Accounting Methods

An accounting method is set of rules to determine when income and expenses are reported. A taxpayer chooses an accounting method upon filing of the intial tax return for an entity. The cash method is the most common, however if a business keeps an inventory it must use the accrual method for sales and purchases. With the cash method, income is reported when the taxpayer actually or constructively receives income.

The accrual method of accounting reports income in the year earned and deducts or capitalizes expenses in the year incurred. The purpose of the accrual method is to match income and related expenses in the same year. With the accrual method, income is recognized when the payment is received, income amount is due to the taxpayer, taxpayer earns the income, or the property title has passed. For instance a taxpayer can record income on the accrual method months before the cash is received (especially is nice to smooth earnings) with accounts receivable. Accounts receivable are a current asset, the debit on the balance sheet for amounts credited to revenue. However, transactions amount paid to related parties on the cash method must handled on the cash basis. For tax purposes an company will make an M-1 adjustment for this if the transaction laps the tax year.

Sale of Partnership Interests

Price appreciation or depreciation realized by a partner on partnership basis results in a tax consequence upon sale of a partnership interest. A partners basis is equal to the initial contribution of cash and property or initial basis interest plus partnership adjustments from subsequent activities. If a partnership holds unrealized receivables or inventory these items are taxed at ordinary rates, where as capital assets are taxed a capital gains rates - determined by the holding period of the asset.

When sale of a partnership interest occurs mid year, economic activity must be computed as of the day of sale of interest. For example a partner who sells his 25% holding in a partnership on June 30th would receive a K-1 with the partnerships activities for the first two quarters of the year. These amounts would be special allocation determined either by an accounting software P&L as of 6/30 or similar activity. The K-1 would be marked final. The partner would record on his 1040 either a gain or loss from sale of partnership interest - capital gains on Schedule D and sale of hot assets on from 4797. A partnership with real estate would record gain based upon the holding period of the asset and depreciation received by the partner would be ordinary income recapture to beginning ownership basis.

To compute the gain on sale of partnership assets, create a spreadsheet showing adjusted basis in one column and FMV in another with resulting gain in the third column multiplied by adjusting tax rates. The agreement of sale of partnership interest can allocate sale price according to assets (and likely the best) so as obtain the customized tax attributes. In other words, depending upon the asset combination of the partnership, you can sell ordinary gain assets at cost and allocate the gains to capital items.

Individual Retirement Accounts

The two most popular retirement accounts are traditional and Roth IRA's. An employee may have a traditional IRA even if covered by an employer-sponsored retirement plan. Contributions to IRA's are limited to the lesser: a.)the participants compensation b.) statutory limits. Contributions cannot be made in a year the participants has reached age 70 1/2 or for any later year. Contributions can be $5,000 for individuals under age 50, and $6,000 for age 50 and older.

A traditional IRA contribution is deductible from income and distributions are taxed. A Roth IRA is subject to the same rules a traditional but the contributions are not deductible, yet the distributions are tax free. For younger taxpayers, Roth investment accumulations may provide a more advantageous way to reel in substantial non-taxed capital gains.

IRA investments can be made in mutual funds, brokerage companies, life insurance companies and other financial institutions. An IRA cannot invest invest in collectibles such as artwork, gems or stamps.

An excess contributions occurs when a taxparers contributes an amount that exceeds the statutory or participant compensation amounts. A 6% penalty applies each year the excess remains in the account. Form 5329 is used to calculate and pay the penalty.

A Simplified Employee Pension is a, IRA for businesses were employees can contribute up to 25% of wages to $49,000 and Self employed individuals can contribute 20% of net SE income after one half SE tax deduction, up to $49,000.

Filing Gift Tax Return

A form 709 Gift Tax Return must be filed by April 15th if a tax payer has made a gift in excess of $13,000 to anyone other than a spouse or charity during the tax year. Gifts in excess of $13,000 or gifts of future interests of value in excess of $13,000 must be reported. Their is a lifetime gift tax exclusion of $5,000,000 for taxpayers who gifts in excess of $1,000,000 for duration.

Sale of Business Property

Form 4797 is used to report the sale of business property and other depreciable and amortizable property. On part I are reported losses on property held for more than one year, which recieve ordinary loss treatment. On part II are reported sales for property held for one year or less and on Part III property sold held for more than one year for which depreciation is a taxable component. Part IV included recapture of depreciation and amortization under Section 179 and Section 280F when business use declines below 50%.

IRC Section 1231 provides the best of both worlds on the sale of business assets and residential property. If cumulative Section 1231 losses have exceeded Section 1231 gains from the prior 5 years then the difference is treated as ordinary income.

Taxation for Investor and Traders

For tax purposes the tax treatment for a trader in securities or commodities depends on their tax classification.

A trader is engaged in the business of buying and selling securities for one's own account. To be classified as a trader the trader must seek to profit from daily market fluctuations in the prices of securities or commodities and not from dividends, interest or capital appreciation. Factors that are considered for this include the typical holding periods for securities bought and sold, the frequency and dollar amount of trades during the year, the extent to which a taxpayer pursues the trading activity to produce income from a livelihood, and the amount of time devoted to the activity. A trader who chooses to elect mark to market accounting methods reports both gain and losses as ordinary income instead of capital gain and losses on form 4797.

An investor typically seeks to profit from investment earnings and capital appreciation.

A dealer in securities in the business of resale to customers and typically profit from the business transaction and not from appreciation in the security.

Dealers report transaction on a Schedule C, Investors report transaction on Schedule D, and Traders on schedule D, unless they market to market which they then report on Part II form 4797.

Personal Service Corporations

Personal Service Corporations exist where corporations are formed for professional services such as accounting, actuarial science, architecture, consulting, engineering, health, law and the performing arts.

A qualified personal service corporation is taxed at a flat rate of 35% of taxable income. A corporation is a PSC if it meets both of following tests

1. Substantially all the corporation's activities involve the performance of personal services
2. At least 95% of the corporations stock by value is owned by a. employees performing personal services b. retired employees who were involved with the corporation c. an estate of an employee or retiree d. any person who acquired the stock of the corporation as a result of the death of an employee or retiree.

A PSC has a safe harbor of $150,000 for accumulated earnings. IRC 535.