Chapter 7
Accounting Periods & Methods
and Depreciation
©2003 South-Western College Publishing, Cincinnati, Ohio
Objective
Have a general understanding
of the different accounting
periods and methods allowed
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Transparency 7-2
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”
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Tax Years for Partnerships
 Partnerships don’t pay taxes themselves but
must file an informational tax return (1065)
 Tax year must be the same tax year as 50%
of partners
 If partner’s tax years are different, use tax year of
principal owners (principal is 5% or more owner)
or least deferral method
 Otherwise use calendar year
May use fiscal year if it results in a deferral period of no
more than three months
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Tax Year for S Corporations
 S Corporations don’t pay taxes themselves but
must file an informational tax return (1120S)
 They must use a calendar year; however,
 May elect a fiscal year if the S corporation can
demonstrate a business purpose, or
 A fiscal year results in a deferral period of less than
3 months and S corporation agrees to make annual
“required tax payment.”
deferral period = period of time from fiscal year-end to
December 31
required tax payment also applies to fiscal year-end
partnerships
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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.
Calculation
The “required tax payment” =
(cash flow in deferral period x 39.6%) - prior year’s tax payment
Deferral period is 7 months.
$360,000/12 x 7 months = $210,000 cash flow.
($210,000 x 39.6%) - $15,000 = $68,160 deposit due
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Tax Year for Personal Service
Corporation
 A Personal Service Corporation (PSC) is corporation
with shareholder-employee who provides a personal
service (like 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 worth of
salary in beginning nine months. If salaries don’t remain
constant, the PSC can only deduct pro rata amount
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Short Tax Periods
 Occur when taxpayer changes from fiscal
year-end to calendar year-end or visa versa
 Taxpayer must annualize income (see
example in text), calculate tax and then
allocate it to the short period
 At top of tax return must complete: “For Short Tax
Year From _____ to _____”
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Accounting Methods
There are three acceptable accounting methods
 Cash
must use same method
 Hybrid
for tax & books
 Accrual
 Must use one method consistently
 Make an election on your first return by filing using a
particular method
 Must file Form 3115 within first 6 months after initial
election to request permission from IRS to change
accounting methods
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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 < $5M
 Accrual basis taxpayers
 Must report prepaid interest or rent as income when
received (i.e., use cash method)
 Hybrid basis taxpayers
 Cash method but must use accrual for COGS
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Transparency 7-10
Objective
Understand the concept of
depreciation and be able to
calculate depreciation expense
using MACRS tables
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Depreciation (Form 4562)
 Depreciation is a process of allocating the
cost of assets to expense over their useful life
 Land is not depreciated
 Rules for depreciation have changed over the
years
 Pre-1980: depreciated using straight line method
 1980-1986: use ACRS tables
 Post-1986: use MACRS tables
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Personal Property
 Each asset is depreciated according to an IRSspecified recovery period
 3 year
 5 year
Race horses, tractors
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
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Personal Property (continued)
 Depreciation is determined using IRS tables
(Table 2 in text)
 Percentages from tables are based on the doubledeclining balance method of depreciation
Applied to cost basis without regard for estimated
salvage value
 May elect to use tables based on straight line
instead
 Tables include half year convention
1/2 year depreciation in year of acquisition and 1/2 year
depreciation in year of disposition
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Personal Property (continued)
 Always use the half-year convention unless midquarter convention applies
 Assumes asset owned half of year of purchase, regardless
of true purchase date
 Assumes asset owned half of year of disposition, regardless
of true disposition date
 Mid-quarter convention is required if taxpayer
purchases 40% or more of total assets 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
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Personal Property Example
March 15 - purchase furniture for $180,000. Furniture is
a 7-year asset.
Using tables:
Year 1: $180,000 x .1429 = $25,722
Year 2: $180,000 x .2449 = $44,082
November 3 - purchase computer for $12,000. This is a
5-year asset.
Using tables:
Year 1: $12,000 x .20 = $2,400
Year 2: $12,000 x .32 = $3,840
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Bonus Depreciation Property
 Additional depreciation is available for assets
purchased between 9/11/01 and 9/11/04
 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
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Real Property
 Real assets are placed in a recovery period
depending on use
 27.5 year: Residential rental
 39 year: Nonresidential
31.5 year if placed in service before 5/13/93
 Real assets are depreciated using the
straight-line method with a mid-month
convention (Table 4)
 Treats all acquisitions/dispositions as occurring in
the middle of the month
 There is no mid-quarter convention for real estate
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Objective
Know when an election to expense
the cost of an asset may be used
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Election to Expense - Section 179
 §179 allows immediate expensing of qualifying
property
 In 2002, the annual amount allowed is $24,000
 Qualifying property is tangible personal property used in a
business
 §179 limited:
 If cost of qualifying property placed in service in a year
exceeds $200,000, reduce §179 expense dollar for dollar
 Cannot take §179 expense in excess of taxable income, but
may carry forward any unused amount
 If using 30% bonus take §179 first, then 30%, then
regular depreciation.
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Section 179 Example
In July 2002, purchase a tooling machine (7-year asset)
for $39,000. The taxable income from business is
$45,500 and total asset acquisitions for year are
$82,453.
Calculation
Cost
$39,000
§179 expense
(24,000)
Adjusted depreciable basis
$15,000
less 30% bonus
( 4,500)
Remaining depreciable basis
$10,500
x Table %
0.1429
$ 1,500
Total depreciation: $20,000 + $4,500 + $1,500 = $30,000
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Objective
Understand the limitations placed
on depreciation of “listed” property
and luxury automobiles
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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
 If business usage drops from > 50% to < 50%, must claim
excess depreciation as income on Form 4797
 Separate section on page 2 of Form 4562 for listed
property
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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 2001 is:
Year 2001 - $3,060
Year 2002 - $4,900
Year 2003 - $2,950
Year 2004 and subsequent years - $1,775
 Automobiles may be wholly depreciated, it will just take
much longer than five years
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Special First-Year Depreciation for
Automobiles
 Extra depreciation of $4,600 is allowed
 New autos placed in service between 9/11/01 and
9/11/04 and
 Used > 50% for business
 The $4,600 increases the luxury auto limit
 May use 30% Bonus depreciation in addition
to regular depreciation
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Luxury Auto Example
In July 2002, purchase a new automobile (5-year
asset) for $50,000. The automobile was used 60% of
the time for business.
Calculation
30% Bonus depreciation (50,000 X .3)
$15,000
Regular depreciation (50,000 - 15,000).2
7,000
Total
$22,000
Times business use percentage 60%
X .60
Possible depreciation
$13,200
Luxury limitation 60% of ($3,060 + $4,600)
$ 4,596
Total depreciation: $4,596
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Objective
Know the tax treatment for goodwill
and certain other intangible assets
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Intangible Assets
 Section 197 intangible assets (see list in text)
acquired by purchase may be amortized
based on a 15-year period
 Many intangible assets are excluded from Section
197 provisions, for example, may not depreciate
internally generated assets like patent and
copyright
 Must allocate for partial year in year of
acquisition
 Report in separate section of Form 4562
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Objective
Be able to determine whether
parties are classified as related for
tax purposes and understand the
tax treatment of related party
transactions
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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 is later sold to an unrelated party, all
previously disallowed losses may be taken against gain
 §267 also applies to unpaid interest and expenses
between related parties
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Transparency 7-30
The End!
My head hurts!
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