Chapter
6
Taxable Income from
Business Operations
Taxable Year
Income is reported for the taxpayer’s “taxable year” →
12-month period which generally corresponds to its
fiscal year.
Individual taxpayers must generally choose a calendar year.
Firms often choose a fiscal year corresponding with the
annual operating cycle
Changing tax years requires permission - most common
reason is merger of firms with different year-ends.
Cash Method
Under the cash method, gross income includes cash or
property actually RECEIVED during the tax year.
Deductions are usually taken in the year cash or property is
PAID.
Cash method income includes receipt of noncash goods
Anti-abuse provision: Constructive receipt doctrine.
Means that you can’t “turn your back” on cash income available to
you
Occurs when taxpayer has unrestricted access to and control of the
income. Example: pre-payment receipt of cash you have received
NO constructive receipt if the amount is available only on surrender of
a valuable right, or if there are substantial limits on the right to receive
it.
Exceptions - Cash Method
Cash method - deduct expenses when PAID. A
check is payment when mailed.
An asset must still be capitalized. The cost of
the asset may be recovered over the asset life (e.g.
depreciation, cost of goods sold). Major repairs may
result in IRS dispute regarding expense versus
capitalization.
Inventory must be accounted for on the accrual
method, even for cash basis taxpayers. This is
called a HYBRID method of accounting.
Cash Method Deductions - Prepaid Expenses
Where an expense (e.g., prepaid rent or an
insurance premium) covers more than the following
tax year, the deduction must be spread over the
period to which the expense applies (12 month
rule).
Special rule for prepaid interest—must be
capitalized and deducted over the period for which
interest is actually charged.
Exception for individuals: prepaid interest (points) can be
deducted on the purchase of a home. Does not apply to
refinancing.