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Revenue is recognized on the sale of inventory, recorded when the business receives cash, and then expenses are recognized when cash is paid. This is used for the cash basis accounting method. “Under the accrual basis accounting, revenues recognition: Revenue is recognized when both of the following conditions are met: revenue is earned and revenue is realized or realizable. Revenue is earned when products are delivered or services are provided” (Accountinginfo.com, 2015). Bob’s business is a used car business. The majority of his income will be from sales of single used cars to individual customers. The revenue is realized and earnedwhen Bob sells the used car and delivers it to the customer, along with the legal document of ownership. When Bob sells a service such as a warranty, he can recognize total income upon receipt, but the expense is amortized over the term of the contract. However, he needs to pay all taxes upfront. Since Bob uses the accrual accounting method, he can defer income from
Final Milestone 4payments received to the next tax year using the straight-line basis. This way Bob does not have to pay all the taxes at one time. Many used car dealerships offer a financing plan to customers. When Bob sells the car through the financing plans, he can only report the gain that he receives each year. “Under the installment method, you include in income each year only part of the gain you receive, or are considered to have received. You do not include in income the part of the payment that is a return of your basis in the property. You must also include in income any interest as ordinary income” (IRS, 2015). Bob can take advantage from Section 179 Deductions when he purchases, constructs or expands his dealership. Economic Impact and Tax Consequences:Unlike sole proprietors, S Corporations are pass-through entities which means the profitsand losses are divided among shareholders and included on the shareholders’ personal incometax returns. Shareholders of S Corporations are not treated as self-employment; therefore they arenot subject to self-employment taxes. More information can be found in Rev. Rul. 59-221. Bob’sbusiness will benefit from being an S Corporation because he can receive his compensationthrough a distribution rather than salary. Bob’s distribution is not subject to self-employment tax.For example, assume Bob owns 100% of the stock of his S Corporation. He is also an employee.His business generates $1,000 of taxable income. If Bob takes $1,000 as his salary, he will report$1,000 of wage income on his income tax returns. He is also liable for payroll taxes. On the otherhand, if Bob receives $1,000 as a distribution rather than a salary, he will not be subject to self-employment taxes. “The self-employment tax in an S Corporation setting is limited to thecompensation received for services, rather than applied to all income received from the business,as long as shareholder-employees pay themselves reasonable compensation.” (AICPA, 2015).
Final Milestone 5The payroll tax issue for S Corporation is, what is a reasonable compensation? How does the