How can we help?

You can also find more resources in our Help Center.

63 terms

Tax Chapter 7

prep for final exam
means than an expenditure is recorded as an asset on the balance sheet rather than a current expense
-if the firm is never allowed any tax deduction for the capitalized expenditure, the before-tax cost equals its after-tax cost
PV of Tax Savings
-tax savings are usually maximized (and after-tax cost minimized) if the expenditure is deductible in the current year
-the PV of tax savings decreases if the firm must capitalize the expenditures and postpone its deduction until some future year
Internal Revenue Code: Deductions
-without any restrictions, firms would immediately deduct every business expenditure
-basis premise of the code states that no expenditure is deductible unless the Internal Revenue Code authorizes the deduction
-Supreme Court: "the burden of clearly showing the right to a claimed deduction is on the taxpayer"
Internal Revenue Code: Deductions allowed & disallowed
-allows firms to deduct all 'ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business'
-prohibits a deduction for payments for 'permanent improvements or betterments made to increase the value of any property'
-relaxes this prohibition by allowing firms to recover many capital expenditures in the form of future deductions (but firms minimize their cost by deducting expenditures as soon as possible)
Current Deduction vs. Capital Cost
-if the expenditure creates or enhances a distinct asset with a useful life substantially beyond the current year, the expenditure must be capitalized
-even if the expenditure does not create or enhance a specific asset, the expenditure must be capitalized if it results in a significant long-term benefit to the firm
-if tax treatment is uncertain, capitalization is the norm while deductibility is the exception
Repairs & Cleanup Costs
-repair and maintenance costs that are regular and recurring in nature and do not materially add to either the value or the useful life of as asset are deductible
-in contrast, expenditures that substantially increase the value or useful life of an asset are nondeductible capital improvements
-the expense of adapting an existing asset to a new or different use must be capitalized to the cost of the asset
Environmental Cleanup Costs
-IRS maintains that many such costs must be capitalized
-many firms argue that these costs should be currently deductible
Deductions of Capital Expenditures as Subsidies 1
-tax law contains special rules permitting firms to deduct expenditures that are clearly capital in nature
-preferential rules reduce the firm's after-tax cost of the expenditure and represent an indirect federal subsidy
Deductions of Capital Expenditures as Subsidies 2
-firms may deduct the first $15,000 of the annual cost of the removal of architectural and transportation barriers from building or transportation equipment to make such facilities more accessible to handicapped or elderly people
-deduction for research & experimental expenditures: available even if the research leads to the development of an identifiable asset with an extended useful life to the firm
Farm Preferential Deductions
farmers are allowed to deduct soil and water conservation expenditures, which includes the cost of leveling, grading, terracing land, constructing drainage ditches and earthen dams, and planting windbreaks to inhibit soil erosion
-farmers get a second tax break in the form of a deduction for the cost of fertilizers or other materials used to enrich farmland
Oil & Gas Deductions
-oil and gas producers can deduct intangible drilling and development costs (IDC) associated with locating and preparing wells for production
-expenditures such as wages, fuel, repairs to drilling equipment, hauling, and supplies that contribute to the development of a productive well undeniably result in a long-term benefit to the producer and are usually capitalized for F/S purposes
Deductible Advertising Costs
advertising costs are deductible, even though a firm's successful advertising campaign can increase its market share and improve its competitive position for years to come
Tax Basis
-when a firm capitalizes an expenditure to a new asset account, the amount of the expenditure becomes the firm's tax basis in the asset
-basis: a taxpayer's investment in any asset or property right- the measure of uncovered dollars represented by the asset
-an asset's basis plays a key role in the calculation of cash flows because taxpayers are entitled to recover this basis at no cost
-this recovery occurs either through a series or future deductions or when the taxpayer disposes of the asset
Deducting a Portion of a Capitalized Cost
-1st consequence: the asset's initial tax basis is reduced by the deduction; the reduced basis is called the asset's adjusted basis
-2nd consequence: the deduction generates a tax savings that reduces the after-tax cost of the asset
Zero Tax Basis
a zero tax basis does not imply anything about the value of the asset to the firm
-it simply indicates that the firm has deducted the entire expenditure that created the asset
Cost Basis
-the majority of assets reported on a firm's balance sheet have an initial cost bases- the price paid to acquire the asset
-cost basis includes any sales tax paid by the purchaser and any incidental costs related to putting the asset into production
-if assets are acquired in exchange for property or services, the cost basis of the asset equals the FMV of the property surrendered or the services performed
Leveraged Cost Basis
-when a firm acquires an asset through debt financing, the cost basis of the asset equals its entire cost, not just the firm's equity in the asset
-leverage: the use of borrowed funds to create tax basis; can reduce the purchaser's after-tax cost of the asset
Cost Recovery Methods
-the after-tax cost of a capitalized expenditure depends on the time period over which the firm can recover the expenditure as a deduction
-thus, time period variable tax savings is achieved when the cost of a capitalized expenditure is recovered over the shortest possible period
Periodic Cost Recovery Methods
-cost of goods sold
-if none of these recovery methods is applicable, a cost is recoverable only when the firm disposes of the asset or when that asset ceases to exist
Inventory & COGS
-firms can't deduct the cost of manufactured or purchased inventory but must capitalize the cost to an asset account
-the cost of the inventory on hand is carried on the balance sheet, while the COGS reduced gross income from sales
COGS Formula
Cost of inventory on hand at the beg. of year
+ cost of inventory manufactured or purchased during year
=Total cost of inventory available for sale
-cost of inventory on hand at the end of the year

*assumes that all expenditures that contributed to the value of inventory are capitalized to the inventory account
* assumes that the total cost of inventory is properly allocated between the inventory on hand at the end of the year and the inventory sold during the year
Unicap Rules
-firms typically prefer to treat expenditures as deductible period costs rather than product costs that must be capitalized to inventory
-unicap rules contains explicit rules that must be included in inventory
-strict & complicated
Unicap Rules 2
-firms must capitalize all direct costs of manufacturing, purchasing, or storing inventory and any indirect costs that "benefit or are incurred by reason of the performance of production or resale of activities"
-must be capitalized to the extent they relate to a firm's production or resale function:
-officer's compensation
-pension, retirement, and other employee benefits
-rents paid on buildings and equipment used on manufacturing process
-repair and maintenance of production assets
Computing COGS
-if a firm knowns the actual cost of each item, it can use the specific identification method to value ending inventory and compute COGS
-FIFO & LIFO conventions: used when specific ID is not possible
-the selection of an inventory costing convention may have a substantial effect on annual taxable income
-during a period of rising prices, it is advantageous to use LIFO, but firms that use LIFO for tax purposes must also use it for F/S purposes- affects EPS
Book & Tax Concepts of Depreciation
-Under GAAP, firms write off or depreciate the capitalized cost of tangible assets over their estimated useful lives
-as a result, the cost of an asset is expensed over the years in which the asset contributes to the firm's revenue generating activity
-deprecation applied only to wasting assets that: loss value over time because of wear & tear, physical deterioration, or obsolescence; have a reasonable ascertainable useful life
Modified Accelerated Cost Recovery System (MACRS)
-congress refined this system in 1986, in effect today
-Under MACRS, the estimated useful life of an asset is irrelevant in computing tax depreciation.
-Because the MACRS computation is independent of the computer of book depreciation, the depreciation deduction on a firm's tax return & depreciation expense on its financial statements are usually different numbers
MACS Recovery Periods
-MACRS applies to both depreciable realty (buildings, improvements, and other structures permanently attached to land) & personalty (any tangible asset not part of a building or permanent structure) used in trade, business, or income-producing activity
-Every depreciable asset is assigned to 1 of 10 recoverable periods
-MACRS recovery period is typically shorter than the asset's useful life; reduces the after-tax cost of the assets and acts as an incentive for firms to make capital acquisitions
Depreciation Methods
-the method by which annual depreciation is calculated is a function of the recovery period
-assets with 3,5,7, or 10 year recovery periods are depreciated used a 200% DB method
-assets with a 15 or 20 year recovery period are depreciated using a 150% DB
-properties with a 25, 27.5, 39, or 50 year recovery period must be depreciation with straight-line (accelerated in name only)
-in each case, the depreciation method switches to straight line when a straight line computer over the remaining recovery period results in a greater deduction than the DB method
MACRS Tax Savings
-depreciation deductions are accelerated into the early years of the recovery period
-such front-end loading of depreciation further reduces the after-tax cost of tangible personalty
Half-Year Convention
-Under MACRS, all personalty with recovery periods from 3 to 20 years, are assumed to be placed in service or disposed of exactly half way through the year
-in the first year of the recovery period, 6 months of depreciation is allowed, regardless of when the asset was actually placed in service
Half-Year Convention Exception
-if more than 40% of the depreciable personalty acquired during the taxable year is placed in service during the last 3 months of the year, the firm may use a mid-quarter convention with respect to all personalty placed in service during the year
-assets placed in service during any quarter of the year are assumed to be placed in service midpoint (1.5 months) through the quarter
-constrains a taxpayer that might be tempted to accelerate future-year property acquisition into the last quarter of the current year to take advantage of cost recovery deductions available under the midyear convention
Mid-month Convention
-applied to the year in which depreciable realty (25, 27.5, 39, or 50 year recovery period) is placed in service of disposed of
-realty placed in service during any month is treated as placed in service midway thought the month
3 Year Recovery Period
-small manufacturing tools
-racehorses and breedings hogs
-special handling devices used in food manufacturing
5 Year Recovery Period
-cars, trucks, buses, helicopters
-computers, typewriters
-duplicating equipment
-breeding & dairy cattle
-cargo containers
7 Year Recovery Period
-office furniture & fixtures
-railroad cars & locomotives
-most machinery & equipment
10 Year Recovery Period
-single purpose agricultural and horticulture structures
-assets used in petroleum refinery
-vessels, barges, and other water transportation equipment
-fruit or nut-bearing trees & vines
15 Year Recovery Period
-land improvements such as fencing, rods, sidewalks, bridges, irrigation systems & landscaping
-telephone distribution plants
-service station buildings
20 Year Recovery Period
-certain farm buildings
-municipal sewers
25 Year Recovery Period
-commercial water utility property
27.5 Year Recovery Period
-residential rental property (duplexes & apartments)
39 Year Recovery Period
-nonresidential real property (office buildings, factories, and warehouses)
50 Year Recovery Period
-railroad grading or tunnel bore
-MACRS deductions do nto represent cash outflows, and they do not correlate to any decline in the FMV of the asset
-while operating assets typically lose value as they age, the annual MACRS deduction in no way reflects such loss
-firms may claim depreciation deductions for assets that may appreciate in value over time
-the adjusted tax basis in a business asset is the capitalized cost that the firm has not yet deducted & conveys no information concerning FMV
Limited Depreciation: Passenger Automobiles
-tax law contains a major exception to MACRS for depreciation allowed for passenger automobiles held for business use
-passenger automobiles: four-wheeled vehicles manufactured primarily for the use on public roads with an unloads gross vehicle weight of 6,000 pounds or less
-vehicles strictly used in the business of transporting people or property for compensation (taxis, limos, hearses, ambulances, etc) are excluded from this definition
-annual depreciation limited to a certain amount depending on the year a automobile is placed in service
-cannot be avoided by leasing instead of purchasing
Section 179 Expensing Election
-allows a firm to elect to expense (rather than capitalize) a limited dollar amount of the cost of certain property placed in service during the year
-limit is $125,000 indexed annually for inflation
-increased to $250,000 for qualifying property placed in business is 2008-2009
-increased to $500,000 for 2010 property
-provides significant economic stimulus
Section 179 Election Property
-includes tangible depreciable personalty and off-the-shelf computer software, the cost of which is amortizable over 36 months
-allows many small firms to simply deduct the cost of their newly acquired assets and avoid the burden of maintaining depreciation or amortization schedules
-firms that purchase qualifying property with an aggregate cost in excess of the limited dollar amount may expense part of the cost of an specific asset or assets; the unexpensed cost is capitalized and recovered through depreciation/amortization
Section 179 Expense Election Limitations 1
-if a firm purchases more than a threshold amount of qualifying property in a year, the annual dollar amount is reduced by the excess of the total cost of property over the threshold
-a firm that purchases more than 2.5 million of qualifying property in 2011 cannot benefit from a section 179 election because its limited dollar amount is reduced to 0
Section 179 Expense Election Limitations 2
-once a firm elects to expense the cost of qualifying property, the expense is generally deductible
-the deduction (not the expense) is limited to taxable business income computed without regard to the deduction
-any nondeductible expense resulting from this taxable income limitation carries forward to succeeding taxable years
Bonus Depreciation
-2008 economic stimulus act also provided for 50% bonus depreciation in the year of acquisition for qualified property placed in service during 2008
-includes most new tangible personal property, computer software, and certain leasehold improvements
-adjusted basis of the property is reduced by the amount of bonus depreciation for purposes of computing regular MACS depreciation over the recovery life of the asset
-also available for 2009 & 2010
-2010 Tax Relief Act further enhances this incentive, providing for 100% bonus depreciation for property placed in service between Sep. 8th, 2010-Jan. 1,2012 (fully deductible in year acquired)
Section 179 & Bonus Depreciation Combined
-if property qualified for both the Section 179 deduction & the 50% bonus depreciation, the section 179 is applied first
Purchase vs. Leasing Decision
-both options provide the firm with the use of the asset over time, but the cash flows associated with each option are different
-managers should choose the option that minimizes the after-tax cost of the acquisition in PV terms
Amortization of Intangible Assets
-tax basis in intangible assets may be recoverable under some type of amortization method allowed by the Internal Revenue Code
-as a general rule, amortization is allowed only if the intangible asset has a determinable life
-the cost basis in an intangible asset with an indeterminable life generally is not amortizable but can be recovered only upon disposition of the asset
15-Year Amortization Rule
-licenses, permits, and similar rights granted by a government, franchises, trademarks, and trade names
-tax law requires that the capitalized cost basis of these intangible assets be amortized over an arbitrary 15 year period, beginning in the month in which the asset is acquired
-applies regardless of how the asset was acquired or the period of time during in which the asset confers a legal right or benefit to the owner
*15 years= 180 months
Organizational & Start-Up Costs
-tax law contains a specific rule for the tax treatment of the organizational costs of forming a partnership or corporation
-costs include legal and accounting fees attributable to the formation and any filing or registration fees required under state or local law
-a new partnership or corporation can deduct the lesser of its actual organization costs or $5,000
-$5,000 maximum is reduced by the amount by which total costs exceed $50,000
-entity must capitalize any nondeductible organizational cost and may elect to amortize such cost over a 180-month period starting with the month in which business begins
Start-Up Expenditures
-include both the upfront costs of investigating the creation or purchase of a business & the routine expenses incurred during the pre-operating phases of a business
-apply regardless of organizational form
-the pre-oparting phase ends only when the business has matured to the point it can generate revenues
-a firm can deduct the lesser of its actual start up expenditures or $5,000 (reduced by the amount that total expenditures exceed $50,000)
-firm must capitalize any nondeductible start-up expenditures and may elect to amortize such cost over a 180-month period starting with the month in which business begins
-does not apply to expansion costs of an existing business
Leasehold Costs & Improvement
-leasehold costs incurred as up-front costs to acquire a lease on a property must be capitalized and amortized over the term of the lease
-in contrast, if a firm pays for physical improvements to a leased property, the cost of the leasehold improvements must be capitalized to an asset account, assigned to a MACRS recovery period & depreciated under MACRS
-cost recovery applies even when the term of the lease is shorter than the MACRS recovery period
Business Acquisition Intangibles
-if the purchaser of an entire business pays a lump-sum price for the business, it must allocation a portion of the price to each balance asset required
-the price allocated to each asset equals that asset's FMV and becomes the purchaser's cost basis in the asset
-if the lump-sum price exceeds the value of the balance sheet assets, the excess is allocated to the unrecorded intangible assets of the business (goodwill and going-convern value)
-for tax purposes, firms recover the cost of acquisition intangibles over a 15-year period
Goodwill & Going-Concern Value
Goodwill: value created by the expectancy that customers will continue to patronize the business

Going-Concern Value: value attributable to the synergism of business assets working in coordination
Common Acquisition Intangibles
-information-based intangibles such as accounting records, operating systems or manuals, customer lists, and advertiser lists
-customer-based or supplier-based intangibles such as favorable contracts with major customers or established relationships with key suppliers
-know-how intangibles such as designs, patterns, formulas, and other intellectual property
-workforce intangibles such as the specialized skills, education, or loyalty of company employees and favorable employment contracts
-covenants not to compete and similar arrangement with prior owners of the business
Book/Tax Difference for Goodwill
-firms are not required to amortize the cost of goodwill for financial reporting purposes
-annual deduction for goodwill amortization is a favorable temporary difference between book income and taxable income
-for financial reporting purposes, firms must test their purchased goodwill annually for any impairment to its value
-if the value of goodwill is impaired, the firm must record an impairment expense and write down the value of the goodwill reported on its balance sheet: not deductible
-unfavorable temporary difference between book & tax income
Depletion of Natural Resources
-firms engaged in the business of extracting minerals, oil, gas, and other natural deposits from the earth incur a variety of up-front costs to locate, acquire, and develop their operating mines and wells
-some of these costs must be capitalized and recovered over the period of years that the mine or well is productive
-Cost Depletion: the method for recovering a firm's investment in an exhaustible natural resource
Cost Depletion Formula
(units of production sold during the year/estimated total units in the ground at the beginning of the year)*unrecovered basis in the mine or well
Percentage Depletion
-to encourage the high-risk activity of exploration & extraction, congress invented percentage depletion, an annual deduction based on the gross income generated by a depletable property multiplied by an arbitrary depletion rate
-in any year, a firm is allowed to deduct the great of the cost depletion or percentage depletion attributable to its properties
-not limited to the capitalized cost of the mine or well
-available in every year that they property generates gross income, regardless of the fact that the tax basis has been reduced to zero
-indirect preferential rate; may not exceed 50% of taxable income from debletable property