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Chapter 7
Accounting Periods & Methods & Depreciation
Income Tax Fundamentals 2007
Gerald E. Whittenburg & Martha Altus-Buller
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logo, and South-Western are trademarks used herein under license.
Accounting Periods

Problem when taxpayer’s tax year differs
from calendar year

Partnerships don’t pay tax as an entity
 Tax year must be the same tax year as 50%
of partners
 If majority of partners’ tax years are different,
use tax year of principal partners

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Principal partner is partner with at least 5% share
in profits or capital
If principal partners have different tax years
Use accounting period with the least
aggregated deferral
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Tax Year for Personal Service Corporation

A Personal Service Corporation (PSC) is a
corporation with shareholder-employees whom
provide a personal service

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For example, an architect or dentist
Generally must adopt calendar year
Can adopt a fiscal year if
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Can prove business purpose or
Fiscal year results in a deferral period of less than 3
months and shareholders’ salaries for deferral period
are proportionate to salaries received during rest of
the period and corporation limits its deduction [see
next slide]
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logo, and South-Western are trademarks used herein under license.
Short Period Taxable Income

If taxpayer has a short year [other than first/last
year of operation], tax calculated based on
following example:

Example: In 2006, Fed-Mex changes from a
calendar year to tax year ending 9/30. For the
short period 1/1/06 – 9/30/06, Fed-Mex’s TI =
$20,000.


Calculate tax for the short period
 Annualize TI
20,000 x 12/9 = 26,667
 Tax on annualized TI
26,667 x 15% = 4,000
 Allocate tax to short period 4,000 x 9/12 = $3,000
Individual taxpayers rarely change tax years
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logo, and South-Western are trademarks used herein under license.
Accounting Methods

Cash receipts/disbursements method
 Recognize income when cash actually/constructively
received
 Recognize deduction in year of payment - exception:
can’t deduct prepaid rent or interest
 This method most common for individuals for overall
accounting method
 Can’t use cash basis if taxpayer is a

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C corporation, or
Partnership with a corporation as a partner, or
Trust with UBI (unrelated business income)

Above regulations don’t apply to certain organizations
©2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star
logo, and South-Western are trademarks used herein under license.
Accounting Methods [continued]

Accrual method



Recognize income when earned and can be
reasonably estimated
Recognize deduction when incurred and can
be reasonably estimated
Hybrid method

An example of a hybrid taxpayer, is one that
utilizes cash method for
receipts/disbursements but accrual for cost
of products sold
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logo, and South-Western are trademarks used herein under license.
Depreciation [Form 4562]

Depreciation is a process of allocating
and deducting the cost of assets over
their useful lives



Does not mean devaluation of asset
Land is not depreciated
Maintenance vs. depreciation


Maintenance expenses are incurred to keep
asset in good operating order
Depreciation refers to deducting part of the
original cost of the asset
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logo, and South-Western are trademarks used herein under license.
Personal Property Recover Periods

Each asset is depreciated according to an IRSspecified recovery period

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3 year
5 year
Computer, cars and light
trucks, R&D equipment, certain energy
property & certain equipment
7 year Mostly business furniture and equipment
and property with no ADR life
10 year Trees and vines
15 year Treatment plants
20 year Sewers
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logo, and South-Western are trademarks used herein under license.
Personal Property

Depreciation is determined using IRS
tables (Table 2 on p. 7-9 in text)


Salvage value not used in MACRS
Tables based on half-year convention
1/2 year depreciation taken in year of
acquisition
 1/2 year depreciation taken in final year


May elect to use tables based on straight
line instead (Table 3 on p. 7-10 in text)
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logo, and South-Western are trademarks used herein under license.
Mid-Quarter Convention

Mid-quarter convention is required if taxpayer
purchases 40% or more of total assets (except
real estate) in last quarter of tax year


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Then must apply this convention to every asset
purchased in the year
Excluding real property and §179 property
Must use special mid-quarter tables
 Found at major tax service such as Commerce
Clearing House [CCH] or Research Institute of
America [RIA]
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logo, and South-Western are trademarks used herein under license.
Real Estate

Real assets depreciated based on a recovery
period depending on use
 Real assets are depreciated using the
straight-line method with a mid-month
convention (Table 4); for real estate acquired
after 1986 use
 27.5 years: Residential rental
 39 years:
Nonresidential
 Treats all acquisitions/dispositions as
occurring mid-month [mid-month convention]
 No mid-quarter convention for real estate
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logo, and South-Western are trademarks used herein under license.
Election to Expense - §179

§179 allows immediate expensing of qualifying property

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For 2006, the annual amount allowed is $108,000
Qualifying property is tangible personal property used in a
business

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But not real estate or off-the-shelf computer software
§179 election to expense limited

If cost of qualifying property placed in service in a year >
$430,000, then reduce §179 expense $ for $


For example, if assets purchased in current year = $500,000,
then $70,000 reduction in §179 capability so limited to
$108,000 – 70,000 = $38,000 election to expense and the
remaining 462,000 is depreciated over assets’ useful lives.
Cannot take §179 expense in excess of taxable income may carry forward any unused amount
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logo, and South-Western are trademarks used herein under license.
Election to Expense - §179

When using with regular MACRS
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Take §179 first, then reduce basis
MACRS depreciation calculated on reduced basis
For example
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In 2006, a seven-year piece of property placed in
service costing $125,000; taxable income = $1.25
million. What is total depreciation including election to
expense?
First – claim $108,000 deduction under §179, reduce
basis to $17,000, then multiply by 14.29% MACRS
rate
 [108,000] + [17,000 x 14.29%] = $110,429 total
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logo, and South-Western are trademarks used herein under license.