This course is the first course in a five-course US Federal Tax Specialization. It covers and focuses on the U.S. federal tax system as it relates to individuals, employees, and sole proprietors. Key concepts covered include gross income and items that are statutorily included or excluded in it, personal and business expenses that qualify as tax deductions, and the differing tax treatments for employees versus self-employed taxpayers. Unlike many other introductory courses in tax and as part of this course’s comprehensive wrap-up, learners will be provided with practical and tangible experience reporting both income and expenses on the main individual tax return used in the US, Form 1040. If you have enjoyed this course, consider enrolling in our online graduate Accounting program. The University of Illinois at Urbana-Champaign, consistently ranked as one of the nation's top three accounting programs, now offers a master’s in accounting at a very affordable tuition rate and is completely online. The iMSA is a full Master of Accountancy program and students graduate with an MS that is highly recognized. Try an open course or two, then apply for admission into the credit-bearing version as you may be eligible to take credit-bearing courses during the application process. If you are missing any prerequisites for the full degree, you can complete Coursera courses to demonstrate readiness and strengthen your application for the iMSA. For more information on this exciting iMSA online program, refer to this link: https://www.coursera.org/degrees/imsa
Timing of Deductions
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Do curso por University of Illinois at Urbana-Champaign
Federal Taxation I: Individuals, Employees, and Sole Proprietors
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University of Illinois at Urbana-Champaign
56 ratings
Curso 1 de 5 em Specialization U.S. Federal Taxation
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MODULE 5: DEDUCTIONS AND LOSSES: IN GENERAL
In this module, you will learn about deductions, which is the term used in tax to describe an expense that is allowed to reduce a taxpayer’s tax liability. You will discover what Adjusted Gross Income is, why it is important, and how to calculate it. You will also learn the proper tax treatment of semi-profitable activities, such as hobbies.
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Petro Lisowsky, PhD, CPAAssociate Professor of Accountancy
College of Business: Department of Accountancy
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Welcome back.
After having discussed the concepts behind what trade and business expenses
are deductible, in this video we'll examine when an expense is deductible.
So generally speaking,
the timing of deductions is determined by the taxpayer's accounting method.
Recall that four accounting methods are acceptable to the IRS, cash, accrual,
special and hybrid.
Here, we'll discuss cash and accrual since they are the dominant accounting methods
used by business taxpayers.
First the Cash Method.
When is an expense deductible under the Cash Method?
Here, an expense is deducted when it's paid with either cash, or property, or
services.
Also even under the Cash Method, a current deduction for
a capital expenditure is not allowed.
That is, generally, a business taxpayer cannot immediately deduct
the entire value of business equipment or machinery in the first year of use.
Instead the taxpayer must capitalize the equipment as an asset, then depreciate it.
Therefore, over time, the entire cost of the asset will be deducted.
There are some exceptions that do allow for
immediate deduction of capital expenditures but we'll look at those
issues later in the course when we discuss property transactions and appreciation.
Under the Cash Method, it's also important to note that prepaid expenses are not
deductible currently if they expire or
can be consumed beyond the end of the year following payments.
In simpler terms, there's a one-year rule for prepaid expenses.
For example, if in December of the current year a business taxpayer prepays for
the next year's subscription to a business database.
Then the prepayment is fully deductible because the use of that database will not
extend beyond the end of the year following the payment.
Any prepaid items that fail the one-year rule must be prorated and
deducted when they apply.
Therefore to the extent the prepayment is for
expenses to be incurred in the next year, they are deductible this year.
But to the extent the prepayment is for expenses to be incurred in the year after
next year, then the expenses are deductible in the year after next year.
That is when the product or service is consumed.
And even under this one-year rule,
the prepayments of expenses must be required and not voluntary in nature.
Again, our example of prepaying the subscription to a business database.
The vendor here of the database likely requires a one-year
subscription to be paid in full before allowing access to the database.
That is, the payment is required.
Another general exception is that the tax law restricts the use of the Cash Method
to small businesses, farms, personal service corporations and
certain partnerships.
The second widely used accounting method is the Accrual Method.
Here the general rule is that expenses are deducted when they're incurred, not
necessarily when cash is paid or property is delivered or services are rendered.
So what does this mean to incur an expense for it to be deducted?
Well, there are two tests.
The All Events Test and the Economic Performance Test.
Both tests must be met for the expense to be deducible under the accrual method.
First the All Events Tests states that a deduction is allowed
when all events have occurred to create the taxpayer's liability and
the amount of the liability can be determined with reasonable accuracy.
For example, let's say a machine breaks and
I call a service repair person to fix it.
The person fixes my machine and bills me $500, and I pay the bill in three months.
What does the All Events Test say as to when
the business taxpayer gets the deduction?
Well, under the Accrual Method, once the repair person fixes the machine and billed
for $500, it means that all the events have occurred to create a liability to
the business owner and the liability can be determined with reasonable accuracy.
Here, the bill is $500.
In this case the business owner can claim a deduction for
$500 on the day the service person bills the business owner,
and not when the actual cash payment is made.
Note that under the Cash Method,
the $500 deduction will only occur once the bill is paid.
That is the deduction can only be claimed in three months.
The second test here is the Economic Performance Test.
This says that the accrued services, property, or use of property giving
rise to the liability can only be deducted when the service, property, or
use of property has actually been performed, provided, or used.
So back to our service repair example.
Because a service repair person fixed the machine,
the service that gave rise to the $500 bill has actually been performed.
Therefore, under the Economic Performance Test, the $500 bill is
deductible to the accrual business owner when the repair person bills the owner.
Importantly, note here that both the All Events Test and
the Economic Performance Test must be met in order for
the accrual basis taxpayer to deduct an expense.
For example, if the repair person begins working on a machine, but does not yet
know the final cost, the All Events Test has not been met.
If the service repair person must come back later to actually fix the machine,
the Economic Performance Test has also not been met.
Both of these tests must be met in order for
the expense to be deductible to the accrual basis taxpayer.
There is an exception here for accrual basis taxpayers.
If there is a recurring expense,
a deduction is allowed even if there's no economic performance, at least not yet.
So if the item is recurring and treated consistently year over year, the accrued
item is immaterial, or accruing results in better reflection of income.
The All Events Test is met, and economic performance occurs within a reasonable
period of time, but not to exceed eight and a half months after the year end,
then the expense can be deducted by the accrual basis taxpayer.
A final important item to note with Accrual Method taxpayers
is regarding reserves for estimated expenses.
Here the tax law does not allow a deduction for reserves or for estimated
amounts because principally, the Economic Performance Test has not been met.
For example, a company that builds washing machines might estimate that 1% of its
washing machine may need repairs and they value the repairs at $100,000 per year.
Can the washing machine company deduct the $100,000 on its current year tax return?
The answer here is no, because the company has not actually yet
repaired the washing machine.
That is, economic performance has not occurred.
In fact, the actual expense might only be $75,000 this year,
in which case the company would be over-deducting $25,000.
The IRS does not want these types of estimates to creep into the tax return for
fear that taxpayers will have the incentive to overestimate the deductions,
and thus under report their income.
Therefore the business has to wait until they incur the cost of fixing the washing
machine before deducting the known exact amount.
In all, we discussed when an expense is deductible.
Under the Cash Method,
an expense is generally deductible when it's paid in cash, property, or services.
While under the Accrual Method,
an expense is generally deductible when it's incurred.
That is, when the All Events Test and the Economic Performance Test are both met.
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