Timing of Deductions

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Do curso por University of Illinois at Urbana-Champaign

Federal Taxation I: Individuals, Employees, and Sole Proprietors

63 classificações

University of Illinois at Urbana-Champaign

Federal Taxation I: Individuals, Employees, and Sole Proprietors

63 classificações

Curso 1 de 5 em Specialization U.S. Federal Taxation

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

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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 difference in tax treatments for special types of acitivites, such as hobbies and rentals.

Timing of Deductions7:56

Conheça os instrutores

Petro Lisowsky, PhD, CPA
Associate Professor of Accountancy
College of Business: Department of Accountancy
Matthew Hutchens
Lecturer of Accountancy
Department of Accountancy

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 does it 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 depreciation.

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 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 payments.

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.

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 deductible under the accrual method.

First, the all events test 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 builds me $500 and I pay the bill in three months.

What is 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 build 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 the service repair person fix 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

the 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's 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 8.5 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 one percent of

its washing machines 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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