CHAPTER 18



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 Modified 1

2 Fiscal year: natural business year Unchanged 2

3 Converting cash basis income to accrual New

method income

4 Change in tax year: short-period tax Unchanged 4

5 Accrual method: required use New

6 Change in accounting method: adjustment Unchanged 6

7 Change in accounting method: adjustment Unchanged 7

8 Ethics problem Unchanged 8

9 Installment method: interest on deferred taxes Unchanged 9

10 Ethics problem Modified 10

11 Installment method: benefits New

12 Installment method: contingent sale price Modified 12

13 Installment method: depreciation and recapture Unchanged 13

14 Installment method: imputed interest Unchanged 14

15 Installment sales between related parties Modified 15

16 Disposition of installment obligations Unchanged 16

17 Long-term contracts: completed contract method Unchanged 17

18 Long-term contracts: percentage of completion Unchanged 18

method

19 Long-term contracts: capitalization versus Unchanged 19

expense

20 Issue recognition Unchanged 20

21 Long-term contract methods Unchanged 21

22 Long-term contract methods Unchanged 22

23 Percentage of completion method Modified 23

24 Inventory capitalization requirements Unchanged 24

25 Lower of cost or market and LIFO Unchanged 25

6-1

Status: Q/P

Question/ Present in Prior

Problem Topic Edition Edition

26 Changing from FIFO to LIFO, lower of cost Unchanged 26

or market

27 Dollar-value LIFO Unchanged 27

28 Change in accounting method: inventories Unchanged 28

Bridge Discipline

Problem

1 Partnership tax and accounting year Unchanged 1

2 Depreciation Unchanged 2

3 Lower of cost or market Unchanged 3

Research

Problem

1 Accounting methods: dollar-value LIFO Unchanged 1

2 Change in accounting method Unchanged 2

3 Qualifying indebtedness New

4 Capitalization of holding costs Unchanged 4

5 Internet Activity Unchanged 5

6 Internet Activity New

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 March 31).

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

Blue 1/31 30 4 1.2

White 6/30 40 9 3.6

Aggregate deferral months 4.8

Test for Fiscal Year Ending January 31

Months of

Partner Year Ends Profit % Deferral Product

Red 9/30 30 8 2.4

Blue 1/31 30 0 0

White 6/30 40 5 2.0

Aggregate deferral months 4.4

Test for Fiscal Year Ending June 30

Months of

Partner Year Ends Profit % Deferral Product

Red 9/30 30 3 0.9

Blue 1/31 30 7 2.1

White 6/30 40 0 0

Aggregate deferral months 3.0

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. 6-4 and 6-5

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. 6-5 and 6-6

| 3. a. |Total cash received | $780,000 |

| |Less: loan proceeds |(60,000) |

| |Plus: ending accounts receivable | 150,000 |

| |Less: beginning accounts receivable | (110,000) |

| |Accrual basis sales | $760,000 |

| | | |

Note that the prepaid income must be included in accrual basis income because all of it will not be earned until after the end of the tax year following the year of receipt (as discussed in Chapter 4).

b. Pink should use the cash method. If it uses the accrual method, it must pay taxes on its uncollected accounts receivable.

c. The allowance for bad debts method (i.e., reserve method) is not permitted for tax purposes. Such an allowance is contrary to the all-events test.

4. a. The corporation must file Form 1128 by July 15, 2002 requesting permission for the change. p. 6-7

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. Only the manufacturing proprietorship (b.) is required to use the accrual method. The accounting firm (a.) is unincorporated and inventories are not an income-producing factor. The health club (c.) is incorporated, but its gross receipts are less than $5 million and inventories are not an income-producing factor to the business. Inventories are an income-producing factor for the grocery store (d.), but its average annual gross receipts are less than $1 million. Therefore, the grocery store is eligible for the small business exception. A farming business (e.) is permitted to use the cash method even if inventories are material. pp. 6-10 and 6-11

6. 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 2002 taxable income may minimize the tax on the adjustment.

pp. 6-12, 6-13, and Example 9

7. a. The change to the accrual method would mean that the company would be required to make a § 481 adjustment, increasing taxable income for the balance of the accounts receivable on the first day of the tax year of the change.

b. If the change is involuntary, the company must increase income for the first year open under the statute of limitations. The additional tax will be immediately due. If the change is voluntary, the taxpayer would make the change effective for the year of the change and the adjustment due to the change can be spread evenly over the current year and the three following years.

p. 6-13

8. 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 to 6-11

9. Smith, Raabe, and Maloney, CPAs

5191 Natorp Boulevard

Mason, OH  45040

December 1, 2002

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. 6-20

10. 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?

pp. 6-9 to 6-12

11. This problem can be solved using future values – comparing Floyd’s change in after-tax cash flow at the end of one year under two options. The installment sale is preferable (future value of $81,766, as compared to $79,281 under the cash transaction) because it will allow Floyd to shift income to a lower tax bracket, as well as defer the tax on one-half of the gain.

|Option 1- Sell for cash | | |

| Cash received | $100,000 | |

| Less: basis | (25,000) | |

|Recognized gain | $ 75,000 | |

|Tax @ .35 | $26,250 | |

|After-tax proceeds ($100,000 - $26,250) | $73,750 | |

|Compounded 1 year: {1 + [(1 - .25) X .10]} | $79,281 | $79,281 |

| | | |

|Option 2 – Installment sale | | |

|Cash received: year 1 | $50,000 | |

|Gross profit % = ($100,000 - $25,000)/$100,000 = | X 0.75 |* |

|Recognized gain | $37,500 | |

|Tax @ .35 | $13,125 | |

|After-tax proceeds ($50,000 - $13,125) | $36,875 | |

|Compounded 1 year: {1 + [(1 - .25) X .10]} | $39,641 | $39,641 |

| | | |

|Cash received: year 2 | $52,000 | 52,000 |

|Interest: imputed at 4% X $50,000 | $2,000 | |

|Tax on interest @ .25 | $500 | (500) |

|Sales proceeds | $50,000 | |

|Gross profit % = ($100,000 - $25,000)/$100,000 = | X 0.75 | |

|Taxable gain | $37,500 | |

|Tax @ .25 | $9,375 |(9,375) |

|Total future value | | $81,766 |

*The selling price is calculated net of the $2,000 imputed interest.

pp. 6-13 and 6-14

12. Maximum sales price $600,000

Basis (200,000)

Maximum gain $400,000

Gain        = $400,000 = 2/3 profit ratio

Contract Price 600,000

$270,000 X 2/3 = $180,000 reported profit.

pp. 6-15, 6-16, and Example 13

13. The $30,000 gain on the office equipment is all depreciation recapture under §1245. Such gain must be recognized in the year of the sale. The installment gain is $390,000[$600,000 - $30,000 (depreciation recapture) - $180,000 (basis)]. The contract price is $600,000.

Tom’s recognized gain in the year of the sale is calculated as follows:

$390,000 X $240,000 = $156,000

$600,000

To this amount must be added the $30,000 depreciation recapture gain. So the recognized gain is $186,000 ($156,000 + $30,000). pp. 6-13 and 6-14.

14. a. The contract does not contain interest at least equal to the Federal rate and the principal amount exceeds $4,217,500; 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

2001 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

2002 Interest, one year at 8%* on $5,993,229 ($5,762,720 + $230,509)

*Compounded semiannually $489,047

2003 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. 6-16, 6-17, 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 $2,828,700, 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

2001 Recognized gain ( $1,800,000  X $800,000) $ 514,286

$2,800,000

2002 Recognized gain $ -0-

2003 Recognized gain (   $1,800,000 X $2,000,000) $1,285,714

$2,800,000

Interest income $ 508,800

pp. 6-16, 6-17, and Concept Summary 6-1

15. Father would recognize all of his deferred gain in 2002.

Gain        X Collections* = $200,000  X $140,000 = $140,000

Contract price $200,000

* Including deemed collections resulting from Son’s sale of the land.

Father recognizes no additional gain in 2003 since all of his realized gain of $140,000 was recognized in 2002.

pp. 6-17 and 6-18

16. a. The gift to George's daughter is a taxable disposition of the installment obligation. George must recognize a $30,000 gain, at the time of the gift:

$100,000 - $40,000 X $50,000 = $30,000 gain

$100,000

In addition, George must recognize $15,000 (60% X $25,000) in 2002 for the payment he received on January 1, 2002.

b. The transfer to the controlled corporation is not a taxable disposition of the installment obligation. The corporation, though, will recognize the income as the installment payments are collected. George will recognize $15,000 gain for the payment he received on January 1, 2002.

c. George must report $30,000 gain in 2002:

( $100,000 - $40,000 X $25,000) = $15,000

$100,000

from the payment that was received on December 31, 2002 as well as $15,000 gain from the payment that was received on January 1, 2002. The transfer of the installment obligations to George's estate is not a taxable event. The estate, or its beneficiaries, though, will recognize the deferred realized gain when the installment obligation is collected.

p. 6-19

17. a. Since a $150,000 item is in dispute, the profit to be reported in 2002 would be $2,200,000 - $1,980,000 - $150,000 = $70,000. In 2003, a deduction of $30,000 ($180,000 - $150,000) will be available.

b. At the end of 2002, it cannot be determined whether the contract will yield a profit or loss. (If the dispute is settled in favor of the contractor, a profit will result, but if it is settled in favor of the customer, the contractor would recognize a loss.) Therefore, the $80,000 loss is deferred until 2003 when the dispute is resolved. See Reg. § 1.451-3(d)(3).

p. 6-21 and Example 22

18. Smith, Raabe, and Maloney, CPAs

5191 Natorp Boulevard

Mason, OH  45040

September 18, 2002

Daffodil Corporation

P. O. Box 1000

Harrisonburg, Virginia 22807

To the Board of Directors of Daffodil Corporation:

You asked me to summarize the tax accounting implications on entering into the proposed line of high volume and low gross profit rate contracts. The new contracts would generally cause an acceleration of your tax liabilities.

With the increased volume, gross receipts would exceed $10,000,000 a year (i.e., estimated at $12,000,000), and the company will be required to use the percentage of completion method. Under your present method of accounting, the completed contract method, the profit on a contract is not recognized until the contract is completed, which is generally the year following the year when the contract is started, or the second year after the contract is started. Under the percentage of completion method, a portion of the profit on a contract is included in income each year based on the cost incurred during the year as a percent of the total estimated cost of the contract.

As a result of exceeding $10,000,000 in gross receipts, all contracts are subject to the percentage of completion method, and not just the new type of contract you are considering. Therefore, in deciding whether to enter these contracts, or the contract terms, you should take into account the added interest expense (or loss of income from funds) caused by earlier payments of income taxes.

Please contact me if you would like to ask any question, or would like me to make the calculations of the actual effects of changing to the percentage of completion method.

Sincerely,

Stuart Day, CPA

Partner

pp. 6-20 and 6-21

19. a. Rust must capitalize the payroll taxes.

b. Rust may expense the current service costs.

c. Rust is required to capitalize only the straight-line depreciation.

d. Rust must capitalize the sales tax.

e. Rust may expense past service costs.

f. Rust may expense costs of successful bids.

pp. 6-24 and 6-25

20. The accounting method issues that need to be addressed include the following:

• Is Eagle actually buying and selling prefabricated buildings as inventory rather than constructing buildings?

• Is Eagle merely providing a service for the customer?

• Is Eagle a contractor eligible for the completed contract method?

• If Eagle is a contractor eligible for the completed contract method, how does Eagle account for payments received on incomplete contracts?

• Does Eagle qualify for the 2% rebate?

• If Eagle qualifies for the rebate, is this an addition to income or a reduction in cost?

• If Eagle qualifies for the rebate, when is the rebate included in gross income (or, used to reduce materials costs)?

pp. 6-20 to 6-26

21. a. The aircraft builder must use the percentage of completion method, assuming the aircraft are unique.

b. The homebuilder can use the completed contract method, regardless of the size of the contractor's business.

c. The taxpayer must use the accrual method. The taxpayer is a manufacturer and can use the long-term contract accounting method only if the product is unique. In this case, the same product is produced for other customers. Therefore, the product is not unique and the accrual basis rules apply.

d. The contract to pave a parking lot is probably considered a real estate contract. The small real estate contractor can use the completed contract method.

pp. 6-20 and 6-21

22. a. If the contract is to produce "unique" property, the taxpayer must use the percentage of completion method to report the profit on the contract. If the property is not unique, the accrual method can be used to report the income.

b. The uniform capitalization rules apply to the contract. Thus, bidding costs attributable to successful contracts must be added to the contract costs. Costs of bidding on unsuccessful contracts are expensed.

c. If the company uses higher estimates of the total costs of the contract, the company will show a larger profit in the year of completion. Under the look-back method, the company will also be required to pay interest on the underpayment of taxes in prior years caused by the higher than actual cost estimates.

pp. 6-20 and 6-21

23. a. 2002 Gross profit =

[ Total cost to date X Contract price] - Total cost to date

Total estimated cost

= [($1,400,000/$2,100,000) X $2,400,000] - $1,400,000 = $1,600,000 - $1,400,000 = $200,000

2003 Gross profit =

Contract price - Total contract cost - 2002 gross profit = $2,400,000 - $1,960,000 - $200,000 = $240,000

b. Smith, Raabe, and Maloney, CPAs

5191 Natorp Boulevard

Mason, OH  45040

August 16, 2002

Board of Directors

Swallow Company

400 Front Avenue

Ashland, Oregon 97520

Dear Board of Directors:

You asked my advice regarding the estimates that should be used for percentage of completion calculations applied to long-term contracts. In answering this question, I shall first consider the consequences of errors in the estimates where:

(1) estimated costs are less than the actual cost.

(2) estimated costs are greater than the actual cost.

Under the percentage of completion method of accounting, the income is allocated to each period based on the cost incurred in that year as a percentage of the estimated total cost. When the contract is completed, the contract profit is reallocated to each year using the actual cost of the contract (each year the profit is allocated based on its actual cost as a percent of total actual cost). Interest is computed at the Federal rate on the difference between the profits originally reported on the return and the recomputed profits.

In the case of the low estimate, you overpay your taxes and receive taxable interest. The interest is based on the Federal rate for borrowing, which is less than the rate your company pays to borrow money, and less than the rate the shareholders should expect to earn on their investments. Thus, the low cost estimates should be avoided.

In the case of the high estimates of costs, you defer taxes. However, you are charged interest on the underpayment of taxes. Although the interest rate is lower than the rate at which you or the shareholders pay to borrow funds, the lookback interest is not deductible. Thus, with a Federal rate of 8%, the nondeductible interest is equivalent to (8%)/(1-.35) = 12.31% deductible interest, a rate that is higher than the shareholders and the company presently pay for funds.

In conclusion, the percentage of completion calculations should be based on your best estimate of the cost of completing the contracts.

Please call me if you have any further questions.

Sincerely,

Melissa King, CPA

Partner

pp. 6-22 and 6-23

24. Bluebird’s ending inventory is calculated as follows:

Purchases $700,000

Less: discount (14,000)

Add: freight and handling 60,000

Add: off-site storage 30,000

Add: purchasing costs 35,000

Add: additional insurance 5,000

Total cost of goods available for sale $816,000

Invoice cost of ending inventory as a percent of 15%

purchases for sale = $105,000/$700,000

Ending inventory=$816,000 X 15% $122,400

pp. 6-24 and 6-25

25. a. The inventories cannot be written off under lower of cost or market because the company has not reduced its offering price and the replacement cost of the goods is (apparently) not less than the original cost of the goods.

b. At the time of the LIFO election, the inventories must be written-up to their cost. The adjustment due to the change, an increase in taxable income, can be spread over three years.

pp. 6-24 to 6-26

26. a. Item A $10,000

Item B 25,000

LIFO beginning inventory $35,000

b. The previous write-down of Item A must be restored to income since the lower of cost or market method cannot be used in conjunction with LIFO. Therefore, the taxpayer recognizes $333 in gross income due to the change; one-third of the $1,000 must be allocated to the year of change and to each of the two following years.

pp. 6-24 to 6-26

27. Amber Company's inventory, as measured by base period prices, has decreased by $100,000 ($1,800,000 - $1,700,000). Therefore, the company has depleted at least some of a LIFO layer. Under the LIFO assumption, the Year 2 layer is reduced from $100,000 at base period prices to $0. The company's inventory as of the end of the year is $1,767,500 as computed below.

Base Period Cost LIFO Index LIFO Layer

Base inventory $1,250,000 1.00 $1,250,000

Year 1 layer 450,000 1.15 517,500

Year 2 layer -0- -0-

$1,700,000 $1,767,500

pp. 6-27 and 6-28

28. Smith, Raabe, and Maloney, CPAs

5191 Natorp Boulevard

Mason, OH  45040

July 27, 2002

Mr. Jeffrey Robin, President

Robin Furniture Corporation

1000 East Maryland

Evansville, Illinois 47722

Dear Mr. Robin:

You asked me to review the Robin Furniture Corporation's accounts to determine the adjustments that will be required for tax purposes. My tentative conclusions are summarized below:

Obsolete inventory items. The company uses the LIFO inventory method for valuing its ending inventories. Under that method goods must be valued at their cost, regardless of their actual value. In order to obtain a write-down for the obsolete goods, the goods must be discarded.

Freight on inventories. Freight is a cost of the goods and should be capitalized as part of the inventory. Since the company has consistently expensed freight in the past, a change in accounting methods is required. The application for change needs to be completed. This will require restating the inventory value to include the freight and a corresponding increase in income. The increase in income can be spread evenly over four years, the year of the change and the three succeeding years.

Accrued payroll taxes. The accrual for payroll taxes is an acceptable method of accounting. However, changing to that method requires the filing of an application in accordance with the procedures outlined in the above discussion of freight on inventories. Such a payroll tax adjustment will result in a decrease in taxable income.

Bad debt reserve. The provision in the law allowing bad debt reserves was repealed in 1986. Thus, the balance in the reserve account should be eliminated next year through the change in accounting methods procedures, spreading the positive adjustment to income over four years (the year of change and the three succeeding years).

It is important that these changes be quickly accomplished in order to avoid penalties associated with the inventories and bad debts, and to minimize the tax liability in regard to the payroll tax adjustment.

Please contract me if you would like further explanations or assistance in accomplishing the changes.

Sincerely,

Amy Snider, CPA

Partner

pp. 6-9 to 6-13, 6-25 and 6-26

BRIDGE DISCIPLINE PROBLEMS

1. a. White can select either a calendar year or a fiscal year for financial reporting purposes.

b. For Federal income tax purposes, the Code in §706 and the related regulations establishes the following sequence for the selection of a partnership tax year.

• Majority interest partners.

• Principal partners.

• Least aggregate deferral method.

Green and Bronze have the same tax year end. Since they own over 50% (10% + 45% = 55%), the majority interest partners provision is satisfied. Thus, White’s tax year ends on June 30th. pp. 6-4 and 6-5

2. a. Even though Beige uses the cash method and follows a policy of writing off all fixed assets as rapidly as possible, it, in effect, must use the accrual method (i.e., must use MACRS) in deducting the cost of the office building. Depreciation for the current year for the office building is calculated as follows:

$500,000 X 1.177% (Table 4-3) = $5,885

b. For financial reporting purposes, the current year depreciation for the office building is calculated as follows:

$500,000 X 1.177% (Table 4-3) = $5,885

c. Since MACRS is used for both financial reporting purposes and Federal income tax purposes, the book – tax differential is $0.

3. The client obviously wants to receive a “clean opinion” from the external auditor. The external auditor is more concerned with net income for financial reporting purposes being overstated. On the other hand, the IRS agent is more concerned with taxable income being understated.

This difference of perspective for financial reporting purposes and Federal income tax purposes will not affect the amount of the total expenses and total deduction for the spare parts, but it will affect the timing of the expenses and deductions.

RESEARCH PROBLEMS

1. In Mountain State Ford Truck Sales, Inc., 112 T.C. No. 7 (1999), the Tax Court concluded that the taxpayer had violated the requirement that inventories must be carried at cost. Therefore, the IRS could force the taxpayer to change the calculations. Furthermore, because the taxpayer could not determine the actual costs of the goods, the IRS could terminate the LIFO election.

2.

CLIENT LETTER

Smith, Raabe, and Maloney, CPAs

5191 Natorp Boulevard

Mason, OH  45040

December 29, 2002

Ms. Agnes Boyd

Violet Company

100 Whitaker’s Mill

Fargo, North Dakota 58105

Dear Ms. Boyd:

You asked me to review the correspondence you received regarding Violet Company’s incorrect treatment of certain repair equipment. Both you and the IRS agent agree that the equipment should be accounted for as fixed assets rather than as inventories. The issue is whether the change to the fixed asset treatment should be accomplished through a change in accounting methods or as a correction of errors. I concur with the IRS agent that a change in accounting methods is required. However, I disagree with the agent in regard to the spread period for the adjustment.

In a case involving facts similar to yours, Diebold Incorporated v. United States, 90-1 USTC ¶ 50,003, 65 AFTR2d 90-648, 891 F.2d 1579 (CA-Fed, 1989), the Federal Circuit Court of Appeals upheld the Claims Court position that because the taxpayer had used the method for two consecutive years the taxpayer had adopted an accounting method. Moreover, changing that method, even though the method was incorrect, requires advance permission from the IRS. However, because you are attempting to make a voluntary change, you should be allowed to spread the adjustment over the year of change and the three succeeding years. See Rev. Proc. 97-27, 1997-1 C.B. 680.

Most of the communications with the IRS agent have been over whether the adjustments require a change in methods or amended returns. Now that it seems clear the change in methods is required, I recommend that a Form 3115 should be filed as soon as possible to make the change effective for the first day of 2001.

Please contact me if you have any further questions.

Sincerely,

R. B. Thompson, CPA

Smith, Raabe, and Maloney, CPAs

5191 Natorp Boulevard

Mason, OH  45040

TAX FILE MEMORANDUM:

DATE: December 29, 2002

FROM: Agnes Boyd

SUBJECT: Violet Company

Change in Accounting Method

We were contacted by Agnes Boyd, the President of Violet Company, regarding a dispute with the IRS. Violet discovered that certain equipment used in its repair operation had been accounted for as inventory rather than as fixed assets. This incorrect treatment applied to all years in which the equipment had been used, and all of those years are open under the statute of limitations. Violet filed amended returns for all years affected by the incorrect treatment to obtain a refund of overpayments of taxes for the years affected. The IRS refused to accept the amended returns. The IRS reasoned that Violet was actually changing accounting methods and this can only be accomplished through a request for change in methods. In addition, the IRS concluded that an adjustment due to a voluntary change in accounting method must be taken into income for the year of the change.

I researched the Violet case and found authority directly on point, [Diebold, 90-1 USTC ¶ 50,003, 65 AFTR2d 90-648. 891 F.2d 1579 (CA-Fed, 1989)]. I suggested to Ms. Boyd that Violet make the voluntary change and spread the adjustment over four years. The agent was right that a change in method is required, but the agent was incorrect in regard to the spread period. Apparently, the agent had not read Rev. Proc. 97-27.

3. According to Temp. Reg. § 15A.453-1(b)(2)(iv), a liability for an expense incidental to the sale is not a “qualifying indebtedness.” Legal fees relating to the taxpayer’s sale of the property are provided as an example of such incidental expenses. Thus, your client will not be able to treat the $15,000 as a negative adjustment in calculating the contract price.

4. In Von-Lusk, 104 T.C. 207 (1995), the Tax Court held that under § 461(f) the capitalization of interest does not begin until physical production on the property begins. However, the other holding costs such as insurance and taxes must be capitalized. The Tax Court reasoned that when Congress specifically deferred capitalization of interest until production begins, by implications all other costs related to holding the property must be capitalized.

5. The Internet Activity research problems require that the student access various sites on the Internet. Thus, each student’s solution likely will vary from that of the others.

You should determine the skill and experience levels of the students before making the assignment, coaching them where necessary so as to broaden the scope of the exercise to the entire available electronic world.

Make certain that you encourage students to explore all parts of the World Wide Web in this process, including the key tax sites, but also information found through the web sites of newspapers, magazines, businesses, tax professionals, government agencies, political outlets, and so on. They should work with Internet resources other than the Web as well, including newsgroups and other interest-oriented lists.

Build interaction into the exercise wherever possible, asking the student to send and receive e-mail in a professional and responsible manner.

6. See the Internet Activity comment above.

7. See the Internet Activity comment above.

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