Chapter 7
Accounting Periods & Methods & Depreciation
Income Tax Fundamentals 2008
Gerald E. Whittenburg &
Martha Altus-Buller
Student’s Copy
Accounting Periods

Problem when taxpayer’s tax year differs
from calendar year – quite rare

Partnerships don’t pay tax as an entity
 Tax year must be the same tax year as 50% of
partners
 If majority of partners’ tax years are different,
must use tax year of principal partners


Principal partner is partner with at least 5% share
in profits or capital
If principal partners have different tax years,
partners required to use least aggregate
deferral method (see pp. 7-2 – 7-3)
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Tax Year for Personal Service Corporation

A Personal Service Corporation (PSC) is a
corporation with shareholder-employees whom
provide a personal service


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For example, architects or dentists
Generally must adopt calendar year
Can adopt a fiscal year if



Can prove business purpose
or
Fiscal year results in a deferral period of less than 3
months and


Shareholders’ salaries for deferral period are proportionate to
salaries received during rest of the period
or
Corporation limits its deduction [see next slide]
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Short Period Taxable Income

If taxpayer has a short year [other than first/last
year of operation], tax calculated based on
following example:

Example: In 2007, Fed-Mex changes from a
calendar year to tax year ending 9/30. For the short
period 1/1/07 – 9/30/07, Fed-Mex’s TI = $20,000.


Calculate tax for the short period
 Annualize TI
20,000 x 12/9 = 26,667
 Tax on annualized TI
26,667 x 15% = 4,000
 Allocate tax to short period 4,000 x 9/12 = $3,000
Individual taxpayers rarely change tax years
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Accounting Methods

There are three acceptable accounting methods
for reporting taxable income [TI]




Cash
Hybrid
Accrual
must use same method
for tax & books
Must use one method consistently


Make an election on your first return by filing using a
particular method
Must obtain permission from IRS to change accounting
methods
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Accounting Methods [continued]

Accrual method



Recognize income when earned and can be
reasonably estimated
Recognize deduction when incurred and can
be reasonably estimated
Hybrid method

An example of a hybrid taxpayer is one that
utilizes cash method for receipts and
disbursements, but accrual for cost of
products sold
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Depreciation [Form 4562]

Depreciation is a process of allocating
and deducting the cost of assets over
their useful lives



Does not mean devaluation of asset
Land is not depreciated
Maintenance vs. depreciation


Maintenance expenses are incurred to
keep asset in good operating order
Depreciation refers to deducting part of
the original cost of the asset
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Personal Property Recovery Periods

With MACRS, each asset is depreciated
according to an IRS-specified recovery period

3 year
5 year

7 year

ADR* midpoint of 4 years or less
Computer, cars and light
trucks, R&D equipment, certain energy
property & certain equipment
Mostly business furniture and equipment
and property with no ADR life
*See book for Asset Depreciation Range [ADR] classifications
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Personal Property

Depreciation is determined using IRS tables


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Table 2 on p. 7-9
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


Table 3 on p. 7-10
Must use either MACRS or straight-line for all
property in a given class placed in service during
that year
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Mid-Quarter Convention

Mid-quarter convention is required if taxpayer
purchases 40% or more of total assets (except
real estate) in the last quarter of tax year



Must apply this convention to every asset purchased in
the year
Excludes real property and §179 property
Must use special mid-quarter tables
 Found at major tax service such as Commerce
Clearing House [CCH] or Research Institute of America
[RIA]
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Real Estate

Real assets depreciated based on a recovery
period depending on type of property
 Real assets are depreciated using the
straight-line method with a mid-month
convention (Table 4 on p. 7-12)
 Used for real estate acquired after 1986



Treats all acquisitions/dispositions as occurring
mid-month [mid-month convention]
27.5 years: Residential rental
39 years: Nonresidential
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Election to Expense - §179

§179 allows immediate expensing of qualifying property


For 2007, the annual amount allowed is $125,000
Qualifying property is tangible personal property used in a
business


But not real estate or off-the-shelf computer software
§179 election to expense is limited by 2 things

If cost of qualifying property placed in service in a year >
$500,000, then reduce §179 expense $ for $


For example, if assets purchased in current year =
$600,000, then $100,000 reduction in §179 capability so
limited to $125,000 – 100,000 = $25,000 election to expense
and the remaining 575,000 of basis is depreciated over
assets’ useful lives.
Cannot take §179 expense in excess of taxable
income - may carry forward any unused amount
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Election to Expense - §179


When using with regular MACRS, take §179 first,
then reduce basis to calculate MACRS
For example


In 2007, NanoPaint Inc. placed a seven-year piece of
property into service costing $142,000 when taxable
income = $1.25 million. Total asset purchases =
$217,000. What is total depreciation including election
to expense?
First – claim $125,000 deduction under §179, reduce
basis to $17,000, then multiply by 14.29% MACRS rate
 [125,000] + [17,000 x 14.29%] = $127,429 total
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logo, and South-Western are trademarks used herein under license.