Tax Accounting Issues
Chapter 8
pp. 263 - 300
2015 National Income
Tax Workbook™
Tax Accounting Issues
p. 263
 Issue 1: Cash & Accrual Methods
 Issue 2: Choosing a Tax Accounting
Method
 Issue 3: Book-Tax Conformity
 Issue 4: Inventories
 Issue 5: UNICAP Rules
 Issue 6: Cost of Goods Sold
 Issue 7: Installment Sale Method
Tax Accounting Issues
p. 263
 Issue 8: Accounting for Soil & Water
Conservation Expenses
 Issue 9: Accounting and Reporting
Rules for Tips
 Issue 10: Changing a Tax Accounting
Method
 Issue 11: Correcting Depreciation
Errors
Issue 1: Cash and Accrual
p. 264
 The two most commonly used tax
accounting methods.
 Taxpayers filing their first tax return
can adopt any permissible method of
tax accounting.
 Once a method has been adopted,
changes typically require IRS consent.
Cash Method - Income
p. 264
 Include income when it is actually or
constructively received.
 Under constructive receipt doctrine, income
may be included before it is actually received if it
is credited to the taxpayer’s account, set apart
for the taxpayer, or otherwise made available to
the taxpayer.
 Income is not constructively received if there is
a substantial limitation or restriction on the
taxpayer’s receipt of the income.
Cash Method - Expenses
p. 265
 Cash method taxpayers typically claim
deductions when they pay expenses.
 However, cash method taxpayers may not be
able to claim a current deduction for expenses
paid for a future accounting period.
 An expense paid by a cash method taxpayer
in advance is deductible only in the year the
service or property that was purchased is
used or consumed.
Capitalized Prepaid Expenses
p. 265
 Prepaid expenses must be capitalized.
 If the expense qualifies under the 12-month rule, a
taxpayer is not required to capitalize prepaid expenses
(although the taxpayer can elect to capitalize such
expenses).
 The 12-month rule applies to:
▪ Amounts paid to create rights or benefits for the
taxpayer that do not extend beyond the earlier of 12
months after the right or benefit begins, OR
▪ The end of the tax year after the tax year in which
payment is made
Application of the 12 Month Rule
(PRACTIONER NOTE)
p. 265
 The 12-month rule is used to determine
whether a prepaid expense can be deducted in
the year the expense is paid.
 It does not affect:
▪ Either the determination of when a liability
has accrued under the accrual method,
▪ OR
▪ The determination of whether the economic
performance test has been met.
Accrual Method - Income
p. 265 - 266
 Accrual method taxpayers include income
when earned.
 Income is considered earned, and included
in gross income, when:
▪ All the events have occurred that fix the
right to receive the income,
▪ AND
▪ The amount of income can be determined
with reasonable accuracy.
Accrual: When not to Include Income?
p. 265 - 266
 Income is not considered earned, and
included in gross income, when:
▪ The amount owed can’t be estimated
accurately,
▪ OR
▪ If there is reasonable certainty that amounts
owed won’t be collected.
Accrual Method: All Events Test
p. 266
 Accrual method taxpayers claim a liability
in the tax year in which:
 1. All the events have occurred that establish
the fact of the liability,
 2. The amount of the liability can be
determined with reasonable accuracy, and
 3. Economic performance has occurred with
respect to the liability.
Economic Performance
p. 266
 3 Scenarios that determine Economic Performance of
when liability arises for a taxpayer:
 1. If the taxpayer receives services from another
person, economic performance occurs when the
services or property is provided.
 2. If the taxpayer uses property, economic performance
occurs ratably over the period of time the taxpayer is
entitled to the use of the property.
 3. If the taxpayer provides services or property to
another person, economic performance occurs as the
taxpayer incurs costs to satisfy the liability.
Recurring Items Exception
p. 266 - 267
 Normally, recurring items are treated as incurred during the
year, even though economic performance has not yet occurred.
 However, the exception applies if all the following occur:
▪ 1. The all events test is met
▪ 2. Economic performance occurs on or before the earlier of the
fifteenth day of the ninth calendar month after the close of that
tax year, or the date of a timely filed return (including
extensions) – thus the 9 month, 15 day deadline
▪ 3. The liability is recurring
▪ 4. Either the amount of the liability is not material, or accruing
the liability in the year in which the all events test is met results in
a better match against income than accruing the liability in the
year of economic performance.
Issue 2: Choosing a Tax Accounting
Method
p. 267
 Some taxpayers are:
▪ Prohibited from using the cash method,
▪ AND
▪ Required to use the accrual method.
 This section reviews the requirements for
selecting a permissible tax accounting
method.
Taxpayers who Cannot use the Cash
Method
p. 267
 I.R.C. § 448(a) prohibits the following
from using the cash method:
▪ C corporations,
▪ Partnerships with a C corporation as a
partner, and
▪ Tax shelters
 This prohibition includes any hybrid
method that includes the cash method.
Taxpayers who cannot use the Cash
Method
p. 267
 Three exceptions in I.R.C allow use of the
cash method by:
▪ 1. Certain farming businesses
▪ 2. Qualified personal service corporations
▪ 3. Taxpayers with average gross receipts
not exceeding $5,000,000.
• “Definition of Small Business per
Chapter 13, p. 562”
Farming Business
p. 267 - 268
 Prohibition on use of the cash method by does
not apply to a farming business.
 Broad exceptions to allow farming businesses
to use cash method in the following scenarios:
▪ Operating as S corporations
▪ Farming corporations that meet a gross
receipts test (under $1,000,000).
▪ Family farming corporations that meet a
gross receipts test (under $25,000,000).
Qualified Personal Service
Corporations (QPSC)
p. 268
 Qualified personal service corporations can use the
cash method of tax accounting, even if they are C
corporations or partnerships with a C corporation
partner.
 A qualified personal service corporation
must meet:
 1. A function test
 AND
 2. An ownership test
QPSC– Function Test
p. 268
 Substantially (95% or more) all of the activities of the personal
service corporation must involve the performance of services in a
qualifying field.
 Qualifying fields are the following:
▪ 1. Health
▪ 2. Law
▪ 3. Engineering
▪ 4. Architecture
▪ 5. Accounting
▪ 6. Actuarial science
▪ 7. Performing arts
▪ 8. Consulting
QPSC– Ownership Test
p. 269
 Substantially all (95% or more) of the stock of the personal
service corporation must be owned directly by employees
performing services for the corporation in a qualifying field.
 Ownership call also be indirect through one or more
partnerships, S corporations, or qualified personal service
corporations that are not tax shelters or partnerships with a C
corporation as a partner.
 The ownership test will also be met if the stock is owned by
retired employees who had formerly performed services
for the corporation in a qualifying field.
QPSC– Ownership After Death of
Employee (PRACTIONER NOTE)
p. 269
 The ownership test will still be met if substantially all of the
stock is owned by:
▪ The estate of an employee or retired employee,
▪ OR
▪ By a person who acquired the stock by reason of the death
of the employee or retired employee
▪ NOTE: The employee or retired employee must have
performed services for the corporation in a qualifying field.
 This exception applies only to the 2-year period beginning
on the date of the death of the employee.
QPSC– Ownership After Death of
Employee (PRACTIONER NOTE)
p. 269
 The ownership test will still be met if substantially all of the
stock is owned by:
▪ The estate of an employee or retired employee,
▪ OR
▪ By a person who acquired the stock by reason of the death
of the employee or retired employee
▪ NOTE: The employee or retired employee must have
performed services for the corporation in a qualifying field.
 This exception applies only to the 2-year period beginning
on the date of the death of the employee.
Entities with Gross Receipts of Not
More than $5,000,000
p. 269
 C corporations and partnerships with a C corporation partner
can use the cash method of tax accounting if the average
annual gross receipts of the entity for the 3 previous tax years
does not exceed $5,000,000.
 If an entity has not been in existence for the preceding 3-year
period, the gross receipts test is applied for the time that the
entity (or trade or business) has been in existence.
Other Restrictions on Method on
Accounting
p. 269 - 270
 Special Rule for Inventories
▪ Taxpayers are required to use the accrual method for sales and
purchases of merchandise if it is necessary to use an inventory.
▪ It is necessary to use an inventory if the production, purchase,
or sale of merchandise of any kind is an income-producing
factor.
 Clear Reflection of Income
▪ The taxpayer’s choice of tax accounting method must be a
permissible method, and it also has to clearly reflect income.
▪ An accounting method clearly reflects income if it is consistent.
▪ Consistency includes both use of the same method from year to
year and use of the same method for income and expenses.
Issue 3: Book-Tax Conformity
p. 270
 This section explains whether a taxpayer has to use the
same methods of accounting for calculating taxes and for
managing its business.
 IRC (Internal Revenue Code) 466 requires use of the same
accounting methods for tax reporting and for bookkeeping
(book-tax conformity).
 HOWEVER,
 Courts and IRS administrative guidance have frequently held
that tax reporting methods can differ from financial accounting
methods.
Issue 3: Book-Tax Conformity
p. 270
 Courts have considered the objectives of financial and tax
accounting, which are very different.
 A primary goal of financial accounting is to provide useful
information to management, shareholders, creditors, and
other interested persons.
 A primary goal of tax accounting is the equitable collection
of revenue.
Issue 3: Book-Tax Conformity
p. 270
 Differences in book and tax accounting methods have been
allowed if a taxpayer’s books contain records and data that
allow reconciliation of the differences between a taxpayer’s
return and its books.
 EXAMPLE:
▪ IRS held that a corporation that maintained its books on the
accrual method could file income tax returns on the cash
method.
▪ Book-tax conformity was not required because the
taxpayer’s books and records clearly showed the
adjustments made to convert its books to the cash method.
Accounting Methods Must Clearly
Reflect Income (PRACTIONER NOTE)
p. 270
 Variations between tax reporting and financial
accounting methods have been allowed only if the
taxpayer’s method of tax accounting clearly reflects
income.
 All items of income and expense have to be
treated the same every year.
 A combination of tax accounting methods is allowed
if it is used consistently.
Electronic Records
(PRACTIONER NOTE)
p. 271
 In an examination the IRS may request a copy of the
taxpayer’s electronic files, including files created by
accounting software and the accompanying metadata.
 If those records are prepared on the accrual basis, and the
taxpayer uses the cash method for federal income tax
purposes, the taxpayer must be able to reconcile the two
methods.
 The taxpayer may also have to reconcile book income with
tax income on Form 1120, U.S Corporation Income Tax
Return, Schedule M-1 Reconciliation of Income (Loss) per
Books With Income Per Return.
Issue 4: Inventories
p. 271
 This section describes:
 1. When taxpayers are required to keep
inventories.
 2. Whether those taxpayers are required to use
the accrual method.
 3. How to identify and value inventory.
Issue 4: Inventories
p. 271
 If a taxpayer produces, purchases, or sells
merchandise in its business, the taxpayer
must keep an inventory.
 The taxpayer must use the accrual method
for purchases and sales of merchandise.
Rev Procedure 2001-10 – Qualifying
Taxpayer
p. 271
 A qualifying taxpayer can use the cash
method even if the taxpayer produces,
purchases, or sells merchandise.
 A taxpayer must meet 2 requirements:
▪ 1. Average annual gross receipts must be
$1,000,000 or less.
▪ 2. The taxpayer cannot be a tax shelter.
Treatment of Inventory
p. 271
 Qualifying taxpayers that do not want to keep
an inventory must treat inventoriable items in
the same manner as materials and supplies
that are not incidental.
 Examples of inventoriable items are:
▪ Merchandise purchased for resale.
▪ Raw materials purchased for use in
producing finished goods.
Qualifying Small Business Taxpayer
p. 271 - 272
 A qualifying small business taxpayer can use the cash method of
accounting even if the taxpayer produces, purchases, or sells
merchandise, and is required to keep inventories.
 A qualifying small business taxpayer must meet three
requirements:
▪ 1. Average annual gross receipts cannot be more than
$10,000,000.
▪ 2. The taxpayer cannot be prohibited from using the cash
method under I.R.C. § 448.
▪ 3. The taxpayer’s principal business activity has to be an
eligible business (see next slide for list of ineligible principal
business activities.)
Ineligible Principal Business Activities
p. 272
 1. Mining Activities (Code 21)
 2. Manufacturing Activities (Codes 31 –
33)
 3. Wholesale Trade (Code 42)
 4. Retail Trade (Codes 44 – 45)
 5. Information Industries (Code 51)
Identification of Inventory
p. 272 - 273
 FIFO (First in, First Out) Method
▪ The items purchased or produced first are the first items
sold, consumed, or otherwise disposed of.
▪ The items in inventory at the end of the tax year are
matched with the costs of similar items that were most
recently purchased or produced.
 LIFO (Last In, First Out) Method
▪ Items of inventory purchased or produced last are the
first items sold, consumed, or otherwise disposed of.
▪ Items included in closing inventory are considered to be
from the opening inventory in the order of acquisition and
from those acquired during the tax year.
Valuation of Inventory
p. 273
 Cost Method
 Includes all direct and indirect costs associated with the
inventory item.
 Cost means the invoice price minus any trade or other
discounts. (Transportation is added to the invoice price.)
 Includes: Raw Materials & Supplies, Direct Labor & Indirect
production costs.
 Lower of Cost or Market
 Compares the market value of each inventory item with its
cost and uses the lower of the two as the inventory value.
 Market value: Market price of each of the costs allocable to
the goods being valued.
Inventory and Uniform Capitalization
Rules
p. 273
 Treas. Reg. § 1.263A-7 requires a taxpayer using inventories
to adopt the Uniform Capitalization (UNICAP) rules.
 In the first year of adoption, the UNICAP rules are applied to
revalue all inventory costs accumulated in prior years.
 I.R.C. § 481(a) requires an adjustment equal to the difference
between the original value of the inventory and the revalued
inventory.
Issue 5: UNICAP Rules
p. 274
 This section reviews:
 1. The activities that are subject to the UNICAP rules.
 2. The costs that have to be capitalized under the
UNICAP rules.
 3. How those costs are allocated.
Issue 5: UNICAP Rules
p. 274
 UNICAP rules require capitalization of the direct
costs and a portion of indirect costs to produce:
▪ To produce certain real property or tangible
personal property,
▪ AND
▪ To acquire certain property for resale.
Issue 5: UNICAP Rules
p. 274
 For property that is inventory, capitalize means
that the costs are included in inventory costs.
 For self-constructed assets capitalize means that
the cost is added to basis.
The activities that are subject to the
UNICAP rules.
p. 274
 The UNICAP rules apply to real property and tangible
personal property that is:
 Property produced by a taxpayer,
 AND
 To the acquisition of property that is inventory or
other property held primarily for sale to customers.
The activities that are subject to the
UNICAP rules.
p. 274








Examples of tangible personal property:
1. Films
2. Sound recordings
3. Videotapes
4. Books
5. Artwork
6. Photographs
7. Similar property containing words, ideas, concepts,
images, or sounds
The activities that are subject to the
UNICAP rules.
p. 274
 Tangible personal property does not include property that is
representative or evidence of value.
 Examples of these types of tangible personal property:
 1. Stock and securities
 2. Debt instruments
 3. Mortgages or loans
Activities that are not subject to the
UNICAP rules.
p. 274 - 275
 There are a number of activities that are
excluded from the application of the UNICAP
rules.
 Pages 274 to 275 of the 2015 Tax Workbook
lists 14 examples of excluded activities to the
UNICAP rules.
Capitalize Direct Costs
p. 275
 The taxpayer is required to capitalize all direct
costs incurred to produce or acquire real or
tangible personal property.
 Direct costs are the direct costs of materials and
labor.
 For a taxpayer who acquires property for resale, the
direct costs are the acquisition costs of the property.
Capitalize Indirect Costs
p. 275 - 276
 Indirect costs are all costs other than direct material
costs and direct labor costs (in the case of property
produced) or acquisition costs (in the case of property
acquired for resale).
 Taxpayers must capitalize all indirect costs that are
allocable to property produced or property acquired for
resale.
 See Figure 8.3 on page 276 for a list of several common
indirect expenses.
Indirect Service Costs
p. 275 - 277
 Capitalizable indirect service costs are those that directly
benefit or are incurred by reason of the performance of the
production or resale activities of the taxpayer.
 A portion of these costs has to be capitalized.
 See page 277 for a list of capitalizable indirect service
costs.
 Mixed Service Costs: Indirect service costs that are
partially allocable to production or resale activities and
partially allocable to nonproduction or non-resale activities.
▪ Mixed service costs are allocated separately from other
costs.
UNICAP Rules for Farming
p. 277 - 279
 UNICAP rules apply to property produced in a
farming business, and the taxpayer is required to
capitalize direct costs and a portion of indirect costs
incurred in the raising or growing of plants and
animals.
 UNICAP does not apply to some farming businesses.
 See pages 277 to 279 for an in depth review of the
UNICAP rules regarding Farming Businesses.
Allocation of Costs
p. 279
 After costs have been identified, they have to be
allocated.
 Once the cost attributable to production and resale
activities has been determined, that cost must be
allocated between cost of goods sold (the cost of
inventory sold during the year) and ending inventory.
Change in Allocation Method
(PRACTIONER NOTE)
p. 280
 A change in the method or base used to allocate
service costs or a change in the taxpayer’s
determination of what functions or departments of the
taxpayer are to be allocated, is a change in method
of accounting.
 The taxpayer has to obtain IRS
consent to the change!
Allocate to Ending Inventory
p. 280
 If the taxpayer keeps an inventory:
▪ The direct and indirect costs of property
produced or property acquired for resale
have to be further allocated between:
• Cost of Goods Sold (COGS)
• AND
• Ending Inventory.
Issue 6: Cost of Goods Sold (COGS)
p. 281
 Cost of Goods Sold (COGS) represents:
▪ The cost to produce or acquire inventory that
has been sold to customers.
▪ In Addition,
▪ Manufacturers and merchants calculate cost
of goods sold to offset receipts from the sale
of those goods.
Issue 6: Cost of Goods Sold (COGS)
p. 281
 COGS is calculated as:
 Beginning inventory
 PLUS
 Production and acquisition costs incurred
during the year
 MINUS
 The closing inventory.
Calculate Beginning Inventory for
COGS
p. 281
 Merchant:
▪ Beginning inventory is the cost of
merchandise on hand at the beginning of the
year.
 Manufacturer or Producer:
▪ Beginning inventory is the cost of raw
materials and supplies, work in process, and
finished goods on hand at the beginning of
the year.
Add Purchases to COGS
p. 281
 Merchant:
▪ Add the cost of all merchandise they bought
for sale during the year
 Manufacturer or Producer:
▪ Add the cost of all raw materials or parts
purchased for manufacture into a finished
product.
COGS: Additional Manufacturing
Costs
p. 281 - 282
 Labor:
▪ Both the direct and indirect labor used in
fabricating raw materials into a finished product.
 Materials & Supplies:
▪ Directly and indirectly used in manufacturing goods
 Other Costs:
▪ If they are direct and necessary expenses of the
resale, manufacturing, or mining operation.
Subtract Inventory at End of Year
p. 282
 Merchant, Manufacturer or Producer:
▪ Subtract the value of inventory on hand at the end
of the year
▪ This includes the portion of the cost that have been
allocated to ending inventory of:
• Raw materials and supplies,
• Labor,
• Overhead expenses.
No Limit on Cost of Good Sold
(PRACTIONER NOTE)
p. 282
 Cost of Goods Sold (COGS) is an
adjustment, not a deduction, and
therefore it is not subject to the limitations
on deductions found in I.R.C. § 162.
Issue 7: Installment Sale Method
p. 282
 This section explains:
▪ When the installment method can be
used
▪ How income is calculated under the
installment sale method,
▪ The special rules for dispositions to
related parties
▪ The dispositions of depreciable property.
Issue 7: Installment Sale Method
p. 282
 The IRC 453 provides a special reporting method
for installment sales.
 An installment sale:
▪ A disposition of property in which at least one
payment is to be received after the close of the tax
year in which the disposition occurs.
 The installment sale method defers recognition of
gain to the tax year when payment is received.
Dealer Dispositions
p. 282 - 283
 The installment sale method cannot be used for dealer
dispositions.
 Dealer Dispositions means:
▪ Any disposition of personal property by a person who
regularly sells or otherwise disposes of personal property of
the same type on the installment plan
▪ Any disposition of real property that is held by the
taxpayer for sale to customers in the ordinary course of the
taxpayer’s trade or business
 Dealer Dispositions does not include:
▪ A disposition on the installment plan of any property used
or produced in the trade or business of farming.
Sales of Inventory
(PLANNING POINTER) p. 283
 The installment sale method cannot be used for sales of
inventory.
 So, when selling a business, the taxpayer should make sure
that the sale agreement separately allocates a value to
inventory.
 If the taxpayer does not allocate a value to inventory, the
IRS can allocate a portion of the sale price to inventory and
disallow the installment sale method for that portion of the
sale price allocated to inventory.
 Use IRS Form 8594, Asset Acquisition Statement, to
allocate a portion of the sale price to inventory.
Calculation of Income under the
Installment Method
p. 283
 Income is recognized as amounts are paid.
 Income recognized in a tax year is a
proportionate share of income realized or to be
realized on the total contract price.
Electing Out of the Installment
Method
p. 283
 Installment sale method automatically applies unless the
taxpayer elects out of the installment method.
 If the taxpayer elects out of the installment method, all gain on
the disposition is taxed in the year of sale, even for cash
method taxpayers.
 The election is made by reporting the entire amount of
gain in the year of sale.
 The election must be made on or before the due date
(including extensions) for filing the taxpayer’s tax return for the
tax year in which the disposition occurs.
Disposition to Related Persons
p. 283 - 284
 1st Disposition: A person disposes of property to a related
person.
 BUT
 Before the person making the 1st disposition receives all
payments owed on the 1st disposition,
 The related person disposes of the property (the 2nd
disposition), then the amount realized on the 2nd disposition is
treated as received at the time of the 2nd disposition by the
person making the 1st disposition.
 The rule doesn’t apply if the 2nd disposition is more than 2 years
after the date of the 1st disposition.
 Exceptions apply to transfers of stock to the issuing corporation,
compulsory or involuntary conversions, and transfers on death.
Sale of Depreciable Property to a
Related Person
p. 284
 If a taxpayer sells depreciable property to related persons,
the installment method does not apply.
 Instead, all payments to be received are considered received
in the year of sale.
 There is an exception for a sale of depreciable property to a
related person if no significant tax deferral benefit is derived
from the sale.
 To qualify for the exception, the taxpayer must show that
avoidance of federal income tax was not one of the
principal purposes of the sale.
Sale of Depreciable Property to a
Related Person
p. 284
 A related person includes the following:
▪ 1. A person and all controlled entities with respect to that
person.
▪ 2. A taxpayer and any trust in which such taxpayer (or his
or her spouse) is a beneficiary, unless that beneficiary’s
interest in the trust is a remote contingent interest.
▪ 3. Except in the case of a sale or exchange in satisfaction
of a pecuniary bequest, an executor of an estate and a
beneficiary of that estate.
▪ 4. Two or more partnerships in which the same person
owns, directly or indirectly, more than 50% of the capital
interests or the profits interests.
Individuals are not Related Parties
p. 284
 The I.R.C. § 1239(c) definition of related parties does not
include individuals.
 Therefore, family members are not related parties for
purposes of the rule that prohibits installment reporting for the
sale of depreciable assets.
 EXAMPLE: Parents can use the installment method to report
gain from the sale of depreciable livestock to their children.
Recapture Income
p. 284
 Recapture income has to be fully recognized in
the year of the disposition
 IN ADDITION,
 Gain in excess of the recapture income can be
taken into account under the installment
method.
Issue 8: Accounting for Soil & Water
Conservation Expenses
p. 285 - 286
 I.R.C. § 175 allows a deduction for soil and
water conservation expenses.
 Provides farmers a deduction for soil or water
conservation expenditures that do not give rise
to a deduction for depreciation, and that are
not otherwise deductible.
 The amount of the deduction is limited to 25%
of the taxpayer’s gross annual income from
farming.
Issue 9: Accounting and Reporting
Rules for Tips
p. 286
 This section explains how to:
▪ Distinguish between tips and service
charges.
▪ AND
▪ Discusses the withholding and reporting
rules for tips and service charges.
Issue 9: Accounting and Reporting
Rules for Tips
p. 286
 Direct and indirect cash tips totaling less than
$20 in a calendar month are excluded from the
definition of wages for FICA purposes.
 Noncash tips from customers are also not wages
for FICA tax purposes.
▪ Examples: Tips received by an employee in a
medium other than cash, such as passes, tickets,
or other goods or commodities.
Issue 9: Accounting and Reporting
Rules for Tips
p. 286
 But all direct and indirect cash tips (regardless of
the amount), and all noncash tips, are:
▪ Included in an employee’s gross income,
▪ AND
▪ Subject to federal income taxes.
Issue 9: Accounting and Reporting
Rules for Tips
p. 286
 Employees who receive $20 or more direct and
indirect cash tips in a calendar month must:
▪ Report all direct and indirect cash tips for the
month to their employer,
▪ AND
▪ Those tips are subject to FICA and federal
income tax withholding.
Issue 9: Accounting and Reporting
Rules for Tips
p. 286
 Direct Tips: Cash tips received from customers and
tips paid electronically.
▪ Examples: Waiters, waitresses, bartenders, and
hairstylists
 Indirect Tips: Cash tips received from other
employees through a tip-pool, tip-splitting, or other
tip-sharing arrangement.
▪ Examples: Bussers, bartenders, cooks, and salon
shampooers.
Tip or Service Charge
p. 286
 Service charges paid to an employee are non-tip
wages.
▪ Automatic gratuities are service charges.
▪ These non-tip wages are subject to social security
tax, Medicare tax, and federal income tax
withholding.
 Tips are discretionary (optional or extra) payments,
and the amount of a tip is determined by the
customer.
Employer Accounting & Reporting
Obligations with Tips
p. 287
 Tips received by an employee in the course of the
employee’s employment are:
▪ Considered remuneration for that employment
▪ AND
▪ Are deemed to have been paid by the employer for
purposes of calculating the employer’s share of
social security and Medicare tax owed.
Employer Accounting & Reporting
Obligations with Tips
p. 287
 The IRC requires the employer to pay:
▪ Social security tax on the cash tips received by
the employee, up to and including the contribution
and benefit base,
▪ AND
▪ Medicare tax on all cash tips received by the
employee.
Employer Liability on Unreported
Tips (PRACTIONER NOTE)
p. 287 - 288
 Employers are not liable to withhold and pay the employee’s
share of FICA taxes on unreported tips.
 The employer is not required to pay the employer’s share
of FICA taxes on the unreported amount………..
 UNTIL………..
 The employer receives notice and demand from the IRS.
▪ The IRS must send the employer a pre-notice Letter 3264
at least 30 days prior to issuing the section 3121(q) notice
and demand.
▪ The pre-notice: Intended to notify the employer of the
FICA tax liability & to allow the employer adequate time to
gather the necessary funds and make a timely tax deposit.
Employee Accounting & Reporting
Obligation for Tips
p. 288
 The employee must report tips in a written statement
furnished to the employer on or before the tenth day of the
month following the month in which the tips were received.
 If the employer does not have a specific form, the employee
can use Form 4070, Employee’s Report of Tips to Employer.
 If an employee fails to report tips to his or her employer, the
employee is liable for the employee’s share of FICA taxes on
the unreported tips.
 The IRC imposes a penalty for failure to report tips to the
employer:
▪ The penalty is up to 50% of the employee’s share of FICA
taxes on the unreported tips.
Tips and Independent Contractors
(PRACTIONER NOTE)
p. 288
 Independent contractors report their tips as
gross income.
 Example: Hair salon booth renters
Reporting Service Charges
p. 289
 Employers report service charges as non-tip wages
paid to the employee.
 Some employers keep a portion of the service
charges.
 Only the amounts distributed to employees are
non-tip wages.
 The employer must withhold taxes on the service
charges that are distributed to employees and treat
the service charge the same as regular wages for
tax-filing requirements.
Large Food & Beverage Establishments
(PRACTIONER NOTE)
p. 289
 Special withholding and reporting rules apply to
employers who operate large food and beverage
establishments (more than 10 employees).
 These employers must allocate tips among their
tipped employees who report tips that are less than a
specified percentage of sales.
Issue 10: Changing a Tax Accounting Method
p. 289
 This section examines:
▪ What changes constitute a change in accounting
method.
▪ What approval is necessary to change a method
of accounting.
▪ What adjustments that may be required by a
change in method of accounting.
Issue 10: Changing a Tax Accounting Method
p. 289
 Taxpayers choose a method of tax accounting
when they first file a return.
 Subsequent changes in method of accounting
typically require IRS approval.
 Although a taxpayer generally cannot retroactively
adopt a new method of accounting by filing an
amended return, if the taxpayer’s first return used
an improper method, the IRS allows the taxpayer to
change to a proper method prior to filing the next
year’s return.
What Constitutes a Change in Tax
Accounting Method?
p. 289
 1. A change from the cash method to the accrual
method, or vice versa.
 2. A change involving the method or basis used to
value or identify inventories.
 3. A change from the cash or accrual method to a longterm contract method, or vice versa.
 4. Certain changes in computing depreciation or
amortization
 5. A change involving the adoption, use, or
discontinuance of any other specialized method of
computing taxable income
Automatic Consent or Advance Consent
p. 290
 There are two procedures to obtain IRS approval of a
change in method of accounting and both procedures require
filing IRS Form 3115, Application for Change in Accounting
Method.
 1. Automatic consent procedure
▪ Filing fee? NO
▪ IRS Review of Form 3115 Before Consent granted? NO
 2. Advance consent procedure (Non-Automatic)
▪ Filing fee? YES
▪ IRS Review of Form 3115 Before Consent granted? YES
▪ NOTE: IRS reviews Form 3115 and issues a consent letter.
Revenue Procedure (Rev Proc) 2015-20
p. 290 - 292
 Permits small business taxpayers to make certain changes in
methods of accounting using the cutoff method, and without
filing Form 3115.
 Unless it is extended, the waiver of the requirement to file
Form 3115 applies only to the first tax year beginning on or
after January 1, 2014.
 See page 291 of the 2015 Tax Workbook for an extensive
detailing of the changes allowed in tax accounting from Rev
Proc 2015-20.
Audit Protection
(PLANNING POINTER)
p. 292
 Most changes in methods of accounting made by filing
Form 3115 are granted with audit protection.
 The taxpayer is not required to change an improper method of
accounting for the same item in a prior year.
 Audit protection for prior years is not provided for changes
in accounting methods using the cutoff method under Rev.
Proc. 2015- 20.
 Therefore, some taxpayers may still want to file Form 3115
to make a change in a method of accounting, and receive
audit protection for prior years.
Issue 11: Correcting Depreciation Errors
p. 292 - 294
 This section describes the two methods to correct
depreciation errors and when they can be used:
 1. Amending the Return
▪ If you were incorrect in calculating depreciation for only 1
tax year, or failed to claim depreciation for only 1 tax year,
you must complete an amended return to correct the error.
 2. File Form 3115 (Application for Change in Acc. Method)
▪ If you were incorrect in calculating depreciation for 2 or
more years, you must correct it by filing Form 3115.
Closed Tax Year
(PRACTIONER NOTE)
p. 294
 If depreciation deductions were missed in a closed
tax year, the return cannot be amended.
 BUT
 The taxpayer can file Form 3115 and claim the
section 481(a) adjustment to get the benefit of the
missed depreciation deductions.
Filing Form 3115
p. 294
 Form 3115 must be filed in duplicate.
 The original is filed with the taxpayer’s tax return in the
year of the change, and a copy must be filed with the IRS
prior to filing the tax return.
 The IRS does not send a notice of acceptance of an
automatic change request.
 Generally, a separate Form 3115 must be filed for each
accounting method change.
Depreciation Corrections: Q&A
p. 300
 Question 1
 I failed to take a depreciation deduction on an asset I am
selling this year. Can I correct this mistake?
Depreciation Corrections: Q&A
p. 300
 Question 1
 I failed to take a depreciation deduction on an asset I am
selling this year. Can I correct this mistake?
 Answer 1: YES
 If you owned the asset for more than 1 tax year, you must file
Form 3115 to change your method of accounting.
 If the missed deduction was for only 1 tax year, file an
amended return for last year.
 NOTE: If you do not correct this error in the year of the sale or
before, you cannot file Form 3115 to correct this mistake in the
future.
Depreciation Corrections: Q&A
p. 300
 Question 2
 I made a math error in calculating my depreciation for the last
4 tax years. How do I correct this error?
Depreciation Corrections: Q&A
p. 300
 Question 2
 I made a math error in calculating my depreciation for the last
4 tax years. How do I correct this error?
 Answer 2
 This is not a change of accounting method, so you must
amend all open tax years.
 Assuming the last 3 years are still open, you can correct those
years by amending the returns,
 BUT
 You will not be able to correct the return filed 4 years ago.
Depreciation Corrections: Q&A
p. 300
 Question 3
 For the last 5 years I depreciated the same asset twice on my depreciation
schedule. How do I correct this error?
Depreciation Corrections: Q&A
p. 300
 Question 3
 For the last 5 years I depreciated the same asset twice on my depreciation
schedule. How do I correct this error?
 Answer 3
 Because this error affects more than 1 tax year, you must file Form 3115
and make a positive adjustment to income.
 NOTE:
▪ If the adjustment is under $50,000:
• You can make the entire adjustment in the year of the change or
spread the adjustment over 4 years, beginning with the year of
change.
▪ If the adjustment is $50,000 or more:
• You must spread the adjustment over 4 years.
Tax Accounting Issues – Chapter 8
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