CERTIFIED FINANCIAL PLANNER CERTIFICATION
PROFESSIONAL EDUCATION PROGRAM
Income Tax Planning
Session 4
Tax Accounting, Sole
Proprietorships and
Partnerships
©2015, College for Financial Planning, all rights reserved.
Session Details
Module
2
Chapter(s) 1 -3
LOs
2-1
Identify characteristics, advantages, and
disadvantages of the cash or accrual method
of accounting.
2-2
Evaluate a situation to select the most
appropriate method of tax accounting to use.
2-3
Identify an advantage or disadvantage of a
particular method of inventory valuation.
2-4
Explain characteristics, advantages, or
disadvantages of a business form.
4-2
Cash Method of Accounting
• Income recognized when actually received
•
•
•
•
(generally)
Constructive receipt doctrine
Expenses deducted when actually paid
Allows for greater flexibility in timing income
and expenses
May be allowed when
inventories are used if
taxpayer meets “small
business exception”
4-3
Accrual Method of Accounting
• Generally must be used if inventory is a
•
•
material income-producing factor.
Income is recognized when earned—all-events
test must be met.
Expenses deducted when liability is
established—all-events test must be met and,
generally, economic
performance must
have occurred.
4-4
All-Events Test for Accrual Method
Income recognition
• All events must have occurred to fix the right to the
income
• Must be able to estimate with reasonable accuracy
Deduction of expenses
• All events must have occurred to fix the obligation
to pay
• Must be able to estimate with reasonable accuracy
• Economic performance generally must have
occurred
4-5
Other Methods of Accounting
Hybrid method of accounting
• Combines cash and accrual methods of
accounting to reflect the nature of the business
(e.g., inventory and service)
Long-term contract method of accounting
• Contract for manufacture of a unique item
• Not normally carried in ending inventory
• Not completed in tax year contract entered into
• Item usually takes more than 12 months to
complete
4-6
Inventory Valuation Last-In, First-Out (LIFO)
Advantages over FIFO
• Increases COGS when prices are rising
• Improves cash flow when prices are rising
• More current costs matched against
current revenues gives more realistic
financial picture
Disadvantages
• Reduces earning figure when prices are
rising
• Understates ending inventory when prices
are rising
4-7
Inventory Valuation First-In, First-Out (FIFO)
Advantages
• In times of declining prices, matches
higher-priced inventory items against
revenues
• Ending inventory figure represents current
cost (replacement) figure
• Higher earnings figure in time of inflation
Disadvantages
• Higher earnings figure in inflationary times
results in greater tax liability
4-8
Sole Proprietorship
Advantages
• Availability of certain retirement plans
• Applicable tax credits or losses reported on
individual 1040
• No tax consequences on formation or
liquidation
• Conduit entity (no double taxation)
• Self-employed health insurance deduction
Disadvantages
•
•
•
•
Unlimited personal liability
Lack of continuity of life
Capital structure limited
Liable for self-employment tax
4-9
General Partnerships
•
•
•
•
•
•
•
•
•
•
Conduit entity
Joint and several liability
Lack of continuity of life
Limited capital structure
Income recognition on disproportionate distribution of
Section 751 “hot” assets
Occasional income recognition on formation
Ability to use special allocations
Losses deductible only to extent of basis in partnership
Basis = cash plus adjusted basis of property contributed
plus share of debt, plus flow-through of income minus
flow-through of losses and distributions
Partners liable for self-employment tax
4-10
Limited Partnerships
Advantages
• Limited personal liability for limited partners
• Special allocations may allow certain tax
items to flow through to specific partners
Disadvantages
• Service limited partners not allowed
• Limited partners cannot have day-to-day
control
• Must have a general partner
4-11
Self-Employed Health Insurance
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•
•
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•
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Above the line deduction
Sole prop, partner, >2% shareholder in S corp.
No effect on SE income
Health insurance and qualified LTC premiums
Taxpayer, spouse, and children through age 26
Limitations
o No participation in subsidized plan
o Limited to business earned income
o Plan must be in business name (unless sole
proprietorship)
4-12
Review Question 1
Which one of the following is not an advantage
of the cash basis method of accounting?
a. Taxes are not paid until income is received.
b. Taxpayers can keep simple records.
c. Taxpayers can control each year’s receipts
and payouts.
d. Constructive receipt serves to defer income.
4-13
Review Question 2
Under which one of the following circumstances
may the long-term contract method of
accounting be used?
a. The manufacture of an item of inventory,
which consistently takes longer than one
year to complete.
b. The manufacture of a unique item for which
the contract is not completed in the year
into which it is entered.
c. The construction of property for which
payments will be received over more than
one taxable year.
4-14
Review Question 3
Which of the following is a correct statement
regarding the FIFO method of accounting for
inventory?
a. During periods of declining inventory prices,
lower taxable income will result.
b. During periods of increasing inventory
prices, the cost of goods sold (COGS) will be
higher.
c. During periods of increasing inventory
prices, lower taxable income will result.
4-15
Review Question 4
Which one of the following is a correct
statement regarding the LIFO method of
accounting for inventory?
a. During periods of declining inventory prices,
lower taxable income will result.
b. During periods of declining inventory prices,
the cost of goods sold (COGS) will be higher.
c. During periods of increasing inventory
prices, lower taxable income will result.
4-16
Review Question 5
Which one of the following is a non-tax
disadvantage of operating as a sole
proprietorship?
I. inability to raise capital
II. unlimited liability
III. lack of continuity of life
a. I and II only
b. II and III only
c. I, II, and III
4-17
Review Question 6
The partner’s tax basis in his or her interest in a
partnership
a. remains unchanged unless additional capital
is contributed or distributions are made.
b. is increased by his or her share of income
reported by the partnership.
c. remains unchanged until the interest is sold
or otherwise disposed.
4-18
CERTIFIED FINANCIAL PLANNER CERTIFICATION
PROFESSIONAL EDUCATION PROGRAM
Income Tax Planning
Session 4
End of Slides
©2015, College for Financial Planning, all rights reserved.