Accounting Periods & Methods 6-XXX
CHAPTER 6
ACCOUNTING PERIODS AND METHODS
SOLUTIONS TO PROBLEM MATERIALS
Status: Q/P
Question/ Present in Prior
Problem Topic Edition Edition
1 Partnership tax year Unchanged 1
2 Fiscal year: natural business year Unchanged 2
3 Fiscal year: personal service corporation Modified 3
4 Change in tax year: short-period tax Unchanged 4
5 Change in accounting method: adjustment Modified 5
6 Change in accounting method: adjustment Modified 6
7 Ethics problem Unchanged 7
8 Installment method: interest on deferred taxes Unchanged 31
9 Ethics problem Unchanged 9
10 Installment method: benefits Unchanged 10
11 Installment method: contingent sale price Modified 11
12 Installment method: contingent sale price Modified 13
13 Installment method: imputed interest Unchanged 14
14 Installment sales between related parties Unchanged 16
15 Disposition of installment obligations Unchanged 17
16 Long-term contracts: completed contract method Modified 18
17 Long-term contracts: percentage of completion Modified 19
method
18 Issue recognition Unchanged 20
19 Long-term contract methods Unchanged 21
20 Long-term contract methods Modified 22
21 Percentage of completion method: lookback Modified 23
22 Inventory capitalization requirements Unchanged 25
23 Lower of cost or market and LIFO Unchanged 27
24 Changing from FIFO to LIFO, lower of cost Unchanged 29
or market
6-1
Status: Q/P
Question/ Present in Prior
Problem Topic Edition Edition
25 Dollar-value LIFO Unchanged 30
26 Change in accounting method: inventories Unchanged 8
Research
Problem
1 Accounting methods: dollar-value LIFO New
2 Change in accounting method Unchanged 2
3 Materiality of inventories: cash method Unchanged 3
4 Accrual method: consignment income Modified 4
5 Internet Activity Unchanged 5
6 Internet Activity Unchanged 6
7 Internet Activity Unchanged 7
PROBLEM MATERIAL
1. a. Since the majority interest partners' rule is satisfied (i.e., Red, who has a 60% interest, is the majority interest partner), the partnership must have the same tax year as Red (i.e., fiscal year ending September 30).
b. Since neither the majority interest partners' rule nor the principal partners' rule is satisfied, the least aggregate deferral method must be used in determining the partnership tax year.
Test for Fiscal Year Ending September 30
Months of
Partner Year Ends Profit % Deferral Product
Red 9/30 30 0 0
White 6/30 40 9 3.6
Blue 1/31 30 4 1.2
Aggregate deferral months 4.8
Test for Fiscal Year Ending June 30
Months of
Partner Year Ends Profit % Deferral Product
Red 9/30 30 3 0.9
White 6/30 40 0 0
Blue 1/31 30 7 2.1
Aggregate deferral months 3.0
Test for Fiscal Year Ending January 31
Months of
Partner Year Ends Profit % Deferral Product
Red 9/30 30 8 2.4
White 6/30 40 5 2.0
Blue 1/31 30 0 0
Aggregate deferral months 4.4
Therefore, because the least aggregate deferral is for the fiscal year ending June 30, this will be the fiscal year-end for the partnership.
pp. 6-3 and 6-4
2. a. The corporation should elect to use a fiscal year ending September 30th, the conclusion of its natural business year. This would enable William to defer until the following calendar year the tax on the income earned from October 1st through December 31st of each year.
b. The corporation should elect the calendar year. The calendar year would maximize the loss that William can report in the first two calendar years. Because William materially participates in the business, the loss can be offset against his other income. After the end of the third year the corporation can request permission from the IRS to change to the natural business year.
pp. 6-4 and 6-5
3. a. Allison should receive 3/12 X $100,000 = $25,000 salary. Example 6, p. 6-6
b. Because Allison received only $20,000 salary, the corporation's deduction for the fiscal year ending September 30, 2000 is limited to $80,000 [$20,000 + $20,000[(12 - 3)/3)] even though Andrew may receive more than $80,000. Example 6, p. 6-6
4. a. The corporation must file Form 1128 by July 15, 1999 requesting permission for the change. p. 6-6
b. Short-period income is annualized as follows:
$31,500 X 12/5 $75,600
Tax: $50,000 X .15 = $ 7,500
$25,000 X .25 = 6,250
$600 X .34 = 204
Subtotal $13,954
Deannualize X 5/12
Short-period tax $ 5,814
pp. 6-7, 6-8, and Example 8
5. a. Adjustment
Due to
Change
Cash basis taxable income $60,000
Less beginning accounts receivable (56,000) $56,000
Plus beginning accounts payable 29,000 (29,000)
Less beginning inventory (27,000) 27,000
Plus ending accounts receivable 50,000
Less ending accounts payable (28,000)
Plus ending inventory 30,000
Accrual basis taxable income $58,000
Adjustment due to change $54,000
b. Accrual basis taxable income from a. $58,000
Plus adjustment due to change 54,000
Accrual basis taxable income adjusted $112,000
The net adjustment from the required change exceeded $3,000. Therefore, the taxpayer could elect to spread the adjustment to prior taxable years. However, the effective tax rates in those years would need to be compared to the tax rates of the current year. If the taxpayer's effective tax rates have fallen, including all of the adjustment in 2000 taxable income may minimize the tax on the adjustment.
pp. 6-10, 6-11, and Example 9
6. a. Adjustment
Due to
Change
Cash basis taxable income $55,000
Less beginning accounts receivable (15,000) $15,000
Plus ending accounts receivable 23,000
Plus beginning accrued expenses 15,000 (15,000)
Less ending accrued expenses (16,000)
Less beginning inventory (20,000) 20,000
Plus ending inventory 19,000
Accrual basis taxable income $61,000
Adjustment due to change $20,000
b. The change from the cash to the accrual basis for sales and cost of goods sold is a change from an incorrect method to a correct method because inventories are material to the business. The net adjustment due to these items is $35,000 ($15,000 + $20,000) and must be spread over four years (the year of change and the three succeeding years).
The change in the treatment of accrued expenses is a change from one correct method to another correct method. The net adjustment is a negative $15,000 and must be spread over four years.
Example 9, pp. 6-10 and 6-11
7. The issue is whether Hyacinth can do indirectly what the IRS will not permit it to do directly (i.e., change from the accrual method to the cash method in order to defer the recognition of income and the related income taxes). A new corporation, which is a qualified personal service corporation, can elect the cash method of accounting.
From a form perspective, it appears that Rochelle’s plan for Hyacinth may work without producing any negative tax consequences for Hyacinth. That is, Hyacinth will continue to report its income under the accrual method as the business is prepared for liquidation. The only potential negative tax consequence is that at the time Hyacinth is liquidated and the assets are transferred to a new corporation, there will be recognition at the corporation level (under § 336) for the realized gain on any appreciated assets and at the shareholder level (under § 331) for the excess of the amount realized over the shareholder’s stock basis. For an engineering corporation, these amounts may be insignificant.
Even if Rochelle’s plan is desirable (i.e., no substantial recognition at the corporation or shareholder level on the liquidation), it probably will not work. To permit it to work would open the door for effective changes in accounting method without IRS permission. The IRS can attack Rochelle’s plan with a “substance over form” argument.
The major justification for Rochelle’s plan, in response to the likely IRS position, is that the liquidation of the corporation is a taxable event. Therefore, it would be inappropriate for the “substance over form” argument to be applied.
pp. 6-9 and 6-10
8. Smith, Raabe, and Maloney, CPAs
5101 Madison Road
Cincinnati, Ohio 45227
December 1, 2000
Bluebell & Associates
200 Jerdone
Gettysburg, Pennsylvania 17325
Dear Bluebell & Associates:
You asked about the tax consequences of accepting a lower down payment on the proposed sale of your investment property. Accepting a lower down payment and a larger installment note allows you to defer recognition of a larger amount of gain. However, for tax purposes, you must pay interest on your deferred taxes on the balance of the installment receivable in excess of $5,000,000. If the installment principal is $18,000,000, you will pay interest on the taxes that would be due on only $13,000,000. If the installment principal is $8,000,000, you will pay interest on the taxes that would be due on only $3,000,000. Both options allow you to defer the taxes on $5,000,000 without paying interest. If the rate of interest you receive on the installment note is higher than the rate applied to the deferred taxes, it may be to your advantage to accept a lower down payment. You should also consider your marginal tax rate in current and future years when making your decision.
As you can see, since both options involve an installment note in excess of $5,000,000, the real basis for your decision should be nontax factors. For example, you should consider the yield you would earn on investment of the additional cash received under the high down payment option versus the interest earned on the larger installment note under the lower down payment option. Creditworthiness of the buyer should also be a key consideration.
If you have any further questions, please call me.
Sincerely,
Larry Brown, CPA
Partner
p. 6-18
9. Despite the client’s wishes, the only two alternatives technically available are the amended return and the accounting method switch. You must build a defense against negligence penalties, to protect both yourself as tax preparer and the client as taxpayer. The accounting method switch may be slightly preferable here.
Consider the following issues:
· Did the client qualify for the cash method based on its gross receipts for the year?
· If so, does it continue to so qualify?
· Are the inventory and receivables amounts material in amount?
· Would a switch to the accrual method create any new deductions that would offset the tax increases discussed by the client?
10. a. Cash Installment
Sale Sale
Collections in year of sale: $100,000 $25,000
Less: Tax .35($100,000 - $10,000) ( 31,500)
.35 X ($100,000 - $10,000)($25,000)
$100,000 ( 7,875)
Cash receipts, net of tax, in year of sale $ 68,500 $17,125
Amount received in two years:
Interest income $15,750*
Less: Tax (.35 X $15,750) ( 5,513)
Plus: Principal 75,000
Less: Tax
.35 X ($100,000 - $10,000)($75,000) (23,625)
$100,000
Cash receipts, net of tax, in two years $61,612
*In two years Finch Corporation will collect interest from year 1 of (.10)($75,000) = $7,500 plus interest from year 2 of .10($75,000 + $7,500) = $8,250.
If Finch sells for $100,000 in the year of sale, it will have an additional $51,375 to invest ($68,500 - $17,125 = $51,375) for 2 years at (1 - .35)(.14) = 9.1% rate of return. $1 compounded for two years at 9.1% interest = $1.19. Thus, the $51,375 invested for 2 years will accumulate to equal to (1.19)($51,375) = $61,136, which is less than the value of the deferred payments at the end of two years ($61,612). Therefore, Finch should sell under the deferred payment plan under the stated assumptions.
b. The answer would change. Applying the technique used in a. to compare the options, Finch will have an additional $72,375 [($100,000 - $3,500) - ($25,000 - $875)] to invest for two years if it sells for $100,000 cash. Thus, the $72,375 invested for two years will accumulate to $86,126 (1.19 X $72,375). This is greater than the value of the deferred payments in two years of $82,612 [($15,750 - $5,513) + ($75,000 - $2,625)].
pp. 6-12 and 6-13
11. Maximum sales price $600,000
Basis (200,000)
Maximum gain $400,000
Gain = $400,000 = 2/3 profit ratio
Contract Price 600,000
$100,000 X 2/3 = $66,667 reported profit.
pp. 6-13, 6-14, and Example 13
12. Basis = $30,000 = $2,000 basis per year
Standard life 15 years
Receipts $800
Basis (2,000)
Loss ($1,200)
No; the $1,200 loss is not reported. In taxable years where the amount of the payment received is less than basis allocated to the year, no loss shall be allowed; instead the excess basis shall be reallocated in level amounts over the balance of the 15-year term.
pp. 6-13, 6-14, and Example 15
13. a. The contract does not contain interest at least equal to the Federal rate and the principal amount exceeds $3,885,500; therefore, interest must be imputed and the selling price must be recomputed. Furthermore, the interest income must be reported by the accrual method.
Selling price and contract price (present values, at 8%
in 2 years, semiannual compounding)
Principal ($6,000,000 X .8548) $5,128,800
Interest ($741,600 X .8548) 633,920
$5,762,720
Cash received on date of sale 800,000
Total selling price $6,562,720
Less basis (1,000,000)
Realized gain $5,562,720
Year
1999 Recognized gain ( $5,562,720 X $800,000) $678,100
$6,562,720
Interest, 8%, one-half year [.08($5,762,720)(.50)] $230,509
2000 Interest, one year at 8%* on $5,993,229 ($5,762,720 + $230,509)
*Compounded semiannually $489,047
2001 Recognized gain ( $5,562,720 X $5,762,720) $4,884,620
$6,562,720
Interest, one-half year at 8% on $6,482,276
($5,993,229 + $489,047) $259,291
Total interest ($230,509 + $489,047 + $259,291) $978,847
Total recognized gain ($678,100 + $4,884,620) $5,562,720
pp. 6-15, 6-16, and Concept Summary 6-1
b. The effective interest rate on the note is 12%, which exceeds the Federal rate. Therefore, interest is not imputed. Furthermore, because the principal amount is less than $2,775,400, the seller can elect to report the interest by the cash method assuming the buyer agrees to report expense by the cash method.
Selling price and contract price
Principal $2,000,000
Cash down payment 800,000
Total selling price $2,800,000
Less basis (1,000,000)
Realized gain $1,800,000
Year
1998 Recognized gain ( $1,800,000 X $800,000) $ 514,286
$2,800,000
1999 Recognized gain $ -0-
2000 Recognized gain ( $1,800,000 X $2,000,000) $1,285,714
$2,800,000
Interest income $ 508,800
pp. 6-15, 6-16, and Concept Summary 6-1
14. Father would recognize all of his deferred gain in 2001. Thus, his recognized gain in 2001 would be:
Gain X Collections* = $150,000 X $190,000 = $142,500
Contract price $200,000
* Including deemed collections resulting from Son’s sale of the land.