Opener
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Taxation Chapter of Business
Entities, 2012, eBook
3/e
Content
Chapter1: Business Income, Deductions, and Accounting
Methods
Chapter Opener
p. 1
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Learning Objectives
Upon completing this chapter, you should be able to:
Describe the general requirements for deducting business expenses and
identify common business deductions.
Apply the limitations on business deductions to distinguish between
deductible and nondeductible business expenses.
Identify and explain special business deductions specically permitted
under the tax laws.
Explain the concept of an accounting period and describe accounting
periods available to businesses.
Identify and describe accounting methods available to businesses and
apply cash and accrual methods to determine business income and
expense deductions.
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Chapter Opener
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Rick Grime graduated from Texas State University with a degree in agronomy,
and for the past few years he has been employed by a landscape architect in
Dallas. Nearly every day that Rick went to work, he shared ideas with his
employer about improving the business. Rick nally decided to take his ideas
and start his own landscaping business in his hometown of San Antonio, Texas.
In mid-April, Rick left his job and moved his belongings to San Antonio. Once in
town, Rick discovered he had to do a lot of things to start his business. First, he
registered his new business name (Green Acres Landscaping) and established a
bank account for the business. Next, he rented a used sport utility vehicle (SUV)
and a shop for his place of business. Rick didn't know much about accounting for
business activities, so he hired a CPA, Jane Bronson, to help him. Jane and Rick
decided that Green Acres would operate as a sole proprietorship, but Jane
suggested that as the business grew, he might want to consider organizing it as
a different type of legal entity. Operating as a corporation, for instance, would
allow him to invite new investors or business partners to help fund future
expansion. Rick formally started his business on May 1. He spent a lot of time
attracting new customers, and he gured he would hire employees as he needed
them.
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Rick's CPA, Jane, informed him that he needs to select an overall method for of
accounting Green Acres to compute its taxable income. Jane advised Rick to
use the cash method. However, Rick wanted to prepare GAAP nancial
statements and use the accrual method of accounting. He decided that if Green
Acres was going to become a big business, it needed to act like a big business.
Finally, after much discussion, Rick and Jane reached a compromise. For the
rst year, they would track Green Acres' business activities using both the cash
and the accrual methods. In addition, they would also keep GAAP-based books
for nancial purposes. When ling time comes, Rick would decide which method
to use in reporting taxable income. Jane told Rick that he could wait until he led
his tax return to select the accounting method for tax purposes.
This chapter describes the process for determining gross income and deductions
for businesses as opposed to individuals. Keep in mind that the concepts we
discuss in this chapter generally apply to all types of business entities including
sole proprietorships (such as Rick's company, Green Acres), partnerships, hybrid
entities (such as LLCs), S corporations, and C corporations.1 Because Rick is a
sole proprietor, our examples emphasize business income and deductions from
his personal perspective. Proprietors report business income and deductions on
Schedule C of their individual income tax returns. Schedule C income is subject to
both individual income and self-employment taxes. Entities other than sole
proprietorships report income on tax forms separate from the owners' tax returns.
For example, partnerships report taxable income on Form 1065, S corporations
report taxable income on Form 1120S, and C corporations report taxable income
on Form 1120. Of all these entity types, generally only C corporations pay taxes
on their income.
1
Both S corporations and C corporations are incorporated for state law purposes. However, S corporations
are taxed as ow-through entities (S corporation income is taxed to its owners) while C corporations (or
taxable corporations) are taxed as separate taxable entities. Hybrid entities may opt to be taxed as either
ow-through entities or taxable corporations.
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