Agenda 315 BA 128A1

1
Agenda 3-15 BA 128A-1

• Questions from lecture
• Form groups
• Review Chapter 1011
• Assignment - I10-27,29,42 I11-44,46
• Additional - I10-24,34, I11-37,51

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Depreciation, Depletion and Amortization

• For assets/property used in trade or business or
  held for production of income
• Disallowed depreciation - personal use assets ,
  indefinite life assets - e.g. land/securities
• Rules -
• before 1981 - same as financial accounting
  standards
• 1981-1986 - ACRS - provide stimulus for
  investment
• After 1986 - MACRS - follow economic useful life
  of assets
• Deduction allowed in year asset place into
  service
• Capitalization vs. Expenses

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Types of property

• Tangibles - land, building, equipment natural
  resources (depletion)
• Intangibles - goodwill (amortization), patents,
  stocks, bonds
• Personal use property
• Personal property - equipment, vehicles,
  furniture
• Real Property - land and structure permanently
  attached to the land

4
Rules

• Conversion of personal use asset to business -
  valued at lesser of adjusted basis or FMV as of
  conversion date
• Pre 1981 - Financial accounting methods of
  depreciation - Straight line, Declining Balance,
  Sum of the years digit
• Useful life determined by experience and business
  practice
• Can elect ADR system (asset depreciation range
  system) for useful life references

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ACRS

• Stimulate private investment, accelerated cost
  recovery system
• Improve business productivity, simplify taxpayer
  compliance and facilitate IRS administration
• Provide great tax benefits
• Personal property - ACRS table or straight line,
  half year convention for 3,5,10,15 recovery
  period, all assets treated as if acquired in the
  mid point of the year, no cost recovery in the
  year of sale/disposition
• Real property - residential/nonresidential real
  property used in trade or business or held for
  the production of income
• recovery periods 15.18.19 years for different
  property acquired at different dates P I10-6
• After 6/22/84, mid month convention is used
• Can elect to use st. line 3- year ACRS can have
  recovery periods of e.g. 3,5,12 years (See page
  I10-6), similar to ACRS, half year convention for
  personal property, mid month for real estate and
  no cost recovery for personal property in year of
  disposition

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MACRS

• Class lives generally lengthened
• No salvage value for both ACRS and MACRS
• Personal property - half year convention,
  conversion to st. line if yields larger amount,
  amount reduced by half in year of disposition,
  recovery period is 3,5,7,10,15 years
• Requires the use of mid-quarter if aggregate
  basis of all personal property in service in the
  last 3 months gt 40 of the cost of all personal
  property placed in service during the tax year
  (exclude section 179 property and property place
  and disposed in the same year) - however this
  does not mean half year convention always yields
  more.
• Disposal calculation needs to be consistent, half
  year or quarter
• May elect straight line, same recovery period or
  use the ADS

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MACRS- real property

• Residential - 27.5 years recovery period, 80 of
  income has to derive from dwelling purpose
• Non-residential, 39 years
• mid-month
• Straight line
• Capital improvements depreciated over its econ.
  life, not the life of the building

8
Alternative depreciation System (ADS)

• Certain property is required or taxpayers can
  elect - property outside the US is required,
  recovery period is much longer
• Use of straight over lengthened period and same
  convention - midyear, month or quarter
• Annual election

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Section 179

• Apply only to tangible personal business property
• 18500 in 1998 in year of acquisition and has to
  be placed in service the same year
• Not applied to real estate
• Election made on annual basis
• Limitations
• cannot be related party transaction
• Phase out gt200,000 property acquired for
• Cannot exceed taxpayers income, excess
  carryforward to unlimited of years, cost basis
  is reduced immediately

10
MACRS restrictions

• gt50 business use, if not, ADS system is used
• MACRS recapture if business use fall below 50,
  excess depreciation included in ordinary income
• Use ADS subsequently even if business gt50 later
• Luxurious automobile restriction, leasing
  restriction

11
Depletion

• Intangible drilling and development costs applies
  to oil, gas and geothermal wells
• Deducted or capitalized
• Amount of depletion claimed each year greater
  of of depletion and cost depletion amounts.
• Methods - cost depletion(units sold) and of
  depletion (15 of gross income)

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Amortization

• Straight line
• Apply to goodwill other purchased intangibles
• Research and experimental expenditures
• Start-up expenditures and others
• Section 197 - acquisition of substantial part of
  business - 15 year amortization period
  -definition of 197 assets PI10-19 (including
  goodwill, licenses, workforce/customer lists

13
Amortization

• Partial disposal of Section 197 assets - no
  recognition of loss allowed - other assets basis
  is increased
• RE expenditures - election - expense in the year
  occurred, defer/amortized the costs. If no
  election - capitalized
• Expense not qualify as RE (table I10-5)
• Capital expenditures in connection with RE
  cannot be expensed
• Amortization commences the month in which
  benefits from the expenditures are realized

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Chapter 11 - Accounting period

• Period to recognize income and expense
• Tax year fiscal year
• If no fiscal year - tax year calendar year
• Tax year determined when first tax return is
  filed, need IRS approval for change
• Partnerships - follow the tax year of majority
  partners, if partners do not have the same tax
  years, use the period that results in the smaller
  deferral of income
• S-corp, PSC - generally use calendar year unless
  there is a business purpose
• Allow tax year to fall on same last day of the
  month or day closest to the end of the month

15
Change in accounting period

• Generally required IRS approval, need a
  substantial business purpose (e.g. natural
  business year)
• Exceptions - newly married spouse, change to
  52-53 weeks with same calendar month, partnership
  changes, corporation (with no accounting change
  in the last 10 years, no NOL, no change in
  corporate status, taxable income from short year
  is gt 90 of preceding full tax year
• Taxpayers changing accounting period have to
  annualize their income - prevent income to be
  taxed at lower rate

16
Accounting methods

• Cash method (no inventory)
• Accrual method (all events and economic tests)
• all events - rights to receive, amount determined
  at reasonable accuracy or liability is
  established for expenses
• economic performance - services/property provided
• Hybrid

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Inventories

• Accounted for using best accounting practice
  (GAAP) or clearly reflect income
• At cost or lower of cost or market
• If use LIFO, cannot use lower of cost or market
• COGM - uniform capitalization method full
  absorption method
• if use LIFO, financial accounting needs to use
  LIFO, other inventory methods allowed to use,
  FIFO, specific identification, avg costs methods
• LIFO - value LIFO, LIFO pools, use government
  price indices for different pools - conversion
  from FIFO to LIFO

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Long Term contracts

• Construction of property/good that cannot be
  completed within the tax year period after it has
  begun
• Methods to account for income
• of completion - (according to of work
  completed)
• completed contract method - (income reported in
  year contract is completed)
• modified of completion - (if cost is hard to
  estimate, recognized income until 10 of costs
  incurred)
• Look back interest adjustments (compare to actual
  costs)
• Costs include DL, DM and OH, indirect costs such
  as selling, marketing, advertising RD can be
  deducted currently, GA expenses and interest
  costs need to be allocated

19
Installment sale

• Installment sale - at least 1 payment is received
  after close of the taxable year in which the
  disposition occurs.
• Not applicable to inventory by dealers and
  publicly traded property
• Computations PI1-17, compute Gross profit,
  contract price and compute gross profit .
  Subject to depreciation recapture and excess
  mortgage

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Installment sale

• Installments as gifts - taxable event - recognize
  gain/loss between face value and adjusted basis
• Repossession of property sold on installment
  basis is a taxable event - recog gain/loss
  between value of repossessed property and
  adjusted basis of installment obligation
• Borrowed funds from installment obligation
• Related party installment sales

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Imputed interest

• Installment basis contract with no interest or
  low rate of interest
• IRS apply rate according to fed government rate
  on borrowed funds
• If principal lt 2.8 million, interest rate
  limited to 9, related party rate limited to 6
• Exemption - personal use property, original issue
  discount (bond), lt 6months due payments
• e.g. compensation related loans, gift loans or
  corporate shareholder loans

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Change in accounting methods

• Requires IRS approval except changing to LIFO
• negative or positive adjustment (e.g. from cash
  to accrual or vice versa)
• involuntary change
• voluntary change
• may spread amount over a period (table I11-5)