1) The question is asking for a 1040, so the taxes in question are personal taxes. No dependents
so there will be 2 exemptions (1 for each member of the couple).
2) The business is unincorporated, in my opinion, the business is likely a sole proprietorship, so
it is not considered a separate entity from John and Ellen Brite. If the business were
incorporated, it would be taxed separately as a corporation and would require form 1120.
3) The old store building would be used to calculate a taxable gain/loss if it were exchanged for
another building. In this case, I don’t see anything that would indicate this amount will be used
in the problem. Some states have business real property taxes, but this question only asks for
federal tax.
4) Land is a similar consideration as the old building. It would be used to calculate gain/loss for
taxes if an exchange occurred.
5) Equipment with 7 year recovery can be used to calculate depreciation for tax purposes.
Taxation uses MACRS (Modified Accelerated Cost Recovery System) to calculate depreciation.
If you search MACRS depreciation, it will take you to the IRS website, which provides tables to
calculate the depreciation. There is a table for property (I believe it has a 39 year life, but it is
subject to interpretation depending on the type of property that this building actually qualifies
as). There are a variety of conventions that are used for tax purposes, and the IRS tables provide
you with depreciation percentages for the various useful lives. MACRS simply accelerates
depreciation for tax purposes so that you reduce current tax liability. Since accelerated
depreciation results in a higher current expense, income and thus tax liability is lowered.
Depreciation from MACRS would be entered as an itemized business expense on the 1040.
Note, to take this deduction, the property needs to be used for business purposes. You would use
the mid-month convention for this depreciation (this is simply saying that you get ½ month of
depreciation in the first month and then the remaining months of the year). See the IRS website
for better descriptions of the conventions (there is really no reasoning behind these
conventions/useful lives, so there is not much of a logical explanation to provide.
6) Equipment gives a 7-year recovery, and you know that it was entered into services on
1/10/2008. This is important because for tax purposes the period of the month/year that the
equipment/property is entered into service determines the MACRS convention used. In this
case, you would use the half-year convention, in my opinion. This just means you treat the
equipment as if it was placed in service at the mid-point of the first year of its life. So in this
case, you would treat it as if it was placed in service on 7/1/2002. Therefore, you would get ½ of
the year 2002 of depreciation. Additionally, should this asset be disposed of, you will take only
½ a year of depreciation (treating it as if it was disposed on at the mid point of the year).
7) The FIFO cost of inventory will establish COGS for sales figures. This will determine
profit/income for tax purposes. You are allowed to use either FIFO or LIFO for tax purposes,
but most companies choose LIFO since it results in a lower net income for tax purposes, because
prices of goods are generally rising.
8) the addition of equipment is going to trigger depreciation as described above. See the IRS
tables for the requisite useful lives for this.
9) There is no gain/loss on the purchase on 3/1/2013, so I don’t really see this as a taxable event.
It will have inventory impacts (from a FIFO perspective) and will impact depreciation. The
building will follow the mid month convention, land is never depreciated, equipment will use the
mid year convention. There are instances when mid quarter conventions may apply, but this
only occurs when 50% of property was acquired in the 1st quarter/other specified regulations. I
think you should be safe with the mid-month for the real property (39 year life) and the mid year
(5 year life) convention for equipment
10) Sale of equipment is going to trigger a taxable event. This will either be a gain or loss on the
sale (this is based on the depreciation method chosen. I am not sure, based on the problem, what
method of depreciation is called for-IRS allows several methods, including 200% declining
balance and 150% declining blance). The gain on this sale, should there be one, would be taxed
as a capital gain. The loss would be considered a capital loss, which can offset other capital
losses. Furthermore, these losses can be carried back 2 years and forward 20 years to offset
previous and future capital losses. Additionally, if this asset (equipment) is considered a section
179 asset, a gain would be taxed as a capital gain, while a loss can offset ordinary losses. This is
a HUGE benefit of section 179 assets, as their gains are taxed at the lower capital gains rates and
their losses can offset ordinary losses, which will result in greater tax savings.
11) The car referenced in the same paragraph as the sale of the asset is deductible as a business
expense (would require the Brites to itemize deductions using a Schedule A). Additionally, the
mileage is partially deductible under IRS regulations. I am not positive of the current deduction
for mileage per the IRS, but it will be on the IRS website.
12) Sale of 8000 light bulbs is where FIFO considerations come in. Based on the acquired
inventory, there are 4000 bulbs at $5, and 3000 lightbulbs at $6. Additionally, there are 1000
bulbs $7 (purchased in august). These prices per inventory will get you to the net income from
selling 8000 bulbs at $15 (this gives you income of 75,000).
13) The other sources of revenue for Brite-On are considered income for the Brites on their 1040
14) Provided the couple itemizes deductions (highly likely given the business expenses), the
personal expenses are deductible on schedule A.
15) Income on savings account of $275 is considered ordinary income. The 5000 estimated
quarterly tax payments will be considered a credit against tax due in the current year (this
$20,000 of estimated payments will be entered as a credit near the end of the 1040).
16) Any income John receives from the business is considered a salary (since he spends 100% of
time there), while any income Ellen receives is not considered salary, it’s just a
distribution/payment.
17) Additional facts will provide some more detail regarding the depreciation considerations
described above.