students2009-Ch05 part 4 method change

students2009-Ch05 part 4 method change - Changes In...

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Unformatted text preview: Changes In Accounting Methods & Periods GENERAL RULE – Accounting methods and periods generally are, once elected, irrevocable CHANGE IN ACCOUNTING PERIOD – File Form 1128. CHANGE IN ACCOUNTING METHOD – File Form 3115. 1 Change of Accounting Method Why change method? Involuntary change forced by IRS Voluntary changes Must receive permission from IRS, even if change is from impermissible method. Why? • Possible omission of income • Possible duplication of expenses 2 Taxable Income Change of Accounting Method Example: • 2006 business on cash basis • 2006 earns income • 2007 bills client and switches to accrual • 2007 receives • Result – – – No income in 2006 since on cash method and didn’t receive No income in 2007 since on accrual method and earned in 2006 Magic! Change of Accounting Method: Permission to change required Why? To eliminate omission of income and duplication of deductions, must ask permission to change. Permission normally granted if the taxpayer agrees to report the omitted income or eliminate the double deduction that otherwise results. 5 Change of Accounting Method: § 481(a) adjustment Insures no omission of income Insures no duplication of deduction Covers cumulative effect of change Adjustment period 4 years for voluntary change Negative adjustments included all in the year of the change. Procedural rules favor voluntary changes 6 Example of Sec. 481(a) Adjustment Involuntary change 7 Problem 5-33: Change in Method Accounts receivable Inventory balance Income Accounts payable § 481 Adjustment 70,000 130,000 200,000 (20,000) $180,000 8 Example of Sec. 481(a) Adjustment Taxpayer has been using cash method Used cash method through 2001 Year of change is 2002, first year of accrual method 9 Example of Sec. 481(a) Adjustment End of year 2001 (year prior to change) Accounts receivable (income not reported using cash method) $150,000 PRO IRS 70,000 PRO IRS (72,000) PRO Taxpayer $148,000 Inventories (expensed using cash method) Accounts payable (expenses not reported using cash method) Overall cumulative effect 10 Example of Sec. 481(a) Adjustment Involuntary Change later audit in 2004 Assume change is forced by IRS at time of Taxpayer must absorb 2002 (year of change) (year of change) all effects of change in $148,000 additional taxable income (150+70-72) in 2002 Interest, penalties, etc. have already run for 2 years 11 Example of Sec. 481(a) Adjustment Voluntary change 12 Example of Sec. 481(a) Adjustment Voluntary change and IRS approves Alternatively if file Form 3115 within 2002 Sec. 481(a) adjustment is spread over 4 yrs ($148,000/4 = $37,000) Taxpayer includes $37,000 per year in 2002, 2003, 2004 and 2005 (instead of $148,000) 13 Example of Sec. 481(a) Adjustment Voluntary change (cont.) Generally 4 year forward spread is mandatory Taxpayer may elect to include all in year of change, if total adjustment is $25,000 or less Negative adjustments may be included all in the year of the change. Note that cumulative effect may be positive (income) or negative (deduction) 14 Example of Sec. 481(a) Adjustment Involuntary Change Assume that the change is forced by IRS at time of later audit in 2004 Taxpayer must absorb all effects of change in year of change, 2002 $148,000 additional taxable income Interest, penalties, etc. have already run for 2 years 15 Example of Sec. 481(a) Adjustment Voluntary Change Alternatively assume taxpayer files Form 3115 within 2002, and IRS approves Sec. 481(a) adjustment is spread over 4 years. ($148,000/4 = $37,000) Thus taxpayer includes $37,000 per year in 2002, 2003, 2004 and 2005. 16 Example of Sec. 481(a) Adjustment Voluntary Change Generally 4 year forward spread is mandatory However, taxpayer may elect to include all in year of change, if total adjustment is $25,000 or less Negative adjustments included all in the year of the change. Note that cumulative effect may be positive (income) or negative (deduction) 17 Change of Accounting Method: Obtaining permission to change Must File Form 3115 Must file in year for which change is desired 18 19 Identification of the Taxpayer WHO IS THE TAXPAYER? WHO REPORTS THE INCOME? 20 Lucas v. Earl 2 USTC 496, 281 U.S. 111 (USSC, 1930) The taxpayer, Guy C. Earl, and his wife entered into a contract in 1901 agreeing that 1901 “any property either of us now has or may hereafter acquire in any way, either by earnings (including salaries, fees, etc.) or any rights by contract or otherwise, during the existence of our marriage, or which we or either of us may receive by gift, bequest, devise, or inheritance, and all the proceeds, issues, and profits of any and all such property shall be treated and considered, and hereby is declared to be received, held, taken, and owned by us as joint tenants, and not otherwise, with the right of survivorship.” Board of Tax Appeals (Tax Court) agrees with IRS CA-9 reversed. Supreme Court in 1930 says…. 21 Lucas v. Earl 2 USTC 496, 281 U.S. 111 (USSC, 1930) Justice Holmes for the Supreme Court There is no doubt that the statute could [have been written to] tax salaries to those who earned them and provide that the tax could not be escaped by anticipatory arrangements and contracts however skillfully devised to prevent the salary when paid from vesting even for a second in the man who earned it. [However,] That seems to us the import of the statute before us and we think that no distinction can be taken according to the motives leading to the arrangement by which the fruits are attributed to a different tree from that on which they grew. 22 Assignments of Income The Fruit of the Tree Doctrine 23 Identification of the Taxpayer Income from personal services Assignment of income doctrine Income taxed to the person who earns the income since he controls the source. Cannot arbitrarily assign income earned by the taxpayer to another through contract or otherwise 24 Identification of the Taxpayer Income from property Income taxed to owner of the property Shift income by shifting ownership of property 25 Interest Free and Below-Market Loans Problem: How to shift income from high-bracket to low-bracket taxpayer without losing control of property Interest free loans Solution 26 Interest Free and Below-Market Loans Typical Income Shifting Plan High-bracket loans $100,000 to low-bracket Transfer is a loan rather than a gift to ensure control Loan is a demand loan enabling continuous control Low bracket taxpayer invests the $100,000 to produce investment income Investment income is taxed at low rate Loan is interest free so no income at high-bracket §7872 enacted to attack 27 Interest Free and Below-Market Loans § 7872 Attack Loans affected Demand loans bearing interest less than the applicable federal rate Term loans where the amount loaned exceeds the present value of all payments due under the loan discounted at the AFR Hypothetical treatment. As if the borrower/debtor paid interest to the lender who subsequently transfers an equal amount back to the borrower Result: 28 Interest Free and Below-Market Loans § 7872 Attack Impute interest Borrower/debtor deemed to pay interest to the lender who subsequently transfers an equal amount back to the borrower Result: Lender treats hypothetical “payment” from borrower as Lender treats hypothetical “payment” from borrower as income (thus moving the income back to the lender) income (thus moving the income back to the lender) Borrower may have deduction for the “payment” Borrower may have deduction for the “payment” Lender’s payment to Borrower is treated as gift, Lender’s payment to Borrower is treated as gift, compensation or dividend, depending on relationship compensation or dividend, depending on relationship 29 Interest Free and Below-Market Loans § 7872 Hypothetical Treatment Interest income to lender L Deemed interest payment L B Interest free demand loan Gift, Compensation, Dividend 30 Interest Free and Below-Market Loans § 7872 Attack Exception for loans not exceeding $10,000 No tax consequences if loans outstanding never exceed $10,000 during year unless A gift loan and borrower uses loan proceeds to purchase or carry income producing assets A nongift loan and one of its purposes is tax avoidance 31 Interest Free and Below-Market Loans § 7872 Attack Exception for loans not exceeding $100,000 If loans do not exceed $100,000, Lender is still treated as having made a gift as determined above Borrower's hypothetical interest payment is deemed equal to his net investment income (which is considered zero if less than $1,000) 32 Interest Free and Below-Market Loans § 7872 Attack Exception for loans to qualified continuing care facility (§ 7872(g)) Must meet certain requirements 33 Income from Community Property Community property in general Rights of married couples in property Community property: considered owned equally by each spouse Separate property: considered owned by either husband or wife but not both Ten community property states 34 10 Community Property States 35 Income from Separate Property in Community Property States Income from separate property Is community property in TX, LA, ID and each spouse is responsible for reporting his or her share In remaining 7 states, treated as separate property and the spouse that owns the property is responsible for reporting the income. Income from personal services Treated as community property! 36 Separate property income is community property 37 ...
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