Depreciation – the IRS playground

Tax Rules for Qualified Leasehold Improvements

Article written by EricBank

Many small businesses, especially retailers, restaurants and service providers, lease offices, buildings, warehouses and storefronts rather than allocating capital for their purchase. Often, the lessees make improvements to the leased properties, such as installing fixtures, lighting and alike. Certain types of leasehold improvements made before Jan 1, 2014 qualify for tax breaks by way of bonus depreciation-- half of the cost in the first year and the remainder over 15 years. Businesses can also depreciate non-qualified leasehold improvements, albeit at a slower rate.

Qualified Leasehold Improvement Property

The Internal Revenue Service requires that leasehold improvement property meet certain requirements to receive bonus depreciation. First of all, qualified property is limited to interior space of a non-residential structure. The lessee must exclusively occupy the space and the lease must allow the improvements. Improvements made during the property's first three years of service don't qualify. In addition, the property must fall under the Section 1250 classification for depreciable structural components and buildings. Improvements made after Jan. 1, 2014 don't qualify for bonus or accelerated depreciation.

Qualifying Improvements

Once meeting the general IRS criteria, a business can count almost any upgrade or modification to the leased property made before 2014 as a qualified leasehold improvement. This includes any money the business spends to improve HVAC equipment, doors, ceilings, non-structural partition walls, lighting fixtures, sprinkler systems, plumbing and electrical systems. But here is an important twist: because it doesn't sit within leased interior space, installing rooftop HVAC equipment doesn't qualify for bonus depreciation.

Non-Qualified Improvements

You can still depreciate leasehold improvements you make after 2013, but must use the regular 39.5-year depreciation period. This includes money you spend on improvements to escalators and elevators, building enlargements, common-area structural component improvements and internal framework improvements. Leasehold improvements don't qualify if the lessee and lessor are related -- family member, affiliated group members, trustees, executors and corporate subsidiaries.

Subsequent Owners

If the lessor makes qualified leasehold improvements and then sells the property to a new lessor, the tax benefits might not follow. For the improvement qualification to continue, one of the following must apply:

·       The old and new lessees are the same taxpayer,

·       The property passes to the new lessor after the original lessor's death,

·       The property passes from one corporation to an acquired corporation, or

·       The old and new lessors barter the property for another one and maintain the original cost basis

Other Depreciation Changes for 2014

2014 saw other changes to depreciation rules. For example, the depreciation limits that provide for immediate expensing of five-, seven-and 15-year property changed, from a $500,000 limit in 2013 to a $25,000 limit in 2014. Section 179 business property generally includes:

·       Equipment

·       Tangible personal property used by the business

·       Vehicles with gross weight exceeding three tons

·       Computers and off-the-shelf software

·       Furniture

·       Attached, non-structural building components, such as a printing press

Other 2014 changes saw the expiration of

·       The seven-year depreciation period for entertainment complexes exhibiting motor sports

·       Accelerated depreciation afforded to Indian reservation property

·       The three-year depreciation period for race horses

QuickBooks will generate reversing entries with a click of a checkbox!

Year-End Accrued Expense Reversals

Article written by EricBank

While many businesses maintain their books on a cash basis, the vast majority perform accrued accounting, the method recommended under generally accepted accounting principles (GAAP). One consequence of the GAAP method for closing your books at year's end is to remove the balances from temporary accounts for income and expenses and distribute those balances to retained earnings, a permanent account that appears on the balance sheet. Under the GAAP matching principle, you must recognize expenses and income when incurred, not when you exchange money. To ensure that you book accruals in the correct periods while avoiding double counting, you make reversal entries from accrued expenses at the start of the new year to reverse year-end incurred expenses that haven't been billed.

Reversing Accrued Expenses

Your business might experience unpaid income and expenses at the end of the current accounting period. For instance, suppose in December you use $400 of electricity but the utility won't invoice you until January. You could choose to avoid reversal accounting by simply booking $400 as a debit to the utility expense account and a credit to A/P. But here's the rub: suppose someone tries to pay the utility invoice when your company receives it in January, unaware that it's already been booked. The expense would be double-counted, a potential problem you can avoid by using reversal entries.

At Year Close

If you want to use reversal entries at year close, first set up a liability account named accrued expenses. This account is different from other expense accounts because it doesn't enter retained earnings via the income statement at period close. In other words, use accrued expenses as if it was a balance sheet account, although it in fact never goes on the balance sheet. Its sole purpose is to carry a balance into the start of the new year. In our example, you would book the $400 electricity expense in December as a debit to utility expense and a credit to accrued expenses, thereby recognizing the expense in the current period.

Year-End Income Statement

You've followed GAAP by booking the expense in the current period and showing it on the year-end income statement as an operating expense. As you close the books, you will sweep your net income, reported at the bottom of the income statement, into retained earnings and then zero out all the temporary income and expense accounts, but not accrued expenses. You might use an intermediate temporary account, income summary, to transfer all your regular income and expense accounts and then update retained earnings with the income summary balance. In any event, you enter the new year with zero balances in your temporary accounts.

Reversal Entries

In January, you reverse the accrued expense transactions. For example, you would debit $400 to the accrued expense account and credit it to the utility account, creating a balance of negative $400. When you get the utility invoice in January, debit the utility account and credit A/P or cash for $400. This doesn't create a new expense, but it does return your utility account to a zero balance and it pays the bill. You can set up your accounting system to do this automatically.

How Do You Handle Inventory that You Can No Longer Make A Profit on?

Accounting for Distressed Inventory

Article written by EricBank

The profitable management of a merchandising business requires that you sell your inventory for more than its cost. Your gross profit margin is your sales revenues minus the cost of goods sold (COGS). In the best of all worlds, you'd sell each item at its anticipated gross profit margin, but sometimes you have to deal with spoiled, damaged, distressed or otherwise devalued inventory. In this article, we'll describe the proper methods to account for distressed inventory.

Distressed Inventory

Inventory can become distressed for all sorts of reasons, including:

·       Damage from shipping and storage

·       Spoilage

·       Defects in its manufacture

·       Obsolescence

·       Health and safety issues

Distressed inventory boosts your COGS and reduces the value of your ending inventory, as seen in the inventory equation:

COGS = inventory purchases + beginning inventory - ending inventory

Sometimes, perfectly good inventory disappears -- a problem called "shrinkage" -- which also lowers the value of your ending inventory for the period. The net result is that a higher COGS means a lower amount of taxable income. In effect, your inventory losses are a tax deduction.

Write-Offs

If you do cash accounting, you can write off inventory losses directly as you become aware of them. The proper entry is to debit COGS, an expense account, and to credit the inventory account, a current asset. The problem with this procedure is that you will be potentially allocating the loss well after it occurs, and generally accepted accounting principles (GAAP) do not allow this if you use accrual accounting. The famous "matching principle" instructs you to recognize expenses in the period they actually occur, and match them to the revenues for that period. To apply the matching principle to inventory write-offs, you must establish inventory reserve accounts.

Inventory Reserves

The inventory reserve account appears right below the inventory line on the balance sheet -- it is a contra-asset account that reduces the net value of ending inventory. The account usually has a name like "allowance for inventory losses." At the start of a reporting period, make an estimate of how much you expect to lose in the period due to distressed inventory and shrinkage. Debit this amount to COGS (or to a special expense account for this purpose, if you wish) and credit it to the reserve account. This accounting entry fulfills the requirements of the matching principle by recognizing losses up front, in the period they are likely to occur. When you eventually encounter an actual inventory loss, debit the loss amount to the reserve account and credit it to inventory. In this way, you reduce the remaining reserve amount and lower your inventory value without creating another expense, since you already took the expense at the start of the period.

Lower of Cost or Market

Sometimes, your inventory can lose value because it becomes unfashionable or obsolete. When this occurs, you might find that the selling price is below the amount you spent to acquire the inventory. GAAP requires you to recognize this loss. To do so, employ the "lower of cost or market" method (LCM) to reduce the value of your inventory to its realizable worth. The realizable value is how much you can obtain by selling the inventory minus whatever it costs you to prepare and sell it. With LCM, you should create a reserve account for LCM losses and an expense account, such as "LCM write-down losses" to record the estimated loss. GAAP doesn't allow you to reverse an LCM markdown once it's made, even if the price of the inventory recovers.

Are You Keeping Up With All of the New Rules and Regulations?

New Rules for Revenue Recognition

Article written by EricBank

The guardian of U.S. generally accepted accounting principles, the Financial Accounting Standards Board (FASB), has been working for some time with its counterparts at the International Accounting Standards Board to harmonize their respective accounting guidelines. One result, which goes into effect in 2017, deals with revenue recognition for contract sales, whether the contract is written, spoken or a result of regular business practices.

The Five-Part Model

The new model describes in five steps the FASB rules for recognizing revenue. This is especially important for small businesses that often work without written contracts. Although the new rules cover most selling situations, a few contract types, such as those for leases and insurance, operate under different rules. Here is a summary of the FASB five-part revenue recognition model:

1.    Identify the Contract -- According to FASB, a contractual agreement between two or more parties specifies rights and obligations that are legally enforceable. The new GAAP rules apply separately to each contract, though under certain circumstances the parties can combine multiple contracts.

2.    Identify Performance Obligations -- Contracts contain one or more performance obligations, which are commitments to transfer from seller to customer specified goods and services. Under the new rules, you might be obliged either to combine multiple performance obligations or to account for each one separately. Sometimes, performance obligations involve third parties.

3.    Determine Transaction Price -- When a seller transfers goods or services, it expects the customer to pay cash or some other form of consideration. FASB gives four guidelines to help determine the price for a transaction:

.   You are to predict the most likely value if you need to consider multiple variables.

.   Take into account the time value of money, or interest.

.   Measure non-cash considerations at fair market value.

.   If the seller pays an inducement or offers a discount to the customer, reducethe transaction price accordingly. However, do not reduce the price because of uncertainty of payment -- there are other procedures for handling that.

4.    Allocate Transaction Price -- Use the standalone price, real or estimated, to allocate revenue and discounts among multiple performance obligations. If the contract price changes, update revenue as of the period of the change.

5.    Recognize Revenue -- The last step is to identify the point where a seller fulfills the obligation to transfer goods or services. There are two cases:

.   Transfers Over Time -- FASB gives a number of criteria that a seller should follow to recognize revenue when transfers occur over a period of time.

.   Transfers at a Point in Time -- There are five types of events that indicate the transfer has occurred, including the right to getting paid, the customer assuming legal title, and physically transferring goods from the seller to the customer or to a third party.

FASB also discusses special topics, such as repurchase agreements and consignment arrangements. Although the final implementation is a few years away, many companies are already planning for the new rules, and there is no prohibition against getting an early start.

Service is Forever!

Just a little pick-me-up in case you've been having one of "those" weeks!

Do you have your arms around your cashflow?

Accounts Receivable for Small Businesses

Article written by EricBank

As a small business owner, you need to forecast your cash flow in order to pay your bills, withdraw capital and purchase inventory. One important aspect of cash collection is called terms of sale, which includes the time expected to receive payment, penalties/discounts for late or early payment and a provision for unpaid bills. Most companies extend credit to business customers so that the customers don't have to pay for purchases on the sale date. Accounts receivable (A/R) is where you record and track invoices, credit, payments and balances. Let's take a closer look at some important aspects of A/R.

Terms of Sale

A term of 2/10 net 30 designates that a business customer will get a 2 percent discount if it makes payment within ten days, but that it must make full amount within 30 days. You may charge interest on the balance that the customer hasn't paid within the 30 day window as compensation for delayed collection. You monitor your A/R via aging reports that categorize receivables by the time interval since the original sale. You may decide to use a collection agency to track down accounts that are delinquent for over 90 days. The worst-case scenario is that you'll have to write off the entire invoice.

Because of high collection costs, it's prudent to include a note on your invoice stating that for bills over 90 days past due, the buyer assumes responsibility for collection-related expenses.

The Float

Your business customers maintain accounts payables (A/P), a liability account, to record the credit granted to them and payments due. Float is the amount of interest your customer can earn on unpaid A/P by lending cash instead of using it to pay invoices. Of course, you can earn float too by delaying your payments to suppliers. In our example, the 2/10 net 30 terms mean that the customer can earn 30 days of interest on the amount due before paying the bill. However, there is a cost for doing this: the customer is implicitly paying 2 percent interest for the latter 20 days of the period, which is the discount that the customer forgoes by not paying within the first 10 days. In other words, the first 10 days provide free float to the customer, while the subsequent 20 days has a float cost of 2 percent. Customers with cash flow problems may decide to conserve cash by delaying A/P payments, although they will have to pay implicit or real interest to the creditor -- you.

Factoring A/R

Factors are financial companies that help businesses monetize their A/R. The factor is an agent that purchases your A/R for an agreed cash amount that is always less than the total amount due for collection. The discount price that the factor pays is its source of revenue and a cost to the creditor. This has the effect of replacing A/R with (a smaller amount of) cash on the balance sheet, and you treat the factoring cost as a loss on sale. The amount you receive from the factor might be contingent upon the factor's ability to collect the bills due -- this is called "factoring with recourse." Alternatively, sometimes businesses use A/R as collateral for borrowing.

Do You keep two sets of books? Is there anything wrong with that?

Deferred Income Tax Liability vs. Tax Payable 

Article written by EricBank

Small companies benefit from professional tax preparation in many ways. For example, companies usually keep two sets of accounting books, but there is nothing sinister about that. Rather, the practice stems from the different requirements for financial and tax reporting. A company must maintain periodic and annual financial information according to generally accepted accounting principles (GAAP), but also must file an annual tax return that follows IRS rules and doesn't necessarily adhere to GAAP. The role of an enrolled agent is to know the different accounting and reporting requirements for financials and taxes. We can see an example of these different requirements in the reporting of taxable income, tax payments and deferred income tax liability.

GAAP Tax Payable

Under GAAP, a company's pretax income determines its income tax payable. Bear in mind that companies also might have to pay other taxes, such as payroll, local and state tax. The recognition procedure for the income tax a company must pay is to debit the tax expense account and credit the income tax payable account, a liability. Eventually, the company will remit cash to the IRS. At that time, it reduces by the check amount the balances in the cash and tax payable accounts.

How Differences Come About

The difference between the GAAP book values and IRS tax values of a company's liabilities and assets results in a deferred tax liability, which is a GAAP-based future obligation to pay taxes. As an example, suppose ZYX Corp makes a one-year installment sale of merchandise for $30,000. Under GAAP, ZYX must immediately record an income entry of the full amount. However, under IRS rules, only the revenue received in the current year from an installment sale, which in this case is, say, $10,000, is subject to current taxation. This creates a temporary difference of $20,000 income between the financial and tax books.

Deferred Tax Liability

Suppose further that ZYX is in a tax bracket of 25 percent, which means it must pay a quarter of its net income to the IRS. The current tax resulting from the installment sale is 25 percent of $10,000, or $2,500 (for the sake of simplicity, we'll disregard any costs associated with the sale). ZYX credits income tax payable in Year 1 for $2,500, but the GAAP-based income statement shows a total tax expense equal to 25 percent of $30,000, or $7,500. The deferred tax liability is the tax that will eventually become due when the installment sale is completed in Year 2, equal to $7,500 minus $2,500, or $5,000.

Reconciling the Books

ZYX collects in Year 2 the remainder of the income, $20,000, from the installment sale, which creates the expected $5,000 tax liability. Therefore, it records in its financial books a debit to the deferred tax liability account and a credit to the tax payable account for $5,000, thereby zeroing out the deferred liability. When ZYX sends a check to the IRS, it decreases income tax payable and cash by $5,000. ZYX also updates its Year 2 tax books by the payment of $5,000 arising from the $20,000 installment sales in the second year. Now, both the financial and tax books match with regard to this sale. 

If you are not comfortable with the distinctions between financial and tax reporting, consider using profession accountants, bookkeepers and enrolled agents to ensure you don't overpay your taxes.

Have you thought about who should represent you if you have an issue with the IRS?

Representation Before the IRS

Article written by EricBank

The rules concerning who can represent you before the Internal Revenue Service are currently in flux. In February 2014, The D.C. Circuit Court of Appeals ruled that the Internal Revenue Service couldn't limit the ranks of paid tax return preparers to four categories: CPAs, enrolled agents (EAs), attorneys and registered tax return preparers (RTRPs). Until the court struck down the IRS rules, the first three categories were allowed to represent taxpayers before the IRS in any examination or proceeding, whereas RTRPs representation rights were limited. Before the court decision, individuals who did not belong to any of the four categories were barred from representing taxpayers before the IRS.

A "Voluntary" Program

The IRS wanted, and rightly so, to ensure that paid yet uncertified tax preparers were properly trained, and therefore created mandatory testing and continuing education requirements for RTRPs. Here is the irony: the court never said that holding paid tax preparers to a high standard of training was a bad idea, it simply said that the IRS overstepped its authority in creating the new rules. In response, the IRS has established the voluntary Annual Filing Season Program as a sort of stopgap until, and if, Congress passes laws enabling the IRS to re-establish its rules regarding representation.

The program requires non-certified tax preparers to take "voluntary" courses and pass tests in order to receive a Record of Completion, which the IRS mandates if the non-certified person wants to provide certain limited representation before the IRS. While attorneys, EAs and CPAs can represent taxpayers in any IRS procedure, the holders of a Record of Completion are not allowed "to represent the taxpayer before appeals officers, revenue officers, Counsel, or similar officers or employees of the IRS" according to IRS Revenue Procedure 2014-42.

Invitation to Chaos

This is where the Law of Unintended Consequences comes into play. The average taxpayer is not going to be familiar with the representation distinctions set up by the IRS. In other words, if you have someone other than an attorney, EA or CPA prepare your taxes for you, do not assume that person will be able to represent you in all IRS matters. The unintended consequences: confusion and added expense. Imagine, for instance, you have a Record-of-Completion-holder prepare your taxes and then the IRS audits the return. The IRS rules against you and you appeal the ruling. You might then suddenly discover that the preparer can no longer represent you, so you will have to find a new representative, an expensive time-consuming, and daresay upsetting, proposition.

Suing the IRS

The American Institute of CPA's is suing the IRS on the grounds that the new rules, once again, overstep the IRS' authority and is an end-run around the court ruling. The bottom line: not all tax preparers are equal. Enrolled agents have the necessary education and certification necessary to expertly prepare returns AND represent you in all IRS matters. Remember, CPAs and attorneys do not have to specialize in taxes, but EA's must. Until the pending lawsuit is resolved, using an uncertified tax preparer is a crapshoot.