Principles of Taxation for Business and

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Chapter 06 - Taxable Income from Business Operations

Chapter 6 Taxable Income from Business Operations

Questions and Problems for Discussion

1. This lucky event increased Firm LK’s net worth by $72,000 and, therefore, resulted in $72,000
recognized income to the firm.

2. a. The annual business cycle for a plant and garden center might end in the late autumn
indicating an October 31 or November 30 fiscal year end.

b. A bakery has no obvious annual business cycle to suggest a particular taxable year.

c. The annual cycle for a chimney cleaning business might end in late spring indicating an April
30 fiscal year end, or the cycle might end in early autumn indicating a September 30 fiscal
year end.

d. The annual cycle for a moving and transport business might end in late summer indicating
an August 31 fiscal year end.

e. A software consulting business has no obvious annual cycle to suggest a particular taxable
year.

3. Corporation DB can elect a different overall method of accounting for each of its three business
ventures.

4. If the two corporations have different marginal tax rates, an intercompany transaction could
result in a shift of income from the high tax entity to the low tax entity or a shift of a deduction
from the low tax entity to the high tax entity. A method of accounting that accomplishes such a
shift and doesn’t reflect an arm’s length transaction price between the related corporations is
highly vulnerable to IRS challenge.

5. Evidently, the increase in the after-tax cost of business lunches reduced KJ Inc.’s demand for
the service provided by Al’s Steak House. To the extent that the restaurant’s profitability declined
because of the aggregate reduction in demand by the business community, the restaurant’s
owners bear the incidence of the indirect tax increase.

6. The death benefits received by a corporate beneficiary under its key-person life Insurance
policies are nontaxable. Therefore, the cost associated with the nontaxable income (the annual
premiums on the policies) is nondeductible by the corporation. In contrast, if other parties (the
officer’s spouse and children) are named as beneficiaries, the premiums paid by the corporation
represent additional officers’ compensation, which is a deductible business expense.

7. a. Taxable income exceeds book income by $215 (disallowed 50 percent of meal expense).

b. Book income exceeds taxable income by $700 ($3,500 tax-exempt interest  $2,800
nondeductible interest expense).

c. Taxable income exceeds book income by $17,400 ($7,400 nondeductible lobbying

expenses + $10,000 nondeductible political contribution).

8. No, the cash method doesn’t require that the taxpayer receive currency. The receipt of property
(such as the case of wine) triggers income recognition based on the value of the property.

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Chapter 06 - Taxable Income from Business Operations

9. Under the cash method, income from the provision of goods and services is not recognized until
payment for the goods and services is received, an event that usually occurs after the income is
earned under the accrual method. Thus, the cash method results in deferral from the year
income is earned until the year payment is received. In a growing business, this annual deferral
results is continuous. Therefore, in NPV terms, the tax cost associated with the cash method is
less than the tax cost associated with the accrual method, even though each method results in
the same total income recognition over the life of the business.

10. Firms that provide audited financial statements to external users (investors, creditors, regulatory
agencies, etc.) must prepare the statements in accordance with GAAP. The SEC requires
publicly held corporations to follow GAAP in the preparation of financial statements.

11. A tax preference may take the form of an income item reported for financial statement purposes
but never included in gross income, or a tax deduction that is not based on an expense or loss
reported for financial statement purposes. The resulting book/tax differences are permanent
differences, which are more valuable than temporary differences in NPV terms.

12. A deferred tax asset is similar to a prepaid tax resulting from an excess of taxable income over
book income. The asset creates no independent value for the firm. A deferred tax liability is
similar to a deferred tax resulting from an excess of book income over taxable income. The
liability has no independent cost to the firm.

13. Under GAAP, income is not realized until earned. If a firm receives payment for goods or
services to be provided in a future year, the prepayment is recorded in a liability account as
unearned revenue. Under the tax law, many prepayments of income must be included in taxable
income, even if the income has not yet been earned. The GAAP treatment is conservative
because it prevents an overstatement of book income. The tax treatment is conservative
because it prevents an understatement of taxable income (financial ability to pay).

14. A net operating loss suggests that a business is losing money. Most unprofitable business
ventures don’t last for 20 years.

Application Problems

1. a. Nello must recognize the $8,400 excess of the account payable over the settlement payment
($23,400 - $15,000) as discharge-of-debt income. Nello’s tax cost of the income is $2,940
($8,400 × 35%), and its net cash outflow is $17,940 ($15,000 cash paid + $2,940 tax cost).
b. Bonview can deduct the $8,400 excess of the account receivable over the settlement
payment ($23,400 - $15,000) as a bad debt. Nello’s tax savings from the deduction is $2,520
($8,400 × 30%), and its net cash inflow is $17,520 ($15,000 cash received + $2,520 tax
savings).

2. a. PT’s tax on $92,000 income is $19,530 ($13,750 + 34% [$17,000 excess income over
$75,000]).
b. In this case, PT must annualize the $92,000 income reported on the short-period return.
$92,000 short-period income  (12 months  4 months) = $276,000 annualized income.
The tax on $276,000 annualized income is $90,890 ($22,250 + 39% [$176,000 income over
$100,000]). This tax must be deflated to reflect the four months of operations in the short
period.
$90,890  (4 months  12 months) = $30,297.

3. a. Because the property and casualty insurance premium is deductible, the after-tax cost is
$3,640 ($5,600 – [$5,600 × 35%]).
b. Because the fine is nondeductible, the after-tax cost is $1,200.
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Chapter 06 - Taxable Income from Business Operations

c. Because the life insurance premium is nondeductible, the after-tax cost is $3,700.
d. Because the political contribution is nondeductible, the after-tax cost is $50,000.
e. Because only 50 percent of the entertainment expense is deductible, the after-tax cost is
$6,435 ($7,800 – [$3,900 × 35%]).

4. Northwest Company is allowed a domestic production activities deduction equal to 9% of net

income generated by the Portland plant. Consequently, its taxable income is computed as
follows.
Net income from Portland plant $3,100,000
Net income from Vancouver plant 4,800,000
Domestic production activities deduction
(9% × $3,100,000) (279,000)
Taxable income $7,621,000

5. a. $22 taxable income. Although Firm B received $522 cash, the $500 principal repayment was
a nontaxable return of investment. Only the $22 interest is income.
b. No taxable income. Although Firm B received $600 cash, the receipt created a liability for
repayment of the deposit and did not increase net worth.
c. No taxable income. Although Firm B received $10,000 cash, the receipt created a liability for
repayment of the loan and did not increase net worth.
d. $888 taxable income. Although Firm B earned only $180 of the prepaid rent this year, (15
days in December × $12), the income is recognized in the year payment is received.

6. a. The recording of the account receivable had no effect on Firm F’s taxable income.
b. The write-off of the account receivable had no effect on Firm F’s taxable income.

7. Although Firm Q is a cash basis taxpayer and received only $10,000 cash, it recognizes the
$23,400 total value of the cash and noncash payment as taxable income.

8. a. As a cash basis taxpayer, RTY recognizes no income for the services performed and $4,000
prepaid rent income.
b. As an accrual basis taxpayer, RTY recognizes $17,800 income for the services performed
and $4,000 of prepaid rent income.

9. a. No deduction. The $50,000 results in a benefit extending beyond the following taxable year
and must be capitalized.
b. No deduction. Brillo must use the accrual method to account for purchases of inventory.
Thus, the $79,000 is capitalized to inventory.
c. No deduction. The $1,800 cost of the refrigerator is capitalized to an asset account.
d. $4,800 deduction.
e. $22,300 deduction.

10. a. Even though NC adopted the cash method as its overall method of accounting, it must use
the accrual method to account for inventory purchases. Therefore, its cost of goods sold for
its first taxable year is $254,400 ($319,000 purchases  $64,600 inventory on hand at year-
end), and it is using a hybrid method of accounting.
b. $254,400 (no difference)

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Chapter 06 - Taxable Income from Business Operations

11. a. LSG can deduct the entire $9,450 expenditure in 2015, the year of payment, because the
expenditure results in a benefit with a duration of less than 12 months and the benefit
doesn’t extend beyond 2016.
b. LSG must capitalize the $9,450 expenditure because it results in a benefit with a duration of
more than 12 months. LSG can amortize the capitalized expenditure at a rate of $525 per
month ($9,450 ÷ 18 months), and can amortize and deduct $1,050 in 2015 ($525 × 2
months).

12. a. Even as a cash basis taxpayer, Firm F can deduct only $4,720 of the interest payment (the
interest relating to the four-month period from September 1 through December 31).
b. $4,720 (no difference)

13. a. Under the cash method of accounting, Wahoo must recognize the entire $36,000
prepayment as 2015 income.
b. Even as an accrual basis taxpayer, Wahoo must recognize the entire $36,000 prepayment
as 2015 income.

14. EFG’s net book income before tax $500,000

Bad debt expense per books $12,500
Bad debt deduction (write-offs) (13,800)
(1,300)
Nondeductible fine 17,500
Nondeductible contingent liability 50,000
Advanced payment for inventory no difference
EFG’s taxable income $566,200

15. a. 35% × $31,000 excess of book income over taxable income = $10,850 deferred tax liability
b. No deferred tax asset or liability from permanent book/tax difference.
c. 35% × $55,000 excess of taxable income over book income = $19,250 deferred tax asset

16. a. GT’s tax expense is $238,000 (34% × $700,000 book income).

b. GT’s tax payable is $275,400 (34% × $810,000 taxable income).
c. The excess of tax payable over tax expense is a $37,400 net increase in deferred tax
assets.

17. a. Net income before tax $600,000

Permanent book/tax differences 15,000
$615,000
Tax rate .34
Corporation H’s tax expense $209,100
b. Taxable income $539,000
Tax rate .34
Corporation H’s tax payable $183,260
c. Tax expense $209,100
Tax payable (183,260)
Net increase in deferred tax liabilities $25,840

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Chapter 06 - Taxable Income from Business Operations

18. a. Net income before tax $378,200

Permanent book/tax differences (33,500)
$344,700
Tax rate .34
Corporation H’s tax expense $117,198
b. Taxable income $457,100
Tax rate .34
Corporation H’s tax payable $155,414
c. Tax payable $155,414
Tax expense (117,198)
Net increase in deferred tax assets $38,216

19. Micro’s net book income before tax $505,100

Domestic production activities deduction
(9% × $319,600) (28,764)
Prepaid royalty income 40,000
Accrued bonus expense no difference
NOL carryforward deduction (21,400)
Micro’s taxable income $494,936

20. a. GreenUp should report $20,000 revenue in 2015, $65,000 revenue in 2016, and $15,000
revenue in 2017 for financial statement purposes.
b. Under the one-year deferral method, GreenUp must recognize $20,000 taxable income in
2015 and $80,000 taxable income in 2016.

21. Cornish can’t deduct an accrued expense that fails the all-events test. Cornish’s liability for the
accrued expense is fixed because it has a binding contract with the construction company. The
$65,000 amount of the accrual is an estimate; only $7,200 (the billed amount) is determinable
with reasonable accuracy. Economic performance with respect to the $7,200 accrual has
occurred because the construction company has provided the services to Cornish.
Consequently, Cornish’s current year deduction is limited to $7,200.

22. a. If KLP uses the cash method of accounting, it can deduct $100,000 in the year of payment.
b. For financial statement purposes, KLP must accrue a $100,000 expense in the year the
winner was selected and its liability to pay the prize became fixed. However, because of the
economic performance requirement for awards, prizes, or jackpots, KLP is not allowed a tax
deduction until the year of payment.

23. a. Economic performance with respect to Ernlo’s liability for the purchased oil doesn’t occur
until the oil is delivered in October. Consequently, Ernlo can deduct the $12,450 cost in its
fiscal year ending June 30, 2016.
b. Under the recurring item exception, Ernlo can deduct the $12,450 cost in its fiscal year
ending June 30, 2015, because economic performance (delivery) occurred within 8½
months after the close of the year.

24. a. Economic performance with respect to HomeSafe’s liability for future service calls doesn’t
occur until HomeSafe provides the service. Consequently, HomeSafe can’t deduct any of
the $48,900 accrued expense in 2015. In 2016, it can deduct the $36,300 cost of the service
calls provided in 2016 (484 service calls × $75 cost per call).
b. Under the recurring item exception, HomeSafe can deduct $27,150 of the $48,900 accrued
expense in 2015 (362 service calls made within 8½ months after the close of 2015 × $75
cost per call). It can deduct $9,150 in 2016 (122 service calls made from September 16
through December 31 × $75 cost per call).
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Chapter 06 - Taxable Income from Business Operations

25. a. BZD can deduct the $55,000 accrued compensation expense in 2015 because the
compensation was paid by March 15, 2016 (2½ months after year-end).
b. BZD can deduct $20,000 of the $40,000 accrued bonus expense in 2015 (amount paid by
March 15, 2016) in 2015. The $20,000 bonus payment made on May 1, 2016, is deductible
in 2016.
c. BZD can’t deduct any of the $219,700 accrued vacation pay expense in 2015 because none
of the expense was paid by March 15, 2016. BZD will deduct the expense in the year of
payment.

26. a. Deduction for accrued expense in 2014 $180,000

Tax rate .35
2014 tax savings $63,000
PV of 2016 payment
($180,000  .873 discount factor at 7%) (157,140)
NPV of after-tax cost $(94,140)

b. After-tax cost in 2016

($180,000 payment  $63,000 tax savings) $(117,000)
NPV of after-tax cost ($117,000  .873 discount factor at 7%) $(102,141)

27 a. Economic performance with respect to Extronic’s liability for state income tax occurs when
the tax is paid. Consequently, Extronic can deduct the $273,900 tax paid during 2015
($41,900 balance due of 2014 tax + $232,000 estimated tax payments).

b. Under the recurring item exception, Extronic deducted the $41,900 accrued expense for
2014 tax in 2014 because the liability was paid within 8½ months after the close of 2014. It
can deduct the $19,200 accrued 2015 expense because the liability was paid within 8½
months after the close of 2015. Consequently, Extronic’s 2015 deduction for state income
tax is $251,200 ($232,000 estimated tax payments + $19,200 accrued tax payable).

28. a. Company N can deduct the $7,740 interest payment in 2016, the year in which related party
Creditor K recognized the payment as income.
b. Company N can deduct the $7,740 interest expense in 2015. Even though Creditor K is a
related party, it recognized the payment as income in 2015 under its accrual method of
accounting.
c. Company N can deduct the $7,740 interest expense in 2015 because Company N and
Creditor K are unrelated.

29. a If Mrs. T owns no Acme stock, she and Acme are not related parties. Thus, Acme can
deduct the $20,000 bonus in 2015, the year in which the expense was accrued.
b. If Mrs. T owns 63 percent of Acme’s stock, she and Acme are related parties. Thus, Acme
must wait to deduct the $20,000 bonus until 2016, the year in which Mrs. T includes the
payment in income.

30. a. GK’s bad debt expense for financial statement purposes is $90,000, which is the addition to
the allowance for bad debts.
b. GK’s tax deduction for bad debts is $77,300, the amount of actual write-offs of accounts
receivable.

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Education.
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Chapter 06 - Taxable Income from Business Operations

31. a. For financial statement purposes, the $65,000 write-off was charged against the allowance
for bad debts and did not reduce financial statement income. For tax purposes, the $65,000
write-off was deducted in the computation of taxable income.
b. For financial statement purposes, the $65,000 recovery was credited to the allowance for
bad debts and did not increase financial statement income. For tax purposes, the $65,000
recovery was included in taxable income under the tax benefit rule.

32. TRW’s taxable income for the eight-year period is computed as follows:
2007 2008 2009 2010 2011 2012 2013 2014
Tax. income before
NOL deduction 20,000 158,000 81,000 (741,000) 21,000 398,000 687,000 905,000
NOL deduction (158,000) (81,000) NA (21,000) (398,000) (83,000)
Taxable income 20,000 -0- -0- -0- -0- 604,000 905,000

33. a. 34% × $90,000 unfavorable temporary difference = $30,600 deferred tax asset
b. 34% × $710,000 NOL carryforward = $241,400 deferred tax asset
c. Negative tax expense $272,000 ($30,600 + $241,400). Negative tax expense can also be
computed by multiplying Rony’s $800,000 book loss by its 34 percent tax rate.

34. a. Rony’s tax expense is $408,000 (34% × $1,200,000 book income).

b. Rony’s tax payable is $136,000 (34% × $400,000 taxable income).
c. Rony’s reduction in its deferred tax assets is $272,000.

Issue Recognition Problems

1. Should Firm G have recognized $200,000 or only $150,000 income in 2013? If Firm G
recognized $200,000 income in 2013, can it deduct the $30,000 settlement paid in 2015? If Firm
G recognized $200,000 income in 2013, can it request a $11,700 refund ($30,000  39 percent),
or must it be content with a $10,200 tax savings from a 2015 deduction ($30,000  34 percent)?

2. Must Corporation DS recognize the $15,000 discharged debt as income, even though the
cancellation did not increase the insolvent corporation’s net worth?

3. Is the discovery of the underlying painting a realization event that triggers $249,700 income for
the theater company? Did the discovery of the underlying painting merely increase the value of
the asset purchased for $300, an increase that doesn’t represent realized income?

4. Is BL Inc. required to request permission from the IRS to change from an incorrect to a correct
method of accounting?

5. In which year (2015 or 2016) does Company A recognize the $160,000 income from the
consulting engagement? Because Company A used the cash method in 2015 (when the
consulting engagement was completed) and the accrual method in 2016 (when the cash was
received), does the $160,000 income from the consulting engagement escape taxation entirely?

6. Was Mr. RJ in constructive receipt of the $3,500 income in the earlier year because he could
have picked up the check from the client’s receptionist if he had checked his phone messages
during the holidays?

7. Assuming that Maxo accrues a liability for the $14,420 bill from the publisher, can it deduct the
accrued expense? Does an accrued liability fail the all-events test if the taxpayer notifies the
creditor that it is contesting the amount of the liability?

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Chapter 06 - Taxable Income from Business Operations

8. Does the $18,000 property tax refund represent either financial statement income or taxable
income to Firm K?

9. Is $75,000 an arm’s length price for the advertising provided by HT to LT? Did HT undercharge
for the service rendered to LT to shift income to a related party with a zero marginal tax rate?

10. Can a taxpayer choose the carryback year in which an NOL is deducted or must an NOL
carryback be deducted in chronological order?

11. Can BL deduct TM’s NOL carryforwards? If a taxpayer purchases a business that generated
NOL carryforwards, does the purchaser acquire the carryforwards along with all the other
business properties?

Research Problems

1. Section 458 provides a special method of accounting available to publishers and distributors of
magazines, paperback books, and musical records, tapes, and discs. According to Section
458(a), accrual basis taxpayers can exclude the income realized on sales of these items that are
returned before the close of the “merchandise return period.” According to Section 458(b)(7), the
merchandise return period for magazines is the two-month and 15-day period after the close of
the taxable year. According to Section 458(b)(6), the income excluded is limited to the refund paid
by the taxpayer for the returned items. Based on these rules, Bontaine Inc. can exclude $82,717
(refund paid in January 2016 for December 2015 sales) from its 2015 taxable income.

2. In CharlesSchwab Corp. v. Commissioner, 107 T.C. 282 (1996), aff’d, 161 F.3d 1231 (CA-9,
1998), cert. denied (1999), the Tax Court and the Ninth Circuit Court of Appeals held that
discount brokerage houses must accrue commission income on the earlier trade date instead of
the later settlement date. Based on this decision, CheapTrade should recognize $1,712,400
commission income in 2015.

3. The answer to this research problem depends on whether Moleri has made an election under
Section 461(c) and Reg. §1.461-1(c) to accrue real property tax ratably over the twelve months of
the calendar year to which the tax relates. If this election is in effect, Moleri deducts $17,395
(7 months × [$29,820 ÷ 12 months]) of the 2015 tax on its return for the fiscal year ending July
31, 2015. It also deducts the 5 months of its 2014 property tax payment relating to August
through December 2014. If this election is not in effect, Moleri deducts the entire 2015 tax
because it paid the tax (i.e. economic performance occurred) during the year. Reg. §1.461-
4(g)(6)(iii)(A).

4. This case is based on U.S. Freightways Corp. v. Commissioner, 270 F. 3d 1137 (CA-7, 2001),
rev’g 113 TC 329 (1999). The accrual basis freight company deducted its entire annual payment
for permits and licenses, even when the annual term of the permit or license extended into the
following year. The company based this accounting treatment on the regulatory rule allowing a
deduction for prepaid expenses providing a benefit that doesn’t extend substantially beyond the
end of the year following the year of payment. The IRS argued that this “12-month” rule applied
only to cash basis taxpayers. Although the Tax Court agreed with the IRS, the Seventh Circuit
reversed the Tax Court and allowed the deduction. This decision paved the way for Reg.
§1.263(a)-4(f) (promulgated on December 31, 2003), paragraph (f) of which provides a 12-month
rule applying to both cash and accrual basis taxpayers. Under this regulation, Jetex Inc. can
deduct $1,119,200 in 2015.

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Education.
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Chapter 06 - Taxable Income from Business Operations

Tax Planning Cases

1. The net income deferred from 2015 until 2016 through use of the cash method is computed as
follows.
Accrual method:
Income from billings $3,500,000
Expenses incurred (800,000)
Net income in 2015 $2,700,000

Cash method:
Cash received $2,900,000
Expenses paid (670,000)
Net income in 2015 (2,230,000)
Income deferred until 2016 under cash method $470,000
Tax on income deferred one year
($470,000  34%) $159,800
NPV of deferred tax
($159,800  .952 discount factor at 5%) (152,130)
Decrease in tax cost from cash method $7,670

2. a. Yes. VB’s positive taxable income in 2013 indicates that the corporation either carried back
its 2010 NOL or claimed it as a carryforward deduction in 2013.

b. VB’s carryback of $170,000 of the 2015 NOL would generate the following refund.
Tax paid in 2013 $10,000
Tax after $60,000 NOL carryback -0-
Refund $10,000

Tax paid in 2014 $26,150

Tax after $110,000 NOL carryback -0-
Refund 26,150
Total refund received $36,150
The NPV of VB’s remaining $180,000 NOL carryforward into 2017 is computed as follows.
NOL carryforward deduction $180,000
Projected 2017 marginal tax rate .34
Projected tax savings from deduction $61,200

NPV of tax savings

($61,200  .907 discount factor at 5%) $55,508
The total value of the 2015 NOL is $91,658 ($36,150 + $55,508).

c. The NPV of a $350,000 NOL carryforward into 2017 is computed as follows.

NOL carryforward deduction $350,000
Projected 2017 marginal tax rate .34
Projected tax savings from deduction $119,000

NPV of tax savings

($119,000  .907 discount factor at 5%) $107,933
VB should give up the carryback and carry the 2015 NOL forward as a deduction to 2017 to
maximize the value of the NOL deduction.

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