos- es, combining cash and accrual meth- ods. It uses the accrual method for calculating gross profit and the cash method for remaining income and expenses.