Chapter Six: Tax Timing Issues

The Tax Year

Chosen implicitly when first return filed, and thereafter need IRS permission to change

Co-ordination of entity and owner tax years

Pass-thru results transfer to owners at the end of the entity year. Potential deferral loophole

Solution #1: mandatory synchronization of entity w/ majority of owners, or if no majority, a "least deferral"

Solution #2: Allow natural business years if deferral <= 3 mos and a tax deposit w/o interest compensates for the deferral benefit

Short years

Short years may occur when entities are created, or when there is a change of year (e.g. fiscal corporation elects to become calendar S-corporation), or due to acquisitions and similar ownership changes

To prevent tax savings from short years interacting w/ progressive rate structure, must "annualize" the tax computation for that year

Accounting method changes

Changes may be due to taxpayer preference, or crossing a threshhold ($10 mm mark, or start to sell inventory) or taxpayer realizes (perhaps as a result of audit) that an incorrect method is being used

IRS permission is required for changes of method

As opposed to correcting an error in the application of a method. IRS may also require method changes as a result of audit

The Sec. 481 adjustment

An income adjustment for the year of the change is needed to prevent double omission or double inclusion of items. Depending on who proposes the change (Tp or IRS or required by law) and the correctness of the old method, the net adjustment may all hit in 1 year, be spread over prior years of the old method, or may be spread forward over up to four years.

The Installment Method

When does the installment method apply?

Seller financing of non-inventory, non-traded, non-recapture assets. In practice, real estate. Is automatic when there's a payment after the year of sale, unless seller elects out on return

How does it work?

Compute a constant fraction = total gain/contract price. Multiply by payment received in year T to determine gain in year T

TG=selling price - sales expenses - adj. basis. Contract price = selling price - liabs assumed by buyer = total amount seller will receive. If debt > basis, ratio is 1 and excess is gain in year of sale

This is applied to principal received on the seller financing, after subtracting stated/imputed interest

What's the effect for the Tp?

The gov't collects tax on the interest, so the deferral is not the primary benefit (unless deferring into low bracket years).

One benefit is seller's liquidity, another is that seller is earning (taxable) interest on a pre-tax amount, not an after-tax amount. If rates are constant, this is the equivalent of exempting the return on the after-tax sale proceeds

The buyer, meanwhile, has debt financed basis

Loophole blocking rules

Related party second dispositions trigger gain - the anti-Rushing Trust rule

Hypothecation of installment receiveables

Sale of depreciable property to controlled entity

Contingent payment rateable basis recovery -- which itself led to the ACM corporate tax shelter

Methods for Contractors

Accrual or Cash (if otherwise eligible)

IRS defeated on attempt to accelerate small contractor receiveables by requiring shift to accrual on theory that they were selling "merchandise"

Completed Contract

Only for certain real estate construction and some small business multiyear contracts

Defer all revenue and cost until the year of completion

Percent of Completion

Generally required for all but small contractors. Include revenue and cost based on estimated % of completion at year end. After its over, there's a lookback and interest is charged/paid on the difference between estimate and retrospective actual.

Inventory Accounting

Review financial acctg inventory formulae:

• Y = Sales - COGS - Overhead/"MG&A", etc.
• COGS = Purchases, labor, etc + opening inventory - closing inventory
• Inventory = cost of goods not yet sold

Y= sales - overhead - purchases, etc +/- changes in inventory, therefore an increase in inventory means an increase in income. Example. Buy 10 items for $10 each. Sell 5 for $20 each. Using the $ to pay for the goods. Income is $50 even though no net cashflow

Cost Accounting for inventories

Prime costing vs full absorbtion. Q of which costs belong in overhead, and which vary with goods sold. Reclassifying MG&A/overhead into purchases, labor etc. increases cost of goods sold, and thus cost of goods not yet sold = inventory

Uniform Capitalization Sec. 263A

Allows IRS by regulation to prescribe cost accounting rules for income tax. The regs. go beyond GAAP "full absorbtion" in reclassifying MG&A, so tend to increase closing inventories. Yet another book-to-tax difference

Required for all mfgrs, other businesses w/ trailing gross over $10mm (potential change in method as business grows.) Farmers are exempt.

Inventory Methods: Flow of Costs Conventions

Costs of inventory can be specifically identified, or abstracted with flow of cost conventions. These treat the flow of costs as a line (FIFO) or as a stack (LIFO). Firms can choose specific identification (if it's possible), FIFO or LIFO to account for inventory costs. Continued example: year 2 bot 10 more items for $15 each. Sell 10 for $25 each. Do the goods sold have year 1 or year 2 costs? What's the cost of the goods not yet sold?

LIFO can save money, but it gets complicated

Saves when old costs are less than current costs, since LIFO uses old costs for of goods not yet sold

Also requires book/tax conformity, w/ SEC required footnote

Example using "simplified" LIFO

The Sec. 474 simplified dollar value single pool method (there are many, many "flavors" of LIFO).

take FIFO "physical" inventory

Use gov't price index to deflate inventory to opening prices (as of start of LIFO)

calculate change in inventory in opening year prices

inflate the change to current year prices

Difference from prior year adds to or draws down a "LIFO layer"