Small Business Tax Issues

Transcription

1 Small Business Tax Issues Course #6585A/QAS6585A Course Material

2 Small Business Tax Issues (Course #6585A/QAS6585A) Table of Contents Page Chapter 1: Choice of Entity I. Overview 1-1 Review Questions & Solutions 1-10 Chapter 2: Filing and Paying Business Taxes I. Federal Income Tax: General Rules 2-1 II. Income Taxation of Disregarded Entities: The Limited Liability Company 2-8 III. Taxation of Partnerships 2-14 IV. Taxation of Corporations 2-17 V. Income Taxation of Subchapter S Corporations 2-27 VI. Excise Taxes 2-29 Review Questions & Solutions 2-30 Chapter 3: Federal Employment Taxes I. Overview of Employment Taxes 3-1 II. Employee vs. Independent Contractor 3-9 III. Statutory Classes of Workers 3-18 Review Questions & Solutions 3-30 Chapter 4: Accounting Periods and Methods I. Accounting Periods 4-1 II. Accounting Methods 4-2 Review Questions & Solutions 4-11 Form 3115 and Instructions 4-15 Chapter 5: Dispositions of Business Property I. Types of Dispositions 5-1 II. Other Rules 5-16 III. Calculating Gain or Loss 5-20 Review Questions & Solutions 5-30 Chapter 6: General Business Credit I. Overview 6-1 Review Questions and Solutions 6-17 Miscellaneous Forms 6-19 Chapter 7: Business Income I. Business Income: Defined 7-1 II. Specific Types of Income 7-1 III. Other Income 7-9 IV. Items that Are Not Income 7-11 V. Accounting for Income 7-12 Review Questions & Solutions 7-14 Table of Contents i

3 Table of Contents (cont.) Page Chapter 8: How to Figure the Cost of Goods Sold I. Introduction 8-1 II. Figuring Cost of Goods Sold Schedule C Lines Review Questions & Solutions 8-6 Schedule C Form Chapter 9: Figuring Gross Profit I. Overview 9-1 Review Questions & Solutions 9-4 Chapter 10: Business Expenses I. Introduction and Overview 10-1 II. Timing and Amount of Deductions 10-5 III. Selected Categories of Generally Deductible Expenses 10-8 IV. Travel, Meals and Entertainment Expenses V. Business Use of the Home VI. Limits and Exclusions for Deduction of Expenses Review Questions & Solutions Chapter 11: Figuring Net Profit or Loss I. Overview 11-1 Review Questions & Solutions 11-2 Chapter 12: Maintaining Business Records I. General Record Keeping Requirements 12-1 II. Records for Certain Types of Business Expenses 12-7 Review Questions & Solutions Glossary Index Table of Contents ii

4 Chapter 1: Choice of Entity I. Overview The purpose of this course is to provide general information about the federal tax laws that apply to small business owners, many of whom are sole proprietors or statutory employees. This chapter provides readers with an understanding of the options open to small business owners when selecting a legal entity. The type of entity affects many facets of a business s operation, including management and taxation. Today, there are more choices than ever in selecting the appropriate business entity. Historically, there were three choices: the sole proprietorship, the partnership and the corporation. Now there are a number of hybrids that combine various characteristics of each traditional entity, such as the limited liability company, which combines the limited liability of a corporation with the flexibility and tax advantages of a partnership. All states offer limited liability companies as an option for most types of businesses. Other recent options include the limited liability partnership. State law can also play an important role in determining the best entity. State law governs many important aspects of business entities, both tax and non-tax (i.e., in some states an S corporation is treated more favorably than in others). A. SOLE PROPRIETORSHIP A sole proprietorship is an unincorporated business that is owned by one individual. It is the simplest form of business organization to start and maintain. A sole proprietorship has no separate legal existence apart from the owner. Its liabilities are the personal liabilities of the owner. The income and losses of the business are included on the owner s personal tax return. Unlike partnerships and corporations for which there are a host of statutory provisions a sole proprietor is not subject to any unique set of laws. General business and tax laws apply, including those governing contracts and torts. Choice of Entity 1-1

5 MAJOR ATTRIBUTES: SOLE PRACTITIONER ü No requirements for formation; no franchise fee or license to obtain (unless local entity requires business license or fictitious name filing) ü No formalities required for operation, i.e. no meetings or corporate filings ü Sole proprietor has complete management authority; may or may not utilize agents ü Owner personally liable for all debts and obligations of the business ü All profits and losses are included in the owner s personal tax return; the business is not recognized for tax purposes ü Business normally dies with the owner ü Business or assets thereof may be transferred or sold at the sole discretion of the owner ü Owner may decide to convert business to different type of entity, i.e. to form singlemember LLC ü All judicial proceedings occur in the name of the owner The major advantages and disadvantages of the sole proprietorship are based on its characteristics. The major advantage is probably its simplicity: there are no papers to file, no mandatory meetings, and no franchise fee to pay. A sole proprietor may make decisions at any time about any matter. On the other side of the coin, the sole proprietor is personally liable for all the debts and obligations of the business. If a sole proprietor elects to engage agents in the operation of the business, including, but not limited to, employees, he or she is also vicariously liable for all of the agents actions committed in the scope of the business. B. PARTNERSHIPS A partnership is the relationship existing between two or more persons or entities who agree to carry on a trade or business together. Each person or entity contributes money, property, labor, or skill, and expects to share in the profits and losses of the business. There are a number of different types of partnerships recognized by state law. The three major types will be briefly described below. This overview provides a general understanding only; individual states may have different rules. 1. General Partnership At common law, this was the only type of partnership recognized. Aside from the sole proprietorship, the general partnership is the easiest business entity to form. There are no legal requirements aside from the agreement of two or more people or entities to Choice of Entity 1-2

6 operate a business for profit. Each general partner is entitled to manage the enterprise and is jointly and severally liable for the debts and obligations of the partnership. There is no requirement that the partners execute a written partnership agreement or register with a state agency. There are no other formalities required. This makes the general partnership the simplest type of business entity where there is more than one owner. A general partnership is a disregarded entity for purposes of federal income tax. Profits and losses flow through to the partners. The partnership files an informational return only with the IRS. MAJOR ATTRIBUTES: GENERAL PARTNERSHIP ü Has some characteristics of a separate legal entity, i.e. can sue and be sued and hold property in its own name ü All partners entitled to manage the enterprise ü Partnership profits, losses and distributions (including return of capital) are shared in proportion to the partners' contributions, unless the partnership agreement provides otherwise ü Each general partner is jointly and severally liable for the debts and other obligations of the partnership 2. Limited Partnership A limited partnership is comprised of one or more "general" partners and one or more limited partners. The general partner or partners are responsible for managing the partnership and, like partners in a general partnership, are jointly and severally liable for all partnership debts and obligations. The general partner or partners need not be a natural person; a corporation, for example, may serve as the general partner. Limited partners are typically passive investors who are not involved in management of the partnership and who, as a result, are generally not personally liable for the debts and obligations of the partnership beyond their capital contributions. Every state has a body of law governing limited partnerships. While not involved in day-to-day operations of the enterprise, limited partners are entitled to receive information, including an accounting, regarding the partnership and likewise have a right to inspect various partnership records. Limited partners who become involved in management of the partnership or involved in other ways, including being employed by the partnership, risk losing their limited liability status. As with limited liability companies, discussed later in this chapter, a limited partnership may have different classes of partners as set forth in a partnership agreement. Choice of Entity 1-3

7 MAJOR ATTRIBUTES: LIMITED PARTNERSHIP ü Comprised of one or more general partners and one or more limited partners ü General partner can be corporation or other entity; need not be natural person ü Limited partners are passive investors ü Limited liability status can be lost through active involvement in the enterprise ü Must file certificate of limited partnership with appropriate state agency; normally no other formalities ü Limited partners entitled to accounting, inspection of records Partnership profits, losses and distributions (including return of capital) are shared in proportion to the partners' contributions, unless the partnership agreement provides otherwise. A limited partner has the right to assign his or her interest in whole or in part to a third person. However, such assignment merely transfers the right to receive distributions from the partnership; it does not entitle the transferee to become a partner unless provided in the partnership agreement or unless it is approved by all of the general partners. Most states require a limited partnership to file a certificate of limited partnership with the appropriate state agency, normally the secretary of state. This formality is designed to give notice to prospective creditors of the limited liability status of the enterprise. While a certificate is required, there is no legal requirement in most states that a limited partnership execute a written partnership agreement, although it is obviously advisable to do so. The death, withdrawal, removal, incompetence, bankruptcy or dissolution of a general partner normally dissolves a limited partnership unless (1) the partnership agreement provides otherwise, or (2) all remaining general partners continue the business, or (3) where there is no remaining general partner, limited partners agree to continue the partnership according to the requirements of the applicable state law. 3. Limited Liability Partnerships A recent hybrid of the limited partnership, a limited liability partnership must be registered as a limited liability partnership under the laws of the state of organization. Every state has its own technical requirements for formation, which normally include the appointment of an agent for receipt of service of process. Choice of Entity 1-4

8 All of the partners in a limited liability partnership are normally entitled to limited liability status for the acts or omissions of the partnership though not generally for their own acts or omissions. Again, state law varies considerably on this topic. For example, many states reserve limited liability partnership status for certain professional associations, for example, attorneys and certified public accountants. C. CORPORATION The main characteristic of a corporation is that it is a separate legal entity with a life beyond that of its owners. A corporation is a creature of state law and is governed by the provisions of law in its state of organization (although it is obviously subject also to federal law, including the Internal Revenue Code). Creating a corporation requires compliance with the corporate law of the state of organization. A corporation is the most complicated type of business to form and to operate due to the large number of formalities normally mandated. These include the filing of various documents with state agencies, the noticing and holding of meetings, and the maintenance of records. As a separate legal entity, a corporation may operate indefinitely. The death of a shareholder does not affect the legal status of a corporation. Because a corporation is a separate legal entity, it is responsible for its own debts. Shareholders, directors and officers are normally not personally liable for the debts and obligations of the entity. MAJOR ATTRIBUTES: CORPORATION ü A legal entity separate and apart from its owners ü Has power to act in any way allowed by applicable state law and as provided in its Articles of Incorporation ü May only appear in court through a licensed attorney ü Management and control is vested in the board of directors, elected by the shareholders of the corporation ü Shareholders, directors or officers of the corporation are normally not legally responsible for corporate liabilities ü Profits of the corporation are taxable by the corporation as well as shareholders when distributed via dividends ü Has an unlimited lifespan; not affected by the death of shareholders Choice of Entity 1-5

9 Management and control of a corporation is vested in its board of directors, which is elected by the shareholders of the corporation. The board of directors normally appoints officers to run the day-to-day business of the corporation. Such officers may or may not also be shareholders (although as a practical matter they usually are). The profit of a corporation is taxed to both the corporation and to the shareholders when the profit is distributed as dividends. This so-called "double taxation" is often mentioned as a disadvantage of corporate status. D. S CORPORATIONS Originally created in 1958, an S corporation combines the limited liability of a classic C corporation with tax treatment similar to a partnership. In general, an S corporation is not subject to corporate-level income tax on its items of income and loss. Instead, an S corporation passes through its items of income and loss to its shareholders. The shareholders take into account separately their shares of these items on their individual income tax returns. To prevent double taxation of these items when the stock is later disposed of, each shareholder s basis in the stock of the S corporation is increased by the amount included in income (including tax-exempt income) and is decreased by the amount of any losses (including nondeductible losses) taken into account. A shareholder s loss may be deducted only to the extent of his or her basis in the stock or debt of the S corporation. To the extent a loss is not allowed due to this limitation, the loss generally is carried forward with respect to the shareholder. State taxation of S corporations varies. Some states, for example, treat an S corporation as a C corporation and therefore impose an income or franchise tax. The shareholders of a C corporation must elect to become an S corporation. There are a number of important restrictions placed on S corporations, including a cap on the number of shareholders and a requirement that there be only one class of stock. Failure to comply with the many IRS requirements will cause an S corporation to lose its status. The maximum number of shareholders allowed in an S corporation is 100. MAJOR ATTRIBUTES: S CORPORATION ü Shareholders enjoy same limited liability as shareholders of C corporation ü Treated as partnership for purposes of federal taxation ü State taxation of S corporation varies ü Strict formalities for qualification and maintenance of tax status ü Maximum of 100 owners; only one class of stock allowed Choice of Entity 1-6

10 Members of a family may be treated as one shareholder, for the purpose of determining the number of shareholders, whether a family member holds stock directly or is treated as a shareholder by reason of being a beneficiary of an electing small business trust or qualified subchapter S trust. Except as provided by Treasury regulations, the election for a family may be made by any family member and remains in effect until terminated. A family is defined in the Act as the common ancestor and all lineal descendants of the common ancestor, as well as the spouses, or former spouses, of these individuals. An individual shall not be a common ancestor if the individual is more than six generations removed from the youngest generation of shareholders who would (but for this rule) be members of the family. For purposes of this rule, a spouse or former spouse is treated as in the same generation as the person to whom the individual is (or was) married. An IRA (including a Roth IRA) may also be a shareholder of an S corporation, but only to the extent of bank stock held by the IRA on the date of enactment of the provision. A corporation is not eligible to be an S corporation if it: (1) is not a domestic corporation; (2) has more than 100 shareholders; (3) has as a shareholder a person other than an individual, an estate, or certain trusts and tax-exempt organizations; (4) has a nonresident alien as a shareholder; (5) has more than one class of stock; or (6) is an "ineligible" corporation as defined in federal law. A corporation is also ineligible to be an S corporation if it is: (1) a financial institution that uses the reserve method of accounting for bad debts; (2) an insurance company; (3) a corporation for which an election has been made to claim a possession tax credit; or (4) a domestic international sales corporation ("DISC") or former DISC. E. LIMITED LIABILITY COMPANY Limited liability companies have been a popular business form in European and other countries for decades. The first state in the United States to recognize limited liability companies was Wyoming, which allowed them beginning in Florida followed suit in It was not until the IRS agreed in a 1988 Revenue Ruling (Rev. Rul ) to treat LLCs as partnerships for tax purposes that many businesses decided to utilize this new form. This triggered legislative activity throughout the nation and each state sought to give its businesses the opportunity to utilize this new form. By 1996, all 50 states and the District of Columbia had passed laws recognizing limited liability companies and creating statutory frameworks covering their formation, operation and dissolution. Although recognized by the IRS for tax purposes, limited liability companies are purely creatures of state law. A limited liability company is an entity formed by following the procedures required in the state of operation. The owners of an LLC are generally referred to as members. In most states, forming an LLC requires the preparation of only one document, the socalled Articles of Organization, which is filed with the secretary of state or other designated state agency. This document, which is described in detail later in these materials, is usually brief and sets forth general information about the company, including its name, address, agent for service of process, term, and whether it will be run by the members or managers appointed by the members. Every state has detailed rules for what must be contained in this document and generally also offers a fill-in-the blank form that meets its individual statutory requirements. Choice of Entity 1-7

11 In California and a few other states, LLCs are also required to file with the state an operating agreement, which, similar to a partnership agreement, provides a blueprint for how the LLC will be run, the financial obligations of the members, and how profits and losses will be divided. As a practical matter, almost every LLC will want to have a welldrafted operating agreement whether or not it is required. To the extent an operating agreement does not exist or is silent on a particular issue, courts will resolve disputes by referring to each state s default statutory provisions governing operation of limited liability companies. MAJOR ATTRIBUTES: LIMITED LIABILITY COMPANY ü Multi-member LLC may elect to be taxed as corporation or partnership ü Members normally have no personal liability for debts and obligations of the company ü Most states allow single-member companies; there is no maximum number of owners ü More flexibility in management than corporation ü Few, if any, formalities required by state law ü Most states allow easy conversion to other business forms ü May not engage in certain businesses, including banking and insurance, in most states ü Most states expressly allow professional LLCs An LLC may be classified for federal income tax purposes as either a partnership or a corporation. A domestic LLC with at least two members is automatically classified as a partnership for federal income tax purposes unless it elects to be treated as a corporation. This is done by filing IRS Form Generally, a single-member domestic LLC is not treated as a separate entity for federal income tax purposes. The sole member of a domestic LLC should file Schedule C or C- EZ (or Schedule E or F, if applicable). Single-member LLCs that are disregarded as entities separate from their owner for federal income tax purposes are now required to file employment tax returns using the LLC s name and employer identification number (EIN) rather than the LLC owner s name and EIN. Single-member LLCs not previously needing an EIN may now need to obtain an EIN for the payment and reporting of these taxes. Choice of Entity 1-8

12 Unlike a partnership, none of the members of an LLC are personally liable for its debts. Practically, an LLC operates like a limited partnership without the requirement for a general partner. Unlike an S corporation, an LLC has no limits on the number of shareholders, classes of stock, or type of shareholders. Because in most cases losses pass through to the members of an LLC, an LLC can be attractive to corporate investors and wealthy individuals. Other advantages to choosing this business form include: Limited liability for all owners; Flexibility in selecting a management structure; and Limited formalities, such as meetings and record keeping. F. NOTE ON HUSBAND AND WIFE BUSINESSES If an individual and his spouse jointly own and operate an unincorporated business and share in the profits and losses, they are partners in a partnership, whether or not they have a formal partnership agreement. An exception to this rule is when the individual and his spouse wholly own an unincorporated business as community property under the community property laws of a state, foreign country, or U.S. possession. In such cases, the couple may treat the business either as a sole proprietorship or a partnership. Choice of Entity 1-9

13 Chapter 1 Review Questions The following questions are designed to ensure that you have a complete understanding of the information presented in the chapter. They do not need to be submitted in order to receive CPE credit. They are included as an additional tool to enhance your learning experience. We recommend that you answer each review question and then compare your response to the suggested solution before answering the final exam questions related to this chapter. 1. Historically, there were many more options for selecting the appropriate business entity than there are today. a) true b) false 2. Which of the following is the easiest type of business ownership structure to form and maintain: a) general partnership b) sole proprietorship c) limited partnership d) corporation 3. Which of the following statements about a general partnership is not correct: a) all partners are entitled to participate in the management of the business b) each partner is jointly and severally liable for the debts and obligations of the entity c) partners have no personal liability for the debts and obligations of the partnership d) for federal income tax purposes, the partnership is a disregarded entity 4. Which of the following statements about a limited partnership is true: a) both limited and general partners are involved in the day-to-day management of the business b) a limited partnership must be composed of at least two limited and two general partners c) limited partners are typically passive investors d) the general partner must be a natural person 5. The main characteristic of a corporation is that it is a separate legal entity with a life beyond that of its owners. a) true b) false Choice of Entity 1-10

14 6. For purposes of determining federal income tax liability, S corporations are treated as: a) S corporations b) C corporations c) partnerships d) a sole proprietorship 7. In most states, forming an LLC is a complex process. a) true b) false 8. How are limited liability companies classified for federal income tax purposes: a) they must be classified as a partnership b) they must be classified as a corporation c) they are not subject to federal tax d) they may be classified as either a partnership or a corporation, at the discretion of the members Choice of Entity 1-11

15 Chapter 1 Solutions and Suggested Responses 1. A: True is incorrect. The opposite is actually true; there are more choices today than ever before. B: False is correct. Today, there are more choices than ever in selecting the appropriate business entity. Historically, there were three choices: the sole proprietorship, the partnership and the corporation. Now there are a number of hybrids that combine various characteristics of each traditional entity, such as the limited liability company which combines the limited liability of a corporation with the flexibility and tax advantages of a partnership. (See page 1-1 of the course material.) 2. A: Incorrect. General partnerships are relatively easy to begin and maintain, but it is not the easiest business structure. B: Correct. There are no formalities associated with creating or maintaining a sole proprietorship because it has no separate legal existence from the owner. C: Incorrect. Limited partnerships are more involved than either sole proprietorships or general partnerships. D: Incorrect. The corporation is the most complex of all business entities both to create and to maintain. (See page 1-1 of the course material.) 3. A: Incorrect. This is one of the hallmarks of a general partnership. B: Incorrect. There is no immunity from personal liability in a general partnership. C: Correct. Partners in a general partnership are not immune from personal liability. D: Incorrect. A partnership is a disregard entity for federal tax purposes meaning income and losses flow through directly to the individual partners. (See pages 1-2 to 1-3 of the course material.) Choice of Entity 1-12

16 4. A: Incorrect. Only general partners are involved in the day-to-day management of the partnership. Limited partners lose their status if they become too involved in the management of the enterprise. B: Incorrect. Limited partners require only one limited and one general partner for formation. C: Correct. Because they lose their status as limited partners by becoming involved in the management of the partnership, limited partners are normally passive or silent investors. D: Incorrect. A corporation or other entity can be the general partner in a limited partnership. (See pages 1-3 to 1-4 of the course material.) 5. A: True is correct. A corporation is a creature of state law that exists above and beyond its individual investors. It is a separate legal entity meaning that the death of a shareholder does not affect the legal status of the corporation. Because a corporation is a separate legal entity, it is responsible for its own debts. Shareholders, directors, and officers are normally not personally liable for the debts and obligations of the entity. B: False is incorrect. A corporation is a legal entity separate and apart from its owners. (See page 1-5 of the course material.) 6. A: Incorrect. S corporations are treated as corporations for state income tax purposes, but receive different treatment for federal income tax purposes. B: Incorrect. S corporations are not treated as C corporations for federal tax purposes. Some states do treat an S corporation as a C corporation for state income tax purposes. C: Correct. An S corporation combines the limited liability of a classic C corporation with tax treatment similar to a partnership. S corporations are treated as corporations under state law. For purposes of federal income tax, however, S corporations are treated as partnerships. This means that the income, deductions, and tax credits of an S corporation flow through to shareholders; income is taxed at the shareholder level and not at the corporate level. D: Incorrect. This is not the correct answer for determining federal tax treatment of an S corporation. (See page 1-6 of the course material.) Choice of Entity 1-13

17 7. A: True is incorrect. LLCs are generally easy to form. B: False is correct. In most states, forming an LLC requires the preparation of only one document, the so-called Articles of Organization. (See page 1-7 of the course material.) 8. A: Incorrect. The entity may be treated as a partnership, but this classification is not mandated. B: Incorrect. The entity may be treated as a corporation, but this classification is not mandated. C: Incorrect. The LLC is subject to federal income tax as are all for-profit businesses. This is a desirable entity type, however, because of the flexibility in tax treatment. D: Correct. The members may elect to be classified as either a partnership or a corporation for federal income tax purposes. (See page 1-8 of the course material.) Choice of Entity 1-14

18 Chapter 2: Filing and Paying Business Taxes This chapter explains the business taxes that sole proprietors or other types of business entities may have to pay and the forms they may have to file. One significant topic not contained in this chapter is employment taxes. Given the complexity of the issue, employment taxes are the subject of their own discussion in Chapter 3. I. Federal Income Tax: General Rules A. APPLICABLE CHAPTERS For purposes of federal tax, the law sets forth three basic models of taxation of businesses and individuals: subchapter C, subchapter K and subchapter S. Subchapter C applies to corporations. It imposes an entity level tax on the corporation, as well as a tax on individual shareholders who receive corporate distributions (i.e., dividends). Subchapter S status is available to C corporations who meet certain strict statutory requirements. It allows shareholders of relatively small corporations to avoid entity-level taxation: similar to partnership treatment, all of the profits and losses of the corporation are passed through to the individual shareholders. Finally, subchapter K applies to partnerships, limited liability companies and certain other unincorporated entities. Owners are allowed to elect pass-through taxation. Partnerships are not subject to the income tax. However, a partnership is required to file Form 1065, which reports the results of the partnership's business activities. Individual partners pay taxes on their individual returns. The partnership net profit (loss) and the separately reported items are allocated to each partner according to the partnership's profit sharing agreement, and the partners receive separate K-1 schedules from the partnership. Schedule K-1 reports each partner's share of the partnership net profit and separately reported income and expense items. Each partner reports these items on his or her own tax return. The two types of federal taxation that are most frequently considered in making a choice of entity are income tax and self-employment tax. Rules regarding income taxation of specific entities will be discussed below, followed by a discussion of self-employment tax and its application in choice of entity. B. REQUIRED FORMS The type of entity determines the forms that must be filed and the type of tax owed (e.g. self-employment tax), as the following table illustrates. Filing and Paying Business Taxes 2-1

19 Table 2.1 Required Federal Forms By Type of Entity If You Are A: You May Be Liable For: Use Form: Sole proprietor Income tax 1040 and Schedule C 1 or C-EZ (Schedule F 1 for farm business) Self-employment tax 1040 and Schedule SE Estimated tax 1040-ES Employment taxes: Social security and Medicare taxes and income tax withholding 941 (943 for farm employees) Federal unemployment (FUTA) tax 940 or 940-EZ Depositing employment taxes Excise taxes See Excise Taxes Partnership Annual return of income 1065 Employment taxes Same as sole proprietor Excise taxes See Excise Taxes Partner in a partnership Income tax 1040 and Schedule E 3 (individual) Self-employment tax 1040 and Schedule SE Estimated tax 1040-ES Corporation or S 1120 or 1120-A (corporation) Income tax corporation 1120S (S corporation) Estimated tax 1120-W (corporation only) and S corporation shareholder Employment taxes Excise taxes Same as sole proprietor See Excise Taxes Income tax 1040 and Schedule E 3 Estimated tax 1 File a separate schedule for each business. 2 Do not use if you deposit taxes electronically. 3 Various other schedules may be needed ES C. INFORMATIONAL RETURNS If a business makes or receives payments, it may have to report them to the IRS on information returns. The IRS compares the payments shown on the information returns with each person's income tax return to see if the payments were included in income. A business must give a copy of each information return that it is required to file to the recipient or payer. In addition to the forms described below, a business may have to use other returns to report certain kinds of payments or transactions. Filing and Paying Business Taxes 2-2

20 1. Form 1099-MISC Form 1099-MISC, Miscellaneous Income, is used to report certain payments made by a business. These payments include the following items: Payments of $600 or more for services performed for a business by people not treated as its employees, such as fees to subcontractors, attorneys, accountants, or directors; Rent payments of $600 or more, other than rents paid to real estate agents; Prizes and awards of $600 or more that are not for services, such as winnings on TV or radio shows; Royalty payments of $10 or more; and Payments to certain crew-members by operators of fishing boats. Form 1099-MISC is also used to report sales of $5,000 or more of consumer goods to a person for resale anywhere other than in a permanent retail establishment. 2. Form W-2 Employers must file Form W-2, Wage and Tax Statement, to report payments to their employees, such as wages, tips, and other compensation, withheld income, social security and Medicare taxes, and advance earned income credit payments. The law provides for the following penalties if a business does not file Form 1099-MISC or Form W-2 or does not correctly report the information, including the following: Failure to file information returns. This penalty applies if a business does not file information returns by the due date, does not include all required information, or reports incorrect information. Failure to furnish correct payee statements. This penalty applies if a business does not furnish a required statement to a payee by the required date, does not include all required information, or reports incorrect information. These penalties can be waived if the business can show that the failure was due to reasonable cause and not willful neglect. In addition, there is no penalty for failure to include all required information, or for including incorrect information, on a de minimis (small) number of information returns if the business corrects the errors by August 1 of the year the returns are due. (A de minimis number of returns is the greater of 10 or ½ of 1% of the total number of returns the business is required to file for the year.) 3. Form 8300 A sole proprietor or other business entity must file Form 8300, Report of Cash Payments Over $10,000 Received in a Trade or Business, if it receives more than $10,000 in cash in one transaction, or two or more related business transactions. Cash includes U.S. and foreign coin and currency. It also includes certain monetary instruments such as Filing and Paying Business Taxes 2-3

21 cashier's and traveler's checks and money orders. Cash does not include a check drawn on an individual's personal account (personal check). There are civil and criminal penalties, including up to five years in prison, for not filing Form 8300, filing (or causing the filing of) a false or fraudulent Form 8300, or structuring a transaction to evade reporting requirements. Certain other requirements apply to entities going out of business, as shown on the following Table. Table 2.2 Going Out of Business IF you are liable for: THEN you may need to: Income Tax File Schedule C or C-EZ with Form 1040 for the year in which you go out of business File Form 4797 with Form 1040 for each year in which you sell or exchange property used in your business or in which the business use of certain section 179 or listed property drops to 50% or less File Form 8594 with Form 1040 if you sold your business Self-Employment Tax File Schedule SE with Form 1040 for the year you go out of business Employment Taxes File Form 941 for the calendar quarter in which you made final wage payments File Form 940 or Form 940-EZ for the calendar year in which wages were paid Information Returns Provide Forms W-2 to your employees for the calendar year in which you make the final wage payments. These are generally due by the due date of your final Form 941 File Form W-3 to file Forms W-2. These forms are generally due by the due date of your final Form 941 Provide Forms 1099-MISC to each person to whom you have paid at least $600 for services (including parts and materials) during the calendar year in which you go out of business File Form 1096 to file Forms MISC Filing and Paying Business Taxes 2-4

22 D. SELF-EMPLOYMENT TAX Self-employment tax (SE tax) is a social security and Medicare tax primarily for individuals who work for themselves. It is similar to the social security and Medicare taxes withheld from the pay of most wage earners. Many people consider ways to avoid self-employment tax when considering a choice of business entity. The reason is that the self-employment tax rate is 15.3%. This rate consists of two parts: 12.4% for social security (old-age, survivors, and disability insurance) and 2.9% for Medicare (hospital insurance). There is a cap on the amount of income that is subject to self-employment tax. The cap is adjusted each year by the Social Security Administration. For 2013, the amount of income subject to social security tax is $113,700. Remember, however, that there is no cap on the amount of earnings subject to the Medicare tax. New in 2013, wages in excess of $200,000 ($250,000 MJ) are subject to an additional Medicare tax of.9% and a 3.8% additional tax on the lesser of unearned income (exclusions apply) or wages in excess of the $200,000 ($250,000 MJ). Taxpayers can deduct half of their self-employment tax in figuring adjusted gross income; however, the adjustment does not affect the amount of self-employment tax actually owed. 1. Covered Individuals An individual must pay SE tax and file Schedule SE (Form 1040) if either of the following applies: The individual s net earnings from self-employment (excluding church employee income) was $400 or more; or The individual had church employee income of $ or more. The SE tax rules apply no matter how old the individual is and even if he or she is already receiving social security or Medicare benefits. 2. Methods for Figuring Net Earnings There are three ways to calculate net earnings from self-employment: The regular method; The non-farm optional method; and The farm optional method. Individuals must use the regular method unless they are eligible to use one or both of the optional methods. To determine earnings under the regular method, an individual should multiply his total earnings subject to SE tax by 92.35% (.9235) to determine his net earnings under the regular method. Individuals may want to use the optional methods when they have a loss or a small net profit and any one of the following applies: Filing and Paying Business Taxes 2-5

23 They want to receive credit for social security benefit coverage; They incurred child or dependent care expenses for which they could claim a credit (an optional method may increase the individual s earned income, which could increase his credit); They are entitled to the earned income credit (an optional method may increase the individual s earned income, which could increase his credit); or They are entitled to the additional child tax credit (an optional method may increase the individual s earned income, which could increase his credit). 3. Social Security Coverage Social security benefits are available to self-employed persons just as they are to wage earners. Payments of SE tax contribute to a self-employed individual s coverage under the social security system. Social security coverage provides the individual with retirement benefits, disability benefits, survivor benefits, and hospital insurance (Medicare) benefits. Generally, the SSA will provide a credit only for self-employment income reported on a tax return filed within three years, three months, and 15 days after the tax year the income was earned. If you file your tax return or report a change in your selfemployment income after this time limit, the SSA may change its records, but only to remove or reduce the amount. The SSA will not change its records to increase your selfemployment income. 4. Maximum Earnings Subject to SE Tax The amount of income subject to SE tax is both capped for one type of SE tax, but unlimited for another. For example, in 2013, only the first $113,700 of an individual s combined wages, tips, and net earnings is subject to the 12.4% social security part of SE tax, social security tax, or railroad retirement (tier 1) tax. The Medicare portion of SE tax (2.9%) has no cap; and new for 2013, wages in excess of $200,000 ($250,000 MJ) are subject to an additional Medicare tax of.9% and a 3.8% additional tax on the lesser of unearned income (exclusions apply) or wages in excess of the $200,000 ($250,000 MJ). 5. Definition of Self-Employed The IRS considers the following groups of people to be self-employed and therefore subject to self-employment tax: Persons who carry on a trade or business as a sole proprietor or an independent contractor; Members of a partnership that carries on a trade or business; and Persons who are otherwise in business for themselves. A trade or business is generally an activity carried on for a livelihood or in good faith to make a profit. The facts and circumstances of each case determine whether or not an activity is a trade or business. The regularity of activities and transactions and the production of income are important elements. You do not need to actually make a profit to be in a trade or business as long as you have a profit motive. An individual does need, however, to make ongoing efforts to further the interests of the business. Filing and Paying Business Taxes 2-6

24 6. Part-time Business You do not have to carry on regular full-time business activities to be self-employed. Having a part-time business in addition to your regular job or business may also be selfemployment. Example. Rich is employed full time as an engineer at the local plant. He fixes televisions and radios during the weekends. Rich has his own shop, equipment, and tools. He gets his customers from advertising and wordof-mouth. Rich is self-employed as the owner of a repair shop. 7. Independent Contractor People such as doctors, dentists, veterinarians, lawyers, accountants, contractors, subcontractors, public stenographers, or auctioneers who are in an independent trade, business, or profession in which they offer their services to the general public are generally independent contractors. However, whether these people are independent contractors or employees depends on the facts in each case. The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done. The earnings of a person who is working as an independent contractor are subject to SE tax. A detailed discussion of the definition of an independent contractor is provided in Chapter 3. E. SOLE PROPRIETORS A sole proprietorship has no existence separate and apart from its owner. It does not file a tax return and is not liable for taxes. The proprietor himself is liable for all of the profits and losses of the business. A sole proprietor is required to report all net profits from the business, whether they are retained in the business account or not. The individual reports his income on Schedule C of Form Sole proprietors are, as mentioned above, subject to self-employment tax on business profits. Because a sole proprietor is not an employee, no deduction is permitted for fringe benefits offered by the business. A sole proprietor, however, may deduct 100 percent of insurance premiums paid for accident and health insurance for the sole proprietor and the proprietor's spouse and dependents. In fact, a sole proprietor may deduct 100 percent of insurance premiums paid for accident and health insurance, as well as medical reimbursements, for the sole proprietor and the proprietor's spouse and dependents if the sole proprietor provides the coverage to his or her spouse who is an employee of the business. The spouse may exclude the premium payments from income and/or any medical expense reimbursements, provided that the spouse is a bona fide employee of the business. However, if the spouse is self- employed (e.g., a partner) in the business, the accident and health insurance premiums and/or medical expense reimbursements, while deductible by the proprietorship, are included in the spouse's income and may be deducted by the spouse to the extent allowed to a sole proprietor. Filing and Paying Business Taxes 2-7

25 II. Income Taxation of Disregarded Entities: The Limited Liability Company Historically, businesses had to choose between the protection from liability offered by the corporation and the pass-through taxation offered by the partnership or sole proprietorship. This has changed dramatically over the past few decades. Today, all 50 states allow businesses to choose limited liability company (LLC) status and limited liability partnerships (LLP), which essentially allow all partners the protections of limited partner status in a general partnership. Each state has its own specific laws that determine what types of partnerships are eligible and the scope of limited liability offered. A. HISTORICAL TREATMENT One of the many benefits of limited liability company status is the ability of the owners to elect pass-through taxation. But when the IRS first recognized the existence of LLCs as a business form, not all LLCs were able to qualify for pass-through tax status. Federal regulations in place prior to 1997 required an unincorporated business entity whether it be a limited liability company or a partnership to possess certain characteristics or else it was treated as a corporation for federal tax purposes. Under the old regulations (known as the Kintner Regulations ), an unincorporated business association would be taxed as a partnership only if it possessed no more than two of the following corporate characteristics: Centralization of management; Continuity of life; Free transferability of interests; and Limited liability. The continuing of life restriction was the biggest impediment to limited liability companies being taxed as partnerships. It led most early state statutes governing limited liability companies to impose time limitations on the existence of the entity in order to protect its pass-through tax status. That all changed with the adoption of the so-called check-thebox regulations by the IRS. Check-the-box regulations became effective in 1997, eliminating application of the socalled Kintner regulations that had previously been used to determine if a business entity should be treated as a partnership or corporation for purposes of federal taxation. The key change was the elimination of the requirement that a limited liability company have a limited life span in order to qualify for pass-through taxation (under the old regulation, a company with an unlimited life span was too similar to a corporation to avoid being taxed as such). The changes also made possible more flexibility in other types of unincorporated business entities, such as limited liability partnerships. Filing and Paying Business Taxes 2-8

26 While a few states still comply with the outdated federal regulations and have provisions for mandatory dissolution of LLCs, most now give limited liability companies the option of an unlimited life span. B. FEDERAL TAX RETURNS For federal tax purposes, a limited liability company can be treated as either a sole proprietorship, a partnership or a corporation. In order to elect treatment as a partnership, a limited liability company must have at least two members. Those with only one can elect to be treated either as a sole proprietorship or a corporation. Consequently, the applicable tax payment requirements of a limited liability company as discussed above depend on the tax treatment elected by the company. To the extent that a limited liability company elects to be treated as a partnership for purposes of federal taxation, normal rules governing taxation of partnerships apply. To the extent a limited liability company elects to be treated as a corporation for purposes of federal taxation, normal rules governing taxation of corporations likewise generally apply. An in depth discussion of partnership and corporation taxation is obviously well beyond the scope of this course. This section will therefore be limited to a discussion of a few significant areas of taxation affecting limited liability companies. Even though a co-owned LLC itself does not pay income taxes, it must file Form 1065 with the IRS. This form, the same one that a partnership files, is an informational return that the IRS reviews to make sure the LLC members are reporting their income correctly. The LLC must also provide each LLC member with a "Schedule K-1," which breaks down each member's share of the LLC's profits and losses. In turn, each LLC member reports this profit and loss information on his individual Form 1040, with Schedule E attached. The check-the-box regulations give limited liability companies flexibility in deciding how they want to be taxed and therefore what type of tax return to file. 1. Single Member LLC Generally, when an LLC has only one member, the fact that it is an LLC is ignored or disregarded for the purpose of filing a federal tax return. The LLC has the following options for purposes of federal taxation: If the only member of the LLC is an individual, the LLC income and expenses are reported on Form 1040, Schedule C, E, or F; If the only member of the LLC is a corporation, the LLC income and expenses are reported on the corporation s return, usually Form 1120 or Form 1120S; or If a single-member LLC wishes to file as a corporation instead of as a disregarded entity, Form 8832 must be submitted. Otherwise, there is no need to file Form Single-member LLCs may not file a partnership return. Filing and Paying Business Taxes 2-9

27 For a single-member LLC being disregarded as an entity, the taxable year of the proprietor (usually the calendar year) is automatically the taxable year of the proprietorship. There are tax-deductible fringe benefits available to a sole proprietor, although they are more limited than those available to a corporation. A sole proprietor may contribute annually to a Keogh plan to the same limits available under corporate plans, and a proprietor may contribute to an individual retirement account. A sole proprietor may not deduct the cost of premiums for insurance on his own life but may deduct a portion of the cost of health insurance premiums for himself and dependents, subject to certain limitations. A sole proprietorship may deduct 100 percent of the cost of health insurance premiums. Deductions for premiums paid for group term life insurance and health insurance for employees of a sole proprietorship are available to the same extent as though incurred by a corporation. 2. Multiple Member LLCs Most LLCs with more than one member file a partnership return, Form A multimember LLC that wants to file as a corporation must submit Form Form 8832 does not need to be submitted if the LLC wants to file as a partnership. There is one significant limitation to the ability of a multi-member LLC to be treated as a partnership for tax purposes. Pursuant to I.R.S. Code 7704, interests in the company cannot be publicly traded if the company wants to be treated as a partnership. Table 2.3, below, summarizes the forms that a LLC is required to file depending on the number of members it has and the manner in which it elects to be taxed. Table 2.3 Tax Forms Filed By Limited Liability Companies TYPE OF ENTITY Single-member LLC where member is an 1040 individual Single-member LLC where member is a 1120 or 1120S corporation Multi-member LLC filing as partnership 1065 Multi-member LLC filing as corporation 8832 FORM C. EMPLOYMENT AND SELF-EMPLOYMENT TAXES As we saw in the earlier discussion, employment tax requirements apply to LLCs in much the same way as other types of unincorporated businesses. Employees of all LLCs are subject to withholding taxes. Forms W-2 and Forms 1099 must be filed, when required, of all employers. Filing and Paying Business Taxes 2-10

28 1. Self-Employment Taxes Because LLC members are not employees but self-employed business owners, contributions to the social security and Medicare systems (collectively called the "selfemployment" tax) are not withheld from their paychecks. Instead, most LLC owners are required to pay the self-employment tax directly to the IRS. With an S corporation, on the other hand, a shareholder pays the payroll tax on money received as compensation for services, but not on profits that automatically pass through as a shareholder. Any owner who works in or helps manage the business must pay this tax on his or her distributive share i.e., his or her share of profits. However, owners who are not active in the LLC that is, those who have merely invested money but do not provide services or make management decisions for the LLC may be exempt from paying selfemployment taxes on their share of profits. Each owner who is subject to the self-employment tax reports it on Schedule SE, which is submitted annually with a Form 1040 tax return. LLC owners pay twice as much selfemployment tax as regular employees, since regular employees' contributions to the self-employment tax are matched by their employers. a. LLCs Filing Schedule C or E. Members are subject to self-employment taxes on earnings. b. LLCs Filing Partnership Returns. Generally, members pay self-employment tax on their share of partnership earnings. There is a special rule for members who are the equivalent of limited partners. They pay self-employment tax only if the LLC pays them a guaranteed payment for services. As a member, an owner s liability for LLC debts are limited by state law. However, a member, like shareholders in corporations, may be held personally liable in situations involving unpaid employee withholdings if the member in question is determined to be the person responsible for making the payments. Until the IRS clarifies the rules on self-employment tax for members of an LLC, members should assume that 100% of their earnings could be subject to self-employment tax. D. TAXATION OF DISTRIBUTIONS Each LLC member's share of profits and losses, called a distributive share, is set out in the LLC operating agreement. Most operating agreements provide that a member's distributive share is in proportion to his percentage interest in the business. For instance, if Bill owns 70% of the LLC, and John owns the other 30%, Bill will be entitled to 70% of the LLC's profits and losses, and John will be entitled to the other 30%. If the members want to divide profits and losses in a manner that is not proportionate to the members' percentage interests in the business, it is called a "special allocation," and must comply with specific IRS rules. Filing and Paying Business Taxes 2-11

29 Distributions to equity owners of businesses taxed as partnerships are normally not subject to income tax pursuant to IRC 731, which provides, in part, that gain shall not be recognized... except to the extent that any money distributed exceeds the adjusted basis of such partner s interest in the partnership immediately before the distribution. Any gain recognized is generally treated as capital gain from the sale of the partnership interest on the date of the distribution. If partnership property (other than marketable securities treated as money) is distributed to a partner, the partner generally does not recognize any gain until the sale or other disposition of the property. Example. The adjusted basis of Jo's partnership interest is $14,000. She receives a distribution of $8,000 cash and land that has an adjusted basis of $2,000 and a fair market value of $3,000. Because the cash received does not exceed the basis of her partnership interest, Jo does not recognize any gain on the distribution. Any gain on the land will be recognized when she sells or otherwise disposes of it. The distribution decreases the adjusted basis of Jo's partnership interest to $4,000 [$14,000 ($8,000 + $2,000)]. Likewise, I.R.C. 731 provides that a member of a limited liability company may not declare a loss except that upon a distribution in liquidation of a partner s interest in a partnership where no property other than that described in subparagraph (A) or (B) is distributed to such partner, loss shall be recognized to the extent of the excess of the adjusted basis of such partner s interest in the partnership over the sum of: (A) any money distributed; and (B) the basis to the distributee. In addition, passive activity limitations and at-risk rules that apply to partnerships generally may restrict the amount a member of a limited liability company may deduct. The at risk rules of I.R.C. 465 provide that the members are allowed to deduct their shares of LLC losses to the extent they have an adequate amount at risk in the relevant activity. Generally, nonrecourse debt is not included in the amount at risk, but an exception exists for "qualified nonrecourse financing,'' which typically exists when a commercial lender makes a nonrecourse loan secured by real property. Unlike a limited partnership in which the general partner is fully liable for partnership obligations, in an LLC no member may be liable for the LLC's obligations (except to the extent a member has separately agreed to assume them). Accordingly, even if the debt of an LLC is nominally recourse at the entity level, it may be nonrecourse to the members, thereby making it easier for LLC debt secured by real property to constitute "qualified nonrecourse financing.'' Filing and Paying Business Taxes 2-12

30 The limited partnership test is not applicable to all LLC members because LLCs are designed to permit active involvement by LLC members in the management of the business. Further, LLC members unlike limited partners may materially participate in the LLC without losing their limited liability protection. E. RETAINED EARNINGS The benefits of pass-through taxation available to most limited liability companies are obvious. However, there are certain circumstances under which an LLC might benefit from corporate tax status, depending on the nature of the business. One situation where this might be true is when a company has a large amount of retained earnings, that is when a company elects to keep a substantial amount of profits in the company rather than distributing it to its members. Unlike an LLC, a corporation is responsible for paying taxes on corporate profits left or retained in the business. An LLC that elects corporate tax status, therefore, means that the company will pay tax on the earnings based on the income tax rates that apply to corporations. The members do not have to pay personal income taxes on those profits which are left in the company. And, because the corporate income tax rates for the first $75,000 of corporate taxable income are lower than the individual income tax rates that apply to most LLC members, this can save members money in overall taxes. Example. If an LLC needs to purchase expensive equipment at the beginning of each year, it may decide to leave $50,000 in the business at the end of the year. With the regular pass-through taxation of an LLC, these retained profits would probably be taxed at the member s individual tax rate, which is probably over 27%. But with corporate taxation, that $50,000 is taxed at the lower 15% corporate rate. A limited liability company that elects corporate tax status by filing Form 8832 is precluded from switching back to partnership status for five years. F. TAXATION OF A CONVERTED ENTITY The conversion of a partnership into an LLC classified as a partnership for federal tax purposes does not terminate the partnership. The conversion is not a sale, exchange or liquidation of any partnership interest, the partnership s tax year does not close, and the LLC can continue to use the partnership s taxpayer identification number. Filing and Paying Business Taxes 2-13

31 However, the conversion may change some of the partners bases in their partnership interests if the partnership has recourse liabilities that become nonrecourse liabilities. Because the partners share recourse and nonrecourse liabilities differently, their bases must be adjusted to reflect the new sharing ratios. If a decrease in a partner s share of liabilities exceeds the partner s basis, for example, he must recognize gain on the excess. The same rules apply if an LLC classified as a partnership is converted into a partnership. III. Taxation of Partnerships A partnership is not a taxable entity. It files a return, but it is purely informational. A partnership computes its income and files its return in the same manner as an individual. However, certain deductions are not allowed to the partnership. This section will address basic rules in computing profit and loss. A. SEPARATELY STATED ITEMS Certain items must be separately stated on the partnership return and included as separate items on the partners' returns. These items, listed on Schedule K (Form 1065), are the following: Ordinary income or loss from trade or business activities; Net income or loss from rental real estate activities; Net income or loss from other rental activities; Gains and losses from sales or exchanges of capital assets; Gains and losses from sales or exchanges of property described in section 1231 of the Internal Revenue Code; Charitable contributions; Dividends (passed through to corporate partners) that qualify for the dividendsreceived deduction; Taxes paid or accrued to foreign countries and U.S. possessions; Other items of income, gain, loss, deduction, or credit, as provided by regulations. Examples include nonbusiness expenses, intangible drilling and development costs, and soil and water conservation expenses. B. ELECTIONS The partnership makes most choices about how to figure income. These include choices for the following items: Accounting method; Filing and Paying Business Taxes 2-14

32 Depreciation method; Method of accounting for specific items, such as depletion or installment sales; Non-recognition of gain on involuntary conversions of property; and Amortization of certain organization fees and business start-up costs of the partnership. However, each partner chooses how to treat his share of foreign and U.S. possessions taxes, certain mining exploration expenses, and income from cancellation of debt. C. ORGANIZATION EXPENSES AND SYNDICATION FEES Neither the partnership nor any partner can deduct, as a current expense, amounts paid or incurred to organize a partnership or to promote the sale of, or to sell, an interest in the partnership. The partnership can choose to amortize certain organization expenses over a period of not less than 180 months. The period must start with the month the partnership begins business. This election is irrevocable and the period the partnership chooses in this election cannot be changed. If the partnership elects to amortize these expenses and is liquidated before the end of the amortization period, the remaining balance in this account is deductible as a loss. 1. Making the Election The election to amortize organization expenses is made by attaching a statement to the partnership's return for the tax year the partnership begins its business. The statement must provide all the following information: A description of each organization expense incurred (whether or not paid); The amount of each expense; The date each expense was incurred; The month the partnership began its business; and The number of months (not less than 180) over which the expenses are to be amortized. Expenses of less than $10 need not be separately listed, provided the total amount is listed with the dates on which the first and last of the expenses were incurred. A cash basis partnership must also indicate the amount paid before the end of the year for each expense. Filing and Paying Business Taxes 2-15

33 2. Amortizable Expenses Amortization applies to expenses that are: Incident to the creation of the partnership; Chargeable to a capital account; and The type that would be amortized if they were incurred in the creation of a partnership having a fixed life. To satisfy the first prong, an expense must be incurred during the period beginning at a point that is a reasonable time before the partnership begins business and ending with the date for filing the partnership return (not including extensions) for the tax year in which the partnership begins business. In addition, the expense must be for creating the partnership and not for starting or operating the partnership trade or business. To satisfy the third prong the expense must be for a type of item normally expected to benefit the partnership throughout its entire life. Organization expenses that can be amortized include the following: Legal fees for services incident to the organization of the partnership, such as negotiation and preparation of a partnership agreement; Accounting fees for services incident to the organization of the partnership; and Filing fees. 3. Expenses Not Amortizable Expenses that cannot be amortized (regardless of how the partnership characterizes them) include expenses connected with the following actions: Acquiring assets for the partnership or transferring assets to the partnership; Admitting or removing partners other than at the time the partnership is first organized; Making a contract relating to the operation of the partnership trade or business (even if the contract is between the partnership and one of its members); and Syndicating the partnership. Syndication expenses, such as commissions, professional fees, and printing costs connected with the issuing and marketing of interests in the partnership, are capitalized. They can never be deducted by the partnership, even if the syndication is unsuccessful. Filing and Paying Business Taxes 2-16

34 IV. Taxation of Corporations The classic knock on corporations large and small is the onus of double taxation: the corporation pays federal income on its income at the entity level; the profits taken by shareholders normally in the form of dividends are then taxed to the individual. Shareholders who are also employees are allowed to receive a salary that is tax deductible to the corporation so long as it is not excessive. But that does not relieve the corporation of paying taxes on its profits. A. INCOME TAX RETURN Unless exempt under 501 of the Internal Revenue Code, all domestic corporations in existence for any part of a taxable year (including corporations in bankruptcy) must file an income tax return whether or not they have taxable income. A corporation must generally file Form 1120 to report income, gains, losses, deductions, credits, and to figure its income tax liability. Also, certain organizations must file special returns. For more information, see the instructions for Forms 1120 and special returns. Generally, a corporation must file its income tax return by the 15th day of the 3rd month after the end of its tax year. A new corporation filing a short-period return must generally file by the 15th day of the 3rd month after the short period ends. A corporation that has dissolved must generally file by the 15th day of the 3rd month after the date it dissolved. Form 7004 can be filed to request a 6-month extension of time to file a corporation income tax return. The IRS will grant the extension if the form is completed properly, filed, and any tax due is paid by the original due date for the return. Form 7004 does not extend the time for paying the tax due on the return. Interest, and possibly penalties, will be charged on any part of the final tax due not shown as a balance due on Form The interest is figured from the original due date of the return to the date of payment. For more information, see the instructions for Form A corporation that does not file its tax return by the due date, including extensions, may be penalized 5% of the unpaid tax for each month or part of a month the return is late, up to a maximum of 25% of the unpaid tax. If the corporation is charged a penalty for late payment of tax for the same period of time, the penalty for late filing is reduced by the amount of the penalty for late payment. The minimum penalty for a return that is over 60 days late is the smaller of the tax due or $100. The penalty will not be imposed if the corporation can show the failure to file on time was due to a reasonable cause. Corporations that have a reasonable cause to file late must attach a statement explaining the reasonable cause. A corporation that does not pay the tax when due may be penalized ½ of 1% of the unpaid tax for each month or part of a month the tax is not paid, up to a maximum of 25% of the unpaid tax. The penalty will not be imposed if the corporation can show that the failure to pay on time was due to a reasonable cause. Filing and Paying Business Taxes 2-17

35 If income, social security, and Medicare taxes that a corporation must withhold from employee wages are not withheld or are not deposited or paid to the United States Treasury, the trust fund recovery penalty may apply. The penalty is the full amount of the unpaid trust fund tax. This penalty may apply to a responsible person if these unpaid taxes cannot be immediately collected from the business. The trust fund recovery penalty may be imposed on all persons who are determined by the IRS to be responsible for collecting, accounting for, and paying these taxes, and who acted willfully in not doing so. A responsible person can be an officer or employee of a corporation, an accountant, or a volunteer director/trustee. A responsible person also may include one who signs checks for the corporation or otherwise has authority to cause the spending of business funds. Willfully means voluntarily, consciously, and intentionally. A responsible person acts willfully if the person knows the required actions are not taking place. B. INCOME AND DEDUCTIONS Rules on income and deductions that apply to individuals also apply, for the most part, to corporations. However, some of the following special provisions apply only to corporations. 1. Below-Market Loans A below-market loan is a loan on which no interest is charged or on which interest is charged at a rate below the applicable federal rate. A below-market loan generally is treated as an arm's-length transaction in which the borrower is considered as having received both of the following: A loan in exchange for a note that requires payment of interest at the applicable federal rate; and An additional payment. 2. Capital Losses A corporation can deduct capital losses only up to the amount of its capital gains. In other words, if a corporation has an excess capital loss, it cannot deduct the loss in the current tax year. Instead, it carries the loss to other tax years and deducts it from capital gains that occur in those years. Filing and Paying Business Taxes 2-18

36 Example. In 2013, a calendar year corporation has a net short-term capital gain of $3,000 and a net long-term capital loss of $9,000. The short-term gain offsets some of the long-term loss, leaving a net capital loss of $6,000. The corporation treats this $6,000 as a short-term loss when carried back or forward. The corporation carries the $6,000 short-term loss back 3 years to In 2010, the corporation had a net short-term capital gain of $8,000 and a net long-term capital gain of $5,000. It subtracts the $6,000 short-term loss first from the net short-term gain. This results in a net capital gain for 2010 of $7,000. This consists of a net short-term capital gain of $2,000 ($8,000 $6,000) and a net long-term capital gain of $5, S Corporation Status A corporation may not carry a capital loss from, or to, a year for which it is an S corporation. 4. Rules for Carryover and Carryback When carrying a capital loss from one year to another, the following rules apply: When figuring the current year's net capital loss, you cannot combine it with a capital loss carried from another year. In other words, you can carry capital losses only to years that would otherwise have a total net capital gain; If you carry capital losses from two or more years to the same year, deduct the loss from the earliest year first; and You cannot use a capital loss carried from another year to produce or increase a net operating loss in the year to which you carry it back. 5. Charitable Contributions A corporation can claim a limited deduction for charitable contributions made in cash or other property. The contribution is deductible if made to, or for the use of, a qualified organization. A corporation may not take a deduction if any of the net earnings of an organization receiving contributions benefit any private shareholder or individual. a. Cash method corporation. A corporation using the cash method of accounting deducts contributions in the tax year paid. b. Accrual method corporation. A corporation using an accrual method of accounting can choose to deduct unpaid contributions for the tax year the board of directors authorizes them if it pays them within 2½ months after the close of that tax year. This choice is made by reporting the contribution on the corporation's return for the tax year. A copy of the resolution authorizing the contribution and a declaration stating that the board of directors adopted the resolution during the tax year must accompany the return. Filing and Paying Business Taxes 2-19

37 An officer authorized to sign the return must sign the declaration under penalties of perjury. c. Limit. A corporation cannot deduct charitable contributions that exceed 10% of its taxable income for the tax year. Figure taxable income for this purpose without the following: The deduction for charitable contributions; The deduction for dividends received; Any net operating loss carryback to the tax year; and Any capital loss carryback to the tax year. d. Carryover of excess contributions. A corporation may carry over, within certain limits, to each of the subsequent five years any charitable contributions made during the current year that exceed the 10% limit. A corporation may lose any excess not used within that period. For example, if a corporation has a carryover of excess contributions paid in 2011 and it did not use all the excess on its return for 2012, it can carry the rest over to 2013, 2014, 2015, and Do not deduct a carryover of excess contributions in the carryover year until after you deduct contributions made in that year (subject to the 10% limit). You cannot deduct a carryover of excess contributions to the extent it increases a net operating loss carryover. 6. Corporate Preference Items A corporation must make special adjustments to certain items before it takes them into account in determining its taxable income. These items are known as corporate preference items and they include the following: Gain on the disposition of section 1250 property. For more information, see Section 1250 Property under Depreciation Recapture in chapter 3 of Publication 544; Percentage depletion for iron ore and coal (including lignite). For more information, see Mines and Geothermal Deposits under Mineral Property in chapter 10 of Publication 535; Amortization of pollution control facilities. For more information, see Pollution Control Facilities in chapter 9 of Publication 535 and section 291(a)(5) of the Internal Revenue Code; and Mineral exploration and development costs. For more information, see Exploration Costs and Development Costs in chapter 8 of Publication 535. Filing and Paying Business Taxes 2-20

38 7. Dividends-Received Deduction A corporation can deduct a percentage of certain dividends received during its tax year. This section discusses the general rules that apply. a. Dividends from domestic corporations. A corporation can deduct, within certain limits, 70% of the dividends received if the corporation receiving the dividend owns less than 20% of the corporation distributing the dividend. If the corporation owns 20% or more of the distributing corporation's stock, it can, subject to certain limits, deduct 80% of the dividends received. b. Ownership. Determine ownership, for these rules, by the amount of voting power and value of the paying corporation's stock (other than certain preferred stock) the receiving corporation owns. c. Small business investment companies. Small business investment companies can deduct 100% of the dividends received from taxable domestic corporations. d. Dividends from regulated investment companies. Regulated investment company dividends received are subject to certain limits. Capital gain dividends received from a regulated investment company do not qualify for the deduction. For more information, see section 854 of the Internal Revenue Code. e. No deduction allowed for certain dividends. Corporations cannot take a deduction for dividends received from the following entities: A real estate investment trust (REIT); A corporation exempt from tax under section 501 or 521 of the Internal Revenue Code either for the tax year of the distribution or the preceding tax year; A corporation whose stock was held less than 46 days during the 90-day period beginning 45 days before the stock became ex-dividend with respect to the dividend. Ex-dividend means the holder has no rights to the dividend; A corporation whose preferred stock was held less than 91 days during the 180- day period beginning 90 days before the stock became ex-dividend with respect to the dividend if the dividends received are for a period or periods totaling more than 366 days; or Any corporation, if the corporation is under an obligation (pursuant to a short sale or otherwise) to make related payments with respect to positions in substantially similar or related property. Dividends on deposits or withdrawable accounts in domestic building and loan associations, mutual savings banks, cooperative banks, and similar organizations are interest, not dividends. They do not qualify for this deduction. The total deduction for dividends received or accrued is generally limited (in the following order) to: Filing and Paying Business Taxes 2-21

39 80% of the difference between taxable income and the 100% deduction allowed for dividends received from affiliated corporations, or by a small business investment company, for dividends received or accrued from 20%-owned corporations, then 70% of the difference between taxable income and the 100% deduction allowed for dividends received from affiliated corporations, or by a small business investment company, for dividends received or accrued from less-than-20%- owned corporations (reducing taxable income by the total dividends received from 20%-owned corporations). In figuring the limit, determine taxable income without the following items: The net operating loss deduction; The deduction for dividends received; Any adjustment due to the nontaxable part of an extraordinary dividend; and Any capital loss carryback to the tax year. If a corporation has a net operating loss (NOL) for a tax year, the limit of 80% (or 70%) of taxable income does not apply. To determine whether a corporation has an NOL, figure the dividends-received deduction without the 80% (or 70%) of taxable income limit. Example 1. A corporation loses $25,000 from operations. It receives $100,000 in dividends from a 20%-owned corporation. Its taxable income is $75,000 ($100,000 $25,000) before the deduction for dividends received. If it claims the full dividends-received deduction of $80,000 ($100,000 80%) and combines it with an operations loss of $25,000, it will have an NOL of ($5,000). Therefore, the 80% of taxable income limit does not apply. The corporation can deduct the full $80,000. Example 2. Assume the same facts as in Example 1, except that the corporation only loses $15,000 from operations. Its taxable income is $85,000 before the deduction for dividends received. After claiming the dividends-received deduction of $80,000 ($100,000 80%), its taxable income is $5,000. Because the corporation will not have an NOL after applying a full dividends-received deduction, its allowable dividends-received deduction is limited to 80% of its taxable income, or $68,000 ($85,000 80%). Filing and Paying Business Taxes 2-22

40 8. Extraordinary Dividends If a corporation receives an extraordinary dividend on stock held two years or less before the dividend announcement date, it generally must reduce its basis in the stock by the nontaxed part of the dividend. The nontaxed part is any dividends-received deduction allowable for the dividends. An extraordinary dividend is any dividend on stock that equals or exceeds a certain percentage of the corporation's adjusted basis in the stock. The percentages are: 5% for stock preferred as to dividends, or 10% for other stock. Corporations should treat all dividends received that have ex-dividend dates within an 85-consecutive-day period as one dividend. Corporations should treat all dividends received that have ex-dividend dates within a 365-consecutive-day period as extraordinary dividends if the total of the dividends exceeds 20% of the corporation's adjusted basis in the stock. Any dividend on disqualified preferred stock is treated as an extraordinary dividend regardless of the period of time the corporation held the stock. Disqualified preferred stock is any stock preferred as to dividends if any of the following apply: The stock when issued has a dividend rate that declines (or can reasonably be expected to decline) in the future; The issue price of the stock exceeds its liquidation rights or stated redemption price; or The stock is otherwise structured to avoid the rules for extraordinary dividends and to enable corporate shareholders to reduce tax through a combination of dividends-received deductions and loss on the disposition of the stock. These rules apply to stock issued after July 10, 1989, unless it was issued under a written binding contract in effect on that date, and thereafter, before the issuance of the stock. C. GOING INTO BUSINESS When going into business, certain costs incurred to get the business started are treated as capital expenses. A corporation can choose to amortize certain costs over a period of 180 months or more. To qualify, the cost must be one of the following: (1) a business start-up cost, or (2) an organizational cost. Filing and Paying Business Taxes 2-23

41 1. Business Start-up Costs Start-up costs are costs incurred for creating an active trade or business or for investigating the creation or acquisition of an active trade or business. Start-up costs include any amounts paid or incurred in connection with an activity engaged in for profit or for the production of income in anticipation of the activity becoming an active trade or business. A start-up cost is amortizable if it meets both of the following tests: It is a cost the owner could deduct if he paid or incurred it to operate an existing active trade or business (in the same field); and It is a cost the owner pays or incurs before the date his active trade or business begins. Start-up costs include costs for the following: An analysis or survey of potential markets, products, labor supply, transportation facilities, etc.; Advertisements for the opening of the business; Salaries and wages for employees who are being trained, and their instructors; Travel and other necessary costs for securing prospective distributors, suppliers, or customers; and Salaries and fees for executives and consultants, or for similar professional services. Start-up costs do not include deductible interest, taxes, or research and experimental costs. 2. Purchasing an Active Trade or Business Amortizable start-up costs for purchasing an active trade or business include only investigative costs incurred in the course of a general search for, or preliminary investigation of, the business. Investigative costs are costs that help an individual to decide whether to purchase any business and which business to purchase. Alternatively, costs incurred in an attempt to purchase a specific business are capital expenses and cannot be amortized. If an owner completely disposes of his business before the end of the amortization period, he can deduct any remaining deferred start-up costs to the extent allowable under section 165 of the Internal Revenue Code. Filing and Paying Business Taxes 2-24

42 3. Organizational Costs The costs of organizing a corporation are the direct costs of creating the corporation. Organizational costs may be amortized only if they meet all of the following tests: It is for the creation of the corporation; It is chargeable to a capital account; It could be amortized over the life of the corporation, if the corporation had a fixed life; and It is incurred before the end of the first tax year in which the corporation is in business. A corporation using the cash method of accounting can amortize organizational costs incurred within the first tax year, even if it does not pay them in that year. The following are examples of organizational costs: The cost of temporary directors; The cost of organizational meetings; State incorporation fees; The cost of accounting services for setting up the corporation; and The cost of legal services (such as drafting the charter, bylaws, terms of the original stock certificates, and minutes of organizational meetings). The following costs are not organizational costs. They are capital expenses that you cannot amortize: Costs for issuing and selling stock or securities, such as commissions, professional fees, and printing costs; and Costs associated with the transfer of assets to the corporation. 4. Related Persons A corporation that uses an accrual method of accounting cannot deduct business expenses and interest owed to a related person who uses the cash method of accounting until the corporation makes the payment and the corresponding amount is includible in the related person's gross income. Determine the relationship, for this rule, as of the end of the tax year for which the expense or interest would otherwise be deductible. If a deduction is denied under this rule, the rule will continue to apply even if the corporation's relationship with the person ends before the expense or interest is includible in the gross income of that person. These rules also deny the deduction of losses on the sale or exchange of property between related persons. Filing and Paying Business Taxes 2-25

43 For purposes of this rule, the following persons are related to a corporation: Another corporation that is a member of the same controlled group as defined in section 267(f) of the Internal Revenue Code; An individual who owns, directly or indirectly, more than 50% of the value of the outstanding stock of the corporation; A trust fiduciary when the trust or the grantor of the trust owns, directly or indirectly, more than 50% in value of the outstanding stock of the corporation; An S corporation if the same persons own more than 50% in value of the outstanding stock of each corporation; A partnership if the same persons own more than 50% in value of the outstanding stock of the corporation and more than 50% of the capital or profits interest in the partnership; and Any employee-owner if the corporation is a personal service corporation (defined later), regardless of the amount of stock owned by the employee-owner. To determine whether an individual directly or indirectly owns any of the outstanding stock of a corporation, the following rules apply: (1) Stock owned, directly or indirectly, by or for a corporation, partnership, estate, or trust is treated as being owned proportionately by or for its shareholders, partners, or beneficiaries; (2) An individual is treated as owning the stock owned, directly or indirectly, by or for his family. Family includes only brothers and sisters (including half brothers and half sisters), a spouse, ancestors, and lineal descendants; and (3) Any individual owning (other than by applying rule (2)) any stock in a corporation is treated as owning the stock directly or indirectly by that individual's partner. To apply rule (1), (2), or (3), stock constructively owned by a person under rule (1) is treated as actually owned by that person. But stock constructively owned by an individual under rule (2) or (3) is not treated as actually owned by the individual for applying either rule (2) or (3) to make another person the constructive owner of that stock. 5. Personal Service Corporation For this purpose, a corporation is a personal service corporation if it meets all of the following requirements: It is not an S corporation; Its principal activity is performing personal services. Personal services are those performed in the fields of accounting, actuarial science, architecture, consulting, engineering, health (including veterinary services), law, and performing arts; Its employee-owners substantially perform the services in (2); and Filing and Paying Business Taxes 2-26

44 Its employee-owners own more than 10% of the fair market value of its outstanding stock. Where it is necessary to clearly show income or prevent tax evasion, the IRS can reallocate gross income, deductions, credits, or allowances between two or more organizations, trades, or businesses owned or controlled directly, or indirectly, by the same interests. The disallowance of losses from the sale or exchange of property between related persons does not apply to liquidating distributions. 6. U.S. Real Property Interest If a domestic corporation acquires a U.S. real property interest from a foreign person or firm, the corporation may have to withhold tax on the amount it pays for the property. The amount paid includes cash, the fair market value of other property, and any assumed liability. If a domestic corporation distributes a U.S. real property interest to a foreign person or firm, it may have to withhold tax on the fair market value of the property. A corporation that fails to withhold may be liable for the tax, and any penalties and interest that apply. V. Income Taxation of Subchapter S Corporations In general, an S corporation is not subject to corporate-level income tax on its items of income and loss. Instead, an S corporation passes through its items of income and loss to its shareholders. The shareholders take into account separately their shares of these items on their individual income tax returns. To prevent double taxation of these items when the stock is later disposed of, each shareholder s basis in the stock of the S corporation is increased by the amount included in income (including tax-exempt income) and is decreased by the amount of any losses (including nondeductible losses) taken into account. A shareholder s loss may be deducted only to the extent of his or her basis in the stock or debt of the S corporation. To the extent a loss is not allowed due to this limitation, the loss generally is carried forward with respect to the shareholder. Some of the factors to consider when making a choice of entity that includes S corporation status include: The IRS treats a subchapter S corporation like a partnership for income tax purposes, but as a corporation for determining the tax treatment on dissolution; There are significant limits on who, and how many people, can have an ownership interest in an S corporation; and Failure to meet the strict statutory requirements for S corporation status can result in a retroactive loss of status and additional tax liabilities. To be eligible for S corporation status, the corporation must first be duly organized under the laws of its state of organization. S corporation status must then be affirmatively elected by all shareholders. This election is made using Form 2553 and must be filed within the first two and one-half months of the taxable year of the corporation or at any time prior to that, but not more than one year. A late election is considered valid for the following year. Filing and Paying Business Taxes 2-27

45 Once elected, income and deductions pass through to the shareholder in the same fashion as a partnership. However, special allocations available to a partnership (as discussed above) are not available to S corporations. This also holds true for losses, except that they are limited by the shareholders' basis in corporate stock. This is similar to partnership losses, as discussed above. Likewise, capital gains pass through. Subchapter S status may be terminated either voluntarily through a vote of the shareholders or involuntarily. Involuntary termination occurs whenever any of the preconditions for electing the status fail to exist, i.e., when the maximum number of shareholders is exceeded or when a second class of stock is created or stock passes into the hands of an unqualified shareholder. The holders of more than 50% of the stock may terminate the election voluntarily. No special form is required. Once an election has been terminated, the corporation may not again elect for the next four years, except under certain circumstances with the consent of the IRS. A. RIGHT TO OFFSET OTHER INCOME Because subchapter S corporation income and loss items pass through to the shareholders, losses can offset income generated from other activities by shareholders. The losses the subchapter S corporation generates may offset income generated by other activities, provided the shareholder's basis in his or her stock is sufficient to permit the deduction of the loss. B. TAX ON EXCESSIVE PASSIVE INVESTMENT INCOME An S corporation is subject to corporate-level tax, at the highest corporate tax rate, on its excess net passive income if the corporation has (1) accumulated earnings and profits at the close of the taxable year and (2) gross receipts more than 25 percent of which are passive investment income. Excess net passive income is the net passive income for a taxable year multiplied by a fraction, the numerator of which is the amount of passive investment income in excess of 25 percent of gross receipts and the denominator of which is the passive investment income for the year. Net passive income is defined as passive investment income reduced by the allowable deductions that are directly connected with the production of that income. Passive investment income generally means gross receipts derived from royalties, rents, dividends, interest, annuities, and sales or exchanges of stock or securities (to the extent of gains). Passive investment income generally does not include interest on accounts receivable, gross receipts that are derived directly from the active and regular conduct of a lending or finance business, gross receipts from certain liquidations, or gain or loss from any section 1256 contract (or related property) of an options or commodities dealer. Filing and Paying Business Taxes 2-28

46 In addition, an S corporation election is terminated whenever the S corporation has accumulated earnings and profits at the close of each of three consecutive taxable years and has gross receipts for each of those years more than 25 percent of which are passive investment income. An exception to this general rule was created in the American Jobs Creation Act of Under the Act, in the case of a bank (as defined in section 581), a bank holding company (as defined in section 2(a) of the Bank Holding Company Act of 1956), or a financial holding company, interest income and dividends on assets required to be held by the bank or holding company are not treated as passive investment income for purposes of the S corporation passive investment income rules. VI. Excise Taxes A. This section explains the excise taxes a sole proprietor or other business entity may have to pay and the forms that have to be filed if the business is engaged in any of the following: Manufactures or sells certain products; Operates certain kinds of businesses; Uses various kinds of equipment, facilities, or products; or Receives payment for certain services. 1. Form 720 The federal excise taxes reported on Form 720, Quarterly Federal Excise Tax Return, consist of several broad categories of taxes, including the following: Environmental taxes on the sale or use of ozone-depleting chemicals and imported products containing or manufactured with these chemicals; Communications and air transportation taxes; Fuel taxes; Tax on the first retail sale of heavy trucks, trailers, and tractors; and Manufacturers taxes on the sale or use of a variety of different articles. 2. Form 2290 There is a federal excise tax on the use of certain trucks, truck tractors, and buses on public highways. The tax applies to vehicles having a taxable gross weight of 55,000 pounds or more. Report the tax on Form 2290, Heavy Highway Vehicle Use Tax Return. For more information, see the instructions for Form Filing and Paying Business Taxes 2-29

47 Chapter 2 Review Questions The following questions are designed to ensure that you have a complete understanding of the information presented in the chapter. They do not need to be submitted in order to receive CPE credit. They are included as an additional tool to enhance your learning experience. We recommend that you answer each review question and then compare your response to the suggested solution before answering the final exam questions related to this chapter. 1. Partnerships are not subject to federal income tax. a) true b) false 2. Businesses must file informational Form 1099-MISC with the IRS to show payments to independent contractors in excess of: a) $500 b) $600 c) $750 d) $1, There are serious civil and criminal penalties, including up to five years in prison, for not filing Form 8300, or filing (or causing the filing of) a false or fraudulent Form a) true b) false 4. What is the current 2013 rate for federal self-employment tax on incomes up to $113,700: a) 8.5 percent b) 10 percent c) 15.3 percent d) 18.3 percent 5. Self-employment tax reporting rules apply to individuals in which of the following situations: a) the individual has reached normal retirement age, but works as a part-time business consultant b) the individual has another full-time W-2 job, but occasionally works in a home business c) the worker is paid in cash for part-time work, but primarily depends on social security and Medicare benefits to meet monthly living expenses d) all of the above Filing and Paying Business Taxes 2-30

48 6. The cap on income subject to the social security part of the self-employment tax in 2013 is: a) $102,000 b) $113,700 c) $124,800 d) there is no cap on the amount of income subject to self-employment tax 7. A sole proprietorship has no existence separate and apart from its owner. a) true b) false 8. Currently, how many states in the United States allow businesses to choose limited liability company (LLC) status and limited liability partnerships (LLP): a) 10 b) 27 c) 40 d) How are limited liability companies treated for federal income tax purposes: a) they must be treated as a partnership b) they must be treated as a corporation c) they have no tax significance d) they can be treated as a sole proprietorship, partnership, or corporation 10. Must members of a limited liability company pay self-employment taxes: a) no; they are not considered employees and therefore are normally exempt from paying federal self-employment tax b) yes; the company is required to withhold it from their paychecks c) members are subject to self-employment tax, but typically pay it directly to the IRS d) members of a limited liability company are subject to self-employment taxes, but at a lower rate 11. Expenses associated with organizing a partnership are generally tax deductible. a) true b) false 12. Which of the following is the most common criticism of corporations: a) they are complicated to form b) they often have bad, self-serving directors c) they are subject to double taxation d) they are subject to strict SEC rules Filing and Paying Business Taxes 2-31

49 13. There is no limit on the amount of capital losses a corporation may deduct. a) true b) false 14. Business start-up costs include an analysis or survey of potential markets, products, labor supply, transportation facilities, etc. and advertisements for the opening of the business. a) true b) false 15. How are subchapter S corporations treated for federal income tax purposes: a) the same way as a regular C corporation b) in the same manner as a partnership c) S corporations are not subject to federal income tax d) they are not required to file annual returns Filing and Paying Business Taxes 2-32

50 Chapter 2 Solutions and Suggested Responses 1. A: True is correct. Partnerships are not subject to federal income tax. However, a partnership is required to file Form 1065, which reports the results of the partnership's business activities. Individual partners pay taxes on their individual returns. B: False is incorrect. The partners, rather than the partnership, are liable for federal income tax. (See page 2-1 of the course material.) 2. A: Incorrect. This was the old rate. B: Correct. Payments of $600 or more for services performed for a business by a person not its employee must be reported on Form 1099-MISC, Miscellaneous Income. C: Incorrect. The actual amount that triggers reporting is less. D: Incorrect. The actual amount that triggers reporting is less. (See page 2-3 of the course material.) 3. A: True is correct. A sole proprietor or other business entity must file Form 8300, Report of Cash Payments Over $10,000 Received in a Trade or Business, if it receives more than $10,000 in cash in one transaction, or two or more related business transactions. There are civil and criminal penalties, including up to five years in prison, for not filing Form 8300, filing (or causing the filing of) a false or fraudulent Form 8300, or structuring a transaction to evade reporting requirements. B: False is incorrect. Persons who fail to file Form 8300 are subject to many penalties, including criminal prosecution. (See pages 2-3 to 2-4 of the course material.) 4. A: Incorrect. Self-employment tax goes towards social security and Medicare. The current 2012 rate is actually 13.3 percent. B: Incorrect. The actual rate on this tax, which goes towards Medicare and social security, is actually much higher. C: Correct. This rate for 2013 consists of two parts: 12.4 percent goes towards social security, while the remaining 2.9 percent goes towards Medicare for wages up to $113,700. D: Incorrect. While high, the actual rate is a little lower than this. (See page 2-5 of the course material.) Filing and Paying Business Taxes 2-33

51 5. A: Incorrect. Self-employment tax liability applies regardless of the age of the person earning the income assumed herein is that the payment is based on services provided and the amounts exceed $400/yr. B: Incorrect. Income generated and paid as a result of running a home business will generally subject the individual to self-employment income reporting regardless of the fact that he/she may have fulltime work elsewhere. C: Incorrect. Receiving social security and/or Medicare benefits have no impact as to whether an individual has self-employment reporting obligations. D: Correct. The self-employment tax rules apply no matter how old the individual is and even if he or she is already receiving social security or Medicare benefits. In all of these situations, self-employment tax reporting would generally be required. (See page 2-5 of the course material.) 6. A: Incorrect. The amount of income subject to the social security part of the selfemployment tax is capped annually. This was the cap for B: Correct. This is the amount that can be subject to the social security part of the self-employment tax in C: Incorrect. The cap is actually lower. D: Incorrect. There is a cap which is set each year. (See page 2-6 of the course material.) 7. A: True is correct. The essence of a sole proprietorship is that the business and the owner are one in the same. B: False is incorrect. The entity has no legal existence on its own; it does not file tax returns and does not have profits or losses. All of these things inure to the owner. (See page 2-7 of the course material.) 8. A: Incorrect. This number is far too low. B: Incorrect. There are currently many more states in the U.S. than this number suggests that allow businesses to select one of these legal entity structures. C: Incorrect. This number is less than the correct answer. D: Correct. Today, all 50 states allow businesses to choose limited liability company (LLC) status and limited liability partnerships (LLP), which essentially allow all partners the protections of limited partners status in a general partnership. (See page 2-8 of the course material.) Filing and Paying Business Taxes 2-34

52 9. A: Incorrect. One of the great benefits of a limited liability company is that the owners may select the best tax status for them. Partnership is just one option. B: Incorrect. One of the great benefits of a limited liability company is that the owners may select the best tax status for them. Corporate status is just one option. C: Incorrect. There is a significance of selecting LLC status, and that is flexibility in selecting a tax status. D: Correct. This flexibility is one of the principal benefits of electing this type of business structure. To the extent that a limited liability company elects to be treated as a partnership for purposes of federal taxation, normal rules governing taxation of partnerships apply. To the extent a limited liability company elects to be treated as a corporation for purposes of federal taxation, normal rules governing taxation of corporations likewise generally apply. (See page 2-9 of the course material.) 10. A: Correct. There is no federal exemption from self-employment tax for members of a limited liability company. B: Incorrect. Members are subject to the tax but typically pay it directly to the IRS. C: Correct. Members of an LLC are not exempt from self-employment tax. They typically pay it directly to the IRS. D: Incorrect. There is only one rate for self-employment taxes. (See pages 2-10 to 2-11 of the course material.) 11. A: True is incorrect. Such expenses are generally not deductible. B: False is correct. Neither the partnership nor any partner can deduct, as a current expense, amounts paid or incurred to organize a partnership or to promote the sale of, or to sell, an interest in the partnership. (See page 2-15 of the course material.) Filing and Paying Business Taxes 2-35

53 12. A: Incorrect. While they are more complicated to form than other business entities, this is not their biggest source of criticism. B: Incorrect. This can happen in any business and is not the biggest knock on corporations. C: Correct. The biggest knock on corporate status is that their earnings are subject to taxation at the corporate level and then again when the profits are distributed to shareholders through dividends. D: Incorrect. This is not the biggest knock on corporations. (See page 2-17 of the course material.) 13. A: True is incorrect. There is indeed a limit on the amount that can be deducted for federal income tax purposes. B: False is correct. A corporation can deduct capital losses only up to the amount of its capital gains. In other words, if a corporation has an excess capital loss, it cannot deduct the loss in the current tax year. Instead, it carries the loss to other tax years and deducts it from capital gains that occur in those years. (See page 2-18 of the course material.) 14. A: True is correct. Start-up costs are costs incurred for creating an active trade or business or for investigating the creation or acquisition of an active trade or business. Start-up costs include any amounts paid or incurred in connection with an activity engaged in for profit or for the production of income in anticipation of the activity becoming an active trade or business. The examples given qualify. B: False is incorrect. These are clear examples of start-up costs. (See page 2-24 of the course material.) 15. A: Incorrect. The whole idea of subchapter S corporate status is to avoid the tax treatment of a C corporation. B: Correct. The income is passed through to the shareholders much the same way as the income of a partnership is passed through to each partner. Therefore, there is no double taxation with an S corporation. C: Incorrect. They are indeed subject to federal income tax. D: Incorrect. They are not exempt from normal filing requirements. (See page 2-27 of the course material.) Filing and Paying Business Taxes 2-36

54 Chapter 3: Federal Employment Taxes I. Overview of Employment Taxes Employers large and small are responsible for the collection and remittance of the following federal employment taxes: Federal income tax withholding; Social security and Medicare taxes; and Federal unemployment tax (FUTA). Sections 3111 and 3301 of the Internal Revenue Code impose FICA (social security) and FUTA (unemployment) taxes on employers for wages paid to their employees. The Federal Insurance Contributions Act and Federal Unemployment Tax Act both define "wages" as "all remuneration for employment" [26 U.S.C. 3121(a) & 3306(b) (1988)]. 1. Federal Unemployment (FUTA) Tax The federal unemployment tax is part of the federal and state program under the Federal Unemployment Tax Act (FUTA) that pays unemployment compensation to workers who lose their jobs. Employers must report and pay FUTA tax separately from social security and Medicare taxes and withheld income tax. Employers pay FUTA tax only from their own funds. Employees do not pay this tax or have it withheld from their pay. 2. Federal Insurance Contributions Act (FICA) Social security and Medicare taxes pay for benefits that workers and their families receive under the Federal Insurance Contributions Act (FICA). Social security tax pays for benefits under the old-age, survivors, and disability insurance part of FICA. Medicare tax pays for benefits under the hospital insurance part. Employers withhold part of these taxes from their employee's wages and pay a matching amount. For purposes of FICA, all wages (cash or non-cash) derived from employment, unless specifically excluded by statute, are subject to tax. It is immaterial what the wages are called as long as the payment is for services performed. Wages subject to FICA taxes do not include amounts paid to an employee that are in excess of the taxable wage base. Starting in 1991 there is a separate wage base for the social security and the Medicare portions of the FICA tax. Wages are considered to be paid when they are actually made available to the employee; that is, when they are actually or constructively received by the employee. Wages are paid constructively when credited to the account of the employee or when set apart to permit the employee at his or her discretion to draw upon the account or take possession of the amount without substantial limitations or restrictions. At the end of the year, businesses must provide employees with a Form W-2, which details the employees earnings for the year as well as the amounts withheld by the employer for taxes. Independent contractors do not receive a Form W-2. Rather, Federal Employment Taxes 3-1

55 businesses that utilize an independent contractor who is paid $600 or more in the calendar year are required to furnish the worker with a Form The Internal Revenue Service is the federal agency charged with collecting employment taxes and self-employment taxes. Given that responsibility, the IRS also has the authority to determine whether employment taxes are owed. This determination requires finding that a worker is in fact an employee. Table 3.1 Mandatory Federal Filing Requirements for Businesses Employees Form W-2 to report payments to employees, including wages and tips Form 940 or 940-EZ to report federal unemployment tax (FUTA) Independent Contractors Form 1099-MISC for payments of $600 or more for services performed for business by people not classified as employees 3. Federal Penalties To be sure that all taxpayers pay their fair share of taxes, the law provides penalties for not filing returns or paying taxes as required. Criminal penalties may be imposed for willful failure to file, tax evasion, or making a false statement. a. Failure to file tax returns. Employers that do not file tax returns by the due date are subject to a penalty. The penalty is based on the tax not paid by the due date. b. Failure to pay tax. An employer who does not pay required employment taxes is liable for a penalty for each month, or part of a month, that its taxes are not paid. c. Failure to withhold, deposit, or pay taxes. An employer who fails to withhold income, social security, or Medicare taxes from employees, or one who withholds taxes but does not deposit them or pay them to the IRS, may be subject to a penalty of the unpaid tax, plus interest. They may also be subject to penalties if the taxes are deposited after their due date. d. Failure to follow information reporting requirements. The following penalties apply to employers who fail to follow informational reporting requirements: Failure to file information returns. A penalty applies to employers who do not file information returns by the due date, if they do not include all required information, or if they report incorrect information; and Failure to furnish correct payee statements. A penalty applies if employers do not furnish a required statement to a payee by the required date, if they do not include all required information, or if they report incorrect information. Federal Employment Taxes 3-2

56 e. Waiver of penalty. Penalties can be waived under certain circumstances when the employer can demonstrate that the failures were due to reasonable cause and not willful neglect. Once again, remember that it is the worker's status that determines who pays various taxes and the reporting obligations. If an employer-employee relationship exists, the employer is liable for employment taxes under IRC 3102 and Certain workers are subject to FICA taxes even though they are independent contractors under the common law test. These workers are commonly called "statutory employees" and are discussed later. 4. Employer s Credit for Income Tax Withholding The income tax not withheld but paid by the employer on behalf of the employee after January 31 of the following year cannot be taken as a credit on the employee's tax return. The income tax withholding not withheld but paid by the employer after January 31 of the following year as an additional assessment is subject to the provisions of IRC 3402(d). This section provides relief to the employer provided the employer can show that the employee filed a return, reported the wages, and paid the tax. Income tax not withheld from an employee's wages but paid by the employer on behalf of the employee before January 31 of the following year constitutes gross income and is wages subject to FICA, FUTA and income tax withholding. 5. Section 530 Relief Section 530 of the Revenue Act of 1978 provides relief to employers for federal employment tax purposes only. The effect of Section 530 is on taxes imposed under FICA, FUTA, the withholding of income tax at source on wages (WT), and RRTA. Section 530 does not change in any way the status, liabilities, and rights of the worker whose status is at issue. Section 530 only terminates the liability of the employer for the employment taxes and has no effect on the workers. It does not convert individuals from the status of employee to the status of self-employed. The worker is still considered an employee for income tax and tax qualified benefit plan eligibility purposes. 6. IRC Section 3509 IRC 3509 enacted in 1982 provides "statutory offset mechanisms that will apply in reclassification cases." IRC 3509 provides different rates for determining an employer's employment tax liability on the employee's share of the FICA tax on wages paid to an employee. This procedure does not relieve the employer of the employer's share of FICA and FUTA. The employee's liability for FICA tax under IRC 3101 is not affected by IRC 3509 and the employer is not entitled to recover any part of the employee tax assessed under this section. 7. Interest-Free Adjustments IRC 6205 provides that an employer who makes, or has made an under collection or underpayment of employee taxes (FICA/RRTA) or income tax (withholding), may make Federal Employment Taxes 3-3

57 interest-free payments of the tax due when certain conditions are met. This provision does not apply to FUTA. The employer may report the additional tax due on wages and compensation paid as an adjustment on a current return or on a supplemental return for the period in which the adjustment is made. The supplemental return must be filed on or before the due date of the return for the period in which the error was ascertained. If an adjustment is reported but the amount is not paid when due, interest thereafter accrues. An error is ascertained when the employer has sufficient knowledge of the error to be able to correct it. Such knowledge may be obtained, for example, in the course of an examination. In an agreed case, this is when the employer signs Form 2504 (Agreement to Assessment and Collection of Additional Tax and Acceptance of Overassessment (Excise or Employment Tax)). For an unagreed case, it could be at the conclusion of an Appeals conference. Form 2504 is considered to stand in lieu of a supplemental return. The interest-free provisions do not apply if: The issue in question for any period is the same issue raised in a prior period examination; or The taxpayer has been informed of its status as an employer and knowingly underreports employment tax liability in subsequent years. Prior regulations allowed an interest-free adjustment only if a return was filed before the underpayment of tax was ascertained. Proposed amendments in Treasury Regulation Section extend the rules to employers who did not file a return and pay the tax solely because they improperly failed to treat one or more individuals as employees. The signing of Form 2504 at the close of an examination or Appeals conference fulfills the supplemental return requirements for the interest-free adjustment purposes of IRC In addition, full payment of the tax must be made before the due date of the return for the period in which the error was ascertained in order to be a totally interest-free adjustment. If the tax adjustment is not paid when due, interest thereafter accrues. Consider the following examples: Example 1. An employer files and pays the tax for a timely filed employment tax return that is incorrect. During an audit, an error in the FICA tax liability is discovered by the examiner and proposed to the employer on September 15th. The employer signs Form 2504 and pays the additional tax on November 10th. The report period (quarter) in which the erroneously underpaid FICA taxes are ascertained is October through December. The amount of the underpayment may be paid interest free at the time fixed for reporting the adjustment. In this case, on or before January 31st. (Since the amount due was paid before the last day on which the return is required to be filed for the quarter in which the error was ascertained, the amount due may be paid interest free). Federal Employment Taxes 3-4

58 Example 2. Same situation as Example 1 above except that the taxpayer signs the agreement on September 15th. The report period (quarter) in which the erroneously underpaid FICA taxes are ascertained is July through September. The underpayment may be paid interest free at the time fixed for reporting the adjustment. In this case, on or before October 31st. Because the amount due was not paid until November 10th, interest will accrue from November 1st (the first day after the last day fixed for filing the return period in which the error was ascertained, October 31st) through November 10th, the date of payment of the tax. Example 3. Same situation as Example 1 above except that the taxpayer has not paid the tax. The taxpayer signs Form 2504 on October 3rd. The report period in which the underpaid FICA taxes are ascertained is October through December. Since the tax was not paid, interest will be assessed from the first day after the last day fixed for filing the return period in which the error was ascertained until the date of assessment. Thus, the interest computation date of February 1st (the return for this quarter is due on January 31st). 8. Relief for Employer When Employees Have Paid Income Tax on Wages When income tax withholding is involved, and IRC 3509 is not applicable, the withholding is either computed under existing law and regulations or the alternate percentage withholding rate of 28% provided in Regulation section (g)-1(a)(2)(ii) of the Regulations. For payments made prior to 1/1/94, the withholding rate on supplemental wages was 20%. Employers' requests under IRC 3402(d) for relief from the payment of income tax withholding are generally handled at service centers. Since these requests do not constitute claims, Forms 843 (Claim) will not be solicited. The employer is entitled to the abatement of the employee share of FICA under IRC 6521 if the employee paid self-employment tax and the statute has run for claiming a refund of such tax. FICA and FUTA taxes are not abatable under IRC 3402(d). In addition, penalties or interest adjustments are not abated by these procedures. 9. Misclassification Penalty When an employer erroneously classifies an employee as an independent contractor and does not withhold federal payroll taxes, the employer is liable under IRC 3102 and IRC 3403 for the employee's share of FICA tax and the employee's income tax withholding. This is true even if the employer does not withhold the tax from the employee. Although relief provisions under IRC 3402(d) and 6521 are available, employers sometimes find it difficult to locate and get the cooperation of former employees in order to avail themselves of the relief. Public Law dated September 3, 1992 and made Federal Employment Taxes 3-5

59 effectively for assessments made after December 31, 1992, provides "statutory offset mechanisms that will apply in reclassification cases." Section 3509 applies where 530 relief is not available and gives reduced rates for income tax withholding and the employee's share of FICA where an employer failed to deduct employment taxes by reason of treating such employee(s) as an independent contractor. The procedure does not relieve the employer of the employer's share of FICA and FUTA taxes. If Forms 1099 were filed with respect to the workers: Income tax withholding is computed at the rate of 1.5% with no abatement under IRC 3502(d). Abatement rules do not apply. The employer's liability for FICA is computed at the rate of 20% of the employee's share, plus the entire employer's share. If no Forms 1099 were filed: The income tax withholding rate becomes 3%. Abatement rules do not apply; and The FICA tax liability is the employer's share plus 40% of the employee's share. The failure to file penalty (IRC 6651) should be applied if there is no reasonable cause. The failure to deposit penalty (IRC 6656) will apply to delinquent employment tax returns unless there is reasonable cause. The penalty (10%) applies only to the employer's share of FICA tax. If a taxpayer has not filed a return, no accuracy-related penalty would apply. A substitute for return is not considered a return for this purpose. Application of 3509 is mandatory for all assessments made after December 31, A taxpayer cannot waive 3509 when its conditions are met. The section does not apply: In cases of intentional disregard of the requirement to deduct and withhold employment taxes (IRC 3509(c)); In cases where the employer deducts income tax from the wages of an employee but does not deduct FICA tax (IRC 3509(d)(3)); In cases of certain statutory employees for FICA tax purposes (IRC 3509(d)(3)); In agreed and unagreed cases, the provisions of IRC 3509 will be applied to all quarterly returns required to be filed for any completed calendar year under examination. If different rates under IRC 3509 are applied to the same employer, the case file/workpapers should be documented to explain the reasoning for using the different rates. If the employer's failure to file Form 1099 was due to reasonable cause and not willful neglect, the higher rates should not apply. Federal Employment Taxes 3-6

60 The employee's liability for FICA tax under IRC 3101 is not affected by IRC The employer is not entitled to recover from the employee any part of the tax assessed under this section. Treas. Reg (c) provides that an employee is responsible for the employee's share of FICA until it is collected from him or her by the employer. Since IRC 3509 bars the employer from collecting the tax from the employee, the employee remains liable for the FICA tax on their individual Form 1040 return. The employee may file a claim for refund of any self-employment tax which is attributable to the reclassification. The reclassified worker can use Form 4137 to compute the amount of FICA taxes due. It should be used as an attachment to Form 1040 or 1040X. Notice 989, Commonly Asked Questions When IRS Determines Your Workers Status is "Employee", provides instructions to the reclassified worker on how to file a claim for refund. The amount of the refund, however, will be offset by the amount of the employee's share of the tax imposed on the employee under section 3101 as a result of the application of regulation section (c). Ultimate liability is on the employee until collected from the employer. Any expenses the employee claimed on Schedule C would be deducted on Schedule A, subject to the 2% floor. The adjustments on Page 1 of the Form 1040 for ½ of the selfemployment tax and self-employed health insurance would be eliminated. For example, if a worker paid self-employment tax on 2013 net profit of $35,100 ($45,000 less $9,900 related business expenses), and during a subsequent examination of the payor, the IRS reclassified those earnings from self-employment income to gross wages of $45,000, the worker would be entitled to a Self-Employment Contributions Act (SECA) tax refund calculated as follows: $32,415 x 15.3% (2013 SECA rate) = $4, $45,000 x 7.65% (employee FICA rate) = $3, Allowable SECA tax refund = $1, Since the related business expenses are subject to the 2% adjusted gross income limit, this change will increase the taxable income and possibly the Federal income tax. Also certain expenditures, such as medical insurance or a Keogh-type retirement plan, cannot be claimed as a miscellaneous deduction on Schedule A Form Any additional Federal income tax will offset the SECA tax refund. 10. Common Paymaster When two or more related corporations employ the same individual at the same time and pay that individual through a common paymaster which is one of the related corporations, there are limits on the amount of FICA tax due. The related corporations pay FICA as if the corporations were one employer. Treas. Reg (s)-1 provides the requirements for common paymaster status. The provisions of this section apply only to cash payments. Other forms of compensation, such as fringe benefits, would be treated as if they were provided by separate employers for wage limitation purposes. Federal Employment Taxes 3-7

61 11. Computing Income Tax Withholding IRC 3402 requires employers to deduct and withhold income tax from payments of wages. When income tax withholding is involved, and IRC 3509 is not applicable, use the alternate percentage rate of 20 percent provided in Treas. Reg (g)- 1(a)(2)(ii). Where the employer can establish the employee's allowable number of exemptions, from the W-4 on file for the employees during the audit years, the computation can be made based on the laws and regulations in existence during those years. Under IRC 3402(d), the employer may request relief from payment of income tax withholding. Forms 4669 and 4670 are used for this purpose. 12. Mitigation of Statutes of Limitations in Case of FICA and SECA Taxes (IRC 6521) If an amount of compensation is incorrectly treated as either self-employment income under the Self-Employment Contributions Act, or as wages under the Federal Insurance Contributions Act, and the statute of limitations for correcting the error has expired for one of the taxes, the law makes provisions to effect the appropriate adjustments. In such cases, the adjustment under one act will reflect the adjustment which would have been made under the other act notwithstanding the expiration of the statute of limitations which otherwise would prevent such adjustment. 13. Employment Tax on Tip Income Tips are considered wages for purposes of FICA taxes. Tips are also subject to various reporting requirements by both the employee and the employer. Under Treas. Reg , the employer is responsible for deducting and depositing the employee's FICA tax on tips included in the written report furnished by the employee to the extent that collection can be made from the employee's funds on or after the time the written statement is furnished. The employee's funds include wages (exclusive of tips) in the employer's possession and amounts turned over to the employer by the employee. The employer is required to collect employee tax only on tips which are reported by the employee to the employer. If the amount of employee tax on tips exceeds the wages under the control of the employer, the employee may furnish to the employer money equal to the amount of such excess. Employers are also liable for their share of FICA tax on tips reported by the workers under IRC 3121(q). In addition, IRC 3121(q) provides that employers pay their share of FICA taxes on tips reported by their employees in the course of employment. Such remuneration is deemed to have been paid at a time a written statement including such tips is furnished to the employer. If no such statement is furnished (or to the extent the statement is incomplete or inaccurate) such remuneration shall be deemed to be paid on the date on which notice and demand for such taxes is made to the employer. IRC 45B allows a tax credit for the portion of employers' social security taxes paid with respect to employees' cash tips. The employer can claim the tax credit whether or not the employee reports the cash tips. This credit is allowed whether or not the food or beverages are for consumption on or off the premises. Thus, the credit may apply to Federal Employment Taxes 3-8

62 employees who deliver food or beverages. Form 8846, Credit for Employer Social Security and Medicare Taxes Paid on Certain Employee Tips, is used to compute the credit. The employee taxes withheld from wages or made available by the employee will be applied first to the FICA (or RRTA) tax and any excess will then be applied to the income tax withholding. The employer is required to furnish a statement to the employee showing the amount that the employee tax on reported tip income exceeds the amount of employee tax which was collected by the employer from wages. Form W-2 is the form prescribed for furnishing this statement except if an employer files a composite return pursuant to Regulations (a)-8. II. Employee vs. Independent Contractor The Internal Revenue Service is the branch of the federal government charged with collecting employment taxes, including federal income and unemployment insurance. Given the amount of money involved in misclassification, part of the charge of the IRS is to audit businesses to ensure that workers are properly classified as either independent contractors or employees. The burden will always be on the business, or alleged employer to prove that the worker is an independent contractor rather than an employee. Careful attention to every aspect of the relationship with a purported independent contractor is therefore essential. A. COMMON LAW EMPLOYEES / THE IRS 20-FACTOR TEST The first thing the IRS will do in conducting an employment tax audit is to see if any purported independent contractors fall into the categories of statutory employees. These categories, discussed later, provide that, as a matter of law, certain workers are employees for purposes of some or all employment taxes. When no clear statutory provision exists, the IRS will look to the common law classification of the workers in question. The IRS uses its own test to determine the status of a worker as either that of employee or independent contractor. The IRS test is based on common law rather than statute, meaning it is derived from the manner in which the courts have classified workers rather than a legislative enactment. The well-known IRS 20-factor test was promulgated in the form of Revenue Ruling C.B. 296, issued in The 20-factor test is helpful in determining worker status, but it certainly does not give businesses any type of guarantee that they have correctly classified their workers. This ambiguity is the result of several factors: The IRS does not give specific weight to any of the 20 factors; its determinations are made based on the totality of the circumstances. That means that a business could theoretically be okay on 15 of the 20 factors and will still be faced with being told its worker is an employee; The precise nature of the relationship between a business and its worker(s) is very individualized; it is almost impossible to promulgate a rule that will provide guidance to businesses in every situation; even within the same industry, practices can vary greatly. A business that wants to utilize an independent contractor in lieu of an employee should attempt to have as many aspects of its relationship comply with the IRS test. The following table summarizes those factors. Federal Employment Taxes 3-9

63 Table 3.2 The IRS 20-Factor Test FACTOR INSTRUCTIONS EMPLOYEE STATUS Employer has right to direct specific actions of employee, including when and where to work INDEPENDENT CONTRACTOR STATUS Independent contractor not required to comply with specific instructions of principal as to when, where or how to complete the task TRAINING An employee can be required to undergo training mandated by the employer An independent contractor does not receive and is not required to undergo training by the principal or his agents INTEGRATION SERVICES RENDERED PERSONALLY HIRING, SUPERVISING, AND PAYING ASSISTANTS An employee performs his job in conjunction with other employees An employee personally renders the services for which he is employed An employee is not responsible for hiring and paying his own assistant that is done by the employer An independent contractor performs his duties without significant involvement of the principal s employees An independent contractor is not required to personally render the services contracted for; he may utilize his own employees or other independent contractors; he does not need permission to utilize agents in the performance of the contract An independent contractor is responsible for hiring, supervising and paying his own assistants, if necessary to the performance of the contract Federal Employment Taxes 3-10

64 FACTOR CONTINUING RELATIONSHIP EMPLOYEE STATUS An employee has a continuing relationship with his employer INDEPENDENT CONTRACTOR STATUS An independent contractor does not necessarily have a continuing relationship with any particular principal SET HOURS OF WORK An employee has his hours of work established by his employer An independent contractor is able to control the hours he works FULL-TIME REQUIRED An employee is subject to the control of his employer in terms of when he works and can be limited in accepting outside employment An independent contractor is not required to spend all of his work time performing services for the principal; he is free to work for whom and when he chooses DOING WORK ON EMPLOYER'S PREMISES An employee is required to perform his duties on the employer s premises; this is particularly true when work could be performed elsewhere An independent contractor is not required to perform work at any particular location, including the principal s premises; the nature of the work may limit the choice available to an independent contractor ORDER TO SEQUENCE SET An employee is given a set order or sequence in which to perform certain work by his employer and is normally not allowed to select his own pattern or schedule An independent contractor is not required to perform his services in any particular sequence; rather, he establishes his own routing and patterns for performing his services Federal Employment Taxes 3-11

65 FACTOR ORAL OR WRITTEN REPORTS EMPLOYEE STATUS An employee is required to submit regular reports, either oral or written, to his employer INDEPENDENT CONTRACTOR STATUS An independent contractor is not required to report to his principal on a regular basis, although the provisions of his contract may mandate specific progress reports PAYMENT BY HOUR, WEEK, MONTH An employee is paid by the hour, week or month An independent contractor is paid by the job or receives a straight commission PAYMENT OF BUSINESS AND/OR TRAVELING EXPENSES An employee is reimbursed for expenses, including travel, incurred in the performance of his employment duties An independent contractor is responsible for paying all of his own expenses, including travel FURNISHING OF TOOLS AND MATERIALS An employee receives his tools or other materials required for work from his employer An independent contractor furnishes his own tools or other materials SIGNIFICANT INVESTMENT An employee is not required to make a significant investment in order to perform his job; the place of work and necessary equipment are provided by the employer An independent contractor makes a personal investment in his business or trade, such as the renting of an office or the purchase of equipment REALIZATION OF PROFIT OR LOSS An employee is paid the same amount regardless of the outcome of his work, and therefore is unable to either suffer a loss or realize a profit An independent contractor is a business person able to realize a profit or suffer a loss as a result of performing his services for the principal(s) Federal Employment Taxes 3-12

66 FACTOR WORKING FOR MORE THAN ONE FIRM AT A TIME EMPLOYEE STATUS An employee normally works for only one firm or employer at a time INDEPENDENT CONTRACTOR STATUS An independent contractor often works for more than one principal at a time MAKING SERVICE AVAILABLE TO GENERAL PUBLIC RIGHT TO DISCHARGE RIGHT TO TERMINATE An employee generally does not provide services or do work for other people or firms An employee is subject to dismissal by an employer regardless at any time (in the absence of an employment contract limiting the right of an employer to discharge, in which case discharge is governed by terms of the agreement) An employee is free to quit at any time without incurring liability (in the absence of a written employment contract providing otherwise) An independent contractor offers his services to other people or business An independent contractor cannot be fired so long as the independent contractor produces a result that meets the contract specifications An independent contract may only terminate his relationship with the principal according to the terms of their contract Under the common law, a worker is an employee when the person for whom the services are performed has the right to control and direct the individual who performs the services. The right of control is determined by applying the above 20-factors. This control reaches not only the result to be accomplished, but also the details and means by which that result is to be accomplished. Note that control must be present, but need not actually be exercised. Also, note that courts have held that the degree of supervision necessary to demonstrate control is only "such supervision as the nature of the work requires." To determine whether the control test is satisfied in a particular case, the facts and circumstances must be examined. Questions about the relationship between the worker and the prospective employer are asked to ascertain control. Also remember that the IRS will consider factors beyond the 20 specified above. The following points are also helpful when considering the use of independent contractors: Federal Employment Taxes 3-13

67 There is no "magic number" of relevant evidentiary factors; Whatever the number of factors used, the factors merely point to facts to be used in evaluating the extent of the right to direct and control; As in any examination, the IRS will explore all relevant information before answering the legal question of whether the right to direct and control associated with an employment relationship exists; and The IRS will expect a business to have strong and well-documented evidence to support its position that a worker or workers are independent contractors. This includes written contracts, company protocols, records of payments made to workers, etc. The pieces of information that are important to help determine employee status change over time because business relationships change over time. What might have been a crucial piece of evidence in 1985 on which to base a decision about whether a business retained the right to control a worker may not carry the same weight for making an employee status determination currently. For example, the fact that a delivery driver was required to wear a uniform bearing the name of the retail business demonstrated control indicative of an employee relationship. Today, these requirements may be established to provide customers with some assurance that the worker can be safely allowed entry to the home or business. In other words, the wearing of the uniform today may have less to do with the degree of control exercised by the business over the worker than it had in the past. 1. Behavioral Control The common law right of control test deals specifically with the level of control the business has over the manner in which the work is performed. Behavioral control covers facts that show whether the business has a right to direct and control how the work is done, through instructions, training, or other means. The following factors within the IRS test are illustrative of the type of behavioral control that results in the finding of employment status: Instructions; Training; Set hours of work; Integration; Services personally rendered; Federal Employment Taxes 3-14

68 Oral or written reports; Set sequence of work; and Doing work on employer s premises. 2. Financial Control Financial control covers facts that show whether the employer or business has a right to control the business aspects of the worker's job. This includes: The extent to which the worker has unreimbursed business expenses; The extent of the worker's investment in the business; The extent to which the worker makes services available to the relevant market; How the business pays the worker; and The extent to which the worker can realize a profit or incur a loss. 3. Relationship of the Parties The parties own classification is not legally conclusive. That means that the fact that a worker signed a contract in which he agreed he is an independent contractor does not make him in independent contractor. It is, however, certainly relevant to the analysis. Also relevant are other aspects of the relationship, including whether the worker receives or is entitled to the benefits offered to employees. Facts covered by Type of Relationship include: Written contracts describing the relationship the parties intended to create; The extent to which the worker is available to perform services for other, similar businesses; Whether the business provides the worker with employee-type benefits, such as insurance, a pension plan, vacation pay, or sick pay; and The permanency of the relationship. Always remember, however, that no one factor is determinative. The best rule of thumb is that the more a business directs and controls the manner in which the work is performed, the more likely it is that the worker is an employee and not an independent contractor. Federal Employment Taxes 3-15

69 Table 3.3 Determining the Right to Direct or Control Behavioral Control Financial Control Relationship of the Parties Facts that illustrate whether there is a right to direct or control how the worker performs the specific task for which he or she is hired: Instructions Training Facts that illustrate whether there is a right to direct or control how the business aspects of the worker s activities are conducted: Significant investment Unreimbursed expenses Services available to the public Method of payment Opportunity for profit or loss Facts that illustrate how the parties perceive their relationship: Employee benefits Intent of parties/written contracts Permanency Discharge/Termination Regular business activity Let s use the following examples to illustrate these factors: Example 1: Steve Smith, a computer programmer, is laid off when Megabyte Inc. downsizes. Megabyte agrees to pay Steve a flat amount to complete a one-time project to create a certain product. It is not clear how long it will take to complete the project, and Steve is not guaranteed any minimum payment for the hours spent on the project. Megabyte provides Steve with no instructions beyond the specification for the product itself. Steve and Megabyte have a written contract, which provides that Steve is considered to be an independent contractor, is required to pay Federal and state taxes, and receives no benefits from Megabyte. Megabyte will file a Form 1099-MISC. Steve does the work on a new high-end computer which cost him $7000. Steve works at home and is not expected or allowed to attend meetings of the software development group. LIKELY CLASSIFICATION: INDEPENDENT CONTRACTOR Federal Employment Taxes 3-16

70 Example 2: Donna Lee is a salesperson employed on a full-time basis by Bob Blue, an auto dealer. She works 6 days a week and is on duty in Bob's showroom on certain assigned days and times. She appraises trade-ins, but her appraisals are subject to the sales manager's approval. Lists of prospective customers belong to the dealer. She has to develop leads and report results to the sales manager. Because of her experience, she requires only minimal assistance in closing and financing sales and in other phases of her work. She is paid a commission and is eligible for prizes and bonuses offered by Bob. Bob also pays the cost of health insurance and group-term life insurance for Donna. LIKELY CLASSIFICATION: EMPLOYEE The following chart breaks down the facts surrounding Steve and Donna with the IRS 20-factor test to see how the likely classification is determined. Table 3.4 Comparison of Donna and Steve FACTOR Steve Donna INSTRUCTIONS No specific instructions other than for the endproduct Subject to some instructions desired TRAINING No training No indication INTEGRATION SERVICES RENDERED PERSONALLY HIRING, SUPERVISING, AND PAYING ASSISTANTS CONTINUING RELATIONSHIP Does his work at home, is not allowed to attend company meetings, is not integrated into the business Hired to personally perform the services N/A Hired to complete a single project, no promise of continued relationship Works closely with company employees Personally renders all services No Is a permanent employee SET HOURS OF WORK None Yes, during assigned hours FULL-TIME REQUIRED No Yes, works 6 days per week DOING WORK ON EMPLOYER'S PREMISES Does work at his own home Yes, must be on premises to sell cars ORDER TO SEQUENCE SET N/A Probably implicit in the type of work involved ORAL OR WRITTEN REPORTS None Yes Federal Employment Taxes 3-17

71 FACTOR Steve Donna PAYMENT OF BUSINESS No Likely AND/OR TRAVELING EXPENSES FURNISHING OF TOOLS AND MATERIALS Steve furnishes his own computer Yes SIGNIFICANT INVESTMENT REALIZATION OF PROFIT OR LOSS Steve uses his own expensive computer Potential for both None Probably no potential for a true loss WORKING FOR MORE THAN ONE FIRM AT A TIME MAKING SERVICE AVAILABLE TO GENERAL PUBLIC No restrictions in the contract No evidence either way Apparently impossible given the time demands of the dealership Like above, probably impossible RIGHT TO DISCHARGE Not clear from the facts Not clear from the facts RIGHT TO TERMINATE Not clear from the facts Not clear from the facts Even if Donna had a contract with the auto dealership in which the parties acknowledged that she was an independent contractor, that status would not pass muster under the IRS 20-factor test. Likewise, even if a few of the facts surrounding Steve were changed, i.e. assuming he was allowed to attend company meetings, that alone would not likely change his status from independent contractor to employee. III. Statutory Classes of Workers Before applying the 20-factor test to determine the status of common law workers, an IRS examiner will generally first look see if any workers fall into one of several categories of workers defined by statute. IRC 3121(d) contains four separate and independent categories of employee. A worker is an employee if he or she is one of the following: Common law employees (as discussed in detail above, are determined by applying the 20-factor test); Corporate officers; Certain statutory employees; and Employees covered by an agreement under 218 of the Social Security Act. Federal Employment Taxes 3-18

72 A. CORPORATE OFFICERS Corporate officers are specifically included within the definition of an employee under FICA, FUTA, and for federal income tax withholding purposes (IRC 3121(d)(1), 3306(i), and 3401(c)). The common law standard is not applicable. Federal regulations provide that generally an officer of a corporation is an employee of the corporation. However, an officer is not considered to be an employee of the corporation if two requirements are met: The officer does not perform any services or performs only minor services; and The officer is not entitled to receive, directly or indirectly, any remuneration. The officer must meet both requirements to be excepted from employee status. In determining whether services performed by a corporate officer are considered minor or nominal, the IRS will examine the character of the service, the frequency and duration of performance, and the actual or potential importance or necessity of the services in relation to the conduct of the corporation's business. A director of a corporation, acting in the capacity of a director, is not an employee of the corporation for those services, even if that worker also serves as an employee or officer of the corporation for other services. Therefore, part of the compensation paid to this worker can be for services rendered as an independent contractor (director) and part of the payments can be for services rendered as an employee. When an IRS examiner determines that a corporate officer is an employee, the examiner will normally examine all payments to the officer, such as amounts labeled as draws, loans, dividends, or other distributions, to determine whether the payments are in fact wages for FICA, FUTA, and income tax withholding purposes. B. STATUTORY EMPLOYEES If a worker is not an employee under the usual common law rules of a corporate officer, the worker and the business may nevertheless still be subject to employment taxes. IRC 3121(d)(3) lists individuals in four occupational groups who, under certain circumstances, are considered employees for FICA tax, and, in some instances employees for FUTA tax, but not for income tax withholding. These workers are referred to as statutory employees. They are: Agent-drivers or commission-drivers; Full-time life insurance salespersons; Home workers; and Traveling or city salespersons. Workers in these four occupational groups are employees for FICA tax purposes, even if they do not meet the common law test but meet the general and specific requirements for each occupational group. Federal Employment Taxes 3-19

73 1. General Requirements To qualify as a statutory employee, a worker must first meet general requirements prescribed specifically for the category under which the worker is qualifying (26 CFR (d)-1). The basic requirements are that: The contract of service contemplates that the worker will personally perform substantially all the work; and The worker has no substantial investment in facilities other than transportation facilities used in performing the work; and There is a continuing work relationship with the person for whom the services are performed. a. Contract of Service Work performed in these occupational groups is done under a contract of service. The term "contract of service" means the arrangement, oral or written, under which the work is done. This arrangement must contemplate that the worker will do substantially all the work. Thus, if the contract contemplates that the worker will do all the work personally and the alleged employer does not acquiesce in delegating part of this work to another, the fact that the worker does so would not preclude his coverage under this section. The important thing is not whether the worker delegates part of the work to another, but rather whether the arrangement contemplates the worker will do so. The mutual intent of the parties governs. Sometimes a worker delegates part of his work to another when his contract or work agreement expressly forbids doing so. Conversely, the contract may contemplate a delegation of part of the work and the worker performs all the services himself. Here you should determine whether the contract of service is being violated or whether it was modified to permit the change. A contract which contemplates hiring a chauffeur would not affect the personal service requirement because the services of the chauffeur are incidental to the selling activity. Similarly, the right to hire a substitute or assistant occasionally would not preclude qualifying for this provision. b. Substantial Investment in Facilities The term "substantial investment" refers to substantial facilities being furnished by the worker for conducting the business; they cannot be precisely defined. All the facts of each case must be considered to determine whether the facilities furnished by the worker for the work are substantial. Several factors listed below will be considered by the IRS in making these determinations: What is the value of the worker's investment compared to total investment? Are the facilities furnished essential to the work or for the personal convenience of the worker? Are the facilities being purchased or leased from the person for whom the services are performed? Federal Employment Taxes 3-20

74 Are the facilities furnished by the worker considerably more extensive than those usually furnished by other workers performing comparable services? Facilities include such items as office furniture and fixtures, premises, tools, and machinery. An expense may or may not relate to furnishing facilities. Expenses for facilities (for example, expenses for an office, store, showroom, warehouse, stenographic service, utilities, etc.) may be considered in determining whether the facilities furnished represent a substantial investment. Generally, a worker who maintains an office in his own home does not have a substantial investment, but the worker who maintains an office outside his home frequently has a substantial investment in facilities. Facilities do not include: Education, training or experience, or goodwill; Tools, instruments, or clothing commonly or frequently provided by employees; A vehicle for the worker's transportation; or Transportation facilities for carrying the goods or commodities or for supplying laundry or dry-cleaning services. c. Continuing Relationship Work is considered to be of a continuing nature if it is regular or frequently recurring. Regular part-time work for example, two days per week is considered a continuing relationship. Regular seasonal employment is also work of a continuing nature. A singlejob transaction, even though it takes a considerable period of time, is not generally a continuing relationship. 2. Agent Driver or Commission Driver This group is limited to workers who distribute meat or meat products, vegetables or vegetable products, fruit or fruit products, bakery products, beverages (other than milk), or laundry or dry-cleaning services. These products and services are defined in their commonly accepted sense. The worker may sell at retail or wholesale establishments. He may operate from his own truck or one belonging to the company for which he works. Ordinarily, he services customers designated by the company as well as those he solicits. The following requirements, in addition to the three general requirements described above, must be met if the worker is to qualify as a statutory agent-driver or commission-driver. He may also be engaged in distributing products or services in addition to these if handling the additional products or services is incidental to handling the specified items. If the products are sold for the same principal, all the services are considered within the occupational category. A rule of thumb is that the services are incidental if the time spent handling the additional products or services is 20 percent or less of the time spent handling all products or services. If the time factor does not appear realistic, consider other factors such as ratio of income. If distributing additional products or services for the same principal is not incidental to handling the products or services listed above, the Federal Employment Taxes 3-21

75 worker is not an employee. If the worker distributes for more than one principal, his services for each principal will be considered separately. The worker, who on his own account, buys merchandise and sells it, or furnishes services to the public as a part of his own independent business, is not included in this occupational category. 3. Full-Time Life Insurance Salespersons Ordinarily, this group includes salespersons whose full-time occupation is soliciting life insurance applications and/or annuity contacts primarily for one life insurance company. They are usually furnished with office space, stenographic help, telephone facilities, forms, rate books and advertising materials by the company or its general agent. In addition to meeting the three general requirements, an individual must be a full-time life insurance salesperson, that is, one whose entire or principal business activity is devoted to soliciting life insurance and/or annuity contracts primarily for one life insurance company. Generally, the contract of employment will show whether a salesperson meets these requirements. The intention of a salesperson and his company, shown by the contract of employment and their mutual performance, not the time devoted to the work, will govern in determining whether an individual is a full-time or a part-time salesperson. Thus, the entire or principal business activity of an insurance salesperson will be considered to be soliciting life insurance or annuity contracts if his arrangement with a life insurance company provides for soliciting life insurance or annuity contracts (or for soliciting such contracts and only incidentally soliciting accident and health insurance contracts) for such company as his entire or principal business activity. When the contract clearly shows that full-time services are intended, a salesperson meets the full-time requirement. On the other hand, if part-time services are contemplated by the contract, a salesperson is not a statutory employee. This applies, regardless of the amount of time devoted to the work, unless a question is raised that the contract does not show what both parties originally or later intended. If the performance of a salesperson is not consistent with the written contractual terms, determine whether the parties came to a mutual understanding on the deviation. If the parties agreed to the change in their original agreement or the company acquiesces in it, a salesperson's status will be modified, effective with the date the change took place. The salesperson s status before that date will be governed by the terms of the original contract. If the performance of a salesperson is not consistent with the contract terms and the company knows of the inconsistency but refuses to change the original agreement or to acquiesce in the deviation, determine whether there is a reasonable basis for the company's position. Example (Reasonable Position). The company has a set policy restricting the number of full-time salespersons it may employ in a certain territory and notifies all its salespersons under part-time contracts of this policy. It is aware that Federal Employment Taxes 3-22

76 some of its part-time salespersons are devoting their whole time to selling for the company, but it discourages this custom and treats such salespersons as part-time workers in every respect, that is, pays them at a lower rate of commission than a full-time salesperson and does not include them in its pension and bonus plans, etc. Example (Unreasonable Position). The company considers all its salespersons full-time if they work exclusively for their company. The company may know that only one hour a month is devoted to the sale of insurance by the salespersons, and the remainder of their time is spent in other work. If the company's position is reasonable, a salesperson's status will be determined by the terms of the contract, regardless of his work history. However, if the company's position is unreasonable, a salesperson's status will be determined by a complete evaluation of the situation. If there is no written contract, or the contract does not clearly reveal the mutual intent of the parties on the full-time or part-time aspects of the relationship, a salesperson's status will be determined by the mutual intent of the parties shown by their answers to questions. If the contract does not show whether full-time or part-time services are intended and the parties disagree, the determination of a salesman's status will be based on a complete factual evaluation. Whether a salesperson's work for the company is his entire or principal business activity will be decided after considering the factors discussed in the following paragraphs under those headings. The company's classification of a salesperson should be given considerable weight, if there is a reasonable basis for the classification. An entire business activity may or may not be full-time. A salesperson does not necessarily have to spend eight hours a day, five days a week, in one sole business activity to meet the full-time requirement. A salesperson may work regularly a few hours a day and qualify as a full-time insurance salesperson if other factors in the work relationship indicate a full-time status. On the other hand, many salespersons work for only one firm but spend only an hour or two a day, or a day or two a week, at their occupations or make sales only occasionally. Generally, even though the services are a salesperson's only work effort, the services are not substantial enough to be considered an "entire business activity." In other words, a salesperson is not an employee if his efforts are so irregular, intermittent, or sporadic that he would be considered not to be engaged in any business activity. A principal business activity is one which takes the major part of a salesperson's working time and attention. When a salesperson is engaged in several business activities, it is necessary to determine his principal business activity. In making this determination, consider factors such as: The opinions of the parties involved. A statement by the company that a salesperson is or is not required to devote their work effort principally to the sales of its policies should be given considerable weight. A similar statement by a salesperson should be supported by other evidence. Federal Employment Taxes 3-23

77 The salesperson's total working time, that is, the amount of time he spends in connection with all of his business activities. What proportion of that time does he spend in soliciting for the firm? The ratio of his earnings from the services to his total earnings. Does the ratio indicate that the major part of his income comes from this firm? Insurance companies usually treat part-time and full-time salespersons differently for commission rates, renewal schedules, pension plans, etc. In what category has the company placed the salesperson? Type of Insurance Sold. The salesperson's efforts must be devoted principally to soliciting life insurance or annuity contracts. Occasional or incidental sales of other types of insurance, such as accident and health insurance will not affect this requirement. However, a salesperson who is required to devote substantial effort to selling applications for insurance contracts other than life insurance or annuity contracts (e.g., accident and health, fire, automobile, etc.), does not meet the requirement. 4. Life Insurance Subagents It may sometimes be necessary or desirable to determine whether life insurance subagents are employees of the general agent or of the insurance company. Generally, subagents hired by the general agent are employees of the insurance company if the contracts of employment are countersigned or approved by the insurance company. If not, fully explore the contractual arrangements to determine whether the general agent or the insurance company is the employer. If the subagents are found to be employees of the general agent, this fact will usually preclude the general agent from meeting the personal service requirement since he may, if he chooses, delegate a substantial part of the sales services to his subagents. In addition, most general agents cannot meet the full-time requirement. The various services required of them in operating and supervising their general agencies indicate that it is not contemplated that they devote their full time to soliciting life insurance or annuity contracts. 5. Homeworkers This group generally includes people who make buttons, quilts, gloves, bedspreads, clothing, needlecraft products, etc. The work is done away from the employer's place of business, usually in the worker's own home, the home of another, or in his own workshop. The work is done on goods or materials furnished by the employer and in accordance with the employer's specifications. The worker returns the processed material to the employer or to a person designated by the employer. To qualify as an employee, the homeworker must meet, in addition to the three general requirements previously listed, the following requirements: The homeworker must do the work in accordance with specifications given by the employer. Generally, these specifications are simple and consist of patterns, samples, etc.; The material or goods on which the work is done must be furnished by the employer; and Federal Employment Taxes 3-24

78 The finished products must be returned to the employer or a person designated by the employer. It is immaterial whether the employer calls for the work or the worker delivers it to them. A homeworker who meets the requirements is a statutory employee. However, IRC 3121(a)(10) provides that the pay which the homeworker receives for such work is not wages unless $100 or more in cash is received by the wage earner in the calendar year from one employer. Thus, a homeworker may be employed by several employers, but if his pay from one employer is to constitute wages, he must receive at least $100 cash in the year from that employer. If the $100-cash-pay test is met, all the non-cash pay from the same employer can be included as wages. 6. Full-Time Traveling or City Salespersons This category includes the salesperson who operates away from the employer's premises. His full-time business activity is selling merchandise for a principal employer. The test of "full-time" relates to an exclusive or principal business activity for a single firm or person, and not to the time spent on a job. Side-line sales activities for some other person do not exclude a salesperson from coverage. Salespersons are ordinarily paid on a commission basis. Generally, they are not controlled as to the details of their service or the means by which they cover their territories. However, they are expected to work their territory with some regularity, take orders, and send them to the employer for delivery to the purchaser. This group does not include agent-drivers or commission-drivers. In order for a traveling or city salesperson to fall within the statutory test, he must meet, in addition to the three general requirements, the following requirements: His entire or principal business activity must be devoted to soliciting, on behalf of and transmitting to his principal, orders for merchandise; The orders must be obtained from wholesalers, retailers, contractors, or operators of hotels, restaurants, or other similar establishments; and The merchandise he sells must be bought for resale or must be supplied for use in the purchasers' business operations. The definition of an entire and a principal business activity, given under "Full-time life insurance salesperson" applies here. In addition, you should consider whether the contractual arrangement requires devoting a major portion of the salesperson's time and efforts to sales activity for the firm. A worker who buys merchandise and sells it on his own account is not included in this occupational category. Neither is a manufacturer's representative who holds himself out as an independent businessperson and serves the public through his connection with a number of firms. The multiple-line salesperson generally is not an employee because his principal business activity is not soliciting orders for one principal. However, a salesperson who solicits orders primarily for one principal is not excluded because of side-line activities on behalf of other persons or firms. The salesperson may be an employee of the person for whom the orders were principally solicited. Federal Employment Taxes 3-25

79 Salespersons must sell to the classes of purchasers described in IRC 3121(d)(3)(D). They may also sell incidentally to others. In addition to considering the percentage of a salesperson's total working time spent in soliciting orders from the specified classes of purchasers, other factors, e.g., rates of income, number of sales, etc., will also be considered by IRS examiners. If the sales to excluded purchasers are incidental, all of the salesperson's services for its principal are considered within the occupational category. A wholesaler buys merchandise in large quantities and usually sells in small quantities to jobbers or to retail dealers but not to the ultimate consumer. The wholesaler does not process the merchandise in any way to cause it to lose its identity. A retailer deals in merchandise by selling it in small quantities, usually to persons who consume or use it. Retail establishments may perform service functions or processing or manufacturing operations with respect to the items they sell without losing their character as retail establishments. For example, a store which sells drapery and slip cover material and makes draperies and slip covers for the consumer is a retail establishment and not a manufacturer. A neighborhood bakery is essentially a retail store, even though it changes the form of raw to prepared materials. Contractors include such service organizations as window-washing contractors, wall cleaning contractors, other service contractors, and construction contractors. The phrase "other similar establishments" refers solely to establishments similar to hotels and restaurants. It is limited to establishments whose primary function is furnishing food and/or lodging. An entity not within the included classes of purchasers may, through a unit of its organization, carry on a clearly identifiable and separate business which is in the included category. A salesperson who solicits orders from the entity for merchandise for resale by or for use in business operations in that unit has met the requirement regarding "classes of purchasers." For example, sales made to an unincorporated university bookstore, owned and operated by the university, are sales made to a purchaser included in the statutory definition of "traveling or city salesman." Merchandise must be for resale or for use in the business operations of the purchaser. The phrase "merchandise for resale" includes only tangibles which do not lose their identity as they pass through the hands of the purchaser. The phrase "supplies for use in the business operations" means supplies principally used in conducting the purchaser's business. Generally, it includes all tangible merchandise not considered "merchandise for resale." Services such as radio time, advertising space, etc. are intangible and outside of this definition. However, advertising novelties, calendars, etc. constitute supplies within this definition. The fact that a salesperson performs substantial work in servicing the article he sells, does not necessarily preclude him from meeting the requirements of IRC 3121(d)(3)(D). For example, a salesperson that spends a day selling a machine and a day supervising its installation and perhaps training the purchaser's personnel in its use may still have performed services as a full-time salesperson. Furnishing such services by a salesperson may be a necessary part of the inducement for the buyer to purchase. The question, therefore, is whether his total activity is essentially a selling activity. If it is, the Federal Employment Taxes 3-26

80 services related to such sales, even though substantial, are an integral part of the sale. If it is not, he does not meet the requirements for coverage. C. STATUTORY NON-EMPLOYEES Workers in certain occupations will not be treated as employees for FICA, FUTA, or federal income tax withholding purposes provided they meet certain qualifications. These workers are referred to as "statutory non-employees." IRC 3508 provides that, for all IRC purposes, qualified real estate agents and direct sellers are statutory non-employees. IRC 3506 provides that, for purposes of subtitle C of the Code relating to employment tax, qualifying companion sitters are statutory non-employees. 1. Qualified Real Estate Agents IRC 3508(b)(1) provides that an individual is a qualified real estate agent if the following requirements are met: The worker is a licensed real estate agent; Substantially all of such worker's remuneration for services is directly related to sales or other output rather than to the number of hours worked; and A written contract exists between the worker and the business for which services are being performed that provides that the worker will not be treated as an employee for federal tax purposes. Proposed Treas. Reg. section (b)(2) defines services performed as a real estate agent and provides examples. Services performed as a real estate agent do not include management of property. 2. Direct Sellers IRC 3508(b)(2) provides that a worker is a direct seller if the following qualifications are met: The worker is engaged in the sale of consumer products in the home or in other than a permanent retail establishment; Substantially all of such worker's remuneration for services is directly related to sales or other output rather than to the number of hours worked; and A written contract exists between the worker and the business for which services are being performed that provides that the worker will not be treated as an employee for federal tax purposes. Federal Employment Taxes 3-27

81 3. Newspaper Carriers and Distributors The Small Business Job Protection Act of 1996 added qualifying newspaper distributors and carriers as direct sellers. Under the amendment, a person engaged in the trade or business of the delivery or distribution of newspapers or shopping news qualifies as a direct seller provided all remuneration is directly related to sales or output, rather than hours worked. Also, the services must be performed pursuant to a written contract that provides the person will not be treated as an employee for federal tax purposes. 4. Companion Sitters IRC 3506 provides that a companion sitter will not be an employee of a companion sitting placement service if the companion sitting placement service neither pays nor receives the salary or wages of the sitter. The placement service may be compensated on a fee basis by either the sitter or the individual for whom the sitting is performed. The companion sitter is deemed to be self-employed unless considered to be a statutory or common law employee of the individual for whom the services are performed. D. TAX IMPLICATIONS OF STATUTORY STATUS Statutory employees are not employees for the purpose of deducting trade or business expenses. Therefore, they may deduct their expenses on Schedule C rather than as miscellaneous itemized deductions. If statutory employees also have earnings from selfemployment, they may not use expenses from services as a statutory employee to reduce net earnings from self-employment for SECA proposes. This is because services as a statutory employee do not constitute the carrying on of a trade or business for purposes of SECA. Statutory employees are required to file a Schedule C for services performed as a statutory employee which is separate from the Schedule C that reports net earnings from self-employment. If a statutory employee relationship exists, the employer is liable for FICA. Employers of statutory employees described in IRC 3121(d)(3)(A) and (D) (agent drivers and traveling or city salespersons) are also liable for FUTA. Statutory employees are not subject to income tax withholding. Except for full-time life insurance salespersons, statutory employees remain independent contractors for employee benefit purposes. Thus, they are not eligible to participate in the employee benefit plans sponsored by the business for employees and cannot enjoy the exclusions from income for amounts paid under accident and health insurance arrangements under IRC 104, 105, and 106 to the extent that those income tax exclusions apply only to employees. However, statutory employees can establish and maintain their own self-employed retirement plans. Full-time life insurance salespersons are an exception. They are treated as employees not only for FICA tax purposes, but also for certain employee benefit programs maintained by the business (for more detailed information, refer to IRC 7701 (a)(20)). Thus, they may participate as employees under the firm's group term life insurance program under IRC 79, apply the exclusions available to employees participating in the business's accident and health plans under IRC 104, 105, and 106, and participate as an employee in the business's qualified deferred compensation or retirement plans under IRC 401(a) and the business's cafeteria plan under IRC 125. On the other Federal Employment Taxes 3-28

82 hand, a full-time life insurance salesperson may not base contributions to a selfemployed retirement plan (commonly called a Keogh plan) on the compensation received from the insurance business. Table 3.5 Employment Tax Treatment for Various Categories of Workers Type of Income Tax FICA FUTA Worker Withholding Common Law Withhold Taxable Taxable Employee Corporate Officer Withhold Taxable Taxable Statutory Employees Agent or Commission No withholding Taxable Taxable Driver Full-time Life No withholding Taxable Exempt Insurance Salesperson Full-time Traveling or No withholding Taxable Taxable City Salesperson Home Worker No withholding Taxable if paid $100 or more in cash during the calendar year Exempt 218 Employee Withhold Taxable Exempt Statutory Non- Employees Qualified Real Estate Agent IRC 3508(b)(1) Direct Seller IRC 3508(b)(2) Companion Sitter IRC 3506 No withholding Exempt 1 Exempt No withholding Exempt 1 Exempt No withholding Exempt 1 Exempt 1 However, statutory non-employees are subject to SECA. Federal Employment Taxes 3-29

83 Chapter 3 Review Questions The following questions are designed to ensure that you have a complete understanding of the information presented in the chapter. They do not need to be submitted in order to receive CPE credit. They are included as an additional tool to enhance your learning experience. We recommend that you answer each review question and then compare your response to the suggested solution before answering the final exam questions related to this chapter. 1. Employers are responsible for collecting and/or paying which of the following federal employment taxes: a) unemployment b) social security c) income taxes d) all of the above 2. Federal employment taxes are collected by which government agency: a) Internal Revenue Service b) Department of Labor c) Department of Health and Human Services d) Equal Employment Opportunity Commission 3. What is the penalty on an employer who erroneously classifies an employee as an independent contractor and does not withhold federal payroll taxes: a) the employer must pay the employee s share of FICA tax for the period of the misclassification b) the employer must pay three times the employee s income tax liability for the tax year c) the employer must pay the employee s income tax withholding for the period of the misclassification d) both a and c above 4. Which of the following statements about an employer s liability for tips is most correct: a) tips are not considered wages, and therefore employers are not liable for doing any withholding b) employers are required to collect taxes from tipped employees only on those tips which the employee reports to the employer c) employers are liable for collecting taxes on all tips collected by employees, whether or not they are reported to the employer d) employers are required to collect taxes on 50 percent of the tips collected by employees Federal Employment Taxes 3-30

84 5. In the event of a dispute, who bears the burden of proving that a worker is an independent contractor and not an employee: a) the burden is always on the employee, because he is the one to benefit from a reclassification b) the benefit is always on the government because it is usually the one trying to prove that a worker is an employee rather than an independent contractor c) the burden is on the party seeking the reclassification d) the burden is on the employer 6. Under the common law, a worker is an employee when the person for whom the services are performed has the right to control and direct the individual who performs the services. a) true b) false 7. The relationship between a business and a worker is not relevant in determining whether the worker is an employee or an independent contractor. a) true b) false 8. Which of the following is not in the category of statutory employees: a) taxi cab drivers b) full-time life insurance sales people c) agent-drivers d) home workers 9. Both full and part-time life insurance sales people can be considered statutory employees for purposes of being subject to FICA taxes. a) true b) false 10. Which of the following is a common characteristic of statutory home workers: a) they do their work in the employer s place of business b) they produce products with materials they furnish themselves c) the workers sell the goods or services themselves d) none of the above Federal Employment Taxes 3-31

85 11. Newspaper carriers are considered to be statutory non-employees under the Small Business Job Protection Act of a) true b) false 12. Companion sitters are always classified as employees of a companion sitting placement service for tax purposes. a) true b) false Federal Employment Taxes 3-32

86 Chapter 3 Solutions and Suggested Responses 1. A: Incorrect. Employers must calculate and pay their share of federal unemployment taxes. However, this is not the best answer. B: Incorrect. Employers must collect both social security and Medicare taxes from employees to cover medical benefits and retirement benefits in old age. However, this is not the best answer. C: Incorrect. Employers are responsible for withholding and remitting federal income taxes for their employees. However, this is not the best answer. D: Correct. Employers are required to collect and remit all of the above federal employment taxes. (See page 3-1 of the course material.) 2. A: Correct. The Internal Revenue Service is the federal agency charged with collecting both employment taxes and self-employment taxes. Given that responsibility, the IRS also has the authority to determine whether employment taxes are owed. B: Incorrect. The Department of Labor is not a tax collection agency. C: Incorrect. The Department of Health and Human Services is not a tax collection agency. D: Incorrect. While the Equal Employment Opportunity Commission can and frequently does levy fines onto businesses for alleged employment related wrongdoing, its primary purpose is to encourage fair employment practices and not that of a tax collection agency. (See page 3-2 of the course material.) 3. A: Incorrect. Under IRC Section 3102, the employer is liable for the employee s share of FICA or unemployment tax. However, this is not the best answer. B: Incorrect. The penalties for misclassification can be steep, but are not this steep. C: Incorrect. Under IRC Section 3102, the employer is liable for the employee s income tax withholding. However, this is not the best answer. D: Correct. Because A and C are both correct, D is the best answer. (See page 3-5 of the course material.) Federal Employment Taxes 3-33

87 4. A: Incorrect. Tips are in fact included within the definition of wages, and therefore employers have certain obligations with respect to collecting taxes on tips. B: Correct. Federal law makes employers responsible for collecting taxes on tips that are reported by the employee to the employer. C: Incorrect. Employers are only liable for collecting taxes on tips that are reported to them by their employees. D: Incorrect. Employers are required to collect taxes on all of the tips that are reported to them by the employee. There is no such 50 percent rule. (See page 3-8 of the course material.) 5. A: Incorrect. The burden is never on the employee. It is generally on the employer. B: Incorrect. Although it is the government that seeks a reclassification, the employer bears the burden of proof. C: Incorrect. The burden is on the employer regardless of who is seeking the reclassification. D: Correct. This is why misclassification is such a big and expensive issue for the employer. They bear the burden of proof and the liability of a mistake. (See page 3-9 of the course material.) 6. A: True is correct. The right to control test is the classic test used by the IRS to determine a worker s status. The right of control is determined by applying the 20 factors in the IRS 20-factor test. This control reaches not only the result to be accomplished, but also the details and means by which that result is to be accomplished. Note that control must be present, but need not actually be exercised. Also, note that courts have held that the degree of supervision necessary to demonstrate control is only "such supervision as the nature of the work requires." B: False is incorrect. This is indeed the way the IRS determines worker status. (See page 3-13 of the course material.) Federal Employment Taxes 3-34

88 7. A: True is incorrect. The relationship is not determinative, but it is relevant. B: False is correct. The parties own classification is not legally conclusive. That means that the fact that a worker signed a contract in which he agreed he is an independent contractor does not make him an independent contractor. It is, however, certainly relevant to the analysis. Also relevant are other aspects of the relationship, including whether the worker receives or is entitled to the benefits offered to employees. (See page 3-15 of the course material.) 8. A: Correct. A taxi cab driver is not one of the categories of statutory employees. Whether such a person is an employee or not is determined by using the common law right of control test. B: Incorrect. The Internal Revenue Code classifies several groups as statutory employees for purposes of FICA and, in some cases, for purposes of FUTA taxes. One of those groups is full-time life insurance sales people that meet certain other requirements. C: Incorrect. The Internal Revenue Code classifies several groups as statutory employees for purposes of FICA and, in some cases, for purposes of FUTA taxes. One of those groups is agent-drivers that meet certain other requirements. D: Incorrect. The Internal Revenue Code classifies several groups as statutory employees for purposes of FICA and, in some cases, for purposes of FUTA taxes. One of those groups is home workers that meet other technical requirements in the Internal Revenue Code. (See page 3-19 of the course material.) 9. A: True is incorrect. Part-time insurance sales people cannot be considered statutory employees. B: False is correct. If a worker is not an employee under the usual common law rules or a corporate officer, the worker and the business may nevertheless still be subject to employment taxes. One category is life insurance sales persons; however, this category covers only full-time sales people. (See page 3-22 of the course material.) Federal Employment Taxes 3-35

89 10. A: Incorrect. To the contrary, homeworkers typically do their work in their own home. However, this is not the best answer. B: Incorrect. To the contrary, employers of statutory employee homeworkers typically provide the materials as well as instructions for the production of goods. However, this is not the best answer. C: Incorrect. To the contrary, the workers generally give the finished products to the employer or a designate of the employer. However, this is not the best answer. D: Correct. None of the above are characteristics of homeworkers, and therefore this is the best answer. (See pages 3-24 to 3-25 of the course material.) 11. A: True is correct. Workers in certain occupations are not treated as employees for federal tax purposes. Such workers also include qualified real estate agents, direct sellers and companion sitters. B: False is incorrect. Newspaper carriers are one of the occupations which federal law classifies as statutory non-employees. (See page 3-28 of the course material.) 12. A: True is incorrect. Under some circumstances, companion sitters are not classified as employees. B: False is correct. Under IRC 3506, a companion sitter will not be classified as an employee of a companion sitting placement service if the service neither pays nor receives the salary or wages of the sitter. (See page 3-28 of the course material.) Federal Employment Taxes 3-36

90 Chapter 4: Accounting Periods and Methods A business must calculate its taxable income and file an income tax return for an annual accounting period called a tax year. Also, it must consistently use an accounting method that clearly shows its income and expenses for the tax year. I. Accounting Periods When preparing a statement of income and expenses (generally an individual or business income tax return), the taxpayer must use his books and records for a specific interval of time called an accounting period. The annual accounting period for income tax return purposes is called the taxpayer s tax year. A taxpayer can use one of the following tax years: A calendar tax year; or A fiscal tax year. Unless the taxpayer has a required tax year, he adopts a tax year by filing his first income tax return using that tax year. A required tax year is a tax year required under the Internal Revenue Code or the Income Tax Regulations. A. CALENDAR TAX YEAR A calendar tax year is 12 consecutive months beginning January 1 and ending December 31. A taxpayer must adopt the calendar tax year if any of the following apply: He keeps no books; He has no annual accounting period; His present tax year does not qualify as a fiscal year; or His use of the calendar tax year is required under the Internal Revenue Code or the Income Tax Regulations. If an individual filed his first income tax return using the calendar tax year and he later begins business as a sole proprietor, he must continue to use the calendar tax year unless he receives IRS approval to change it or is otherwise allowed to change it without IRS approval. A taxpayer who adopts the calendar tax year must maintain his books and records and report his income and expenses for the period from January 1 through December 31 of each year. Accounting Periods and Methods 4-1

91 B. FISCAL TAX YEAR A fiscal tax year is 12 consecutive months ending on the last day of any month except December. A week tax year is a fiscal tax year that varies from 52 to 53 weeks but does not have to end on the last day of a month. If a taxpayer adopts a fiscal tax year, he must maintain his books and records and report his income and expenses using the same tax year. C. CHANGE IN TAX YEAR Generally, a taxpayer must file Form 1128, Application To Adopt, Change, or Retain a Tax Year, to request IRS approval to change a tax year. If the taxpayer qualifies for an automatic approval request, a user fee is not required. If the taxpayer does not qualify for automatic approval, a ruling must be requested and a user fee is required. II. Accounting Methods A. OVERVIEW An accounting method is a set of rules used to determine when and how income and expenses are reported. A business s or individual s accounting method includes not only the overall method of accounting they use, but also the accounting treatment used for any material item. An owner chooses an accounting method for his business when he files his first income tax return that includes a Schedule C for the business. After that, a business that wants to change its accounting method must generally get IRS approval. Generally, a business or individual can use any of the following accounting methods: Cash method; An accrual method; Special methods of accounting for certain items of income and expenses; or A combination method using elements of two or more of the above. An individual or business must use the same accounting method to figure the taxable income and to keep the books. Also, an accounting method that clearly shows the income must be used. 1. Business and Personal Items A taxpayer can account for business and personal items under different accounting methods. For example, a taxpayer can figure his business income under an accrual method, even if he uses the cash method to figure personal items. Accounting Periods and Methods 4-2

92 2. Two or More Businesses If an individual has two or more separate and distinct businesses, he can use a different accounting method for each, if the method clearly reflects the income of each business. The businesses are separate and distinct only if the taxpayer maintains complete and separate books and records for each business. B. CASH METHOD Most individuals and many sole proprietors with no inventory use the cash method because they find it easier to keep cash method records. However, if an inventory is necessary to account for an individual s income, he must generally use an accrual method of accounting for sales and purchases. 1. Income Under the cash method, a taxpayer must include in his gross income all items of income he actually or constructively receives during the tax year. If the taxpayer receives property or services, he must include the fair market value in income. Example. On December 30, 2012, Mrs. Sycamore sent William a check for interior decorating services he provided to her. William received the check on January 2, He must include the amount of the check in income for a. Constructive Receipt. A taxpayer has constructive receipt of income when an amount is credited to his account or made available to him without restriction. He does not need to have possession of it. If the taxpayer authorizes someone to be his agent and receive income for him, he is treated as having received it when his agent received it. Example. Interest is credited to Mark s bank account in December Mark does not withdraw it or enter it into his passbook until Mark must include it in his gross income for b. Delaying Receipt of Income. A taxpayer cannot hold checks or postpone taking possession of similar property from one tax year to another to avoid paying tax on the income. He must report the income in the year the property is received or made available to him without restriction. Example. Frances Jones, a service contractor, was entitled to receive a $10,000 payment on a contract in December She was told in December that her payment was available. At her request, she was not paid until January She must include this payment in her 2012 income because it was constructively received in Accounting Periods and Methods 4-3

93 c. Checks. Receipt of a valid check by the end of the tax year is constructive receipt of income in that year, even if the recipient cannot cash or deposit the check until the following year. Example. Dr. Redd received a check for $500 on December 31, 2012, from a patient. She could not deposit the check in her business account until January 2, She must include this fee in her income for d. Debts Paid by Another Person or Canceled. If a taxpayer s debts are paid by another person or are canceled by his creditors, he may have to report part or all of this debt relief as income. e. Repayment of Income. If a taxpayer includes an amount in income and in a later year he has to repay all or part of it, the taxpayer can usually deduct the repayment in the year in which he makes it. If the amount repaid is over $3,000, a special rule applies. 2. Expenses Under the cash method, a taxpayer generally deducts expenses in the tax year in which he actually pays them. This includes business expenses for which the taxpayer contests liability. However, the taxpayer may not be able to deduct an expense paid in advance or he may be required to capitalize certain costs. a. Expenses Paid in Advance. Taxpayers can deduct an expense paid in advance only in the year to which it applies. Example. Susan is a calendar year taxpayer and she pays $1,000 in 2012 for a business insurance policy effective for one year, beginning July 1. Susan can deduct $500 in 2012 and $500 in C. ACCRUAL METHOD Under an accrual method of accounting, taxpayers generally report income in the year earned and deduct or capitalize expenses in the year incurred. The purpose of an accrual method of accounting is to match income and expenses in the correct year. 1. Income General Rule Under an accrual method, taxpayers generally include an amount in their gross income for the tax year in which all events that fix their right to receive the income have occurred and they can determine the amount with reasonable accuracy. Accounting Periods and Methods 4-4

94 Example. Luke is a calendar year, accrual method taxpayer. He sold a computer on December 28, Luke billed the customer in the first week of January 2013, but he did not receive payment until February Luke must include the amount received for the computer in his 2012 income. 2. Income Special Rules The following are special rules that apply to advance payments, estimating income, and changing a payment schedule for services. a. Estimated Income. If a taxpayer includes a reasonably estimated amount in gross income, and later determines the exact amount is different, he should take the difference into account in the tax year in which he makes the determination. b. Change in payment schedule for services. If a taxpayer performs services for a basic rate specified in a contract, he must accrue the income at the basic rate, even if he agrees to receive payments at a lower rate until he completes the services and then receives the difference. c. Advance payments for services. Generally, taxpayers report an advance payment for services to be performed in a later tax year as income in the year they receive the payment. However, if they receive an advance payment for services they agree to perform by the end of the next tax year, they can elect to postpone including the advance payment in income until the next tax year. However, they cannot postpone including any payment beyond that tax year. d. Advance payments for sales. Special rules apply to including income from advance payments on agreements for future sales or other dispositions of goods a taxpayer holds primarily for sale to his customers in the ordinary course of business. If the advance payments are for contracts involving both the sale and service of goods, it may be necessary to treat them as two agreements. An agreement includes a gift certificate that can be redeemed for goods. Treat amounts that are due and payable as amounts they received. Taxpayers should generally include an advance payment in income for the tax year in which it is received. 3. Expenses Under the accrual method of accounting, taxpayers generally deduct or capitalize a business expense when both of the following apply. The all-events test has been met. The test has been met when: All events have occurred that fix the fact of liability, and The liability can be determined with reasonable accuracy. Economic performance has occurred. Accounting Periods and Methods 4-5

95 a. Economic performance. Taxpayers generally cannot deduct or capitalize a business expense until economic performance occurs. If the expense is for property or services provided to the taxpayer, or for his use of property, economic performance occurs as the property or services are provided or as the property is used. If the expense is for property or services the taxpayer provides to others, economic performance occurs as the taxpayer provides the property or services. Example. ABC Partners is a calendar year taxpayer and uses an accrual method of accounting. ABC buys office supplies in December ABC received the supplies and the bill in December, but paid the bill in January ABC can deduct the expense in 2012 because all events that fix the fact of liability have occurred, the amount of the liability could be reasonably determined, and economic performance occurred in that year. ABC s office supplies may qualify as a recurring expense. In that case, ABC can deduct them in 2012 even if the supplies are not delivered until 2013 (when economic performance occurs). b. Keeping inventories. When the production, purchase, or sale of merchandise is an income-producing factor in a taxpayer s business, the taxpayer must generally take inventories into account at the beginning and the end of his tax year. If he must account for inventory, he must generally use the accrual method of accounting for purchases and sales. c. Special rule for related persons. A taxpayer cannot deduct business expenses and interest owed to a related person who uses the cash method of accounting until he makes the payment and the corresponding amount is includible in the related person's gross income. Determine the relationship, for this rule, as of the end of the tax year for which the expense or interest would otherwise be deductible. If a deduction is not allowed under this rule, the rule will continue to apply even if the relationship with the person ends before the expense or interest is includible in the gross income of that person. Related persons include members of the taxpayer s immediate family, including only brothers and sisters (either whole or half), his spouse, ancestors, and lineal descendants. D. COMBINATION METHOD A taxpayer can generally use any combination of cash, accrual, and special methods of accounting if the combination clearly shows his income and expenses and it is used consistently. However, the following restrictions apply. If an inventory is necessary to account for the taxpayer s income, he must generally use an accrual method for purchases and sales. He can use the cash method for all other items of income and expenses. If a taxpayer uses the cash method for figuring income, he must use the cash method for reporting his expenses. If a taxpayer uses an accrual method for reporting expenses, he must use an accrual method for figuring income. Accounting Periods and Methods 4-6

96 If a taxpayer uses a combination method that includes the cash method, he should treat that combination method as the cash method. E. INVENTORIES Generally, if a business produces, purchases or sells merchandise, it must keep an inventory and use the accrual method for purchases and sales of merchandise. However, the following taxpayers can use the cash method of accounting even if they produce, purchase, or sell merchandise: A qualifying taxpayer under Revenue Procedure in Internal Revenue Bulletin ; or A qualifying small business taxpayer under Revenue Procedure in Internal Revenue Bulletin These taxpayers can also account for inventoriable items as materials and supplies that are not incidental (discussed later). 1. Qualifying Taxpayer An individual or business is a qualifying taxpayer if: Their average annual gross receipts for each prior tax year ending on or after December 17, 1998 is $1 million or less. (The average annual gross receipts for a tax year is figured by adding the gross receipts for that tax year and the two preceding tax years and dividing by three.); or The business is not a tax shelter, as defined under section 448(d)(3) of the Internal Revenue Code. 2. Qualifying Small Business Taxpayer An individual or business is a qualifying small business taxpayer if: The average annual gross receipts for each prior tax year ending on or after December 31, 2000, is more than $1 million but not more than $10 million. (Average annual gross receipts for a tax year is figured by adding the gross receipts for that tax year and the 2 preceding tax years and dividing the total by 3.); The taxpayer is not prohibited from using the cash method under section 448 of the Internal Revenue Code; and The principle business activity is an eligible business (described in Publication 538 and Revenue Procedure ). Accounting Periods and Methods 4-7

97 3. Business Not Owned or Not in Existence For 3 Years If a taxpayer did not own the business for all of the three-tax-year periods used in figuring his average annual gross receipts, the taxpayer should include the period of any predecessor. If the business has not been in existence for the three-tax-year period, it should base its average on the period it has existed including any short tax years, annualizing the short tax year's gross receipts. 4. Materials and Supplies That Are Not Incidental If a business accounts for inventoriable items as materials and supplies that are not incidental, it will deduct the cost of the items it would otherwise include in inventory in the year it sells the items, or the year it pays for them, whichever is later. If the business is a producer, it can use any reasonable method to estimate the raw material in its work in process and finished goods on hand at the end of the year to determine the raw material used to produce finished goods that were sold during the year. 5. Changing Methods If a business is a qualifying taxpayer or small business taxpayer and wants to change to the cash method or to account for inventoriable items as non-incidental materials and supplies, it must file Form 3115, Application for Change in Accounting Method. For more information about the qualifying taxpayer exception, see Revenue Procedure in Internal Revenue Bulletin For more information about the qualifying small business taxpayer exception, see Revenue Procedure in Internal Revenue Bulletin Items Included in Inventory If a business is required to account for inventories, it should include the following items when accounting for its inventory: Merchandise or stock in trade; Raw materials; Work in process; Finished products; and Supplies that physically become a part of the item intended for sale. 7. Valuing Inventory A business must value its inventory at the beginning and end of each tax year to determine its cost of goods sold (Schedule C, line 42). To determine the value of inventory, the business needs a method for identifying the items in its inventory and a method for valuing these items. Accounting Periods and Methods 4-8

98 Inventory valuation rules cannot be the same for all kinds of businesses. The method used to value inventory must conform to generally accepted accounting principles for similar businesses and must clearly reflect income. Further, inventory practices must be consistent from year to year. F. UNIFORM CAPITALIZATION RULES Under the uniform capitalization rules, a business must capitalize the direct costs and part of the indirect costs for production or resale activities. It should include these costs in the basis of property it produces or acquires for resale, rather than claiming them as a current deduction. The costs are recovered through depreciation, amortization, or cost of goods sold when the business uses, sells, or otherwise disposes of the property. 1. Activities Subject to the Rules A business may be subject to the uniform capitalization rules if it does any of the following, unless the property is produced for use other than in a business or an activity carried on for profit: Produce real or tangible personal property. For this purpose, tangible personal property includes a film, sound recording, video tape, book, or similar property; or Acquire property for resale. 2. Exceptions These rules do not apply to the following property: Personal property a business acquires for resale if its average annual gross receipts are $10 million or less; Property produced if the business meets either of the following conditions: Its indirect costs of producing the property are $200,000 or less; or It uses the cash method of accounting and does not account for inventories. G. SPECIAL METHODS There are special methods of accounting for certain items of income or expense. These include the following: Amortization; Bad debts; Depletion; Depreciation; and Accounting Periods and Methods 4-9

99 Installment sales. The details of these are beyond the scope of this course. H. CHANGE IN ACCOUNTING METHOD Once an individual or business has set up its accounting method, it must generally get IRS approval before changing to another method. A change in accounting method includes a change in: The overall method, such as from the cash to an accrual method, and Its treatment of any material item. To get approval, the individual or business must file Form 3115, Application for Change in Accounting Method. It can get IRS approval to change an accounting method under either the automatic change procedures or the advance consent request procedures. The individual or business may have to pay a user fee. Certain taxpayers can presume to have IRS approval to change their method of accounting. The approval is granted for the tax year for which the taxpayer requests a change (year of change), if the taxpayer complies with the provisions of the automatic change procedures. No user fee is required for an application filed under an automatic change procedure generally covered in Revenue Procedure Generally, a taxpayer must use Form 3115 to request an automatic change. Accounting Periods and Methods 4-10

100 Chapter 4 Review Questions The following questions are designed to ensure that you have a complete understanding of the information presented in the chapter. They do not need to be submitted in order to receive CPE credit. They are included as an additional tool to enhance your learning experience. We recommend that you answer each review question and then compare your response to the suggested solution before answering the final exam questions related to this chapter. 1. A calendar tax year begins on January 1. a) true b) false 2. Under which of the following circumstances is a business taxpayer required to use a calendar tax year: a) if he keeps no books b) if he has gross revenues in excess of $100,000 c) if he has gross revenues of less than $100,000 d) both a and b above 3. When does a business owner s choice of an accounting method become effective: a) when he incorporates b) when he files his first income tax return with a Schedule C c) when he first engages in business d) the earlier of a or c 4. Which of the following statements about the accrual method of accounting is true: a) taxpayers generally report income in the year earned b) taxpayers deduct or capitalize expenses in the year after they are incurred c) taxpayers deduct or capitalize expenses in the year they are incurred d) both a and c 5. Most taxpayers are prohibited from using a combination of cash, accrual, and special methods of accounting. a) true b) false 6. Businesses that produce, purchase or sell merchandise are normally required to use the accrual method for purchases and sales of merchandise. a) true b) false Accounting Periods and Methods 4-11

101 7. What must a taxpayer do to change his accounting method after it has been established: a) once a method has been established, it cannot be changed under any circumstances b) there is no formal process so long as the board of directors agrees to the change c) seek approval from the IRS d) seek approval from his CPA Accounting Periods and Methods 4-12

102 Chapter 4 Suggested Solutions And Responses 1. A: True is correct. A taxpayer can use either a calendar tax year or a fiscal tax year. A calendar tax year is 12 consecutive months beginning January 1 and ending December 31. B: False is incorrect. By definition, a calendar tax year begins on January 1. (See page 4-1 of the course material.) 2. A: Correct. Taxpayers that keep no books are required to adopt the calendar tax year. B: Incorrect. There is no such income threshold. C: Incorrect. There is no such income threshold. D: Incorrect. Because B is incorrect, D cannot be correct either. (See page 4-1 of the course material.) 3. A: Incorrect. The selection does not occur until their first income tax return is actually filed. B: Correct. The method is effectively chosen when the taxpayer files a return for the first time. C: Incorrect. The operative time is when his first tax return is filed, not when he begins conducting business. D: Incorrect. Neither A nor C is correct, so D cannot be correct either. (See page 4-2 of the course material.) 4. A: Incorrect. Taxpayers do generally report income in the year earned. However, this is not the best answer. B: Incorrect. Under the accrual method, expenses are capitalized or deducted in the year incurred. C: Incorrect. This statement is correct. However, this is not the best answer. D: Correct. Taxpayers using the accrual method report income in the year earned and deduct or capitalize expenses in the year they are incurred. Therefore, this is the best answer. (See page 4-4 of the course material.) Accounting Periods and Methods 4-13

103 5. A: True is incorrect. A combination method is available to taxpayers in many circumstances. B: False is correct. A taxpayer can generally use any combination of cash, accrual, and special methods of accounting if the combination clearly shows his income and expenses and it is used consistently. (See page 4-6 of the course material.) 6. A: True is correct. Generally, if a business produces, purchases, or sells merchandise, it must keep an inventory and use the accrual method for purchases and sales of merchandise. B: False is incorrect. An accrual method is required under these circumstances. (See page 4-7 of the course material.) 7. A: Incorrect. Accounting methods can be changed with IRS approval. B: Incorrect. It is the IRS and not the board which must approve the change. C: Correct. Approval must be sought through a filing with the IRS. This is done by filing Form 3115, Application for Change in Accounting Method. D: Incorrect. The CPA advises the client but is not the one that must approve the change. (See page 4-10 of the course material.) Accounting Periods and Methods 4-14

104 Form 3115 (Rev. December 2009) Department of the Treasury Internal Revenue Service Name of filer (name of parent corporation if a consolidated group) (see instructions) Application for Change in Accounting Method OMB No Identification number (see instructions) Principal business activity code number (see instructions) Number, street, and room or suite no. If a P.O. box, see the instructions. City or town, state, and ZIP code Tax year of change begins (MM/DD/YYYY) Tax year of change ends (MM/DD/YYYY) Name of contact person (see instructions) Name of applicant(s) (if different than filer) and identification number(s) (see instructions) Contact person s telephone number If the applicant is a member of a consolidated group, check this box If Form 2848, Power of Attorney and Declaration of Representative, is attached (see instructions for when Form 2848 is required), check this box Check the box to indicate the type of applicant. Individual Corporation Controlled foreign corporation (Sec. 957) 10/50 corporation (Sec. 904(d)(2)(E)) Qualified personal service corporation (Sec. 448(d)(2)) Exempt organization. Enter Code section Cooperative (Sec. 1381) Partnership S corporation Insurance co. (Sec. 816(a)) Insurance co. (Sec. 831) Other (specify) Check the appropriate box to indicate the type of accounting method change being requested. (see instructions) Depreciation or Amortization Financial Products and/or Financial Activities of Financial Institutions Other (specify) Caution. To be eligible for approval of the requested change in method of accounting, the taxpayer must provide all information that is relevant to the taxpayer or to the taxpayer's requested change in method of accounting. This includes all information requested on this Form 3115 (including its instructions), as well as any other information that is not specifically requested. The taxpayer must attach all applicable supplemental statements requested throughout this form. Part I Information For Automatic Change Request 1 Enter the applicable designated automatic accounting method change number for the requested automatic change. Enter only one designated automatic accounting method change number, except as provided for in guidance published by the IRS. If the requested change has no designated automatic accounting method change number, check "Other," and provide both a description of the change and citation of the IRS guidance providing the automatic change. See instructions. Yes No (a) Change No. (b) Other Description 2 Do any of the scope limitations described in section 4.02 of Rev. Proc cause automatic consent to be unavailable for the applicant's requested change? If "Yes," attach an explanation Note. Complete Part II below and then Part IV, and also Schedules A through E of this form (if applicable). Part II Information For All Requests Yes No 3 Did or will the applicant cease to engage in the trade or business to which the requested change relates, or terminate its existence, in the tax year of change (see instructions)? If Yes, the applicant is not eligible to make the change under automatic change request procedures. 4 a Does the applicant (or any present or former consolidated group in which the applicant was a member during the applicable tax year(s)) have any Federal income tax return(s) under examination (see instructions)?..... If No, go to line 5. b Is the method of accounting the applicant is requesting to change an issue (with respect to either the applicant or any present or former consolidated group in which the applicant was a member during the applicable tax year(s)) either (i) under consideration or (ii) placed in suspense (see instructions)? Signature (see instructions) Under penalties of perjury, I declare that I have examined this application, including accompanying schedules and statements, and to the best of my knowledge and belief, the application contains all the relevant facts relating to the application, and it is true, correct, and complete. Declaration of preparer (other than applicant) is based on all information of which preparer has any knowledge. Filer Preparer (other than filer/applicant) Signature and date Signature of individual preparing the application and date Name and title (print or type) Name of individual preparing the application (print or type) Name of firm preparing the application For Privacy Act and Paperwork Reduction Act Notice, see the instructions. Cat. No E Form 3115 (Rev )

105 Form 3115 (Rev ) Page 2 Part II Information For All Requests (continued) Yes No 4 c Is the method of accounting the applicant is requesting to change an issue pending (with respect to either the applicant or any present or former consolidated group in which the applicant was a member during the applicable tax year(s)) for any tax year under examination (see instructions)? d Is the request to change the method of accounting being filed under the procedures requiring that the operating division director consent to the filing of the request (see instructions)? If Yes, attach the consent statement from the director. e Is the request to change the method of accounting being filed under the 90-day or 120-day window period?.. If Yes, check the box for the applicable window period and attach the required statement (see instructions). 90 day 120 day: Date examination ended f If you answered Yes to line 4a, enter the name and telephone number of the examining agent and the tax year(s) under examination. Name Telephone number Tax year(s) g Has a copy of this Form 3115 been provided to the examining agent identified on line 4f? a Does the applicant (or any present or former consolidated group in which the applicant was a member during the applicable tax year(s)) have any Federal income tax return(s) before Appeals and/or a Federal court?.... If Yes, enter the name of the (check the box) Appeals officer and/or counsel for the government, telephone number, and the tax year(s) before Appeals and/or a Federal court. Name Telephone number Tax year(s) b Has a copy of this Form 3115 been provided to the Appeals officer and/or counsel for the government identified on line 5a? c Is the method of accounting the applicant is requesting to change an issue under consideration by Appeals and/or a Federal court (for either the applicant or any present or former consolidated group in which the applicant was a member for the tax year(s) the applicant was a member) (see instructions)? If Yes, attach an explanation. 6 If the applicant answered Yes to line 4a and/or 5a with respect to any present or former consolidated group, attach a statement that provides each parent corporation s (a) name, (b) identification number, (c) address, and (d) tax year(s) during which the applicant was a member that is under examination, before an Appeals office, and/or before a Federal court. 7 If, for federal income tax purposes, the applicant is either an entity (including a limited liability company) treated as a partnership or an S corporation, is it requesting a change from a method of accounting that is an issue under consideration in an examination, before Appeals, or before a Federal court, with respect to a Federal income tax return of a partner, member, or shareholder of that entity? If Yes, the applicant is not eligible to make the change. 8a Does the applicable revenue procedure (advance consent or automatic consent) state that the applicant does not receive audit protection for the requested change (see instructions)? b If Yes, attach an explanation. 9a Has the applicant, its predecessor, or a related party requested or made (under either an automatic change procedure or a procedure requiring advance consent) a change in method of accounting within the past 5 years (including the year of the requested change)? b If "Yes," for each trade or business, attach a description of each requested change in method of accounting (including the tax year of change) and state whether the applicant received consent. c If any application was withdrawn, not perfected, or denied, or if a Consent Agreement granting a change was not signed and returned to the IRS, or the change was not made or not made in the requested year of change, attach an explanation. 10 a Does the applicant, its predecessor, or a related party currently have pending any request (including any concurrently filed request) for a private letter ruling, change in method of accounting, or technical advice?... b If Yes, for each request attach a statement providing the name(s) of the taxpayer, identification number(s), the type of request (private letter ruling, change in method of accounting, or technical advice), and the specific issue(s) in the request(s). 11 Is the applicant requesting to change its overall method of accounting? If Yes, check the appropriate boxes below to indicate the applicant s present and proposed methods of accounting. Also, complete Schedule A on page 4 of this form. Present method: Cash Accrual Hybrid (attach description) Proposed method: Cash Accrual Hybrid (attach description) Form 3115 (Rev )

106 Form 3115 (Rev ) Page 3 Part II Information For All Requests (continued) Yes No 12 If the applicant is either (i) not changing its overall method of accounting, or (ii) is changing its overall method of accounting and also changing to a special method of accounting for one or more items, attach a detailed and complete description for each of the following: a The item(s) being changed. b The applicant s present method for the item(s) being changed. c The applicant s proposed method for the item(s) being changed. d The applicant s present overall method of accounting (cash, accrual, or hybrid). 13 Attach a detailed and complete description of the applicant s trade(s) or business(es), and the principal business activity code for each. If the applicant has more than one trade or business as defined in Regulations section (d), describe: whether each trade or business is accounted for separately; the goods and services provided by each trade or business and any other types of activities engaged in that generate gross income; the overall method of accounting for each trade or business; and which trade or business is requesting to change its accounting method as part of this application or a separate application. 14 Will the proposed method of accounting be used for the applicant s books and records and financial statements? For insurance companies, see the instructions If No, attach an explanation. 15a Has the applicant engaged, or will it engage, in a transaction to which section 381(a) applies (e.g., a reorganization, merger, or liquidation) during the proposed tax year of change determined without regard to any potential closing of the year under section 381(b)(1)? b If Yes, for the items of income and expense that are the subject of this application, attach a statement identifying the methods of accounting used by the parties to the section 381(a) transaction immediately before the date of distribution or transfer and the method(s) that would be required by section 381(c)(4) or (c)(5) absent consent to the change(s) requested in this application. 16 Does the applicant request a conference with the IRS National Office if the IRS proposes an adverse response? 17 If the applicant is changing to either the overall cash method, an overall accrual method, or is changing its method of accounting for any property subject to section 263A, any long-term contract subject to section 460, or inventories subject to section 474, enter the applicant's gross receipts for the 3 tax years preceding the tax year of change. 1st preceding year ended: mo. yr. 2nd preceding year ended: mo. yr. 3rd preceding year ended: mo. $ $ $ Part III Information For Advance Consent Request Yes No 18 Is the applicant s requested change described in any revenue procedure, revenue ruling, notice, regulation, or other published guidance as an automatic change request? If Yes, attach an explanation describing why the applicant is submitting its request under advance consent request procedures. 19 Attach a full explanation of the legal basis supporting the proposed method for the item being changed. Include a detailed and complete description of the facts that explains how the law specifically applies to the applicant s situation and that demonstrates that the applicant is authorized to use the proposed method. Include all authority (statutes, regulations, published rulings, court cases, etc.) supporting the proposed method. Also, include either a discussion of the contrary authorities or a statement that no contrary authority exists. 20 Attach a copy of all documents related to the proposed change (see instructions). 21 Attach a statement of the applicant s reasons for the proposed change. 22 If the applicant is a member of a consolidated group for the year of change, do all other members of the consolidated group use the proposed method of accounting for the item being changed? If No, attach an explanation. 23 a Enter the amount of user fee attached to this application (see instructions). $ b If the applicant qualifies for a reduced user fee, attach the required information or certification (see instructions). Part IV Section 481(a) Adjustment Yes No 24 Does the applicable revenue procedure, revenue ruling, notice, regulation, or other published guidance require the applicant to implement the requested change in method of accounting on a cut-off basis rather than a section 481(a) adjustment?... If Yes, do not complete lines 25, 26, and 27 below. 25 Enter the section 481(a) adjustment. Indicate whether the adjustment is an increase (+) or a decrease (-) in income. $ Attach a summary of the computation and an explanation of the methodology used to determine the section 481(a) adjustment. If it is based on more than one component, show the computation for each component. If more than one applicant is applying for the method change on the same application, attach a list of the name, identification number, principal business activity code (see instructions), and the amount of the section 481(a) adjustment attributable to each applicant. Form 3115 (Rev ) yr.

107 Form 3115 (Rev ) Page 4 Part IV Section 481(a) Adjustment (continued) Yes No 26 If the section 481(a) adjustment is an increase to income of less than $25,000, does the applicant elect to take the entire amount of the adjustment into account in the year of change? Is any part of the section 481(a) adjustment attributable to transactions between members of an affiliated group, a consolidated group, a controlled group, or other related parties? If Yes, attach an explanation. Schedule A Change in Overall Method of Accounting (If Schedule A applies, Part I below must be completed.) Part I Change in Overall Method (see instructions) 1 Enter the following amounts as of the close of the tax year preceding the year of change. If none, state None. Also, attach a statement providing a breakdown of the amounts entered on lines 1a through 1g. Amount a Income accrued but not received (such as accounts receivable) $ b Income received or reported before it was earned (such as advanced payments). Attach a description of the income and the legal basis for the proposed method c Expenses accrued but not paid (such as accounts payable) d Prepaid expenses previously deducted e Supplies on hand previously deducted and/or not previously reported f Inventory on hand previously deducted and/or not previously reported. Complete Schedule D, Part II. g Other amounts (specify). Attach a description of the item and the legal basis for its inclusion in the calculation of the section 481(a) adjustment. h Net section 481(a) adjustment (Combine lines 1a 1g.) Indicate whether the adjustment is an increase (+) or decrease (-) in income. Also enter the net amount of this section 481(a) adjustment amount on Part IV, line $ 2 Is the applicant also requesting the recurring item exception under section 461(h)(3)? Yes No 3 Attach copies of the profit and loss statement (Schedule F (Form 1040) for farmers) and the balance sheet, if applicable, as of the close of the tax year preceding the year of change. Also attach a statement specifying the accounting method used when preparing the balance sheet. If books of account are not kept, attach a copy of the business schedules submitted with the Federal income tax return or other return (e.g., tax-exempt organization returns) for that period. If the amounts in Part I, lines 1a through 1g, do not agree with those shown on both the profit and loss statement and the balance sheet, attach a statement explaining the differences. Part II Change to the Cash Method For Advance Consent Request (see instructions) Applicants requesting a change to the cash method must attach the following information: 1 A description of inventory items (items whose production, purchase, or sale is an income-producing factor) and materials and supplies used in carrying out the business. 2 An explanation as to whether the applicant is required to use the accrual method under any section of the Code or regulations. Schedule B Change to the Deferral Method for Advance Payments (see instructions) 1 If the applicant is requesting to change to the Deferral Method for advance payments described in section 5.02 of Rev. Proc , C.B. 991, attach the following information: a A statement explaining how the advance payments meet the definition in section 4.01 of Rev. Proc b If the applicant is filing under the automatic change procedures of Rev. Proc , the information required by section 8.02(3)(a)-(c) of Rev. Proc c If the applicant is filing under the advance consent provisions of Rev. Proc , the information required by section 8.03(2)(a)-(f) of Rev. Proc If the applicant is requesting to change to the deferral method for advance payments described in Regulations section (b)(1)(ii), attach the following. a A statement explaining how the advance payments meet the definition in Regulations section (a)(1). b A statement explaining what portions of the advance payments, if any, are attributable to services, whether such services are integral to the provisions of goods or items, and whether any portions of the advance payments that are attributable to non-integral services are less than five percent of the total contract prices. See Regulations sections (a)(2)(i) and (3). c A statement explaining that the advance payments will be included in income no later than when included in gross receipts for purposes of the applicant's financial reports. See Regulations section (b)(1)(ii). d A statement explaining whether the inventoriable goods exception of Regulations section (c) applies and if so, when substantial advance payments will be received under the contracts, and how the exception will limit the deferral of income. Form 3115 (Rev )

108 Form 3115 (Rev ) Page 5 Schedule C Changes Within the LIFO Inventory Method (see instructions) Part I General LIFO Information Complete this section if the requested change involves changes within the LIFO inventory method. Also, attach a copy of all Forms 970, Application To Use LIFO Inventory Method, filed to adopt or expand the use of the LIFO method. 1 Attach a description of the applicant s present and proposed LIFO methods and submethods for each of the following items: a Valuing inventory (e.g., unit method or dollar-value method). b Pooling (e.g., by line or type or class of goods, natural business unit, multiple pools, raw material content, simplified dollarvalue method, inventory price index computation (IPIC) pools, vehicle-pool method, etc.). c Pricing dollar-value pools (e.g., double-extension, index, link-chain, link-chain index, IPIC method, etc.). d Determining the current-year cost of goods in the ending inventory (i.e., most recent acquisitions, earliest acquisitions during the current year, average cost of current-year acquisitions, or other permitted method). 2 If any present method or submethod used by the applicant is not the same as indicated on Form(s) 970 filed to adopt or expand the use of the method, attach an explanation. 3 If the proposed change is not requested for all the LIFO inventory, attach a statement specifying the inventory to which the change is and is not applicable. 4 If the proposed change is not requested for all of the LIFO pools, attach a statement specifying the LIFO pool(s) to which the change is applicable. 5 Attach a statement addressing whether the applicant values any of its LIFO inventory on a method other than cost. For example, if the applicant values some of its LIFO inventory at retail and the remainder at cost, identify which inventory items are valued under each method. 6 If changing to the IPIC method, attach a completed Form 970. Part II Change in Pooling Inventories 1 If the applicant is proposing to change its pooling method or the number of pools, attach a description of the contents of, and state the base year for, each dollar-value pool the applicant presently uses and proposes to use. 2 If the applicant is proposing to use natural business unit (NBU) pools or requesting to change the number of NBU pools, attach the following information (to the extent not already provided) in sufficient detail to show that each proposed NBU was determined under Regulations section (b)(1) and (2): a A description of the types of products produced by the applicant. If possible, attach a brochure. b A description of the types of processes and raw materials used to produce the products in each proposed pool. c If all of the products to be included in the proposed NBU pool(s) are not produced at one facility, state the reasons for the separate facilities, the location of each facility, and a description of the products each facility produces. d A description of the natural business divisions adopted by the taxpayer. State whether separate cost centers are maintained and if separate profit and loss statements are prepared. e A statement addressing whether the applicant has inventories of items purchased and held for resale that are not further processed by the applicant, including whether such items, if any, will be included in any proposed NBU pool. f A statement addressing whether all items including raw materials, goods-in-process, and finished goods entering into the entire inventory investment for each proposed NBU pool are presently valued under the LIFO method. Describe any items that are not presently valued under the LIFO method that are to be included in each proposed pool. g A statement addressing whether, within the proposed NBU pool(s), there are items both sold to unrelated parties and transferred to a different unit of the applicant to be used as a component part of another product prior to final processing. 3 If the applicant is engaged in manufacturing and is proposing to use the multiple pooling method or raw material content pools, attach information to show that each proposed pool will consist of a group of items that are substantially similar. See Regulations section (b)(3). 4 If the applicant is engaged in the wholesaling or retailing of goods and is requesting to change the number of pools used, attach information to show that each of the proposed pools is based on customary business classifications of the applicant s trade or business. See Regulations section (c). Form 3115 (Rev )

109 Form 3115 (Rev ) Page 6 Schedule D Change in the Treatment of Long-Term Contracts Under Section 460, Inventories, or Other Section 263A Assets (see instructions) Part I Change in Reporting Income From Long-Term Contracts (Also complete Part III on pages 7 and 8.) 1 To the extent not already provided, attach a description of the applicant s present and proposed methods for reporting income and expenses from long-term contracts. Also, attach a representative actual contract (without any deletion) for the requested change. If the applicant is a construction contractor, attach a detailed description of its construction activities. 2a Are the applicant s contracts long-term contracts as defined in section 460(f)(1) (see instructions)?.. Yes No b If Yes, do all the contracts qualify for the exception under section 460(e) (see instructions)?.... Yes No If line 2b is No, attach an explanation. c If line 2b is Yes, is the applicant requesting to use the percentage-of-completion method using cost-tocost under Regulations section (b)? Yes No d If line 2c is No, is the applicant requesting to use the exempt-contract percentage-of-completion method under Regulations section (c)(2)? Yes No If line 2d is Yes, attach an explanation of what cost comparison the applicant will use to determine a contract s completion factor. If line 2d is No, attach an explanation of what method the applicant is using and the authority for its use. 3a Does the applicant have long-term manufacturing contracts as defined in section 460(f)(2)?..... Yes No b If Yes, attach an explanation of the applicant s present and proposed method(s) of accounting for longterm manufacturing contracts. c Attach a description of the applicant s manufacturing activities, including any required installation of manufactured goods. 4 To determine a contract s completion factor using the percentage-of-completion method: a Will the applicant use the cost-to-cost method in Regulations section (b)? Yes No b If line 4a is No, is the applicant electing the simplified cost-to-cost method (see section 460(b)(3) and Regulations section (c))? Yes No 5 Attach a statement indicating whether any of the applicant s contracts are either cost-plus long-term contracts or Federal long-term contracts. Part II Change in Valuing Inventories Including Cost Allocation Changes (Also complete Part III on pages 7 and 8.) 1 Attach a description of the inventory goods being changed. 2 Attach a description of the inventory goods (if any) NOT being changed. 3 a Is the applicant subject to section 263A? If "No," go to line 4a Yes No b Is the applicant's present inventory valuation method in compliance with section 263A (see instructions)? If "No," attach a detailed explanation Yes No Inventory Being Changed Inventory Not Being Changed 4 a Check the appropriate boxes below. Identification methods: Present method Proposed method Present method Specific identification FIFO LIFO Other (attach explanation) Valuation methods: Cost Cost or market, whichever is lower Retail cost Retail, lower of cost or market Other (attach explanation) b Enter the value at the end of the tax year preceding the year of change 5 If the applicant is changing from the LIFO inventory method to a non-lifo method, attach the following information (see instructions). a Copies of Form(s) 970 filed to adopt or expand the use of the method. b c Only for applicants requesting advance consent. A statement describing whether the applicant is changing to the method required by Regulations section (a) or (b), or whether the applicant is proposing a different method. Only for applicants requesting an automatic change. The statement required by section 22.01(5) of the Appendix of Rev. Proc (or its successor). Form 3115 (Rev )

110 Form 3115 (Rev ) Page 7 Part III Method of Cost Allocation (Complete this part if the requested change involves either property subject to section 263A or long-term contracts as described in section 460 (see instructions)). Section A Allocation and Capitalization Methods Attach a description (including sample computations) of the present and proposed method(s) the applicant uses to capitalize direct and indirect costs properly allocable to real or tangible personal property produced and property acquired for resale, or to allocate and, where appropriate, capitalize direct and indirect costs properly allocable to long-term contracts. Include a description of the method(s) used for allocating indirect costs to intermediate cost objectives such as departments or activities prior to the allocation of such costs to long-term contracts, real or tangible personal property produced, and property acquired for resale. The description must include the following: 1 The method of allocating direct and indirect costs (i.e., specific identification, burden rate, standard cost, or other reasonable allocation method). 2 The method of allocating mixed service costs (i.e., direct reallocation, step-allocation, simplified service cost using the laborbased allocation ratio, simplified service cost using the production cost allocation ratio, or other reasonable allocation method). 3 The method of capitalizing additional section 263A costs (i.e., simplified production with or without the historic absorption ratio election, simplified resale with or without the historic absorption ratio election including permissible variations, the U.S. ratio, or other reasonable allocation method). Section B Direct and Indirect Costs Required To Be Allocated Check the appropriate boxes showing the costs that are or will be fully included, to the extent required, in the cost of real or tangible personal property produced or property acquired for resale under section 263A or allocated to long-term contracts under section 460. Mark N/A in a box if those costs are not incurred by the applicant. If a box is not checked, it is assumed that those costs are not fully included to the extent required. Attach an explanation for boxes that are not checked. 1 Direct material Direct labor Indirect labor Officers compensation (not including selling activities) Pension and other related costs Employee benefits Indirect materials and supplies Purchasing costs Handling, processing, assembly, and repackaging costs Offsite storage and warehousing costs Depreciation, amortization, and cost recovery allowance for equipment and facilities placed in service and not temporarily idle Depletion Rent Taxes other than state, local, and foreign income taxes Insurance Utilities Maintenance and repairs that relate to a production, resale, or long-term contract activity 18 Engineering and design costs (not including section 174 research and experimental expenses) Rework labor, scrap, and spoilage Tools and equipment Quality control and inspection Bidding expenses incurred in the solicitation of contracts awarded to the applicant.. 23 Licensing and franchise costs Capitalizable service costs (including mixed service costs) Administrative costs (not including any costs of selling or any return on capital) Research and experimental expenses attributable to long-term contracts Interest Other costs (Attach a list of these costs.) Present method Proposed method Form 3115 (Rev )

111 Form 3115 (Rev ) Page 8 Part III Method of Cost Allocation (see instructions) (continued) Section C Other Costs Not Required To Be Allocated (Complete Section C only if the applicant is requesting to change its method for these costs.) 1 Marketing, selling, advertising, and distribution expenses Research and experimental expenses not included in Section B, line Bidding expenses not included in Section B, line General and administrative costs not included in Section B Income taxes Cost of strikes Warranty and product liability costs Section 179 costs On-site storage Depreciation, amortization, and cost recovery allowance not included in Section B, line Other costs (Attach a list of these costs.) Schedule E Change in Depreciation or Amortization (see instructions) Present method Proposed method Applicants requesting approval to change their method of accounting for depreciation or amortization complete this section. Applicants must provide this information for each item or class of property for which a change is requested. Note. See the List of Automatic Accounting Method Changes in the instructions for information regarding automatic changes under sections 56, 167, 168, 197, 1400I, 1400L, or former section 168. Do not file Form 3115 with respect to certain late elections and election revocations (see instructions). 1 Is depreciation for the property determined under Regulations section 1.167(a)-11 (CLADR)?.... Yes No If Yes, the only changes permitted are under Regulations section 1.167(a)-11(c)(1)(iii). 2 Is any of the depreciation or amortization required to be capitalized under any Code section (e.g., section 263A)? Yes No If Yes, enter the applicable section 3 Has a depreciation, amortization, or expense election been made for the property (e.g., the election under sections 168(f)(1), 179, or 179C)? Yes No If Yes, state the election made 4 a To the extent not already provided, attach a statement describing the property being changed. Include in the description the type of property, the year the property was placed in service, and the property s use in the applicant s trade or business or income-producing activity. b If the property is residential rental property, did the applicant live in the property before renting it?.. Yes No c Is the property public utility property? Yes No 5 To the extent not already provided in the applicant s description of its present method, attach a statement explaining how the property is treated under the applicant s present method (e.g., depreciable property, inventory property, supplies under Regulations section , nondepreciable section 263(a) property, property deductible as a current expense, etc.). 6 If the property is not currently treated as depreciable or amortizable property, attach a statement of the facts supporting the proposed change to depreciate or amortize the property. 7 If the property is currently treated and/or will be treated as depreciable or amortizable property, provide the following information for both the present (if applicable) and proposed methods: a The Code section under which the property is or will be depreciated or amortized (e.g., section 168(g)). b The applicable asset class from Rev. Proc , C.B. 674, for each asset depreciated under section 168 (MACRS) or under section 1400L; the applicable asset class from Rev. Proc , C.B. 745, for each asset depreciated under former section 168 (ACRS); an explanation why no asset class is identified for each asset for which an asset class has not been identified by the applicant. c The facts to support the asset class for the proposed method. d The depreciation or amortization method of the property, including the applicable Code section (e.g., 200% declining balance method under section 168(b)(1)). e The useful life, recovery period, or amortization period of the property. f The applicable convention of the property. g A statement of whether or not the additional first-year special depreciation allowance (for example, as provided by section 168(k), 168(l), 168(m), 168(n), 1400L(b), or 1400N(d)) was or will be claimed for the property. If not, also provide an explanation as to why no special depreciation allowance was or will be claimed. Form 3115 (Rev )

112 Instructions for Form 3115 (Rev. March 2012) (Use with the December 2009 revision of Form 3115) Application for Change in Accounting Method Department of the Treasury Internal Revenue Service Section references are to the Internal Revenue Code unless Request Scope Limitations, later. If the requested change is otherwise noted. approved, the filer will receive a letter ruling on the requested change. File a separate Form 3115 for each unrelated item or All references to Rev. Proc are to Rev. Proc , submethod. A user fee is required. See the instructions for C.B. 680 (as modified and amplified by Rev. Proc. Part III later for more information , C.B. 696, as amplified and clarified by Rev. Proc , C.B. 432), as modified by Rev. Proc. For general rules on changing an accounting method under: , C.B. 1072), as clarified and modified by Rev. Proc , C.B. 371 and as clarified and modified Automatic change by Rev. Proc , I.R.B. 330, or its successor. request procedures... See generally Rev. Proc All references to Rev. Proc are to Rev. Proc. Advance consent See Rev. Proc , as amplified, , I.R.B. 330, or its successor. (Note. Rev. Proc. request procedures... clarified and modified by Rev. Proc amplified, clarified, modified, and, in part, superceded , Rev. Proc , Rev. Proc. Rev. Proc , I.R.B. 587.) All references to Rev. Proc are to Rev. Proc , I.R.B. 1, or its successor (updated annually). General Instructions What s New Future developments. The IRS has created a page on IRS.gov for information about Form 3115 at form3115. Information about any future developments affecting Form 3115 (such as legislation enacted after we release it) will be posted to that page. Purpose of Form File Form 3115 to request a change in either an overall method of accounting or the accounting treatment of any item. Two procedures exist under which an applicant may request a change in method of accounting. Automatic change request procedures. Unless otherwise provided in published guidance, you must file under the automatic change request procedures if (a) the change in method of accounting is included in those procedures for the requested year of change, and (b) you are within the scope of those procedures for the requested year of change. See Automatic Change Request Scope Limitations, later. A Form 3115 filed under these procedures may be reviewed by the IRS and you will be notified if information in addition to that requested on Form 3115 is required or if your request is denied. No user fee is required. An applicant that timely files and complies with an automatic change request procedure is granted consent to change its accounting method, subject to review by the IRS National Office and operating division director. See the instructions for Part I and the List of Automatic Accounting Method Changes, later. Ordinarily, a taxpayer is required to file a separate Form 3115 for each change in method of accounting. However, in some cases you are required or permitted to file a single Form 3115 for particular concurrent changes in method of accounting. Further, in some cases you are required or permitted to file a statement in lieu of a Form 3115 for particular changes in method of accounting. See section 6.02(1)(a) and (b) of Rev. Proc for more information. Advance consent request procedures. If you are not within the scope of any automatic change request procedures for the requested year of change or the accounting method change you are requesting is not included in those procedures for the requested year of change, you may be able to file under the advance consent request procedures. See Advance Consent , Rev. Proc , and Rev. Proc For more information, see Rev. Proc (or its successor), particularly section 9. When filing Form 3115, you must determine if the IRS! has published any new revenue procedure, revenue CAUTION ruling, notice, regulation, or other published guidance relating to the specific method the applicant is requesting to change. This guidance is published in the Internal Revenue Bulletin. For the latest information, visit IRS.gov. Who Must File The entity or person required to file Form 3115, whether on its own behalf or on behalf of another entity, is the filer. The entity, trade or business, or person on whose behalf the change in method of accounting is being requested is the applicant. For example, the common parent corporation of a consolidated group is the filer when requesting a change in method of accounting for another member of that consolidated group (or a separate and distinct trade or business of that member), and the other member (or trade or business) on whose behalf the Form 3115 is filed is the applicant. For information on the difference between a filer and an applicant, see Name(s) and Signature(s), later. An applicant is an entity or a person, or a separate and distinct trade or business of an entity or a person (for purposes of Regulations section (d)), whose method of accounting is being changed. For a consolidated group of corporations, the common parent corporation must file Form 3115 for a change in method of accounting for itself or any member of the consolidated group. For a CFC or 10/50 corporation without a U.S. trade or business, Form 3115 must be filed by the designated (controlling domestic) shareholder who retains the jointly executed consent described in Regulations section (c)(3)(ii). If the controlling domestic shareholder is a member of a consolidated group, the common parent corporation must file Form 3115 for the controlling domestic shareholder on behalf of the foreign corporation. For an automatic change, the controlling domestic shareholder(s) (or its common parent) must attach a copy of the Form 3115 to its income tax return for its tax year with or within which the CFCs or 10/50 corporation s year of change tax year ends. Generally, a filer must file a separate Form 3115 for each applicant seeking consent to change a method of accounting. For example, a filer must file a separate Form 3115 for each Mar 22, 2012 Cat. No H

113 File Form 3115 at the applicable IRS address listed below. For applicants (other than exempt organizations) filing... An advance consent request The National Office copy of an automatic Ogden, Utah copy change request Delivery by Internal Revenue Service Internal Revenue Service Internal Revenue Service mail Attn: CC:PA:LPD:DRU Automatic Rulings Branch 1973 North Rulon White Blvd. P.O. Box 7604 P.O. Box 7604 Mail Stop 4917 Benjamin Franklin Station Benjamin Franklin Station Ogden, UT Washington, DC Washington, DC Delivery by Internal Revenue Service Internal Revenue Service Internal Revenue Service private Attn: CC:PA:LPD:DRU Automatic Rulings Branch 1973 North Rulon White Blvd. delivery Room 5336 Room 5336 Mail Stop 4917 service 1111 Constitution Ave., NW 1111 Constitution Ave., NW Ogden, UT Washington, DC Washington, DC For exempt organizations filing an advance consent request or the National Office Ogden, Utah copy copy of an automatic change request By mail Internal Revenue Service Internal Revenue Service Tax Exempt & Government Entities 1973 North Rulon White Blvd. P.O. Box 2508 Mail Stop 4917 Cincinnati, OH Ogden, UT By private delivery service Internal Revenue Service Internal Revenue Service Tax Exempt & Government Entities 1973 North Rulon White Blvd. 550 Main Street, Room 4024 Mail Stop 4917 Cincinnati, OH Ogden, UT When and Where To File corporation (with a single trade or business) that is part of a related group of corporations. A filer also must file a separate Form 3115 for each separate and distinct trade or business Automatic change requests. Except as otherwise specifically (including a QSub or single-member LLC) of each corporation provided, you must file a Form 3115 under the automatic or other entity, even if the requested change in method of change request procedures in duplicate as follows. accounting will be used by all separate and distinct trades or Attach the original to the filer s timely filed (including businesses of an entity. extensions) federal income tax return for the year of change. Attach an original filed on behalf of a CFC or 10/50 Each partnership entity must file on its own behalf even if corporation to the filer s timely filed federal income tax return for multiple related or tiered partnership entities are filing for the tax year of the filer with or within which the CFCs or 10/50 identical changes in method of accounting. corporation s year of change tax year ends. There are three limited exceptions to the requirement to file File a copy of the Form 3115 with the IRS National Office, a separate Form 3115 for each applicant seeking consent to unless the Appendix of Rev. Proc or other published change a method of accounting. The filer may file a single Form guidance requires you to file the copy with the IRS office in 3115 for multiple applicants in each of the 3 following situations Ogden, UT, instead of the IRS National Office. File the copy no (separately, but not in any combination): earlier than the first day of the year of change and no later than A common parent of a consolidated group or other entity the date the original is filed with the federal income tax return requesting an identical change in method of accounting for two for the year of change (or if applicable, for the tax year in which or more (a) members of that consolidated group, or (b) separate the CFCs or 10/50 corporation s year of change tax year ends). and distinct trades or businesses (for purposes of Regulations section (d)) of that entity or members of the If you are making more than one change in method of consolidated group, including a QSub or single-member LLC. accounting on the same Form 3115 (when permitted) and (1) A common parent of a consolidated group requesting an one method change requires you to file a copy of the Form identical change in method of accounting on behalf of two or 3115 with the IRS Office in Ogden, UT, and (2) the other more controlled foreign corporations (CFCs) or noncontrolled method change(s) being requested requires you to file a copy of section 902 corporations (10/50 corporations), or separate and Form 3115 with the IRS National Office, file only one copy of distinct trades or businesses of a CFC or 10/50 corporation, the Form 3115 with the IRS Office in Ogden, UT. However, if that do not engage in a trade or business within the United Rev. Proc or other published guidance describing the States where all controlling U.S. shareholders of the CFC and requested change in method of accounting specifically requires all majority domestic corporate shareholders of the 10/50 you to file a copy of the Form 3115 with both the IRS National corporations are members of the consolidated group. Office and the IRS office in Ogden, UT, you must file a copy A taxpayer requesting an identical change in method of with each office. See section 3.06 of the Appendix of Rev. Proc. accounting on behalf of two or more CFCs or 10/ for an example of when published guidance corporations, or separate and distinct trades or businesses of a specifically requires you to file a copy with both offices. CFC or 10/50 corporation, that do not engage in a trade or Example: You are requesting consent for a change in business within the United States for which the taxpayer is the method of accounting described in section 6.01 of the Appendix sole controlling U.S. shareholder of the CFCs or the sole of Rev. Proc and for a concurrent change to a domestic corporate shareholder of the 10/50 corporation (or any UNICAP method, as permitted in section 6.01(7)(b) of the separate and distinct trade or businesses of any such CFC or Appendix of Rev. Proc File the copy of the Form /50 corporation). with the IRS office in Ogden, UT. For information on what is an identical change in method of In specified circumstances you are required to send accounting, see section 15.07(4) of Rev. Proc additional copies of the Form 3115 to another IRS address. -2-

114 For example, you must file additional copies if the applicant is is filed for multiple applicants in a consolidated group of under examination, before an Appeals office, and/or before corporations, multiple CFCs, or multiple separate and distinct Federal Court. See section 6.03(c) of Rev. Proc for trades or businesses of a taxpayer (including QSubs, or more information. See also Late Application below, and, if the single-member LLCs), attach a schedule listing each applicant applicant is under examination for purposes of Rev. Proc. and its identification number (where applicable). This schedule , the instructions for Part II, lines 4d and 4e. may be combined with the information requested for Part III, Advance consent requests. You must file Form 3115 under line 23a (regarding the user fee) and Part IV (section 481(a) the advance consent request procedures during the tax year for adjustment). If multiple names and signatures are required (for which the change is requested, unless otherwise provided by example, in the case of CFCs see instructions below), attach other published guidance. For example, see Regulations a schedule labeled SIGNATURE ATTACHMENT to the Form section 1.381(c)(4)-1(d)(2)(iii) and 1.381(c)(5)-1(d)(2)(iii), which 3115, signed under penalties of perjury using the same provide different deadlines for filing a Form 3115 in the year of language as in the declaration on page 1 of Form a section 381 transaction. If the tax year for which the change is Receivers, trustees, or assignees must sign any Form 3115 requested is a short period, file Form 3115 by the last day of the they are required to file. short period unless other published guidance provides another Individuals. If Form 3115 is filed for a husband and wife who deadline. File the Form 3115 with the IRS National Office (see file a joint income tax return, enter the names of both spouses below). File Form 3115 as early as possible during the year of on the first line and the signatures of both spouses on the change to provide adequate time for the IRS to respond prior to signature line. the due date of the filer s return for the year of change (or if Partnerships. Enter the name of the partnership on the first applicable, for the tax year of the filer in which the CFCs or 10/ line of Form In the signature section, enter the signature 50 corporation s year of change tax year ends). See Late of one of the general partners or limited liability company Application below and, if the applicant is under examination for members who has personal knowledge of the facts and who is purposes of Rev. Proc , as modified by Rev. Proc. authorized to sign. Enter that person s name and title below the , and Rev. Proc , and the instructions for signature. If the authorized partner is a member of a Part II, lines 4d and 4e. consolidated group, then an authorized officer of the common The IRS normally sends an acknowledgment of receipt parent corporation with personal knowledge of the facts must within 60 days after receiving a Form 3115 filed under the sign. advance consent request procedures of Rev. Proc If the Non-consolidated corporations, personal service filer does not receive an acknowledgment of receipt for an corporations, S corporations, cooperatives, and insurance advance request within 60 days, the filer can inquire to: companies. Enter the name of the filer on the first line of Form Internal Revenue Service, Control Clerk, CC:IT&A, Room In the signature section, enter the signature of the officer 4516, 1111 Constitution Ave., NW, Washington, DC who has personal knowledge of the facts and authority to bind Note: The IRS does not send acknowledgments of receipt for the filer in the matter. Enter that officer s name and official title automatic change requests. below the signature. Late Application Consolidated group of corporations. Enter the name of the common parent corporation on the first line of Form Also In general, a taxpayer that fails to timely file a Form 3115 will enter the name(s) of the applicant(s) on the fourth line if a not be granted an extension of time to file except in unusual member of the consolidated group other than, or in addition to, and compelling circumstances. See Regulations section the parent corporation is requesting a change in method of for the standards that must be met. For information accounting. In the signature section, enter the signature of the on the period of limitations, see section 5.03(2) of Rev. Proc. officer of the common parent corporation who has personal knowledge of the facts and authority to bind the common parent However, a limited 6-month extension of time to file Form corporation in the matter, and that officer s name and official 3115 may be available for automatic change requests. For title below the signature. details, see section 6.02(3)(d) of Rev. Proc and Separate and distinct trade or business of an entity. Enter Regulations section the name of the entity (or common parent corporation if the A taxpayer submitting a ruling request for an extension of entity is a member of a consolidated group) on the first line of time to file Form 3115 must pay a user fee for its extension Form Also enter the name of the separate and distinct request and, in the case of an advance consent request, also a trade or business requesting a change in method of accounting separate user fee for its accounting method change request. on the fourth line. In the signature section, enter the signature For the schedule of user fees, see (A)(3)(b), (A)(4), and of the individual who has personal knowledge of the facts and (A)(5)(d) in Appendix A of Rev. Proc authority to bind the separate and distinct trade or business of the entity in the matter, and that person s name and official title below the signature. Specific Instructions CFC or 10/50 Corporation. For a CFC or 10/50 corporation with a U.S. trade or business, follow the same rules as for other corporations. For a CFC or 10/50 corporation that does not Name(s) and Signature(s) have a U.S. trade or business, the Form 3115 filed on behalf of Enter the name of the filer on the first line of page 1 of Form its controlling domestic shareholder(s) (or common parent) For an automatic change request, the filer must send a must be signed by an authorized officer of the designated signed and dated copy of the Form 3115 to the IRS National (controlling domestic) shareholder that retains the jointly Office and/or Ogden, UT, office and, in some cases, to an executed consent as provided for in Regulations section additional IRS office. For each of these copies, submit either (c)(3)(ii). If there is more than one shareholder, the the copy with an original signature or a photocopy of the original statement described in Regulations section (c)(3)(ii) signed Form The Form 3115 attached to the income tax must be attached to the application. Also, the controlling return (including any additional statements) does not need to be domestic shareholder(s) must provide the written notice signed. The name and signature requirements are discussed required by Regulations section (c)(3)(iii). If the below. designated (controlling domestic) shareholder is a member of a In general, the filer of the Form 3115 is the applicant. consolidated group, then an authorized officer of the common However, in circumstances where the Form 3115 is filed on parent corporation must sign. behalf of the applicant, enter the filer s name and identification Estates or trusts. Enter the name of the estate or trust on the number on the first line of Form 3115 and enter the applicant s first line of Form In the signature section, enter the name and identification number on the fourth line. If Form 3115 signature of the fiduciary, personal representative, executor, -3-

115 administrator, etc., who has personal knowledge of the facts act(s), must be properly reflected on Form For further and legal authority to bind the estate or trust in the matter, and details for an authorized representative and a power of that person s official title below the signature. attorney, see sections 9.03(8) and (9) of Rev. Proc Exempt organizations. Enter the name of the organization on A Form 2848 must be attached to Form 3115 in order for the the first line of Form In the signature section, enter the Service to discuss a Form 3115 with a taxpayer s signature of a principal officer or other person who has personal representative, even if the taxpayer s representative prepared knowledge of the facts and authority to bind the exempt and/or signed the Form organization in the matter, and that person s name and official title below the signature. Preparer (other than filer/applicant). If the individual preparing the Form 3115 is not the filer or applicant, the preparer also must sign. However, for an automatic change request, the preparer need not sign the original Form 3115 attached to the income tax return. Identification Number Enter the filer s taxpayer identification number on the first line of Form 3115 as follows. Individuals enter their social security number (SSN) (or individual taxpayer identification number (ITIN) for a resident or nonresident alien). If the Form 3115 is for a husband and wife who file a joint return, enter the identification numbers of both. All others, enter the employer identification number (EIN). If the filer is the common parent corporation of a consolidated group of corporations, enter the EIN of the common parent on the first line of Form Enter the EIN of the applicant on the fourth line if a member of the consolidated group other than, or in addition to, the common parent is requesting the change in method of accounting. If the common parent is filing the Form 3115 on behalf of multiple applicants in a consolidated group of corporations, multiple CFCs or 10/50 corporations, or multiple and distinct trades or businesses of a member (including QSubs, or single-member LLCs), attach a schedule listing each applicant and its identification number (if applicable). If the applicant is a foreign entity that is not otherwise required to have or obtain an EIN, enter Not applicable in the space provided for the identifying number. Principal Business Activity Code Option to Receive Correspondence by Fax A filer that wants to receive, or wants its authorized representative to receive, correspondence regarding its Form 3115 (for example, additional information letters or the letter ruling) by fax must attach to the Form 3115 a statement requesting this service. The attachment must also list the authorized name(s) and fax number(s) of the person(s) who are to receive the fax. The listed person(s) must be either authorized to sign Form 3115, or an authorized representative of the filer that is included on Form For further details on the fax procedures, see section 9.04(3) of Rev. Proc Type of Accounting Method Change Requested Check the appropriate box described below indicating the type of change being requested. Depreciation or amortization. Check this box for a change in (a) depreciation or amortization (for example, the depreciation method or recovery period), (b) the treatment of salvage proceeds or costs of removal, (c) the method of accounting for retirements of depreciable property, or (d) the treatment of depreciable property from a single asset account to a multiple asset account (pooling), or vice versa). Financial products and/or financial activities of financial institutions. Check this box for a change in the treatment of a financial product (for example, accounting for debt instruments, derivatives, mark-to-market accounting, etc.), or in the financial activities of a financial institution (for example, a lending institution, a regulated investment company, a real estate investment trust, a real estate mortgage investment conduit, etc.)). If the filer is a business, enter the six-digit principal business Other. For advance consent requests, check this box if activity (PBA) code of the filer. The principal business activity of neither of the above boxes applies to the requested change. In the filer is the activity generating the largest percentage of its the space provided, enter a short description of the change and total receipts. See the instructions for the filer s income tax the most specific applicable Code section(s) for the requested return for the filer s PBA code and definition of total receipts. change (for example, change within section 263A costs; deduction of warranty expenses, section 461; change to the Note. An applicant requesting to change its accounting completed contract method for long-term contracts, section 460; method under designated automatic accounting method change etc.). For automatic change requests, this informational numbers 33 and/or 51 in the List of Automatic Accounting Method Changes must also attach to Form 3115 the detailed NAICS code for the applicant s principal business activity. See Rev. Proc , C.B. 815, for further guidance. Address Include the suite, room, or other unit number after the street address. If the Post Office does not deliver mail to the street address and the filer has a P.O. box, show the box number instead of the street address. Contact Person The contact person must be an individual authorized to sign Form 3115, or the filer s authorized representative. If this person is someone other than an individual authorized to sign Form 3115, you must attach Form 2848, Power of Attorney and Declaration of Representative. Form 2848, Power of Attorney and Declaration of Representative Authorization to represent the filer before the IRS, to receive a copy of the requested letter ruling, or to perform any other -4- requirement is satisfied by properly completing Part I, line 1 of Form 3115.! CAUTION You must follow the instructions below to correctly complete Form Applicants requesting a change in method of accounting using the automatic change request procedures must complete Parts I, II, and IV. Applicants requesting a change in method of accounting using the advance consent request procedures must complete Parts II, III, and IV. All applicants must complete Schedules A, B, C, D, and E, as applicable, for the requested change in method of accounting. If more room is needed to respond to any line, attach a schedule providing the applicable information and label it with the line number. Attachments submitted with Form 3115 must show the filer s name and identification number. Also, indicate that the information is an attachment to Form Report amounts in U.S. dollars, and if applicable, in the functional currency with a statement of exchange rates used.

116 Part I Information For Automatic Change Request Automatic Change Request Scope Limitations published guidance specifically states that one or more scope limitation(s) do not apply to the requested change. If any of the scope limitations apply to the requested change in method of accounting and apply to the applicant, automatic consent is not available to the applicant for the requested accounting method change. However, the applicant may be eligible to request its change under the advance consent request procedures. See Part III Information For Advance Consent Request, later in these instructions to determine if these procedures apply to the applicant. An applicant is not eligible to use the automatic change request procedures of Rev. Proc (either in the Appendix or included by reference in other published guidance) if any of the following six scope limitations (section 4.02 of Rev. Proc ) apply, unless the applicable section of the Appendix of Rev. Proc or other published guidance states that the particular scope limitation does not apply to the applicant s Part II Information For All Requests requested change. The scope limitations (unless waived) apply Line 3. Ordinarily, the IRS will not consent to a request for a at the time the copy of Form 3115 would be filed with the IRS change in method of accounting for the applicant s final tax National Office or Ogden, UT. year. If the applicant ceases to engage in the trade or business 1. The applicant is under examination, except as provided in to which the desired change in accounting method relates or section 4.02(1) of Rev. Proc If the applicant is a CFC terminates its existence in the year of change, the applicant is or 10/50 corporation that is not required to file a federal income ordinarily not eligible to make the change under automatic tax return, the applicant is under examination if any of its change request procedures unless the applicable section of the controlling domestic shareholders is under examination for a Appendix of Rev. Proc or other applicable published taxable year(s) in which it was a U.S. shareholder of the CFC or guidance states that section 4.02(5) of Rev. Proc does 10/50 corporation, except as provided in section 4.02(1) of Rev. not apply to the requested change in method of accounting. If Proc the change is requested under the advance consent 2. The applicant is (or was formerly) a member of a procedures, the IRS National Office will consider the reasons consolidated group that is under examination for a tax year(s) for the change in the applicant s final year (see Part III, line 21) the applicant was a member of the group. For more information, in determining whether to approve the requested change. see section 4.02(2) of Rev. Proc The applicant is an entity treated as a partnership or S Note: For lines 4a, 4b, 4c, 5a, 5c, and 6, the reference to corporation and the accounting method to be changed is an applicant includes the applicant and any present or former issue under consideration in an examination with respect to a consolidated group in which the applicant was a member during partner, member, or shareholder of the applicant. For more the applicable tax year(s). A reference to applicable tax years information, see section 4.02(3) of Rev. Proc includes any tax years for which the applicant s present or 4. The applicant engages in a transaction to which section former consolidated group is under examination, before an 381(a) applies within the proposed tax year of change. For Appeals office, and/or before a federal court if the applicant was more information, including exceptions to this limitation, see a member of the group in those tax years. For each of the section 4.02(4) of Rev. Proc applicable lines (4a, 4b, 4c, 5a, 5c, and/or 6), attach to Form 5. The applicant is in the final tax year of its trade or 3115 a list of the beginning and ending dates of the tax year(s) business as described in sections 4.02(5) and 5.04(3)(c) of that the applicant (including its present and former consolidated Rev. Proc group) is under examination, before an Appeals office, and/or 6. The applicant made or applied to make a change in before a Federal court. If the method of accounting the method of accounting for the same item (or for its overall applicant is requesting to change is an issue either under method) within the last 5 tax years, including the year of consideration, placed in suspense, or pending for any tax year change. For more information, see section 4.02(6) and 4.02(7) under examination, or if the method of accounting the applicant of Rev. Proc is requesting to change is an issue under consideration by an Appeals office or by a Federal court, indicate the applicable tax Line 1. Enter the designated automatic accounting method year(s). change number on line 1(a). These numbers may be found in Line 4a. The applicant is under examination if it has a federal the List of Automatic Accounting Method Changes, or in income tax return under examination (including while the subsequently published guidance. Also see the Appendix of taxpayer has a refund or credit under review by the Joint Rev. Proc In general, enter a number for only one Committee on Taxation, and while the taxpayer participates in change. However, the numbers for two or more changes may the Compliance Assurance Process) on the date the Form 3115 be entered on line 1(a) if specifically permitted in applicable is (or would be) filed. For more information, see sections 3.07 published guidance. See section 6.02(1)(b) of Rev. Proc. and 4.02(2) of Rev. Proc , as modified by Rev. Proc , Rev. Proc , and Rev. Proc ; or Do not enter an Internal Revenue Code section on line sections 3.08 and 4.02(1) of Rev. Proc , as applicable.! 1(a). Enter the applicable change number listed in the Line 4b. The applicant s method of accounting is an issue CAUTION instructions or other applicable published guidance. under consideration if the examining agent has given the applicant (or filer) written notification specifically citing the If the accounting method change is not included in the List of treatment of the item as an issue under consideration (or for a Automatic Accounting Method Changes or assigned a number CFC or 10/50 corporation, if any controlling domestic in the published guidance providing the automatic accounting shareholder receives notification that the treatment of a method change, check the box for line 1(b) and identify the distribution or deemed distribution from the foreign corporation, revenue procedure or other published guidance under which or the amount of its earnings and profits or foreign taxes the automatic accounting method change is being requested. deemed paid is an issue under consideration). For further Line 2. Review the applicable accounting method change details, see section 3.08 of Rev. Proc , as modified by section in the Appendix of Rev. Proc (rather than Rev. Rev. Proc , and Rev. Proc , or section 3.09 of Proc as indicated on line 2 of Form 3115), or the Rev. Proc , as applicable. The applicant s method of procedures in other published guidance, if applicable, to accounting is an issue placed in suspense if the examining determine whether the scope limitations of section 4.02 of Rev. agent has given the applicant (or filer) written notification that Proc , apply to the specific change in accounting the issue is placed in suspense. Answering Line 4b satisfies the method requested. In general, the scope limitations of section requirement in section 6.01(2)(b) or 6.01(3)(b) of Rev. Proc of Rev. Proc apply to the requested change 97-27, as modified by Rev. Proc , if applicable, to unless the Appendix of Rev. Proc or other applicable attach a separate statement. -5-

117 Line 4c. The applicant s method of accounting is an issue , Rev. Proc , and Rev. Proc or pending if the IRS has given the applicant (or filer, or in the sections 6.04 and 6.05 of Rev. Proc , as applicable. case of a CFC or 10/50 corporation, any controlling domestic Line 6. The information requested on line 6 may be provided shareholders of a CFC or 10/50 corporation) written notification in an attachment that includes the information requested on line indicating that an adjustment is being made or will be proposed 4f and/or line 5a, as applicable. with respect to the applicant s method of accounting for the tax year(s) under examination. See section 6.03(6) of Rev. Proc. Line 7. If yes is answered to the question on line 7, attach an Attach a copy of this written notification to Form explanation. The applicant may not be eligible to make the For further details, see section 6.01(5) of Rev. Proc , as change (for example, if the issue is under consideration for a modified by Rev. Proc , and Rev. Proc , or tax year under examination). If eligible to make the change, the section 6.03(6) of Rev. Proc , as applicable. applicant may not receive audit protection with the change (for example, if the issue is under consideration for a tax year Line 4d. A filer may request to change a method of accounting before either an Appeals office or a Federal court). See for an applicant that is under examination if the director sections 4.02(6), 6.01, 6.02, and 6.03 of Rev. Proc , as consents to the filing of Form (See section 1.01(3) of modified by Rev. Proc and Rev. Proc , or Rev. Proc for the definition of director.) The director will sections 6.03, 6.04 and 6.05 of Rev. Proc , as consent to the filing of Form 3115 unless, in the opinion of the applicable. director, the method of accounting to be changed would ordinarily be included as an item of adjustment in the year(s) for Line 8. A taxpayer does not receive audit protection under which the applicant is under examination. Submit a request for certain circumstances described in sections 6.01(5), 6.02, 6.03, the consent of the director to the examining agent. If the or 9.02 of Rev. Proc , as modified by Rev. Proc , director consents to the filing of Form 3115, attach the consent Rev. Proc , Rev. Proc or in sections to the Form 3115 filed with the IRS National Office or the 4.02(7)(b), 6.03(5), 6.03(6), 6.04, 6.05, or 7.02 of Rev. Proc. Ogden, UT office. Also, submit the director copy of Form If filing under the automatic change request to the examining agent no later than the date the Form 3115 is procedures, also review the applicable accounting method filed with the IRS National Office or the Ogden, UT office. When change section in the Appendix of Rev. Proc , or the filing under the automatic change request procedures, attach to procedures in other IRS published guidance, if applicable, to the original Form 3115 (which is attached to the filer s income determine if the applicable section of the Appendix of Rev. tax return) a written statement certifying that (a) the written Proc or other available IRS published guidance states consent was obtained from the director and (b) the applicant will that the applicant does not receive audit protection with the retain a copy of the consent for inspection by the IRS. For requested change. If Yes is answered to the question on line further details, see section 6.01(4) of Rev. Proc , as 8, attach an explanation, including the applicable provision of modified by Rev. Proc , or section 6.03(4) of Rev. Rev. Proc , as modified by Rev. Proc , Rev. Proc , as applicable. Proc and Rev. Proc , or Rev. Proc , Line 4e. The following exceptions apply to the under that prevents audit protection. examination scope limitations: Line 9. For further details, see section 9.03(6)(a) of Rev. Proc. 90-day window period. A Form 3115 may be filed under , and either section 8.05 of Rev. Proc or sections Rev. Proc or Rev. Proc for an applicant under 4.02(6) and 4.02(7) of Rev. Proc , as applicable. examination during the first 90 days of any tax year if the Line 10. For further details, see section 9.03(6)(b) of Rev. applicant has been under examination for at least 12 Proc consecutive months as of the first day of the tax year. The 90-day window period does not apply if the method the Line 12. A special method of accounting for an item is a applicant is requesting to change is an issue under method of accounting, other than the cash method or an consideration or placed in suspense by the examining agent. accrual method, expressly permitted by the Code, regulations, For further details, including special rules for CFCs and 10/50 or guidance published in the IRB that deviates from the rules of corporations, see section 6.01(2) of Rev. Proc , as sections 451 and 461 (and the regulations thereunder) that is modified by Rev. Proc , or section 6.03(2) of Rev. applicable to the taxpayer s overall method of accounting Proc , as applicable. (proposed overall method if being changed). For example, the 120-day window period. A Form 3115 may be filed under installment method of accounting under section 453 is a special Rev. Proc or Rev. Proc for an applicant under method of accounting. See section 14.01(3)(e) of the Appendix examination during the 120-day period following the date an of Rev. Proc for additional examples of special examination ends regardless of whether a subsequent methods. examination has commenced. For the definition of when an If the applicant prepared a Schedule M-3 with its last filed tax examination ends, see section 3.07 of Rev. Proc , as return or expects to file a Schedule M-3 with its next tax return, modified by Rev. Proc and Rev. Proc , or please state whether applicant s proposed change in method of section 3.08 of Rev. Proc , as applicable. The 120-day accounting for federal income tax purposes is related to the window period does not apply if the method the applicant is applicant s adoption of the International Financial Reporting requesting to change is an issue under consideration or placed Standards ( IFRS ) for financial statement purposes. (Note: in suspense by the examining agent. Enter the ending date of There is a box on Schedule M-3, Part I, line 4, to indicate the the examination that qualifies the applicant to file under the accounting standard used for financial reporting.) 120-day window. For further details, including special rules for CFCs and 10/50 corporations, see section 6.01(3) of Rev. Proc. Line 13. For each applicant, including each member of a 97-27, as modified by Rev. Proc , or sections 6.03(3) consolidated group, each separate and distinct trade or and 3.08(1)(c) of Rev. Proc , as applicable. business of each member of a consolidated group or other entity (even if the change is for all of a member s or other Line 5a. If the applicant has any federal income tax return entity s trades or businesses), and each eligible CFC or 10/50 before an Appeals office and/or a Federal court, refer to corporation filing a single Form 3115 requesting the identical sections 6.02 and 6.03 of Rev. Proc , as modified by Rev. accounting method change, attach (i) a schedule describing its Proc , Rev. Proc and Rev. Proc , or trade(s) or business(es) for each separate and distinct trade or sections 6.04 and 6.05 of Rev. Proc , as applicable. business, including any QSub or single-member LLC, and (ii) Line 5c. Except as otherwise provided in IRS published the Principal Business Activity code. For guidance on what is a guidance, an applicant that is requesting to change a method of separate and distinct trade or business, see Regulations accounting that is an issue under consideration by an Appeals section (d). For each trade or business, use the most office and/or a Federal court does not receive audit protection specific Principal Business Activity code listed in the for the requested change. For further details, see sections 6.02 instructions for the applicant s federal tax return (or the filer s and 6.03 of Rev. Proc , as modified by Rev. Proc. federal tax return, if applicable). -6-

118 Line 14. Insurance companies must also state whether the The filer is permitted to file a single Form 3115 for multiple proposed method of accounting will be used for annual applicants. See Who Must File, earlier. The filer must pay a statement accounting purposes. separate user fee for each applicant. For each Form 3115 Line 16. For details on requesting and scheduling a requesting an identical change in method of accounting, the filer conference, see sections 9.04(4) and 10 of Rev. Proc pays the regular user fee in section (A)(3)(b) (or the reduced user fee in section (A)(4), if applicable) of Appendix A of Rev. Part III Information For Advance Proc for the first applicant and the lesser user fee in section (A)(5)(b) of Appendix A of Rev. Proc for each Consent Request additional applicant. Advance Consent Request Scope Limitations Example 1. The filer is the common parent of a consolidated group of corporations. The parent is filing a Form An applicant may not use the advance consent request 3115 on behalf of itself and 3 other members of the procedures if any of the following four scope limitations apply at consolidated group. The parent is engaged in one trade or the time the Form 3115 would be filed with the IRS National business. The 3 other included member corporations are Office. See Rev. Proc , as modified by Rev. Proc. engaged in one trade or business each. All the trades or , Rev. Proc , and Rev. Proc businesses are requesting an identical change in method of 1. The change in accounting method is required to be made accounting. There are 4 applicants for the Form The filer according to a published automatic change procedure, such as must submit the regular user fee in section (A)(3)(b) (or the Rev. Proc For more information, see section 4.02(1) reduced fee in section (A)(4), if applicable) of Appendix A of of Rev. Proc Rev. Proc for the first applicant (that is, the common 2. The applicant is under examination, except as provided in parent) and the lesser user fee in section (A)(5)(b) of Appendix section 4.02(2) of Rev. Proc , as modified by Rev. Proc. A of Rev. Proc for each of the other 3 applicants (that , Rev. Proc , and Rev. Proc is, the 3 other members of the consolidated group). 3. The applicant is (or was formerly) a member of a Example 2. The filer is the common parent of a consolidated group that is under examination, or before an consolidated group of corporations. The parent is filing a Form Appeals office, or before a Federal court for the tax year(s) the 3115 on behalf of itself and 3 other members of the applicant was a member of the group. For more information, consolidated group. The parent is engaged in one trade or see section 4.02(5) of Rev. Proc , as modified by Rev. business. Each of the 3 other included member corporations Proc are engaged in two trades or businesses. All of the trades or 4. In the case of a partnership or S corporation, the businesses are requesting an identical change in method of accounting method the applicant is requesting to change is an accounting. There are 7 applicants for the Form The filer issue under consideration in an examination, or by an Appeals must submit the regular user fee in section (A)(3)(b) (or the office, or before a Federal court with respect to a partner, reduced fee in section (A)(4), if applicable) of Appendix A of member, or shareholder of the applicant. For more information, Rev. Proc for the first applicant (that is, the parent s see section 4.02(6) of Rev. Proc , as modified by Rev. trade or business) and the lesser user fee in section (A)(5)(b) of Proc Appendix A of Rev. Proc for each of the 6 applicants (that is the other 6 trades or businesses of the 3 other Line 18. If the requested change is covered by an automatic consolidated group members). change request procedure, and that procedure applies to the Example 3. The filer is the common parent of a applicant for the requested year of change, the applicant is not consolidated group of corporations. Another member of the eligible to file an advance consent request. If the requested consolidated group is the controlling domestic shareholder of a change is covered by an automatic change request procedure, CFC that does not engage in a trade or business within the attach an explanation describing why the applicant is eligible to United States. The CFC has 4 separate and distinct trades or file a request under advance consent request procedures. businesses, all requesting an identical change in method of Line 19. For further details on what is to be included in the accounting. The filer is the common parent of the consolidated attachment, see sections 9.03(1) (facts and other information), group. There are 4 applicants for the Form The filer must 9.03(4) (analysis of material facts), 7.01(8) and 9.03(1) submit the regular user fee in section (A)(3)(b) (or the reduced (statement of supporting authorities), 9.03(2) (statement of fee in section (A)(4), if applicable) of Appendix A of Rev. Proc. contrary authorities), and 9.03(7) (statement identifying pending for the first applicant (that is, the first trade or business legislation) of Rev. Proc of the CFC) and the lesser user fee in section (A)(5)(b) of Line 20. Attach true copies of all contracts, agreements, and Appendix A of Rev. Proc for each of the 3 other other documents directly related to the proposed change in applicants (that is, the other 3 trades or businesses of the method of accounting. See section 9.03(3) of Rev. Proc. CFC). Note. Because the filer is not changing its accounting method, it does not pay a fee on the account of itself. Line 21. For further details on what is to be included in the For information on user fees for tax-exempt organizations, attachment, see section 7.01(1)(d) and 9.03(1) of Rev. Proc. see Rev. Proc , I.R.B. 235 (or its successor) The user fee (check or money order payable to the Internal Line 23. Taxpayers filing under the advance consent request Revenue Service) must be attached to any Form 3115 filed procedures must pay a user fee for each Form 3115 and for under Rev. Proc that is filed with the IRS National Office. each applicant, if applicable. See section 15 and Appendix A of Rev. Proc Part IV Section 481(a) Adjustment Note: Taxpayers filing under an automatic change request Line 24. Ordinarily, an adjustment under section 481(a) is procedure do not pay a user fee. required for changes in method of accounting. However, for The applicable user fee must accompany each Form 3115 certain changes in method of accounting, the taxpayer must filed with the National Office under Rev. Proc The user make the change on a cut-off basis. In those cases, there is no fee for a Form 3115 is the regular user fee provided in section section 481(a) adjustment. (A)(3)(b) of Appendix A of Rev. Proc , unless one (or If the accounting method change is an automatic accounting both) of the following exceptions apply: method change in functional currency under section 985 (see The filer qualifies for a reduced user fee provided in section section of the Appendix to Rev. Proc ), the (A)(4) of Appendix A of Rev. Proc because the filer has adjustments required under Regulations section must gross income less than the specified amount. For the definition be made on the last day of the taxable year ending before the of gross income, see sections (B)(2), (3), and (4) in Appendix A year of change. Any gain or loss that is not required to be of Rev. Proc recognized under Regulations section is not subject to -7-

119 Schedule A Change in Overall Method of Accounting Part I Change in Overall Method section 481. Attach a schedule showing the adjustment required under Regulations section The schedule should include the amount of the adjustment required pursuant to Regulations section , a summary of the computation of such adjustment, and an explanation of any other adjustments required by Regulations section All applicants filing to change their overall method of accounting must complete Schedule A, Part I, including applicants filing Line 25. In computing the net section 481(a) adjustment, a under designated automatic accounting method change taxpayer must take into account all relevant accounts. For some numbers 32, 33, 34, 122, 123, 126, 127, and 128 in the List of changes (for example, a change that effects multiple accounts), Automatic Accounting Method Changes. the section 481(a) adjustment is a net section 481(a) adjustment. See example 2, below, and the example in Lines 1a through 1g. Enter the amounts requested on lines Schedule A, Part 1, line 1h, later. 1a through 1g, even though the calculation of some amounts may not have been required in determining taxable income due Attach a schedule showing the (net) section 481(a) to the applicant s present method of accounting. adjustment for each change in method of accounting for each applicant included in the Form Include a summary of how Note: Do not include amounts that are not attributable to the the (net) section 481(a) adjustment was computed and an change in method of accounting, such as amounts that correct explanation of the methodology used to determine it. The a math or posting error or errors in calculating tax liability. In summary of computation and explanation must be sufficient to addition, for a bank changing to an overall cash/hybrid method demonstrate that the (net) section 481(a) adjustment is of accounting, do not include any amounts attributable to a computed correctly. If the applicant is a CFC or 10/50 special method of accounting (as described in section corporation, or a trade or business of a CFC or 10/ (2)(b) of the Appendix of Rev. Proc automatic corporation, and if its functional currency is not the U.S. dollar, change number 127). state the (net) section 481(a) adjustment in that functional Line 1b. Enter amounts received or reported as income in a currency. This schedule may be combined with the information prior year that were not earned as of the beginning of the year requested on the fourth line on page 1 (list of applicants and of change. For example, an advance payment received in a their identification numbers) and on line 23 (user fee). prior year for goods that were not delivered by the beginning of Example 1. Under its present method, XYZ Corporation is the year of change may be reported upon delivery if the deducting certain costs that are required to be capitalized into taxpayer qualifies under Regulations section If any inventory under section 263A. XYZ Corporation is proposing to amounts entered on line 1b are for advance payments, change its method of accounting to properly capitalize such complete Schedule B. costs. The computation of the section 481(a) adjustment with Line 1h. Enter the net amount, which is the net section 481(a) respect to the change in method of accounting is demonstrated adjustment, on line 1h. Also, enter the net section 481(a) as follows: adjustment on page 3, Part IV, line 25. Beginning inventory for year of change under The following example illustrates how an applicant calculates proposed method... $120,000 the section 481(a) adjustment when changing to an accrual Beginning inventory for year of change under method, a nonaccrual-experience method, and the recurring present method ,000 item exception. Section 481(a) adjustment (positive)... $ 20,000 Example. ABC Corporation, a calendar year taxpayer using the cash method of accounting, has the following items of Example 2. WXY Corporation, a calendar year taxpayer, is unreported income and expense on December 31, a producer and capitalizes costs that are required to be capitalized into inventory under section 263A. Each February, Accrued income... $250,000 WXY Corporation pays a salary bonus to each employee who Uncollectible amounts based on remains in its employment as of January 31 for the employee s the nonaccrual-experience method... 50,000 services provided in the prior calendar year. Under its present Accrued amounts properly method, WXY Corporation treats these salary bonuses as deductible (economic performance has occurred)... 75,000 incurred in the tax year the employee provides the related Expenses eligible for recurring item services. For 2011, WXY Corporation proposes to change its exception... 5,000 method of accounting to treat salary bonuses as incurred in the tax year in which all events have occurred that establish the fact ABC Corporation changes to an overall accrual method, a of the liability to pay the salary bonuses and the amount of the nonaccrual-experience method, and the recurring item liability can be determined with reasonable accuracy, pursuant exception for calendar year The section 481(a) to section 19.01(2) of the Appendix of Rev. Proc The adjustment is calculated as of January 1, 2011, as follows. computation of WXY Corporation s net section 481(a) adjustment for the change in method of accounting for salary Accrued income... $250,000 bonuses is demonstrated as follows: Less: Salary bonuses treated as incurred under the Uncollectible amount... 50,000 present method, but not incurred under the proposed method... $40,000 Net income accrued but not received... $200,000 Beginning inventory as of Jan. 1, 2011, with Less: capitalized salary bonuses computed under the present method... $100,000 Accrued expenses... 75,000 Beginning inventory as of Jan. 1, 2011, with Expenses deducted as recurring item... 5,000 capitalized salary bonuses, computed under the proposed method... 92,000 Total expenses accrued but not paid... 80,000 Decrease in beginning inventory as of Jan. 1, 2011 (8,000) Section 481(a) adjustment... $120,000 Net section 481(a) adjustment (positive)... $32,000 Line 2. If an applicant is requesting to use the recurring item Line 26. See section 7.03(1) of Rev. Proc , as modified exception (section 461(h)(3)), the section 481(a) adjustment by Rev. Proc , or section 5.04(3)(a) of Rev. Proc. must include the amount of the additional deduction that results , as applicable. from using the recurring item exception. -8-

120 Part II Change to the Cash Method For Schedule D Change in the Treatment of Advance Consent Request Long-Term Contracts Under Section 460, Limits on cash method use. Except as provided below, C corporations and partnerships with a C corporation as a partner Inventories, or Other Section 263A may not use the cash method of accounting. Tax shelters, also, Assets are precluded from using the cash method. For this purpose, a trust subject to tax on unrelated business income under section Part I Change in Reporting Income 511(b) is treated as a C corporation with respect to its unrelated From Long-Term Contracts trade or business activities. The limit on the use of the cash method under section 448 does not apply to: 1. Farming businesses as defined in section 448(d)(1). 2. Qualified personal service corporations as defined in section 448(d)(2). 3. C corporations and partnerships with a C corporation as a partner if the corporation or partnership has gross receipts of $5 million or less. See section 448(b)(3) and (c) to determine if the applicant qualifies for this exception. For farming corporations and partnerships with a C corporation as a partner, see section 447 for limits on the use of the cash method. Use of the cash method is also limited under Regulations sections and (c)(2)(i) if the applicant purchases, produces, or sells merchandise that is an income-producing factor in its business. However, for exceptions to this limitation, see section in the Appendix of Rev. Proc Schedule B Change to the Deferral Method for Advance Payments Line 2a. Under section 460(f), the term long-term contract means any contract for the manufacture, building, installation, or construction of property that is not completed in the tax year in which it is entered into. However, a manufacturing contract will not qualify as long-term unless the contract involves the manufacture of (a) a unique item not normally included in finished goods inventory or (b) any item that normally requires more than 12 calendar months to complete. Generally, long-term contracts that do not meet the exceptions under section 460(e) must be accounted for using the percentage of completion method. See section 460 and the related regulations. Line 2b. To qualify for the contract exceptions under section 460(e), the contract must be: 1. A home construction contract as defined in section 460(e)(6)(A), or 2. Any other construction contract entered into by the applicant if, at the time the contract is entered into, it is expected to be completed within 2 years and the applicant s average annual gross receipts determined under section 460(e)(2) for the 3-year period preceding the tax year the contract was entered into did not exceed $10 million. Line 4b. Under the simplified cost-to-cost method, only certain In general, advance payments must be included in gross costs are used in determining both (a) costs allocated to the income in the tax year of receipt for federal income tax contract and incurred before the close of the tax year and purposes. However, an applicant may be entitled to defer the (b) estimated contract costs. These costs are: (1) direct material inclusion in income of certain advance payments, as defined in costs; (2) direct labor costs; and (3) allowable deductions for section 4.01 of Rev. Proc , C.B. 991, or in depreciation, amortization, and cost recovery allowances on Regulations section (a)(1). equipment and facilities directly used to construct or produce Line 1. Rev. Proc , as modified by Rev. Proc. the subject matter of the long-term contract. See Regulations , I.R.B. 443 allows applicants using an accrual section (c). method, in certain circumstances, to defer the inclusion in Part II Change in Valuing Inventories Including income of advance payments to the next tax year. Applicants requesting to change to the Deferral Method for allocable Cost Allocation Changes payments described in section 5.02(4)(a) of Rev. Proc If the applicant is currently using a LIFO inventory method or (other than allocable payments described in section 5.02(4)(c) submethod and is changing to another LIFO inventory method of Rev. Proc ) or for payments for which a method or submethod, Schedule D, Part II is not applicable. Use under section 5.02(3)(b)(i) or (iii) of Rev. Proc applies, Schedule C, Changes Within the LIFO Inventory Method. must file under the advance consent procedures of Rev. Proc. Line 3. If an applicant is subject to, but not in compliance with, All other applicants generally must file under the section 263A, generally on the same Form 3115 the applicant automatic change procedures of Rev. Proc (rather must first comply with section 263A before changing an than Rev. Proc , as indicated on line 1b of Form 3115). inventory valuation method. The applicant must complete Line 2. Regulations section allows applicants using an Schedule D, Part III, Method of Cost Allocation. For exceptions, accrual method, in certain circumstances, to defer the inclusion see Regulations section 1.263A-7(b)(2). in income of advance payments for goods or items in Line 5a. If the applicant properly elected the LIFO inventory accordance with the applicant s financial reports. method but is unable to furnish a copy of Form(s) 970, Application to Use a LIFO Inventory Method, attach the following statement to Form 3115: Schedule C Changes Within the LIFO Inventory Method I certify that to the best of my knowledge and belief (name of applicant) properly elected the LIFO inventory method by Use this schedule to request a change from one LIFO inventory filing Form 970 with its return for the tax year(s) ended (insert method or submethod to another LIFO inventory method or date(s)) and otherwise complied with the provisions of section submethod. All applicants changing within the LIFO inventory 472(d) and Regulations section method or submethods must complete Part I. Complete Part II Line 5c. Attach the two statements required by section only if applicable (5) in the Appendix of Rev. Proc (rather than Rev. Proc , as indicated on line 5c of Form 3115). Part I General LIFO Information Line 6. Applicants changing to the IPIC method must use this method for all LIFO inventories. This includes applicants requesting designated automatic accounting method change numbers 61 or 62 in the List of Automatic Accounting Method Changes, later. -9- Part III Method of Cost Allocation Applicants requesting to change their method of accounting for any property (produced or acquired for resale) subject to section 263A or any long-term contracts as described in section 460 must complete this schedule.

121 If the change is for noninventory property that is subject to 6. To change a useful life under section 167 (except for a section 263A, attach a detailed description of the types of change to or from a useful life, recovery period, or amortization property involved. period that is specifically assigned by the Code, the regulations, There are several methods available for allocating and or other published guidance). capitalizing costs under section 263A, and for allocating and, where appropriate, capitalizing costs properly allocable to long-term contracts. A change to or from any of these methods List of Automatic Accounting Method is a change in accounting method that requires IRS consent. Using the applicable regulations and notice listed below, the Changes applicant should verify which methods are presently being used Listed below are automatic accounting method changes and the proposed methods that will be used before completing providing for the filing of Form This list includes Schedule D, Part III. These methods are as follows: regulatory automatic changes, changes provided for in the Appendix of Rev. Proc , and automatic changes 1. Allocating Direct and Indirect Costs provided for in other guidance. These automatic changes may Specific identification method Regulations sections be modified or supplemented with additional automatic changes 1.263A-1(f)(2) and by subsequently published guidance. Burden rate method Regulations sections 1.263A-1(f)(3)(i) The list provides a brief description of the automatic changes and in method of accounting made using Form A Standard cost method Regulations sections filer/applicant may not rely on the list or the descriptions of 1.263A-1(f)(3)(ii) and accounting method changes in the list as authority for making Any other reasonable allocation method Regulations an accounting method change. A filer/applicant that is within the sections 1.263A-1(f)(4) and scope of, and complies with, all the applicable provisions of the published guidance that authorizes each listed change may rely 2. Allocating Mixed Service Costs on the applicable published guidance as authority for its Direct reallocation method Regulations section automatic accounting method change. If any information in the 1.263A-1(g)(4)(iii)(A). list conflicts with published guidance, the published guidance Step-allocation method Regulations section applies. Each automatic method change described in the 1.263A-1(g)(4)(iii)(B). Appendix of Rev. Proc , as modified, contains a Simplified service cost method: contact person you may call if you need additional information Using the labor-based allocation ratio Regulations section concerning the change (not a toll-free call) A-1(h)(4). Each item in the list below: Using the production cost allocation ratio Regulations Designates an automatic accounting method change number section 1.263A-1(h)(5). for each change for entry on line 1a of Form Any other reasonable allocation method Regulations Briefly describes the accounting method change and its section 1.263A-1(f)(4). primary Code section(s). Indicates in some cases which schedules of Form 3115 to 3. Capitalizing Additional Section 263A Costs complete. Simplified production method: Provides a reference to the basic published guidance (for Without historic absorption ratio election Regulations example, revenue procedure) that provides for the automatic section 1.263A-2(b)(3). change, which filers should review prior to completing Part I, With historic absorption ratio election Regulations section Information For Automatic Change Request, on page 1 of 1.263A-2(b)(4). Form Simplified resale method: 1. Commodity Credit Corporation loans (section Without historic absorption ratio election Regulations 77) for loans received from the Commodity Credit section 1.263A-3(d)(3). Corporation, from including the loan amount in gross income With historic absorption ratio election Regulations section for the tax year in which the loan is received to treating the loan 1.263A-3(d)(4). amount as a loan. See section 2.01 in the Appendix of Rev. U.S. ratio method Notice , C.B Proc Any other reasonable allocation method Regulations 2. Lawyers handling cases on a contingent fee basis section 1.263A-1(f)(4) (including the methods listed above (section 162) from treating advances of money to their under Allocating Direct and Indirect Costs). clients for litigation costs as deductible business expenses to treating those advances as loans. See section 3.01 in the Schedule E Change in Depreciation or Appendix of Rev. Proc ISO 9000 costs (section 162) to treating the costs as Amortization deductible, except to the extent they result in the creation or All applicants requesting to change their method of depreciation acquisition of an asset having a useful life substantially beyond or amortization must complete Schedule E of Form the tax year. See section 3.02 in the Appendix of Rev. Proc. Applicants changing their method of accounting for depreciation or amortization under the automatic change request procedures 4. Restaurant smallwares costs (section 162) to the should see the depreciation changes in the List of Automatic smallwares method described in Rev. Proc , Accounting Method Changes below. C.B. 374 (that is, as materials and supplies that are not incidental under Regulations section ). See section 3.03 Do not file Form 3115: in the Appendix of Rev. Proc To make an election under sections 167, 168, 179, 1400I, 5. Bad debts (section 166) for an applicant other than a 1400L(b), 1400L(c), or 1400N(d), or former section 168; bank, from accounting for bad debts using a reserve or other 2. To revoke an election made under one of those sections; improper method to a specific charge-off method that complies 3. To make or revoke an election under section 13261(g)(2) with section 166. See section 4.01 in the Appendix of Rev. or (3) of the Revenue Reconciliation Act of 1993 (relating to Proc section 197 intangibles); 6. Bad debt conformity for banks (section 166) for 4. To change the placed-in-service date; banks other than new banks, to the method that conforms to 5. To change the salvage value (except for a change in Regulations section (d)(3) for the first time the bank salvage value to zero when the salvage value is expressly makes this change, or to involuntarily revoke this method. This treated as zero by the Code, the regulations, or other published change does not fall under the procedures of Rev. Proc. guidance); or Instead, see Regulations section (d)(3). -10-

122 7. Depreciation or amortization (impermissible) acquired computer software), or to deductible expenses under (sections 56, 167, 168, 197, 1400I, 1400L, 1400N, and former Regulations section (for leased or licensed computer section 168) from an impermissible method to a permissible software). Complete Schedule E of Form 3115 for changes method for changes allowed under Regulations section relating to acquired computer software or developed computer (e)(2)(ii)(d), and for depreciable property owned at the software if the change is to capital expenditures and beginning of the year of change. Complete Schedule E of Form amortization. See section 9.01 in the Appendix of Rev. Proc An applicant changing its method of accounting for depreciation because of a change described in designated 19. Package design costs (section 263) to the automatic accounting method change number 10 (sale or lease capitalization method, to the design-by-design capitalization transactions) must file Form 3115 according to the designated and 60-month amortization method, or to the pool-of-cost automatic accounting method change number 10. See section capitalization and 48-month amortization method. See section 6.01 in the Appendix of Rev. Proc in the Appendix of Rev. Proc Depreciation (permissible) (sections 56 and 20. Line pack gas or cushion gas costs (section 263) to 167) from a permissible method to another permissible treating the costs as capital expenditures, the costs of method listed in section 6.02 in the Appendix of Rev. Proc. recoverable amounts as not depreciable, and the costs of Complete Schedule E of Form See section 6.02 unrecoverable amounts as depreciable. A taxpayer that in the Appendix of Rev. Proc changes its method for the costs of unrecoverable amounts 9. Obsolete. also must change to a permissible method of depreciation for 10. Sale, lease or financing transactions (sections 61, those costs. Complete Schedule E of Form 3115 for changes 162, 167, 168, and 1012) from treating property as sold, relating to the costs of unrecoverable amounts. See section leased or, financed to another permissible method described in in the Appendix of Rev. Proc section 6.03 in the Appendix of Rev. Proc See 21. Removal costs (section 263) for certain costs section 6.03 in the Appendix of Rev. Proc incurred in the retirement and removal of depreciable assets, to 11. Modern golf course greens (sections 167, 168, and a method that conforms with Rev. Rul , C.B. former section 168) either to capitalization of land 712. See section in the Appendix of Rev. Proc preparation costs undertaken in the construction of modern golf 22. Certain uniform capitalization methods used by course greens that are closely associated with depreciable resellers and reseller-producers (section 263A) for assets or to the addition to basis of land for earth moving costs qualifying applicants, to a qualifying method or methods. inextricably associated with the land. Complete Schedule E of Complete Schedule D, Parts II and III, of Form See Form See Rev. Rul , C.B. 587, and section in the Appendix of Rev. Proc section 6.04 in the Appendix of Rev. Proc Certain uniform capitalization methods used by 12. Original and replacement tire costs (section 168) for producers and reseller-producers (section 263A) for qualifying vehicles, to the original tire capitalization method qualifying applicants, to a qualifying method or methods. provided in Rev. Proc , C.B Complete Complete Schedule D, Parts II and III, of Form See Schedule E of Form See section 6.05 in the Appendix of section in the Appendix of Rev. Proc Rev. Proc Research and experimental expenditures under 13. Depreciation of gas pump canopies (sections 167, uniform capitalization methods (section 263A) from 168, and former section 168) for depreciation of certain capitalizing research and experimental expenditures to stand-alone gasoline pump canopies and their supporting inventory to no longer capitalizing these costs to inventory. concrete footings, to classifying the gasoline pump canopies in Complete Schedule D, Part II, of Form 3115, as applicable. See asset class 57.1 of Rev. Proc , C.B. 674, and to section in the Appendix of Rev. Proc classifying the supporting concrete footings in asset class Impact fees (section 263A) for impact fees incurred in of Rev. Proc Complete Schedule E of Form See connection with the new construction or expansion of a section 6.06 in the Appendix of Rev. Proc residential building, to treating the costs as capital expenditures 14. Depreciation of utility assets (sections 167, 168, and allocable to the building. Complete Schedule E of Form 3115 if former section 168) for depreciation of assets owned by a the building is depreciable. See section in the Appendix utility used in general business operations, to classifying assets of Rev. Proc under Rev. Proc , C.B. 674, to conform with Rev. 26. Related party transactions (section 267) for losses, Rul , C.B Complete Schedule E of Form expenses, and qualified stated interest incurred in transactions See section 6.07 in the Appendix of Rev. Proc between related parties, to disallowing or deferring certain 15. Depreciation of cable TV fiber optics (sections 167 deductions attributable to such transactions in accordance with and 168) for depreciation of fiber optic node and trunk line of section 267. See section in the Appendix of Rev. Proc. a cable television distribution system, to the safe harbor method in Rev. Proc , C.B. 304, for classifying 27. Deferred compensation determination (section the unit of property either as providing one-way communication 404) for determining whether an item of compensation is services or two-way communication services. Complete deferred compensation or when the item is paid, from making Schedule E of Form See section 6.08 in the Appendix of the determination by reference to when the item is secured to Rev. Proc making the determination by reference to when the item is 16. Amortizable bond premium (section 171) from actually received. See section in the Appendix of Rev. amortizing bond premium to not amortizing the premium Proc (revoking the section 171(c) election). See section 5.01 in the 28. Bonus or vacation pay deferred compensation Appendix of Rev. Proc (section 404) for bonuses that are deferred compensation, 17. Research and experimental expenditures (section from treating as deductible or capitalizable when accrued, to 174) from the capitalization method to another permissible treating as deductible or capitalizable in the year in which method, from the expense method to another permissible includible in the employee s income, and for vacation pay that is method, from the deferred expense method to another deferred compensation, from treating as deductible or permissible method, or from the current period of amortization capitalizable when accrued to treating as deductible or to a different period of amortization under the deferred expense capitalizable in the year in which paid to the employee. See method. See section 7.01 in the Appendix of Rev. Proc. section in the Appendix of Rev. Proc Grace period contributions (section 404) for 18. Computer software expenditures (sections 162 and contributions made to a section 401(k) qualified cash or 167) for costs of developed, acquired, leased or licensed deferred arrangement or matching contributions under section computer software, to deductible expenses or capital 401(m), from treating contributions made after the end of the expenditures and amortization (for developed software), to tax year but before the due date of the tax return as being on capital expenditures and depreciation or amortization (for account of the tax year without regard to when the underlying -11-

123 compensation is earned to treating such contributions as not C.B. 993) made by vehicle lessees, to the method that being on account of the tax year if they are attributable to excludes these payments from the applicant s gross income compensation earned after the end of that tax year. See section and from the applicant s bases in the purchased vehicles. See in the Appendix of Rev. Proc section in the Appendix of Rev. Proc Obsolete. 40. Exclusion for certain returned magazines, 31. Multi-year insurance policies for multi-year service paperbacks, or records (section 458) for an accrual warranty contracts (section 446) for a manufacturer, method applicant electing to exclude from gross income some wholesaler, or retailer of motor vehicles or other durable or all of the income attributable to qualified sales during the tax consumer goods accounting for multi-year insurance policies for year of magazines, paperbacks, or records that are returned multi-year service warranty contracts, to capitalizing and before the close of the applicable merchandise return period for amortizing the costs. See section in the Appendix of Rev. that tax year. The applicant s Form 3115 need contain only the Proc information listed in Regulations section (d). This 32. Overall cash method ($1 million) (section 446) for election does not fall under the procedures of Rev. Proc. qualifying applicants changing to the overall cash method Instead, see Regulations section Complete Schedule A, Part I, of Form Also, complete 41. Percentage-of-completion (section 460) for an Schedule D, Parts II and III, as applicable. See section in applicant not required by section 460 to use the the Appendix of Rev. Proc percentage-of-completion method to account for its long-term 33. Overall cash method ($10 million) (section 446) for contracts, from an exempt-contract method properly applied to qualifying applicants changing to the overall cash method. the percentage-of-completion method. Complete Schedule D, Complete Schedule A, Part I, of Form Also, complete Parts I and III, of Form See section in the Appendix Schedule D, Parts II and III, as applicable. See section in of Rev. Proc the Appendix of Rev. Proc Timing of incurring employee medical benefits 34. Overall accrual method (section 448) for an applicant liabilities (section 461) for an applicant with an obligation to required by section 448 to change from the cash method for its pay an employee s medical expenses (including medical first section 448 year to an overall accrual method that does not expenses for retirees and employees who filed claims under a meet the scope requirements of Rev. Proc Complete workers compensation act) that is neither insured nor paid from Schedule A, Part I, of Form Also, complete Schedule D, a welfare benefit fund, to treatment as a liability incurred in the Parts II and III, as applicable. This change does not fall under tax year in which the applicant s employee files the claim with the procedures of Rev. Proc Instead, see Regulations the applicant; or, if the applicant has a liability to pay a third section (See automatic method change 123 for party for medical services to its employees, to treatment as a taxpayers within the scope of Rev. Proc ). liability as incurred in the tax year in which the services are 35. Nonaccrual-experience method (section 448) for an provided. See section 19.01(1) in the Appendix of Rev. Proc. applicant changing: to a safe harbor method provided in section (f)(1) (the revenue-based moving average method), 43. Timing of incurring real property taxes, personal (f)(2) (the actual experience method), (f)(3) (the modified Black property taxes, state income taxes, and state franchise Motor method), (f)(4) (the modified moving average method), of taxes (section 461) for a qualifying applicant, to treating (f)(5) (the alternative nonaccrual-experience method); to a these taxes as incurred in the tax year in which the taxes are periodic system; from a NAE method to a specific charge-off paid, or to account for these taxes under the recurring item method; from a sub-method of its current NAE method exception to the economic performance rules, or to revoke the provided in section regarding applicable periods to ratable accrual election under section 461(c). See section another sub-method regarding applicable periods that is in the Appendix of Rev. Proc permitted under section , other than a change to 44. Timing of incurring workers compensation act, tort, exclude tax years from an applicable period under section breach of contract, or violation of law liabilities (section (d)(6); from a sub-method of its current NAE method 461) for a qualifying applicant accounting for self-insured provided in section regarding tracing of recoveries to liabilities arising under any workers compensation act or out of another sub-method regarding tracing of recoveries permitted any tort, breach of contract, or violation of law, to treating the under section (f)(2)(iii); or, to the NAE book safe harbor liability as incurred in the tax year in which (a) all the events method described in section 5.01 of Rev. Proc , have occurred establishing the fact of the liability, (b) the I.R.B Note: an applicant using the NAE book safe amount of the liability can be determined with reasonable harbor method that wants to make certain changes within the accuracy, and (c) payment is made to the person to which the NAE book safe harbor method (as described in sections 5.02 liability is owed. See section in the Appendix of Rev. and 5.03 of Rev. Proc ) must attach a statement to its Proc Federal income tax return in lieu of filing a Form See 45. Timing of incurring certain payroll tax liabilities Rev. Proc , section in the Appendix of Rev. (section 461) for FICA and FUTA taxes, state unemployment Proc , and Rev. Proc , C.B taxes, and railroad retirement taxes, to the method under which 36. Interest accrual on non-performing loans (section the applicant may deduct in Year 1 its otherwise deductible 451) for an accrual method bank accounting for qualified FICA and FUTA taxes, state unemployment taxes, and railroad stated interest on non-performing loans, to the method whereby retirement taxes imposed with respect to year-end wages interest is accrued until either the loan is worthless under properly accrued in Year 1, but paid in Year 2, if the section 166 and is charged off as a bad debt or the interest is requirements of the recurring item exception are met; or, for determined to be uncollectible. See section in the state unemployment taxes and railroad retirement taxes, to the Appendix of Rev. Proc method stated above where the applicant already uses that 37. Advance rentals (section 451) for advance rentals method of accounting for FICA and FUTA taxes; or for FICA other than advance rentals subject to section 467, to inclusion and FUTA taxes to the safe harbor method provided in Rev. in gross income in the tax year received. See section in Proc , C.B See section in the the Appendix of Rev. Proc Appendix of Rev. Proc State or local income or franchise tax refunds 46. Cooperative advertising (section 461) to incurring a (section 451) for an accrual method applicant with state or liability in the tax year in which these services are performed, local income or franchise tax refunds, to accrue these items in provided the manufacturer is able to reasonably estimate this the tax year the applicant receives payments or notice of liability even though the retailer does not submit the required approval of its refund claim (whichever is earlier), according to claim form until the following year. See section in the Rev. Rul , C.B See section in the Appendix of Rev. Proc Appendix of Rev. Proc Distributor commissions (section 263) from 39. Capital cost reduction (CCR) payments (section deducting distributor commissions to capitalizing and 451) for CCR payments (as defined in Rev. Proc , amortizing distributor commissions using the distribution fee -12-

124 period method, the 5-year method, or the useful life method. applicable. See section in the Appendix of Rev. Proc. Complete Schedule E of Form See section in the Appendix of Rev. Proc Change from LIFO inventory method (section 48. Cash discounts (section 471) for cash discounts 472) for an applicant changing from the LIFO inventory granted for timely payment, when such discounts approximate a method for its entire LIFO inventory, or for one or more fair interest rate, from a method of consistently including the dollar-value pools within its LIFO inventory, to the permitted price of the goods before discount in the cost of the goods and method as described in section 22.01(1)(b) in the Appendix of including in gross income any discounts taken to a method of Rev. Proc Complete Schedule D, Parts II and III, of reducing the cost of the goods by the cash discounts and Form 3115, as applicable. See section in the Appendix of deducting as an expense any discounts not taken, or vice Rev. Proc versa. Complete Schedule D, Parts II and III, of Form 3115, as 57. Determining current-year cost under the LIFO applicable. See section in the Appendix of Rev. Proc. inventory method (section 472) for an applicant changing its method of determining current-year cost: to: (a) the actual 49. Estimating inventory shrinkage (section 471) from cost of the goods most recently purchased or produced the present method of estimating inventory shrinkage in (most-recent acquisitions method); (b) the actual cost of the computing ending inventory to the retail safe harbor method in goods purchased or produced during the tax year in the order of section 4 of Rev. Proc , C.B. 857, or to a method acquisition (earliest-acquisitions method); (c) the average unit other than the retail safe harbor method, provided cost equal to the aggregate actual cost of all the goods (a) the applicant s present method of accounting does not purchased or produced throughout the tax year divided by the estimate inventory shrinkage and (b) the applicant s new total number of units so purchased or produced; (d) the specific method of accounting (that estimates inventory shrinkage) identification method; or (e) a rolling-average method if the clearly reflects income under section 446(b). Complete applicant uses that rolling-average method in accordance with Schedule D, Parts II and III, of Form 3115, as applicable. See Rev. Proc , I.R.B. 186, as modified by Rev. section in the Appendix of Rev. Proc Proc , C.B Complete Schedule C, Part I, 50. Small taxpayer ($1 million) inventory exception of Form See section in the Appendix of Rev. Proc. (section 471) for a qualifying applicant with average annual gross receipts of $1,000,000 or less (see Rev. Proc , 58. Alternative LIFO inventory method (section 472) for C.B. 272), from the present method of accounting for a qualifying applicant that sells new automobiles or new inventoriable items (including, if applicable, the method of light-duty trucks, to the Alternative LIFO Method described in capitalizing costs under section 263A) to treating inventoriable Rev. Proc , C.B. 450, as modified by Rev. Proc. items in the same manner as materials and supplies that are , C.B Complete Schedule C of Form 3115, not incidental under Regulations section Complete as applicable. See section in the Appendix of Rev. Proc. Schedule A, Part I, and Schedule D, Parts II and III, of Form , as applicable. See section in the Appendix of Rev. 59. Used vehicle alternative LIFO method (section Proc ) for a qualifying applicant that sells used automobiles and 51. Small taxpayer ($10 million) inventory exception used light-duty trucks, to the Used Vehicle Alternative LIFO (section 471) for a qualifying applicant with average annual Method, as described in Rev. Proc , C.B. 784, gross receipts of $10,000,000 or less (see Rev. Proc , as modified by Announcement , C.B. 668 and C.B. 815), from the present method of accounting for Rev. Proc , C.B Complete Schedule C, inventoriable items (including, if applicable, the method of Part I, of Form See section in the Appendix of Rev. capitalizing costs under section 263A) to treating inventoriable Proc items in the same manner as materials and supplies that are 60. Determining the cost of used vehicles purchased or not incidental under Regulations section Complete taken as a trade-in (section 472) for a qualifying applicant, Schedule D, Parts II and III, of Form 3115, as applicable. See to a method of (a) determining the cost of used vehicles section in the Appendix of Rev. Proc acquired by trade-in using the average wholesale price listed by 52. Obsolete. a consistently used official used car guide on the date of the 53. Qualifying volume-related trade discounts (section trade-in; (b) using a different official used vehicle guide for 471) to treating qualifying volume-related trade discounts as determining the cost of used vehicles acquired by trade-in; (c) a reduction in the cost of merchandise purchased at the time determining the cost of used vehicles purchased for cash using the discount is recognized in accordance with Regulations the actual purchase price of the vehicle; or (d) reconstructing section (b). Complete Schedule D, Parts II and III, of the beginning-of-the-year cost of used vehicles purchased for Form 3115, as applicable. See section in the Appendix of cash using values computed by national auto auction Rev. Proc companies based on vehicles purchased for cash, where the 54. Impermissible methods of inventory identification national auto auction company selected is consistently used. and valuation (section 471) from an impermissible method Complete Schedule C, Part I, of Form See section described in Regulations sections (f)(1) through (5), in the Appendix of Rev. Proc including a LIFO taxpayer restoring a write down of inventory 61. Change to IPIC inventory method (section 472) for a below cost or discontinuing maintaining an inventory reserve; qualifying applicant, from a non-inventory price index from a gross profit method; or from a method of determining computation (IPIC) LIFO inventory method to the IPIC method market that is not in accordance with section ; or in accordance with all relevant provisions of Regulations section changing from a method that is not in accordance with section (e)(3); or, from the IPIC method as described in T.D (c) for determining the value of subnormal goods; to a 7814, C.B. 84 (the old IPIC method) to the IPIC method permitted inventory method (identification or valuation, or both). as described in T.D. 8976, C.B. 421 (the new IPIC Complete Schedule D, Parts II and III, of Form 3115, as method), which includes the following required changes (if applicable. See section in the Appendix of Rev. Proc. applicable): from using 80% of the inventory price index (IPI) to using 100% of the IPI to determine the base-year cost and 55. Core Alternative Valuation Method for dollar-value of a LIFO pool(s); from using a weighted arithmetic remanufactured and rebuilt motor vehicle parts (section mean to using a weighted harmonic mean to compute an IPI for 471) for remanufacturers and rebuilders of motor vehicle a dollar-value pool(s); and from using a components-of-cost parts and resellers of remanufactured and rebuilt motor vehicle method to define inventory items to using a total-product-cost parts that use the lower of cost or market method to value their method to define inventory items. Complete Schedule C of inventory of cores, to the safe harbor method of accounting (the Form 3115, as applicable. See section in the Appendix of Core Alternative Valuation method) to value inventories of cores Rev. Proc as provided for in Rev. Proc , C.B Changes within IPIC inventory method (section Complete Schedule D, Parts II and III, of Form 3115, as 472) for one or more of the following changes within IPIC: -13-

125 (a) from the double-extension IPIC method to the link-chain 73. Market discount bonds (section 1278) from IPIC method, or vice versa; (b) to or from the 10 percent including market discount currently in income for the tax year to method; (c) to a pooling method described in Regulations which the discount is attributable to including market discount in section (b)(4) or Regulations section (c)(2), income for the tax year of disposition or partial principal including a change to begin or discontinue applying one or both payment (revoking the section 1278(b) election). See section of the 5 percent pooling rules; (d) combine or separate pools as in the Appendix of Rev. Proc a result of the application of a 5 percent pooling rule described 74. Interest income on short-term obligations (section in Regulations section (b)(4) or Regulations section 1281) to currently including accrued interest and discount in (c)(2); (e) change the selection of BLS tables from income (to comply with section 1281). See section in the Table 3 (Consumer Price Index for All Urban Consumers Appendix of Rev. Proc (CPI-U): U.S. city average, detailed expenditure categories) of 75. Stated interest on short-term loans (section the monthly CPI Detailed Report to Table 6 (Producer price 1281) for a bank using the cash receipts and disbursements indexes and percent changes for commodity groupings and method of accounting, from accruing stated interest on individual items, not seasonally adjusted) of the monthly PPI short-term loans made in the ordinary course of business to Detailed Report, or vice versa; (f) change the assignment of using the cash method to report such interest. See section one or more inventory items to BLS categories under either in the Appendix of Rev. Proc Table 3 of the monthly CPI Detailed Report or Table 6 of the 76. Sales of mortgage loans (section 1286) for monthly PPI Detailed Report; (g) change the representative accounting for certain sales of mortgage loans in which the month when necessitated because of a change in tax year or a seller also enters into a contract to service the mortgages in change in method of determining current-year cost made consideration for amounts received from interest payments, pursuant to section in the Appendix of Rev. Proc. from a method that is inconsistent with Rev. Rul , ; or (h) change from using preliminary BLS price C.B. 358, to a method that is consistent with Rev. Rul indexes to using final BLS price indexes to compute an However, the change is only an automatic accounting method inventory price index, or vice versa. Complete Schedule C of change for certain taxpayers who are under examination. This Form 3115, as applicable. See section in the Appendix of change does not fall under the procedures of Rev. Proc. Rev. Proc Instead, see Rev. Proc , C.B Replacement cost method for automobile dealers 77. Environmental remediation costs (section 263A) for parts inventory (sections 471 and 472) to the replacement costs incurred to clean up land that a taxpayer contaminated cost method for automobile dealers parts inventory described with hazardous waste from the taxpayer s manufacturing in Rev. Proc , C.B Complete Schedule D, operations, to capitalizing such costs in inventory costs under Parts II and III, of Form 3115, as applicable. See section section 263A. See section in the Appendix of Rev. Proc. in the Appendix of Rev. Proc Mark-to-market (section 475) for accounting for 78. Costs of intangibles and certain transactions (section securities or commodities by commodities dealers, securities 263(a)) for amounts paid or incurred to acquire or create traders, and commodities traders, to the mark-to-market intangibles, or to facilitate an acquisition of a trade or business, method under section 475(e) or (f). An election statement must a change in the capital structure of a business entity, and be filed earlier than the due date of Form See Rev. Proc. certain other transactions, to a method of accounting provided 99-17, C.B. 503, for rules relating to this statement. See in Regulations sections 1.263(a)-4, 1.263(a)-5, and section in the Appendix of Rev. Proc (a)-3(b). Complete Schedule E of Form 3115 for changes 65. Dealer status changes (section 475) for an applicant to a method of accounting provided in Regulations section electing out of certain exemptions from securities dealer status, 1.167(a)-3(b). See Rev. Proc , C.B. 310, as to the mark-to-market method. This change does not fall under modified by Rev. Proc , C.B. 499, and section the procedures of Rev. Proc Instead, see Rev. Proc in the Appendix of Rev. Proc , C.B Bank reserves for bad debts (section 585) for a bank 79. REMIC inducement fees (sections 860A-860G) for (as defined in section 581, including a bank for which a qualified an inducement fee received in connection with becoming the subchapter S subsidiary (QSub) election is filed) to change holder of a noneconomic residual interest in a REMIC, to a safe from the section 585 reserve method to the section 166 harbor method provided under Regulations section specific charge-off method. See section in the Appendix (e)(1) or (e)(2). See Rev. Proc , C.B. to Rev. Proc , and section in the Appendix of Rev. Proc Insurance company premium acquisition expenses 80. All events test method for credit card annual fees (section 832) for certain insurance companies, to a safe (section 451) to a method that satisfies the all events test in harbor method of accounting for premium acquisition expenses accordance with Rev. Rul , C.B See set forth in Rev. Proc , C.B See section section in the Appendix of Rev. Proc in the Appendix of Rev. Proc Ratable inclusion method for credit card annual fees 68. Discounted unpaid losses (section 846) for (section 446) to the ratable inclusion method for credit card insurance companies other than life insurance companies annual fees. See section in the Appendix of Rev. Proc. computing discounted unpaid losses, to the composite method or to alternative methods set forth in Notice , Credit card late fees (section 451) to a method that C.B. 439, and Rev. Proc , C.B See treats credit card late fees as interest income that creates or section in the Appendix of Rev. Proc increases OID on the pool of credit card loans to which the fees 69. Obsolete. relate. See section in the Appendix of Rev. Proc. 70. Functional currency (section 985) to the use of another functional currency for the applicant or its qualified 83. Full inclusion method for certain advance payments business unit (QBU), other than a QBU described in Regulation (section 451) to the full inclusion method as described in section (b)(1)(iii). See section in the Appendix of section 5.01 of Rev. Proc , C.B The Rev. Proc applicant must be using, or changing to, an overall accrual 71. Rule of 78s (section 1272) for stated interest on method of accounting. See section in the Appendix of certain short-term consumer loans, from the Rule of 78s Rev. Proc method to the constant yield method. See section in the 84. Deferral method for certain advance payments Appendix of Rev. Proc (section 451) to the deferral method as described in section 72. Original issue discount (sections 1272 and 1273) to 5.02 of Rev. Proc , C.B. 991 (except as the principal-reduction method for de minimis original issue provided in section 8.03 and 8.04(2) of Rev. Proc ). discount (OID). See section in the Appendix of Rev. Proc. The applicant must be using, or changing to, an overall accrual method of accounting. See section in the Appendix of -14-

126 Rev. Proc , Rev. Proc , as modified and commercial revitalization expenditure allocation. Complete clarified by Rev. Proc , I.R.B Schedule E of Form See section 6.12 in the Appendix of 85. Film producer s treatment of certain creative property Rev. Proc costs (section 446) to account for creative property costs 98. Insurance contracts acquired in an assumption under the safe harbor method provided in Rev. Proc , reinsurance transaction (section 197) for an applicant s C.B See section in the Appendix of Rev. first tax year ending after April 10, 2006, for certain insurance Proc contracts acquired in an assumption reinsurance transaction, to 86. Timber fertilization costs (section 162) for costs comply with Regulations section (g)(5). See Regulations incurred by a timber grower for the post-establishment section (g)(5) and section 6.13 in the Appendix or Rev. fertilization of an established timber stand, to treat such costs Proc as ordinary and necessary business expenses deductible under 99. Obsolete. section 162. See section 3.04 in the Appendix of Rev. Proc Obsolete Obsolete. 87. Change in general asset account treatment due to a 102. Obsolete. change in the use of MACRS property (section 168) to the 103. Obsolete. method of accounting provided in Regulations sections 104. Obsolete (i)-1(c)(2)(ii)(E) and 1.168(i)-1(h)(2) (as in effect before 105. Obsolete. January 1, 2012). Complete Schedule E of Form See 106. Timing of incurring certain liabilities for services or Regulations section 1.168(i)-1(l)(2)(ii) (as in effect before insurance (section 461) for an applicant that is currently January 1, 2012) and section 6.09 in the Appendix of Rev. treating the mere execution of a contract for services or Proc insurance as establishing the fact of the liability under section 88. Change in method of accounting for depreciation due 461 and wants to change from that method for liabilities for to a change in the use of MACRS property (section services or insurance to comply with Rev. Rul , ) to the method of accounting provided in Regulations C.B See section in the Appendix of Rev. Proc. section 1.168(i)-4 or to revoke the election provided in Regulations section 1.168(i)-4(d)(3)(ii) to disregard a change in 107. Impermissible to permissible method of accounting use of MACRS property. Complete Schedule E of Form for depreciation or amortization for disposed depreciable See Regulations section 1.168(i)-4(g)(2) and section 6.10 in the or amortizable property (sections 167, 168, 197, 1400I, Appendix of Rev. Proc L(b), 1400L(c), or 1400N(d) or former 168) for an item 89. Depreciation of qualified non-personal use vans and of certain depreciable or amortizable property that has been light trucks (section 280F) for certain vehicles placed in disposed of by the applicant and for which the applicant did not service before July 7, 2003, to a method of accounting in take into account any depreciation allowance or did take into accordance with Regulations section 1.280F-6(f)(2)(iv). account some depreciation but less than the depreciation Complete Schedule E of Form See Regulations section allowable, from using an impermissible method of accounting 1.280F-6(f)(2)(iv) and section 6.11 in the Appendix of Rev. for depreciation to using a permissible method of accounting for Proc depreciation. Complete Schedule E of Form See section 90. Insurance companies incentive payments to health 6.17 in the Appendix of Rev. Proc care providers (section 446) for deducting provider 108. Change by bank for uncollected interest (section incentive payments, to the method of including those payments 446) for a bank (as defined in Regulation section in discounted unpaid losses without regard to section 404. See (d)(4)(i)) that uses an accrual method of accounting; is section in the Appendix of Rev. Proc subject to supervision by Federal authorities, or by state 91. Up-front network upgrade payments received by authorities maintaining substantially equivalent standards; and utilities (section 61) to a safe harbor method provided in has six or more years of collection experience to change to the Rev. Proc , C.B. 76. See section 1.01 in the safe harbor method of accounting for uncollected interest (other Appendix of Rev. Proc than interest described in Regulation section (a)(2)) set 92. Allocation of environmental remediation costs to forth in section 4 of Rev. Proc , C.B See production (section 263A) to a method that allocates under section in the Appendix of Rev. Proc section 263A environmental remediation costs to the inventory 109. Rotable spare parts (section 263(a)) for an applicant produced during the tax year such costs are incurred. See Rev. that maintains a pool or pools of rotable spare parts that are Rul , C.B. 67, and section in the primarily used to repair customer-owned (or customer-leased) Appendix of Rev. Proc equipment under warranty or maintenance agreements to the 93. Obsolete. safe harbor method provided in Rev. Proc , Credit card cash advance fees (section 451) to a C.B Complete Schedule E of Form See section method that treats credit card cash advance fees as creating or in the Appendix of Rev. Proc increasing original issue discount (OID) on a pool of credit card 110. Rotable spare parts (section 471) from the safe loans that includes the cash advances that give rise to the fees. harbor method (or a similar method) of treating rotable spare See section in the Appendix of Rev. Proc parts as depreciable assets, in accordance with Rev. Proc. 95. Obsolete , C.B. 110, to treating rotable spare parts as 96. Replacement cost method for heavy equipment inventoriable items. See section in the Appendix to Rev. dealers parts inventory (sections 471 and 472) to the Proc replacement cost method for heavy equipment dealers parts 111. Advance trade discount method (section 471) for an inventory described in Rev. Proc , C.B accrual method applicant required to use an inventory method Complete Schedule D, Parts II and III, of Form 3115, as of accounting and maintaining inventories, as provided in applicable. See section in the Appendix of Rev. Proc. section 471, that receives advance trade discounts to the Advance Trade Discount Method described in Rev. Proc. 97. Depreciation of qualified revitalization building in the , C.B See section in the Appendix expanded area of a renewal community (section 1400I) for to Rev. Proc a qualified revitalization building that is placed in service by the 112. Changes to the Vehicle-Pool Method (section applicant after December 31, 2001, in the area of a renewal 472) for a retail dealer or wholesaler distributor (reseller) of community that was expanded by the U.S. Department of cars and light-duty trucks to the Vehicle-Pool Method as Housing and Urban Development and for which the applicant described in Rev. Proc , C.B See section receives a retroactive commercial revitalization expenditure in the Appendix to Rev. Proc allocation. This change applies only if the applicant filed the 113. Payroll tax liabilities (section 461) for an accrual federal tax return for the placed-in-service year of that building method applicant that wants to change its method for FICA and on or before the date the applicant received the retroactive FUTA taxes to the safe harbor method provided in Rev. Proc. -15-

127 , C.B. 686, which provides that, solely for the 121. Repairable and reusable spare parts (section purposes of the recurring item exception, an applicant will be 263(a)) to treat certain repairable and reusable spare parts treated as satisfying the requirement in Regulation section as depreciable property in accordance with the holding in Rev (b)(1)(i) for its payroll tax liability in the same tax year in Rul , C.B. 60, or Rev. Rul , C.B. which all events have occurred that establish the fact of the 60. Complete Schedule E of Form See section in related compensation liability and the amount of the related the Appendix of Rev. Proc , as modified by section compensation liability can be determined with reasonable 4.02(15) of Rev. Proc This change is only available accuracy. See section in the Appendix to Rev. Proc. for spare parts that have been placed in service by the taxpayer in taxable years beginning before January 1, Rolling-average method of accounting for inventories 122. Overall accrual method other than for the first (sections 471 and 472) for an applicant required to account section 448 year (section 446) for a qualifying applicant for for inventories under section 471 and that uses a other than its first section 448 year, from the overall cash rolling-average method to value inventories for financial receipts and disbursements method to an overall accrual accounting purposes to the same rolling-average method to method, or to an overall accrual method in conjunction with the value inventories for federal income tax purposes, in recurring item exception under 461(h)(3). Complete Schedule accordance with Rev. Proc , I.R.B.186. See A, Part I, of Form Also complete Schedule D, Parts II and section in the Appendix to Rev. Proc III, as applicable. See section in the Appendix of Rev Kansas additional first year depreciation for Proc qualified Recovery Assistance property placed in service by the 123. Change in overall method from the cash method to applicant on or after May 5, 2007, during the tax year that an accrual method for the first section 448 year (section includes May 5, 2007, to claim the Kansas additional first year 446) for an applicant that is required by section 448 to depreciation deduction for a class of property for which the change from the overall cash method to an overall accrual taxpayer did not claim the Kansas additional first year method and the applicant qualifies to make the change under depreciation deduction on the taxpayer s timely filed federal tax the automatic consent procedures of Regulation sections return for the tax year that includes May 5, 2007, provided the (g) and (h)(2) as well as Rev. Proc for a year taxpayer did not make an election not to deduct the Kansas of change that is the applicant s first section 448 year. See additional first year depreciation for the class of property. Regulation sections (g) and (h)(2), and section in Complete Schedule E of Form See section 6.22 in the the Appendix to Rev. Proc Appendix to Rev. Proc Change from the cash method to an accrual method 116. Depreciation of MACRS property acquired in a for specific items (section 446) for a qualifying applicant like-kind exchange or as a result of an involuntary using an overall accrual method and accounting for one or more conversion (section 168) to apply the provisions of identified specific items of income and expense on the cash Regulations section 1.168(i)-6 or rely on prior guidance by the method to an accrual method of accounting for the identified Service for determining the depreciation deductions of specific item or items. See section in the Appendix to replacement MACRS property and relinquished MACRS Rev. Proc property, for a like-kind exchange or an involuntary conversion 125. Multi-year service warranty contracts (section of MACRS property for which the time of disposition, the time of 446) for an eligible accrual method manufacturer, wholesaler, replacement, or both occur on or before February 27, 2004 or, or retailer of motor vehicles or other durable consumer goods to apply Regulations section 1.168(i)-6(i)(2) to the relinquished that wants to change to the service warranty income method property and the replacement property for which the time of described in section 5 of Rev. Proc , C.B disposition, the time of replacement, or both occur on or before See Rev. Proc and section in the Appendix to February 26, 2007, if the replacement property replaces Rev. Proc relinquished property for which the taxpayer made a valid 126. Overall cash method for specified transportation election under section 168(f)(1) to exclude it from the industry taxpayers (section 446) for specified application of section 168. Complete Schedule E of Form transportation industry taxpayers, as defined in section See Regulations sections 1.168(i)-6 and 1.168(i)-6(i)(2), and 14.11(2) of Rev. Proc , with average annual gross section 6.18 in the Appendix of Rev. Proc receipts of more than $10,000,000 and not in excess of 117. Lessor improvements abandoned at termination of $50,000,000 to the overall cash receipts and disbursements lease (section 168) for an applicant that is a lessor, from method. See section in the Appendix to Rev. Proc. depreciating under section 168 an improvement described in section 168(i)(8)(B)(i) and (ii) after the improvement was 127. Change to overall cash/hybrid method for certain irrevocably disposed of or abandoned by the lessor at the banks (section 446) for an eligible bank, as defined in termination of the applicable lease by the lessee to complying section 14.12(2)(a) in the Appendix to Rev. Proc , to with section 168(i)(8)(B) by recognizing gain or loss upon an overall cash/hybrid method described in section 14.12(2)(b) disposition or abandonment of the improvement. See section in the Appendix to Rev. Proc See section in the 168(i)(8)(B), and section 6.19 in the Appendix of Rev. Proc. Appendix to Rev. Proc Change to overall cash method for farmers (section 118. Repairable and reusable spare parts (section 446) for a qualifying applicant engaged in the trade or 168) for repairable and reusable spare parts, from item business of farming to the overall cash receipts and accounting to multiple asset accounting (pooling) in accordance disbursements method. See section in the Appendix to with section 6.20(2) in the Appendix of Rev. Proc , or Rev. Proc to using a permissible method of identifying disposed repairable 129. Nonshareholder contributions to capital under and reusable spare parts, as described in section 6.20(3) in the section 118 (section 446) from excluding from gross income Appendix of Rev. Proc Complete Schedule E of Form under section 61 certain payments or the fair market value of See section 6.20 in the Appendix of Rev. Proc , property received (including customer connection fees received as modified by section 4.02(14) of Rev. Proc This by a regulated public utility described in section 118(c)), by change is only available for spare parts that have been placed characterizing the payments or the fair market value of property in service by the taxpayer after 1986 and before taxable years as nontaxable contributions to capital under section 118(a), to beginning after December 31, including the payments or the fair market value of property in 119. Land (sections 167 and 168) from depreciating land gross income under section 61. This change also applies to a to not depreciating land, or from depreciating a nondepreciable regulated public utility described in section 118(c) that changes land improvement to not depreciating a nondepreciable land from including in gross income under section 61 payments or improvement. See section 6.21 in the Appendix of Rev. Proc. fair market value of property received that are contributions in aid of construction under section 118(c) and Regulation section 120. Obsolete and that meet the requirements of sections 118(c)(1)(B) -16-

128 and 118(c)(1)(C) to excluding from income the payments or the engaged in the trade or business of retail sales of new fair market value of the property as nontaxable contributions to automobiles or new light-duty trucks (dealership) from capital under sections 118(a). See section in the capitalizing certain advertising costs as acquisition costs under Appendix to Rev. Proc Regulation section (b) to deducting the advertising 130. Retainages (section 451) for an accrual method costs under section 162 as the advertising services are applicant s retainages under section 451 to a method provided to the dealership. See Regulation section consistent with the holding in Rev. Rul , C.B (d)(2)(i), and section in the Appendix to Rev This change does not apply to retainages under long-term Proc contracts as defined in section 460(f). An applicant changing its 140. Changes within the Used Vehicle Alternative LIFO method of accounting under this section must treat all Method (section 472) for a taxpayer using the Used Vehicle retainages (receivables and payables) in the same manner. Alternative LIFO Method, as described in Rev. Proc , See section in the Appendix to Rev. Proc C.B. 784, as modified by Announcement , 131. Series E, EE, or I U.S. savings bonds (section C.B. 668, and Rev. Proc , C.B. 664, to 454) for a cash method taxpayer changing the taxpayer s use a different official used vehicle guide in conjunction with method of accounting for interest income on Series E, EE, or I the Used Vehicle Alternative LIFO Method, or to a different U.S. savings bonds from reporting as interest income the precise manner of using an official used vehicle guide (for increase in redemption price on a bond occurring in a tax year example, a change in the specific guide category that an to reporting this income in the tax year in which the bond is applicant uses to represent vehicles of average condition for redeemed, disposed of, or finally matures, whichever is earliest. purposes of section 4.02(5)(a) of Rev. Proc ). See A statement in lieu of a Form 3115 is authorized for this section in the Appendix to Rev. Proc change. See section in the Appendix to Rev. Proc Changes to dollar-value pools of manufacturers (section 472) for a manufacturer that purchases goods for 132. Prepaid subscription income (section 455) for an resale (resale goods) and thus must reassign resale goods from accrual method applicant changing its method of accounting for the pool(s) it maintains for the goods it manufactures to one or prepaid subscription income to the method described in section more resale pools, and the manufacturer wants to change from 455 and the related regulations, including an eligible applicant using multiple pools described in Regulation section that wants to make the within 12 months election under (b)(3) to using natural business unit (NBU) pools Regulations section A statement in lieu of a Form 3115 described in Regulation section (b)(1), or vice versa; or is authorized for this change. See section in the Appendix wants to reassign items in NBU pools described in Regulation to Rev. Proc section (b)(1) into the same number or a greater 133. Timing of incurring liabilities for bonuses (section number of NBU pools. See section in the Appendix to 461) to treat bonuses as incurred in the tax year in which all Rev. Proc events have occurred that establish the fact of the liability to 142. Obsolete. pay a bonus and the amount of the liability can be determined with reasonable accuracy. See section 19.01(2) in the Appendix 143. Materials and supplies (section 162) for an applicant to Rev. Proc changing to the method of accounting described in Regulations 134. Timing of incurring liabilities for vacation pay section (reserved) to treat materials and supplies as a (section 461) to treat vacation pay as incurred in the tax year deferred expense to be taken into account in the taxable year in in which all events have occurred that establish the fact of the which they are actually consumed and used in operation. See liability to pay vacation pay, and the amount of the liability can section 3.05 in the Appendix to Rev. Proc , as be determined with reasonable accuracy. The applicant may reserved by section 4.01(1) of Rev. Proc This change make this change if the vacation pay vests in that tax year and is only available for amounts paid or incurred in taxable years the vacation pay is received by the employee by the 15th day of beginning before January 1, the 3rd calendar month after the end of that tax year. See 144. Repair and maintenance costs (section 162) for an section 19.01(3) in the Appendix to Rev. Proc applicant changing from capitalizing under section 263(a) costs 135. Rebates and allowances (section 461) for an accrual paid or incurred to repair and maintain tangible property method applicant s liability for rebates and allowances to the (including network assets) to treating the repair and recurring item exception method under section 461(h)(3) and maintenance costs as ordinary and necessary business Regulation section See section in the Appendix expenses under section 162 and Regulations section to Rev. Proc See section 3.06 in the Appendix to Rev. Proc , as 136. Change from an improper method of inclusion of reserved by section 4.01(1) of Rev. Proc This change rental income or expense to inclusion in accordance with applies only to taxable years beginning before January 1, the rent allocation (section 467) for an applicant that is a 145. Tenant construction allowances (section 168) for an party to a section 467 rental agreement; and is changing its applicant changing from improperly treating the applicant as method for its fixed rent to the rent allocation method provided having a depreciable interest in the property subject to the in Regulation section (d)(2)(iii). See section in the tenant construction allowances for federal income tax purposes Appendix to Rev. Proc to properly treating the applicant as not having a depreciable 137. Permissible methods of inventory identification and interest in such property for federal income tax purposes; or valuation (section 471) for an applicant changing from one from improperly treating the applicant as not having a permissible method of identifying and valuing inventories to depreciable interest in the property subject to the tenant another permissible method of identifying and valuing construction allowances for federal income tax purposes to inventories that is not a change described in another section in properly treating the applicant as having a depreciable interest the Appendix to Rev. Proc or in other guidance in such property for federal income tax purposes. See section published in the IRB. See section in the Appendix to Rev in the Appendix to Rev. Proc Proc Dispositions of structural components of a building 138. Change in the official used vehicle guide utilized in (section 168) for an applicant changing to a unit of property valuing used vehicles (section 471) for a used vehicle that is permissible under applicable legal authority for dealer from not using an official used vehicle guide for valuing determining when the applicant has disposed of a building and used vehicles to using an official used vehicle guide for valuing its structural components for depreciation purposes. This used vehicles; or from using an official used vehicle guide for change will also affect the determination of gain or loss from the valuing used vehicles to using a different official used vehicle disposition of the building (including its structural components). guide for valuing used vehicles. See section in the See section 6.24 in the Appendix to Rev. Proc Appendix to Rev. Proc Obsolete for tax years beginning on or after January 1, Invoiced advertising association costs for new For taxable years beginning on or after January 1, 2012, see vehicle retail dealerships (section 471) for an applicant change number

129 147. Dispositions of tangible depreciable assets (other card in the amount of the gift card, as provided in Rev. Proc. than a building or its structural components) (section , I.R.B See section in the Appendix 168) for an applicant changing to a unit of property that is of Rev. Proc permissible under applicable legal authority for determining 157. Classification of wireless telecommunications assets when the applicant has disposed of a section 1245 property a used by wireless telecommunications carriers (sections depreciable land improvement for depreciation purposes. This 167 and 168) for applicants that have a depreciable interest change will also affect the determination of gain or loss from the in wireless telecommunication assets (as defined in Rev. Proc. disposition of the section 1245 property or the depreciable land , I.R.B. 737) used primarily to provide wireless improvement. See section 6.25 in the Appendix to Rev. Proc. telecommunications or broadband services by mobile phones Obsolete for taxable years beginning on or after that are changing to the method described in Rev. Proc. January 1, For taxable years beginning on or after to determine the recovery periods for depreciation of January 1, 2012, see change 178. certain tangible assets used by wireless telecommunications 148. Debt issuance costs (section 446) for an applicant carriers. See Rev. Proc , adding section 6.26 to the changing its method of accounting to comply with Regulation Appendix of Rev. Proc section , which provides rules for allocating the costs 158. Wireline network property (section 263(a)) for over the term of the debt. See section in the Appendix to certain applicants that have depreciable interest in wireline Rev. Proc network assets (as described in section 4 of Rev. Proc Ratable accrual of real property taxes (section , I.R.B. 740) used primarily to provide wireline 461) for an accrual method applicant for real property taxes telecommunication or broadband services that are changing to that relate to a definite period of time to the method described (a) the wireline network assets maintenance allowance method in section 461(c) and section (c)(1) (ratable accrual described in section 5 of Rev. Proc , or (b) the election) for a taxable year other than the applicant s first adoption of all, or some, of the units of property described in taxable year in which real property taxes are incurred. See section 6 of Rev. Proc , to determine whether section in the Appendix to Rev. Proc expenditures to maintain, replace, or improve wireline network 150. Retail sales facility safe harbor for a motor vehicle assets must be capitalized under section 263(a). See Rev. dealership (section 263A) for a motor vehicle dealership to Proc , adding section 3.07 to the Appendix of Rev. treat its sales facility as a retail sales facility as described in Proc section 5.01 of Rev. Proc , I.R.B See 159. Wireless network property (section 263(a)) for section in the Appendix of Rev. Proc certain applicants that have a depreciable interest in wireless 151. Reseller without production activities safe harbor for network assets (as described in section 4 of Rev. Proc. a motor vehicle dealership (section 263A) for a motor , I.R.B. 743) used primarily to provide wireless vehicle dealership to be treated as a reseller without production telecommunications or broadband services by mobile phones activities as described in section 5.02 of Rev. Proc , that are changing to (a) the wireless network asset I.R.B See section in the Appendix of Rev. maintenance allowance method described in section 5 of Rev. Proc Proc , or (b) the adoption of all, or some, of the units of 152. Deduction for energy efficient commercial buildings property described in section 6 of Rev. Proc , to (section 179D) for an applicant changing to deduct under determine whether expenditures to maintain, replace or improve section 179D amounts paid or incurred for the installation of wireless network assets must be capitalized under section energy efficient commercial building property, subject to the 263(a). See Rev. Proc , adding section 3.08 to the limits of section 179D(b), in the year the property is placed in Appendix of Rev. Proc service. See section 8.04 in the Appendix of Rev. Proc Electric transmission and distribution property (section 263(a)) for certain applicants that have a 153. Advance payments change in applicable financial depreciable interest in electric transmission or distribution statements (Rev. Proc ) for an applicant using the property (as described in section 4 of Rev. Proc , deferral method for including advance payments in gross I.R.B. 326) used primarily to transport, deliver, or sell income in accordance with its applicable financial statement electricity that are changing to the method described in Rev. (AFS) to change its method to recognize advance payments in Proc , to determine whether expenditures incurred to gross income under Rev. Proc consistent with a maintain, replace, or improve transmission and distribution changed manner for recognizing advance payments for its AFS. property are deductible repairs under section 162 or Although the requirement to file a copy of the application with capitalizable improvements under section 263(a). See Rev. the IRS National Office is waived for this application, a taxpayer Proc , adding section 3.09 to the Appendix of Rev. may nevertheless file a copy of the application with the IRS Proc National Office, for example, under the 90-day or 120-day 161. Timing of incurring liabilities under the recurring item window in section 6.03(2) or 6.03(3) of Rev. Proc In exception to the economic performance rules (section all cases, the requirement in section 6.02(3)(c) of Rev. Proc. 461(h)(3)) for an applicant changing to a method of to provide an additional copy of the application to the accounting to conform to any of the holdings in Rev. Rul. examining agent(s), appeals officer(s) and counsel to the , I.R.B. 255, which addresses the not material government, if applicable, applies to this application. See and better matching requirements of the recurring item section in the Appendix of Rev. Proc exception and distinguishes contracts for the provision of 154. California franchise taxes (Rev. Rul ) for an services from insurance and warranty contracts. accrual method applicant changing to recognizing its California 162. Deducting repair and maintenance costs (section franchise tax liability in the tax year following the tax year in 162) for an applicant changing from capitalizing under which the tax is incurred under the Cal. Rev. & Tax Code. See section 263(a) amounts paid or incurred for tangible property to section in the Appendix of Rev. Proc deducting these amounts as repair and maintenance costs 155. Unearned premiums (section 833) for a Blue Cross under section 162 and Regulations section T and for an or Blue Shield organization within the meaning of section applicant changing its units of property under Regulations 833(c)(2) or an organization described in section 833(c)(3) section 1.263(a)-3T(e) solely for purposes of determining required to change its method of accounting for unearned whether amounts paid or incurred improve a unit of property premiums because it fails to meet the MLR requirements of under Regulations section 1.263(a)-3T. See section 4.02(1) of section 833(c)(5). See section in the Appendix of Rev. Rev. Proc , adding section 3.10 to the Appendix of Proc Rev. Proc Gift cards issued as a refund (Rev. Proc Change to the regulatory accounting method (section ) for an accrual method applicant who issues gift 162) for a regulated applicant changing its method of cards as a refund for returned goods changing to treat the accounting for amounts paid or incurred to repair or maintain transaction as the payment of a cash refund and sale of a gift tangible property to follow its method of accounting for -18-

130 regulatory accounting purposes to determine whether an to amounts paid or incurred in taxable years beginning on or amount paid or incurred improves property under Regulations after January 1, section 1.263(a)-3T, consistent with Regulations section 171. Change to the safe harbor routine maintenance on 1.263(a)-3T(k). See section 4.02(2) of Rev. Proc , property other than buildings (section 162) for an adding section 3.11 to the Appendix of Rev. Proc applicant changing its method of accounting for amounts paid 164. Deducting non-incidental materials and supplies or incurred for routine maintenance performed on a unit of when used or consumed (section 162) for an applicant property to the method of treating such amounts as amounts changing its method of accounting for non-incidental materials that do not improve the unit or property, consistent with and supplies to the method of deducting such amounts in the Regulations section 1.263(a)-3T(g). See section 4.01(10) of taxable year in which they are actually used or consumed, Rev. Proc , adding section 3.19 to the Appendix of consistent with Regulations section T. See section Rev. Proc (3) of Rev. Proc , adding section 3.12 to the 172. Non-dealer expense to facilitate the sale of property Appendix of Rev. Proc This change applies only to (section 162) for an applicant that is not a dealer in property the amounts paid or incurred in taxable years beginning on or changing its method of accounting for commissions and other after January 1, costs paid or incurred to facilitate the sale of property to the 165. Deducting incidental materials and supplies when method of capitalizing such costs, consistent with Regulations paid or incurred (section 162) for an applicant that wants to section 1.263(a)-1T(d)(1). See section 4.01(11) of Rev. Proc. change its method of accounting for incidental materials and , adding section to the Appendix of Rev. Proc. supplies to the method of deducting such amounts in the taxable year in which they are paid or incurred, consistent with 173. Capitalizing acquisition or production costs (section Regulations section T. See section 4.02(4) of Rev. Proc. 263(a)) for an applicant changing its method of accounting to , adding section 3.13 to the Appendix of Rev. Proc. capitalizing amounts paid or incurred to acquire or produce This change applies only to amounts paid or incurred property under Regulations section 1.263(a)-2T and, if in taxable years beginning on or after January 1, depreciable, to depreciating such property under section Deducting non-incidental rotable and temporary See section 4.01(12) of Rev. Proc , adding section spare parts when disposed (section 162) for an applicant to the Appendix of Rev. Proc changing its method of accounting for costs to acquire or 174. Capitalizing improvements to tangible property produce non-incidental rotable and temporary spare parts to (section 263(a)) for an applicant changing its method of the method of deducting such costs in the taxable year in which accounting to capitalizing amounts paid or incurred for the taxpayer disposes of the parts, consistent with Regulations improvements to units of property consistent with Regulations section T. See section 4.02(5) of Rev. Proc , sections 1.263(a)-1T and 1.263(a)-3T and, if depreciable, to adding section 3.14 to the Appendix of Rev. Proc depreciating such improvements under section 168. See This change applies only to amounts paid or incurred in taxable section 4.01(13) of Rev. Proc , adding section to years beginning on or after January 1, the Appendix of Rev. Proc Depreciation of leasehold improvements (sections 167. Change to the optional method for rotable and 167, 168, and 197) for leasehold improvements in which the temporary spare parts (section 162) for an applicant applicant has a depreciable interest at the beginning of the year changing its method of accounting for rotable and temporary of change, from improperly depreciating or amortizing these spare parts to the optional method of accounting for rotable and leasehold improvements over the term of the lease (including temporary spare parts (described in Regulations section renewals, if applicable) to properly depreciating or amortizing T(e)), consistent with Regulations section T. See these leasehold improvements under section 167(f)(1), 168, or section 4.02(6) of Rev. Proc , adding section 3.15 to 197, as applicable. This change applies only to taxable years the Appendix of Rev. Proc beginning on or after January 1, Complete Schedule E of 168. Deducting dealer expenses that facilitate the sale of Form See section 6.27 in the Appendix to Rev. Proc. property (section 162) for an applicant that is a dealer in , as modified by section 5.03(1) of Rev. Proc property changing its method of accounting for commissions (creating new section 6.27). and other costs paid or incurred to facilitate the sale of tangible 176. Depreciation of MACRS property (permissible) property to the method of treating such costs as ordinary and (section 168) for MACRS property, from a permissible necessary business expenses, consistent with Regulations method to another permissible method listed in section 6.28(3) section 1.263(a)-1T(d)(1). See section 4.02(7) of Rev. Proc. in the Appendix of Rev. Proc This change applies , adding section 3.16 to the Appendix of Rev. Proc. only to taxable years beginning on or after January 1, Complete Schedule E of Form See section 6.28 in the 169. Deducting de minimis amounts (section 263(a)) for Appendix to Rev. Proc , as modified by section 5.03(2) an applicant changing its method of accounting for amounts of Rev. Proc (creating new section 6.28). paid or incurred to acquire or produce (including any amounts 177. Dispositions of a building or a structural component paid or incurred to facilitate the acquisition and production of) a (section 168) for an applicant changing to an asset that is unit of property to the method of applying the de minimis rule permissible under Regulations section 1.168(i)-8T(c)(4) for under Regulations sections 1.263(a)-2T(g) and determining what building, condominium unit, cooperative unit, 1.263A-1T(b)(14) to such amounts, consistent with Regulations or structural components has been disposed of by the applicant section 1.263(a)-2T. See section 4.02(8) of Rev. Proc , for depreciation purposes; or from a method not specified in adding section 3.17 to the Appendix of Rev. Proc Regulations section 1.168(i)-8T(f)(1), (f)(2)(i), (f)(2)(ii), or This change applies only to amounts paid or incurred in taxable (f)(2)(iii) to a method specified in Regulations section years beginning on or after January 1, (i)-8T(f)(1), (f)(2)(i), (f)(2)(ii), or (f)(2)(iii), as applicable, for 170. Deducting certain costs for investigating or pursuing identifying which buildings, condominium units, cooperative the acquisition of property (section 162) for an applicant units, or structural components in multiple asset accounts have changing its method of accounting from capitalizing to been disposed of by the applicant. This change also will affect deducting amounts paid or incurred in the process of the determination of gain or loss from the disposition of the investigating or otherwise pursuing the acquisition of real building, condominium unit, cooperative unit, or the structural property if the amounts meet the requirements of Regulations component and may affect whether the applicant must section 1.263(a)-2T(f)(2)(iii) or the acquisition of real or capitalize amounts paid to restore a unit of property under personal property if the amounts are for employee Regulations section 1.263(a)-3T(i). This change applies only to compensation or overhead costs under Regulations section taxable years beginning on or after January 1, See 1.263(a)-2T(f)(2)(iv), consistent with section 1.263(a)-2T. See section 6.29 in the Appendix to Rev. Proc , as modified section 4.04(9) of Rev. Proc , adding section 3.18 to by section 5.03(3) of Rev. Proc (creating new section the Appendix of Rev. Proc This change applies only 6.29). -19-

131 178. Dispositions of tangible assets (other than a building by the applicant. This change also may affect the determination or its structural components) (section 168) for an of gain or loss from the disposition of the asset and may affect applicant changing to an asset that is permissible under whether the applicant must capitalize amounts paid to restore a Regulations section 1.168(i)-8T(c)(4) for determining what unit of property under Regulations section 1.263(a)-3T(i). This section 1245 property or depreciable land improvement has change applies only to taxable years beginning on or after been disposed of by the applicant for depreciation purposes; or January 1, See section 6.31 in the Appendix to Rev. from a method not specified in Regulations section Proc , as modified by section 5.03(5) of Rev. Proc (i)-8T(f)(1), (f)(2)(i), (f)(2)(ii), or (f)(2)(iii) to a method (creating new section 6.31). specified in Regulations section 1.168(i)-8T(f)(1), (f)(2)(i), (f)(2)(ii), or (f)(2)(iii), as applicable, for identifying which section 180. General asset account elections (section 168) for an 1245 property or depreciable land improvements in multiple applicant making a late general asset account election under asset accounts have been disposed of by the applicant. This section 168(i)(4) and Regulations sections 1.168(i)-1 and change also will affect the determination of gain or loss from the 1.168(i)-1T for MACRS property placed in service by the disposition of the section 1245 property or the depreciable land applicant in a taxable year beginning before January 1, 2012; improvement and may affect whether the taxpayer must or a late election to recognize gain or loss upon the disposition capitalize amounts paid to restore a unit of property under the of all the assets, or the last asset, in a general asset account in Regulations section 1.263(a)-3T(i). This change applies only to accordance with Regulation section 1.168(i)-1T(3)(ii); or for an taxable years beginning on or after January 1, See item of MACRS property for which the applicant made a valid section 6.30 in the Appendix to Rev. Proc , as modified general asset account election, a late election to recognize gain by section 5.03(4) of Rev. Proc (creating new section or loss upon the disposition of that item in a qualifying 6.30). disposition in accordance with Regulations section 179. Dispositions of tangible depreciable assets in a 1.168(i)-1T(e)(3)(iii). This change also may affect the general account (section 168) for MACRS property for determination of gain or loss from the disposition of the asset which the applicant made a valid general asset election, and may affect whether the applicant must capitalize amounts changing to an asset that is permissible under Regulations paid to restore a unit of property under Regulations section section 1.168(i)-1T(e)(2)(viii) for determining what asset has 1.263(a)-3T(i). This change applies only to the applicant s first been disposed of by the applicant for depreciation purposes; or or second taxable year beginning after December 31, from a method not specified in Regulations section See section 6.32 in the Appendix to Rev. Proc , as 1.168(i)-1T(j)(2)(i), (ii), (iii), or (iv) to a method specified in modified by section 5.03(6) of Rev. Proc (creating new Regulations section 1.168(i)-1T(j)(2)(i), (ii), (iii), or (iv), as section 6.32). applicable, for identifying which assets have been disposed of Privacy Act and Paperwork Reduction Act Notice. We ask for the information on this form to carry out the Internal Revenue laws of the United States. Section 446(e) says that you must obtain IRS approval before you change your method of accounting, except where otherwise provided. To obtain this approval, you are required to provide the information requested on this form. This information will be used to ensure that you are complying with the applicable laws, and to figure and collect the right amount of tax. Failure to provide all of the information requested may delay or prevent processing of this form. Providing false information may subject you to penalties. Routine uses of this information include giving it to the Department of Justice for civil and criminal litigation, and to cities, states, the District of Columbia, and to U.S. commonwealths and possessions for use in the administration of their tax laws. We may also disclose this information to other countries under a tax treaty, to Federal and state agencies to enforce Federal non-tax criminal laws, or to federal law enforcement and intelligence agencies to combat terrorism. You are not required to provide the information requested on a form that is subject to the Paperwork Reduction Act unless the form displays a valid OMB control number. Books or records relating to a form or its instructions must be retained as long as their contents may become material in the administration of any Internal Revenue law. Generally, tax returns and return information are confidential, as required by section The time needed to complete and file this form will vary depending on individual circumstances. The estimated burden for individual taxpayers filing this form is approved under OMB control number and is included in the estimates shown in the instructions for their individual income tax return. The estimated burden for all other taxpayers who file this form is shown below. Learning about the law Preparing and sending Form Recordkeeping or the form the form to the IRS hr., 29 min. 19 hr., 54 min. 23 hr., 48 min. Sch. A 3 hr., 21 min. 1 hr., 51 min. 3 hr., 11 min. Sch. B 1 hr., 25 min. 30 min. 33 min. Sch. C 5 hr., 1 min. 45 min. 2 hr., 4 min. Sch. D 27 hr., 30 min. 1 hr., 59 min. 2 hr., 31 min. Sch. E 3 hr., 49 min. 1 hr., 59 min. 2 hr., 8 min. If you have comments concerning the accuracy of these time estimates or suggestions for making this form simpler, we would be happy to hear from you. You can write to the Internal Revenue Service, Tax Products Coordinating Committee, SE:W:CAR:MP:T:T:SP, 1111 Constitution Ave. NW, IR-6406, Washington, DC Do not send the tax form to this office. Instead, see When and Where To File earlier. -20-

132 Chapter 5: Dispositions of Business Property If a business disposes of business property, it may have a gain or loss that is reported on its income tax return. However, in some cases the business may have a gain that is not taxable or a loss that is not deductible. This chapter discusses whether the business has a disposition, how to figure the gain or loss, and where to report it. I. Types of Dispositions A disposition of property includes the following transactions: Selling property for cash or other property; Exchanging property for other property; Receiving money as a tenant for the cancellation of a lease; Receiving money for granting the exclusive use of a copyright throughout its life in a particular medium; Transferring property to satisfy a debt; Abandoning property; A bank or other financial institution foreclosing on a mortgage or repossessing the property; Property that is damaged, destroyed, or stolen where the owner receives property or money in payment; or Property that is condemned, or disposed of under the threat of condemnation where the owner receives property or money in payment. Certain exchanges of property are not taxable. This means any gain from the exchange is not recognized and the owner cannot deduct any loss. A gain or loss is not generally recognized until the owner sells or otherwise disposes of the property received. A. LIKE-KIND EXCHANGE A like-kind exchange (also called a 1031 exchange ) is the exchange of property for the same kind of property. It is the most common type of nontaxable exchange. To be a likekind exchange, the property traded and the property received must be both of the following: Business or investment property; and Like property. Dispositions of Business Property 5-1

133 Additional requirements apply to exchanges in which the property received is not received immediately upon the transfer of the property given up. If the like-kind exchange involves the receipt of money or unlike property or the assumption of liabilities, a gain may have to be recognized. The like-kind exchange rules also apply to property exchanges that involve three- and four-party transactions. Any part of these multipleparty transactions can qualify as a like-kind exchange if it meets all the requirements described in this section. 1. Reporting the Exchange Taxpayers must report the exchange of like-kind property, even though no gain or loss is recognized, on IRS Form The instructions for the form explain how to report the details of the exchange. 2. Qualifying Property In a like-kind exchange, both the property an individual gives up and the property they receive must be held by them for investment or for productive use in their trade or business. Machinery, buildings, land, trucks, and rental houses are examples of property that may qualify. The rules for like-kind exchanges do not apply to exchanges of the following property: Property used for personal purposes, such as a home and family car; Stock in trade or other property held primarily for sale, such as inventories, raw materials, and real estate held by dealers; Stocks, bonds, notes, or other securities or evidences of indebtedness, such as accounts receivable; Partnership interests; Certificates of trust or beneficial interest; or The right to bring a cause of action to recover damages or otherwise enforce some legal right or obligation. An exchange of the assets of a business for the assets of a similar business cannot be treated as an exchange of one property for another property. Whether an individual engaged in a like-kind exchange depends on an analysis of each asset involved in the exchange. 3. Like-Kind Property There must be an exchange of like-kind property. Like-kind properties are properties of the same nature or character, even if they differ in grade or quality. The exchange of real estate for real estate and the exchange of personal property for similar personal property are exchanges of like-kind property. For example, the trade of land improved with an apartment house for land improved with a store building, or a panel truck for a pickup truck, are examples of a like-kind exchange. Dispositions of Business Property 5-2

134 An exchange of personal property for real property does not qualify as a like-kind exchange. For example, an exchange of a piece of machinery for a store building does not qualify. Also, the exchange of livestock of different sexes does not qualify. The following general rules involving real property also apply: An exchange of city property for farm property, or improved property for unimproved property, is a like-kind exchange; The exchange of real estate an individual owns for a real estate lease that runs 30 years or longer is a like-kind exchange. However, not all exchanges of interests in real property qualify. The exchange of a life estate expected to last less than 30 years for a remainder interest is not a like-kind exchange; and An exchange of a remainder interest in real estate for a remainder interest in other real estate is a like-kind exchange if the nature or character of the two property interests is the same. Depreciable tangible personal property can be either like kind or like class to qualify for non-recognition treatment. Like-class properties are depreciable tangible personal properties within the same general asset class or product class. Property classified in any general asset class may not be classified within a product class. General asset classes describe the types of property frequently used in many businesses. They include the following property: Office furniture, fixtures, and equipment; Information systems, such as computers and peripheral equipment; Data handling equipment except computers; Airplanes (airframes and engines), except planes used in commercial or contract carrying of passengers or freight, and all helicopters (airframes and engines); Automobiles and taxis; Buses; Light general purpose trucks; Heavy general purpose trucks; Railroad cars and locomotives except those owned by railroad transportation companies; Tractor units for use over the road; Dispositions of Business Property 5-3

135 Trailers and trailer-mounted containers; Vessels, barges, tugs, and similar water-transportation equipment, except those used in marine construction; and Industrial steam and electric generation or distribution systems. Example 1. Company A transfers a personal computer used in the business for a printer to be used in the business. The properties exchanged are within the same general asset class and are of a like class. Example 2. Nick transfers a grader to Ron in exchange for a scraper. Both are used in a business. Neither property is within any of the general asset classes. Both properties, however, are within the same product class and are of a like class. If a business exchanges intangible personal property or non-depreciable personal property for like-kind property, no gain or loss is recognized on the exchange. Whether intangible personal property, such as a patent or copyright, is of a like kind to other intangible personal property generally depends on the nature or character of the rights involved. It also depends on the nature or character of the underlying property to which those rights relate. 4. Deferred Exchange A deferred exchange is one in which an individual or entity transfers property used in business or held for investment and later receives like-kind property that will be used in business or hold for investment. (The property received is replacement property.) The transaction must be an exchange (that is, property for property) rather than a transfer of property for money used to buy replacement property. If, before the replacement property is received, the business actually or constructively receives money or unlike property in full payment for the property it transferred, the transaction will be treated as a sale rather than a deferred exchange. In that case, the entity must recognize gain or loss on the transaction, even if it later receives the replacement property. A taxpayer constructively receives money or unlike property when the money or property is credited to his account or made available to him. Money is also constructively received when any limits or restrictions on it expire or are waived. 5. Identification Requirement A taxpayer must identify the property to be received in an exchange within 45 days after the date he transferred the property given up in the exchange. This period of time is called the identification period. Any property received during the identification period is considered to have been identified. Dispositions of Business Property 5-4

136 If the taxpayer transfers more than one property (as part of the same transaction) and the properties are transferred on different dates, the identification period and the receipt period begin on the date of the earliest transfer. The taxpayer must identify the replacement property in a signed written document and deliver it to the other person involved in the exchange. He must clearly describe the replacement property in the written document. For example, the description of real property needs to include the legal description or street address while the description of a car should include the make, model, and year. In the same manner, the taxpayer can cancel an identification of replacement property at any time before the end of the identification period. It is acceptable to identify more than one replacement property. Regardless of the number of properties given up, however, the maximum number of replacement properties that can be identified is the larger of the following: Three; or Any number of properties whose total fair market value (FMV) at the end of the identification period is not more than double the total fair market value, on the date of transfer, of all properties given up. If, as of the end of the identification period, more properties have been identified than are permitted under this rule, the only property that will be considered identified is: Any replacement property received before the end of the identification period, and Any replacement property identified before the end of the identification period and received before the end of the receipt period, but only if the fair market value of the property is at least 95% of the total fair market value of all identified replacement properties. Fair market value is determined on the earlier of the date the property is received or the last day of the receipt period. 6. Like-Kind Exchanges Using Qualified Intermediaries If property is transferred through a qualified intermediary, the transfer of the property given up and receipt of like-kind property is treated as an exchange. This rule applies even if an individual or entity receives money or other property directly from a party to the transaction other than the qualified intermediary. A qualified intermediary is a person who enters into a written exchange agreement with an individual or entity to acquire and transfer the property they give up and to acquire the replacement property and transfer them. This agreement must expressly limit the rights of the individual or entity to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by the qualified intermediary. There are restrictions on who can act as a qualified intermediary. These generally preclude the intermediary from also acting as an agent for one of the parties to the transfer. Dispositions of Business Property 5-5

137 An intermediary is treated as acquiring and transferring property if all the following requirements are met: The intermediary acquires and transfers legal title to the property; The intermediary enters into an agreement with a person other than the taxpayer involved for the transfer of that property to that person, and pursuant to the agreement, that property is transferred to that person; and The intermediary enters into an agreement with the owner of the replacement property for the transfer of that property and the replacement property is transferred to the taxpayer. An intermediary is treated as entering into an agreement if the rights of a party to the agreement are assigned to the intermediary and all parties to that agreement are notified in writing of the assignment by the date of the relevant transfer of property. 7. Partially Nontaxable Exchanges If, in addition to like-kind property, a business receives money or unlike property in an exchange on which a gain is realized, the business will have a partially nontaxable exchange. In such a case, the business is taxed on the gain realized, but only to the extent of the money and the fair market value of the unlike property received in the exchange. A loss is never deductible in a nontaxable exchange in which unlike cash or property is received. To figure the taxable gain, the taxpayer must first determine the fair market value of any unlike property received and add it to any money received. He must then reduce that total by any exchange expenses (closing costs) paid. The result is the maximum gain that can be taxed. Next, the taxpayer must figure the gain on the whole exchange as discussed earlier. The recognized (taxable) gain is the lesser of these two amounts. Example. Johnson Brothers, L.P. exchanges real estate held for investment with an adjusted basis of $8,000 for other real estate it wants to hold for investment. The fair market value of the real estate received is $10,000. Johnson Brothers also receive $1,000 in cash. The partnership paid $500 in exchange expenses. Although the total gain realized on the transaction is $2,500, only $500 ($1,000 cash received minus the $500 exchange expenses) is recognized. 8. Assumption of Liabilities If the other party to a nontaxable exchange assumes any of the transferor s liabilities, that taxpayer will be treated as if it received cash in the amount of the liability. For more information on the assumption of liabilities, see 357(d) of the Internal Revenue Code. Dispositions of Business Property 5-6

138 Example. The facts are the same as in the previous example, except the property the partnership gave up is subject to a $3,000 mortgage for which the partners are personally liable. The other party in the trade has agreed to pay off the mortgage. Figure the gain realized as follows: FMV of like-kind property received $10,000 Cash 1,000 Mortgage treated as assumed by other party 3,000 Total received $14,000 Minus: Exchange expenses (500) Amount realized $13,500 Minus: Adjusted basis of property transferred (8,000) Realized gain $5,500 The realized gain is taxed only up to $3,500, the sum of the cash received ($1,000 - $500 exchange expenses) and the mortgage ($3,000). 9. Unlike Property Given Up If, in addition to like-kind property, a business gives up unlike property, it must recognize gain or loss on the unlike property given up. The gain or loss is equal to the difference between the fair market value of the unlike property and the adjusted basis of the unlike property. Example. Bill, a sole proprietor, exchanges stock and real estate he held for investment for real estate he also intends to hold for investment. The stock he transferred has a fair market value of $1,000 and an adjusted basis of $4,000. The real estate exchanged has a fair market value of $19,000 and an adjusted basis of $15,000. The real estate Bill receives has a fair market value of $20,000. Bill does not recognize gain on the exchange of the real estate because it qualifies as a nontaxable exchange. However, he must recognize (report on his return) a $3,000 loss on the stock because it is unlike property. 10. Basis of Property Received The total basis for all properties (other than money) received in a partially nontaxable exchange is the total adjusted basis of the properties given up, with the following adjustments: a. Add both the following amounts: Any additional costs incurred; Any gain recognized on the exchange. Dispositions of Business Property 5-7

139 b. Subtract both the following amounts: Any money received; Any loss recognized on the exchange. Allocate this basis first to the unlike property, other than money, up to its fair market value on the date of the exchange. The rest is the basis of the like-kind property. 11. Multiple Property Exchanges Under the like-kind exchange rules, a taxpayer generally must make a property-byproperty comparison to figure his recognized gain and the basis of the property received in the exchange. However, for exchanges of multiple properties, a taxpayer does not make a property-by-property comparison if it does either of the following: Transfers and receives properties in two or more exchange groups; or Transfers or receives more than one property within a single exchange group. In these situations, the taxpayer will figure its recognized gain and the basis of the property received by comparing the properties within each exchange group. 12. Exchange Groups Each exchange group consists of properties transferred and received in the exchange that are of like kind or like class. If property could be included in more than one exchange group, it can be included in any one of those groups. However, the following may not be included in an exchange group: Money; Stock in trade or other property held primarily for sale; Stocks, bonds, notes, or other securities or evidences of debt or interest; Interests in a partnership; Certificates of trust or beneficial interests; and Interest in a cause of action. Example. Ben exchanges computer A, automobile A, and truck A for computer R, automobile R, truck R, and $400. All properties transferred were used in Ben's business. Similarly, all properties received will be used in his business. Dispositions of Business Property 5-8

140 The first exchange group consists of computers A and R, the second exchange group consists of automobiles A and R, and the third exchange group consists of trucks A and R. 13. Residual Group A residual group is created if the total fair market value of the properties transferred in all exchange groups differs from the total fair market value of the properties received in all exchange groups after taking into account the treatment of liabilities. The residual group consists of money or other property that has a total fair market value equal to that difference. It consists of either money or other property transferred in the exchange or money or other property received in the exchange, but not both. Other property includes the following items: Stock in trade or other property held primarily for sale; Stocks, bonds, notes, or other securities or evidences of debt or interest; Interests in a partnership; Certificates of trust or beneficial interests; and Standing to bring a lawsuit to collect damages to enforce some type of legal right. Other property also includes property transferred that is not of a like kind or like class with any property received, and property received that is not of a like kind or like class with any property transferred. For asset acquisitions occurring after March 15, 2001, money and properties allocated to the residual group are considered to come from the following assets in the following order: 1. Cash and general deposit accounts (including checking and savings accounts but excluding certificates of deposit). Also, include here excess liabilities of which an individual is relieved over the amount of liabilities assumed. 2. Certificates of deposit, U.S. Government securities, foreign currency, and actively traded personal property, including stock and securities. 3. Accounts receivable, other debt instruments, and assets that are marked to market at least annually for federal income tax purposes. However, see section (b)(2)(iii) of the regulations for exceptions that apply to debt instruments issued by persons related to a target corporation, contingent debt instruments, and debt instruments convertible into stock or other property. 4. Property of a kind that would properly be included in inventory if on hand at the end of the tax year or property held by the taxpayer primarily for sale to customers in the ordinary course of business. 5. Assets other than those listed in (1), (2), (3), (4), (6) and (7). Dispositions of Business Property 5-9

141 6. All section 197 intangibles except goodwill and going concern value. 7. Goodwill and going concern value. Within each category, a taxpayer can choose which properties to allocate to the residual group. If an asset described in any of the categories above, except: (1), is includible in more than one category, include it in the lower number category. For example, if an asset is described in both (3) and (4), include it in (3). Example. Fran exchanges computer A (asset class 00.12) and automobile A for printer B, automobile B, corporate stock, and $500. Fran used computer A and automobile A in her business and will use printer B and automobile B in her business. This transaction results in two exchange groups: (1) computer A and printer B, and (2) automobile A and automobile B. The fair market values of the properties are as follows: Fair Market Value Fran Transfers: Computer A $1,000 Automobile A 4,000 Fran Receives: Automobile B $2,950 Printer B 800 Corporate Stock 750 Cash 500 The total fair market value of the properties transferred in the exchange groups ($5,000) is $1,250 more than the total fair market value of the properties received in the exchange groups ($3,750), so there is a residual group in that amount. It consists of the $500 cash and the $750 worth of corporate stock. 14. Exchange Group Surplus and Deficiency For each exchange group, an individual must determine whether there is an exchange group surplus or exchange group deficiency. An exchange group surplus is the total fair market value of the properties received in an exchange group (minus any excess liabilities assumed that are allocated to that exchange group) that is more than the total fair market value of the properties transferred in that exchange group. An exchange group deficiency is the total fair market value of the properties transferred in an exchange group that is more than the total fair market value of the properties received in that exchange group (minus any excess liabilities assumed that are allocated to that exchange group). Dispositions of Business Property 5-10

142 15. Recognized Gain Gain or loss realized for each exchange group and the residual group is the difference between the total fair market value of the transferred properties in that exchange group or residual group and the total adjusted basis of the properties. For each exchange group, recognized gain is the lesser of the gain realized or the exchange group deficiency (if any). Losses are not recognized for an exchange group. The total gain recognized on the exchange of like-kind or like-class properties is the sum of all the gain recognized for each exchange group. For a residual group, individuals must recognize the entire gain or loss realized. B. LIKE-KIND EXCHANGES BETWEEN RELATED PERSONS Special rules apply to like-kind exchanges between related persons. These rules affect both direct and indirect exchanges. Under these rules, if either person disposes of the property within two years after the exchange, the exchange is disqualified from nonrecognition treatment. The gain or loss on the original exchange must be recognized as of the date of the later disposition. 1. Related Persons Under these rules, related persons include, for example, an individual and a member of his family (spouse, brother, sister, parent, child, etc.), an individual and a corporation in which he has more than 50% ownership, an individual and a partnership in which he directly or indirectly owns more than a 50% interest of the capital or profits, and two partnerships in which an individual directly or indirectly owns more than 50% of the capital interests or profits. An exchange structured to avoid the related party rules is not a like-kind exchange. Example. Bob used a panel truck in his house painting business. Bob s sister used a pickup truck in her landscaping business. In December 2012, Bob exchanged his panel truck plus $200 for his sister's pickup truck. At that time, the fair market value (FMV) of his panel truck was $7,000 and its adjusted basis was $6,000. The fair market value of his sister's pickup truck was $7,200 and its adjusted basis was $1,000. Bob realized a gain of $1,000 (the $7,200 fair market value of the pickup truck minus the $200 he paid minus the $6,000 adjusted basis of the panel truck). Bob s sister realized a gain of $6,200 (the $7,000 fair market value of the panel truck plus the $200 paid minus the $1,000 adjusted basis of the pickup truck). However, because this was a like-kind exchange, Bob recognized no gain. His basis in the pickup truck was $6,200 (the $6,000 adjusted basis of the panel truck plus the $200 he paid). His sister recognized gain only to the extent of the money she received, $200. Her basis in the panel truck was $1,000 (the $1,000 adjusted basis of the pickup truck minus the $200 received, plus the $200 gain recognized). Dispositions of Business Property 5-11

143 In 2013, Bob sold the pickup truck to a third party for $7,000. He sold it within two years after the exchange, so the exchange is disqualified from non-recognition treatment. On his 2013 tax return, Bob must report his $1,000 gain on the 2012 exchange. He also will report a loss on the sale of $200 (the adjusted basis of the pickup truck, $7,200 (its $6,200 basis plus the $1,000 gain recognized), minus the $7,000 realized from the sale). In addition, Bob s sister must report on her 2013 tax return the $6,000 balance of her gain on the 2012 exchange. Her adjusted basis in the panel truck is increased to $7,000 (its $1,000 basis plus the $6,000 gain recognized). 2. Two-Year Holding Period The two-year holding period begins on the date of the last transfer of property that was part of the like-kind exchange. If the holder's risk of loss on the property is substantially diminished during any period, however, that period is not counted toward the 2-year holding period. The holder's risk of loss on the property is substantially diminished by any of the following events: The holding of a put on the property; The holding by another person of a right to acquire the property; or A short sale or other transaction. A put is an option that entitles the holder to sell property at a specified price at any time before a specified future date. A short sale involves property you generally do not own. You borrow the property to deliver to a buyer and, at a later date, buy substantially identical property and deliver it to the lender. The following kinds of property dispositions are excluded from these rules: Dispositions due to the death of either related person; Involuntary conversions; and Dispositions if it is established to the satisfaction of the IRS that neither the exchange nor the disposition had as a main purpose the avoidance of federal income tax. C. INSTALLMENT SALES An installment sale is a sale of property where the seller receives at least one payment after the tax year of the sale. If the seller finances the buyer's purchase of the property, instead of having the buyer get a loan or mortgage from a third party, the seller probably has an installment sale. Dispositions of Business Property 5-12

144 If a taxpayer realizes a gain on an installment sale, he may be able to report part of his gain when each payment is received. This method of reporting gain is called the installment method. Taxpayers cannot use the installment method to report a loss. In addition, a taxpayer can choose to report all of his gain in the year of sale. 1. What Is an Installment Sale? The regular sale of inventory is not an installment sale even if the seller receives a payment after the year of sale. Sales of personal property by a person who regularly sells or otherwise disposes of the same type of personal property on the installment plan are not installment sales. This rule also applies to real property held for sale to customers in the ordinary course of a trade or business. However, the rule does not apply to an installment sale of property used or produced in farming. Dealers of time-shares and residential lots can treat certain sales as installment sales and report them under the installment method if they elect to pay a special interest charge. 2. General Rules If a sale qualifies as an installment sale, the gain must be reported under the installment method unless the seller elects out of using the installment method. a. Stock or securities. A taxpayer cannot use the installment method to report gain from the sale of stock or securities traded on an established securities market. He must report the entire gain on the sale in the year in which the trade date falls. b. Sale at a loss. If a sale results in a loss, the seller cannot use the installment method. If the loss is on an installment sale of business assets, the seller can deduct it only in the tax year of sale. c. Unstated interest. If a sale calls for payments in a later year and the sales contract provides for little or no interest, the seller may have to figure unstated interest, even if they have a loss. 3. Figuring Installment Sale Income Sellers can use the following discussions or IRS Form 6252 to help determine gross profit, contract price, gross profit percentage, and installment sale income. Each payment on an installment sale usually consists of the following three parts: Interest income; Return of the adjusted basis in the property; and Gain on the sale. Dispositions of Business Property 5-13

145 In each year the seller receives a payment, he must include the interest part in income, as well as the part that is his gain on the sale. The seller does not include in income the part that is the return of his basis in the property. Basis is the amount of the seller s investment in the property for tax purposes. 4. Interest Income A seller must report interest as ordinary income. Interest is generally not included in a down payment. However, the seller may have to treat part of each later payment as interest, even if it is not called interest in the agreement with the buyer. Interest provided in the agreement is called stated interest. If the agreement does not provide for enough stated interest, there may be unstated interest or original issue discount. 5. Adjusted Basis and Installment Sale Income (Gain on Sale) After a seller has determined how much of each payment to treat as interest, he must treat the rest of each payment as if it were made up of two parts: A tax-free return of their adjusted basis in the property; and Their gain (referred to as Installment Sale Income on IRS Form 6252). a. Selling price. The selling price is the total cost of the property to the buyer. It includes: Any money the seller is to receive; The fair market value (FMV) of any property the seller is to receive; Any existing mortgage or other debt the buyer pays, assumes, or takes (a note, mortgage, or any other liability, such as a lien, accrued interest, or taxes the seller owes on the property); and Any of the seller s expenses involved in the sale that the buyer pays. The selling price does not include interest, whether stated or unstated. b. Adjusted basis for installment sale purposes. The seller s adjusted basis is the total of the following three items: Adjusted basis; Selling expenses; and Depreciation recapture. Dispositions of Business Property 5-14

146 6. Adjusted Basis Basis is the amount of an investment in the property for tax purposes. The way to figure basis depends on how the property was acquired. The basis of property purchased is generally its cost. The basis of property inherited, received as a gift, built by the owner, or received in a tax-free exchange is figured differently. While an individual owns personal-use property, various events may change the original basis. Some events, such as adding rooms or making permanent improvements, increase basis. Others, such as deductible casualty losses or depreciation previously allowed or allowable, decrease basis. The result is adjusted basis. a. Selling expenses. Selling expenses are any expenses that relate to the sale of the property. They include commissions, attorney fees, and any other expenses paid on the sale. Selling expenses are added to the basis of the sold property. b. Depreciation recapture. If the property sold was depreciable property, the seller may need to recapture part of the gain on the sale as ordinary income. c. Gross profit. Gross profit is the total gain reported on the installment method. To figure gross profit, subtract the adjusted basis for installment sale purposes from the selling price. If the property sold was the seller s home, subtract from the gross profit any gain that can be excluded. d. Contract price. Contract price equals the selling price plus mortgages, debts, and other liabilities assumed or taken by the buyer that are in excess of the seller s adjusted basis for installment sale purposes. e. Gross profit percentage. A certain percentage of each payment (after subtracting interest) is reported as installment sale income. This percentage is called the gross profit percentage and is figured by dividing gross profit from the sale by the contract price. The gross profit percentage generally remains the same for each payment received. Example. Bill sells property at a contract price of $2,000 and his gross profit is $500. Bill s gross profit percentage is 25% ($500 $2,000). After subtracting interest, Bill reports 25% of each payment, including the down payment, as installment sale income from the sale for the tax year he received the payment. The remainder (balance) of each payment is the tax-free return of his adjusted basis. 7. Amount to Report as Installment Sale Income Multiply the payments received each year (less interest) by the gross profit percentage. The result is the seller s installment sale income for the tax year. In certain circumstances, the seller may be treated as having received a payment, even though he received nothing directly. A receipt of property or the assumption of a mortgage on the property sold may be treated as a payment. Dispositions of Business Property 5-15

147 8. Selling Price Reduced If the selling price is reduced at a later date, the gross profit on the sale will also change. The seller must then refigure the gross profit percentage for the remaining payments. Any remaining gain will be spread over future installments. 9. Reporting Installment Sale Income Generally, sellers will use Form 6252 to report installment sale income from casual sales of real or personal property during the tax year. However, special rules may allow for exclusion of income or require reporting on other forms such as Schedule D (Form 1040) or Form Form 6252 Form 6252 should be used to report an installment sale in the year it takes place and to report payments received in later years. It should be attached to the seller s tax return for each year. Form 6252 will help the seller determine the gross profit, contract price, gross profit percentage, and installment sale income. 11. Form 4797 An installment sale of property used in a taxpayer s business or that earns rent or royalty income may result in a capital gain, an ordinary gain, or both. All or part of any gain from the disposition of the property may be ordinary gain from depreciation recapture. For trade or business property held for more than one year, enter the amount from line 26 of Form 6252 on Form 4797, line 4. If the property was held one year or less or the seller has an ordinary gain from the sale of a noncapital asset (even if the holding period is more than one year), enter this amount on Form 4797, line 10, and write From Form II. Other Rules A. ELECTING OUT OF THE INSTALLMENT METHOD If a seller elects not to use the installment method, he generally reports the entire gain in the year of sale, even though he did not receive all the sale proceeds in that year. To figure the amount of gain to report, the seller must use the fair market value (FMV) of the buyer's installment obligation that represents the buyer's debt. Notes, mortgages, and land contracts are examples of obligations that are included at FMV. The seller must figure the FMV of the buyer's installment obligation, whether or not he would actually be able to sell it. If the seller uses the cash method of accounting, the FMV of the obligation will never be considered to be less than the FMV of the property sold (minus any other consideration received). Dispositions of Business Property 5-16

148 Example. Omarosa sold a parcel of land for $50,000. She received a $10,000 down payment and will receive the balance over the next 10 years at $4,000 a year, plus 8% interest. The buyer gave Omarosa a note for $40,000. The note had an FMV of $40,000. Omarosa paid a commission of 6%, or $3,000, to a broker for negotiating the sale. The land cost $25,000 and she owned it for more than one year. Omarosa decided to elect out of the installment method and report the entire gain in the year of sale. To make this election, a seller should not report his sale on Form Instead, a seller should report it on Schedule D (Form 1040) or Form 4797, whichever applies. The election must be made by the due date, including extensions, for filing the seller s tax return for the year the sale takes place. A seller who files his tax return without making the election can still make the election by filing an amended return within 6 months of the due date of his return (excluding extensions). Once made, the election can be revoked only with IRS approval. A revocation is retroactive. A seller will not be allowed to revoke the election if either of the following applies: One of the purposes is to avoid federal income tax; or The tax year in which any payment was received has closed. B. SALE OF A BUSINESS The sale of a business usually is not a sale of one asset. Instead, all the assets of the business are sold. Generally, when this occurs, each asset is treated as being sold separately for determining the treatment of gain or loss. Both the buyer and seller involved in the sale of a business must report to the IRS the allocation of the sales price among the business assets. They must use Form 8594, Asset Acquisition Statement Under Section 1060, to provide this information. The buyer and seller should each attach Form 8594 to their federal income tax return for the year in which the sale occurred. A business usually has many assets. When sold, these assets must be classified as capital assets, depreciable property used in the business, real property used in the business, or property held for sale to customers, such as inventory or stock in trade. The gain or loss on each asset is figured separately. The sale of capital assets results in capital gain or loss. The sale of real property or depreciable property used in the business and held longer than one year results in gain or loss from a 1231 transaction. The sale of inventory results in ordinary income or loss. 1. Partnership Interests An interest in a partnership or joint venture is treated as a capital asset when sold. The part of any gain or loss from unrealized receivables or inventory items will be treated as ordinary gain or loss. Dispositions of Business Property 5-17

149 2. Corporation Interests An individual s interest in a corporation is represented by stock certificates. When these certificates are sold, the individual usually realizes capital gain or loss. 3. Corporate Liquidations Corporate liquidations of property generally are treated as a sale or exchange. Gain or loss generally is recognized by the corporation on a liquidating sale of its assets. Gain or loss generally is recognized also on a liquidating distribution of assets as if the corporation sold the assets to the distributee at fair market value. In certain cases in which the distributee is a corporation in control of the distributing corporation, the distribution may not be taxable. 4. Allocation of Consideration Paid for a Business The sale of a trade or business for a lump sum is considered a sale of each individual asset rather than of a single asset. Except for assets exchanged under any nontaxable exchange rules, both the buyer and seller of a business must use the residual method (explained later) to allocate the consideration to each business asset transferred. This method determines gain or loss from the transfer of each asset and how much of the consideration is for goodwill and certain other intangible property. It also determines the buyer's basis in the business assets. a. Consideration. The buyer's consideration is the cost of the assets acquired. The seller's consideration is the amount realized (money plus the fair market value of property received) from the sale of assets. b. Residual method. The residual method must be used for any transfer of a group of assets that constitutes a trade or business and for which the buyer's basis is determined only by the amount paid for the assets. This applies to both direct and indirect transfers, such as the sale of a business or the sale of a partnership interest in which the basis of the buyer's share of the partnership assets is adjusted for the amount paid under 743(b) of the Internal Revenue Code. 743(b) applies if a partnership has an election in effect under 754 of the Internal Revenue Code. A group of assets constitutes a trade or business if either of the following applies: Goodwill or going concern value could, under any circumstances, attach to them; or The use of the assets would constitute an active trade or business under 355 of the Internal Revenue Code. The residual method provides for the consideration to be reduced first by the cash and general deposit accounts (including checking and savings accounts but excluding certificates of deposit). The consideration remaining after this reduction must be allocated among the various business assets in a certain order. Dispositions of Business Property 5-18

150 For asset acquisitions occurring after March 15, 2001, the allocation must be made among the following assets in proportion to (but not more than) their fair market value on the purchase date in the following order: 1. Certificates of deposit, U.S. Government securities, foreign currency, and actively traded personal property, including stock and securities; 2. Accounts receivable, other debt instruments, and assets that you mark to market at least annually for federal income tax purposes. However, see section (b)(2)(iii) of the regulations for exceptions that apply to debt instruments issued by persons related to a target corporation, contingent debt instruments, and debt instruments convertible into stock or other property; 3. Property of a kind that would properly be included in inventory if on hand at the end of the tax year or property held by the taxpayer primarily for sale to customers in the ordinary course of business; 4. All other assets except 197 intangibles; 5. Section 197 intangibles (other than goodwill and going concern value); and 6. Goodwill and going concern value (whether the goodwill or going concern value qualifies as a 197 intangible). If an asset described in (1) through (6) is includible in more than one category, include it in the lower number category. For example, if an asset is described in both (4) and (6), include it in (4). Example. The total paid in the January 10, 2013 sale of the assets of Company SKB is $21,000. No cash or deposit accounts or similar accounts were sold. The company's U.S. Government securities sold had a fair market value of $3,200. The only other asset transferred (other than goodwill and going concern value) was inventory with a fair market value of $15,000. Of the $21,000 paid for the assets of Company SKB, $3,200 is allocated to U.S. Government securities, $15,000 to inventory assets, and the remaining $2,800 to goodwill and going concern value. a. Agreement. The buyer and seller may enter into a written agreement as to the allocation of any consideration or the fair market value of any of the assets. This agreement is binding on both parties unless the IRS determines the amounts are not appropriate. b. Reporting requirement. Both the buyer and seller involved in the sale of business assets must report to the IRS the allocation of the sales price among section 197 intangibles and the other business assets. Form 8594 is used to provide this information. The buyer and seller should each attach Form 8594 to their federal income tax return for the year in which the sale occurred. Dispositions of Business Property 5-19

151 III. Calculating Gain or Loss A number of factors must be considered in determining if the seller has a gain or a loss. These factors include basis, adjusted basis, amount realized, fair market value and amount recognized, which are defined below. Table 5.1 How to Figure a Gain or a Loss IF your... THEN you have a... Adjusted basis is more than the amount Loss. realized Amount realized is more than the adjusted Gain. basis A. BASIS OF BUSINESS ASSETS Basis is the amount of a taxpayer s investment in property for tax purposes. The basis of property is used to figure a number of things, including depreciation, amortization, depletion, and casualty losses. It is also used it to figure gain or loss on the sale or other disposition of property. The basis of property a taxpayer buys is usually his cost. The taxpayer may also have to capitalize (add to basis) certain other costs related to buying or producing the property. The taxpayer s original basis in property is adjusted (increased or decreased) by certain events. If the taxpayer makes improvements to the property, this increases the basis. If the taxpayer takes deductions for depreciation or casualty losses, this reduces basis. If a taxpayer purchases property to use in his business, the basis is usually his actual cost. If the taxpayer constructs, creates, or otherwise produces property, he must capitalize the costs as his basis. 1. Uniform Capitalization Rules The uniform capitalization rules specify the costs a business must add to basis in certain circumstances. A taxpayer must use the uniform capitalization rules if he does any of the following in his trade or business or activity carried on for profit: Produces real or tangible personal property for use in the business or activity; or Produces real or tangible personal property for sale to customers; or Acquires property for resale. A taxpayer produces property if he constructs, builds, installs, manufactures, develops, improves, creates, raises, or grows the property. Under the uniform capitalization rules, a taxpayer must capitalize all direct costs and an allocable part of most indirect costs incurred due to the production or resale activities. The term capitalize means to include certain expenses in the basis of property produced or in the inventory costs rather than deduct them as a current expense. The taxpayer recovers these costs through Dispositions of Business Property 5-20

152 deductions for depreciation, amortization, or cost of goods sold he uses, sells, or otherwise disposes of the property. Any cost which cannot be used to figure taxable income for any tax year is not subject to the uniform capitalization rules. The following are not subject to the uniform capitalization rules: Property produced that an individual does not use in his trade, business, or activity conducted for profit; Qualified creative expenses paid or incurred as a free-lance (self-employed) writer, photographer, or artist that are otherwise deductible on an individual s tax return; Property produced under a long-term contract, except for certain home construction contracts; Research and experimental expenses allowable as a deduction under 174 of the Internal Revenue Code; and Costs for personal property acquired for resale if the taxpayer (or their predecessor's) average annual gross receipts for the 3 previous tax years do not exceed $10 million. For other exceptions to the uniform capitalization rules, see 1.263A-1(b) of the regulations. 2. Intangible Assets Intangible assets include goodwill, patents, copyrights, trademarks, trade names, and franchises. The basis of an intangible asset is usually the cost to buy or create it. a. Patents. The basis of a patent received for an invention is the cost of development, such as research and experimental expenditures, drawings, working models, and attorneys' and governmental fees. If the inventor deducts the research and experimental expenditures as current business expenses, he cannot include them in the basis of the patent. The value of the inventor's time spent on an invention is not part of the basis. b. Copyrights. If an individual is an author, the basis of a copyright will usually be the cost of getting the copyright plus copyright fees, attorneys' fees, clerical assistance, and the cost of plates that remain in the author s possession. The value of the individual s time is not included. c. Franchises, trademarks, and trade names. If an individual or entity buys a franchise, trademark, or trade name, the basis is its cost, unless the buyer can deduct its payments as a business expense. Dispositions of Business Property 5-21

153 3. Allocating the Basis If an individual or business buys multiple assets for a lump sum, the buyer should allocate the amount paid among the assets received. The individual or business must make this allocation to figure its basis for depreciation and gain or loss on a later disposition of any of these assets. 4. Group of Assets Acquired If an individual or business buys multiple assets for a lump sum, the buyer and the seller may agree to a specific allocation of the purchase price among the assets in the sales contract. If this allocation is based on the value of each asset and the buyer and the seller have adverse tax interests, the allocation generally will be accepted. 5. Trade or Business Acquired If an individual acquires a trade or business, he should allocate the consideration paid to the various assets acquired. Generally, the consideration paid should be reduced by any cash and general deposit accounts (including checking and savings accounts) received. The remaining consideration should be allocated to the other business assets received in proportion to (but not more than) their fair market value in the following order: Certificates of deposit, U.S. Government securities, foreign currency, and actively traded personal property, including stock and securities; Accounts receivable, other debt instruments, and assets which are marked to market at least annually for federal income tax purposes; Property of a kind that would properly be included in inventory if on hand at the end of the tax year or property held primarily for sale to customers in the ordinary course of business; All other assets except 197 intangibles, goodwill, and going concern value; Section 197 intangibles except goodwill and going concern value; and Goodwill and going concern value (whether or not they qualify as 197 intangibles). a. Agreement. The buyer and seller may enter into a written agreement as to the allocation of any consideration or the fair market value (FMV) of any of the assets. This agreement is binding on both parties unless the IRS determines the amounts are not appropriate. b. Reporting requirement. Both the buyer and seller involved in the sale of business assets must report to the IRS the allocation of the sales price among 197 intangibles and the other business assets. Use Form 8594 to provide this information. The buyer and seller should each attach Form 8594 to their federal income tax return for the year in which the sale occurred. Dispositions of Business Property 5-22

154 6. Land and Buildings If an individual or business buys buildings and the land on which they stand for a lump sum, the buyer should allocate the basis of the property among the land and the buildings in order to determine the depreciation allowable on the buildings. Figure the basis of each asset by multiplying the lump sum by a fraction. The numerator is the FMV of that asset and the denominator is the FMV of the whole property at the time of purchase. If the buyer is not certain of the FMV of the land and buildings, he can allocate the basis based on their assessed values for real estate tax purposes. a. Demolition of building. Add demolition costs and other losses incurred for the demolition of any building to the basis of the land on which the demolished building was located. Do not claim the costs as a current deduction. b. Modification of building. A modification of a building will not be treated as a demolition if the following conditions are satisfied: 75 percent or more of the existing external walls of the building are retained in place as internal or external walls; and 75 percent or more of the existing internal structural framework of the building is retained in place. If the building is a certified historic structure, the modification must also be part of a certified rehabilitation. If these conditions are met, add the costs of the modifications to the basis of the building. c. Subdivided lots. If an individual or business buys a tract of land and subdivides it, the basis of each lot must be determined. This is necessary because the buyer must figure the gain or loss on the sale of each individual lot. As a result, the buyer does not recover its entire cost in the tract until he has sold all of the lots. To determine the basis of an individual lot, multiply the total cost of the tract by a fraction. The numerator is the FMV of the lot and the denominator is the FMV of the entire tract. If the individual or business is a developer and sells subdivided lots before the development work is completed, he can (with IRS consent) include in the basis of the properties sold an allocation of the estimated future cost for common improvements. 7. Adjusted Basis Before figuring gain or loss on a sale, exchange, or other disposition of property or figuring allowable depreciation, depletion, or amortization, taxpayers must usually make certain adjustments to the basis of the property. The result of these adjustments to the basis is the adjusted basis. Dispositions of Business Property 5-23

155 8. Increases to Basis Increase the basis of any property by all items properly added to a capital account. These include the cost of any improvements having a useful life of more than one year. However, an owner must subtract any rehabilitation credit allowed for these expenses before adding them to the basis. If any of the credit needs to be recaptured, it will increase the basis by the recaptured amount. If additions or improvements are made to business property, the owner must keep separate accounts for them. Also, the owner must depreciate the basis of each according to the depreciation rules that would apply to the underlying property if the owner had placed it in service at the same time he placed the addition or improvement in service. The following items increase the basis of property: The cost of extending utility service lines to the property; Impact fees; Legal fees, such as the cost of defending and perfecting title; Legal fees for obtaining a decrease in an assessment levied against property to pay for local improvements; Zoning costs; and The capitalized value of a redeemable ground rent. 9. Decreases to Basis The following items decrease the basis of property: Exclusion from income of subsidies for energy conservation measures; Casualty or theft loss deductions and insurance reimbursements; Credit for qualified electric vehicles; Section 179 deduction; Deduction for clean-fuel vehicles and clean-fuel vehicle refueling property; Depreciation; and Nontaxable corporate distributions. Dispositions of Business Property 5-24

156 B. DETERMINING WHETHER GAIN OR LOSS IS ORDINARY OR CAPITAL An individual or business must classify the gains and losses as either ordinary or capital gains or losses. This must be done in order to calculate the business s net capital gain or loss. Generally, an individual or business will have a capital gain or loss if the individual or business disposes of a capital asset. For the most part, everything owned and used for personal purposes or investment is a capital asset. Generally, taxpayers will have a capital gain or loss if they sell or exchange a capital asset. Taxpayers also may have a capital gain if their 1231 transactions result in a net gain. Section 1231 transactions are sales and exchanges of property held longer than 1 year and either used in a trade or business or held for the production of rents or royalties. They also include certain involuntary conversions of business or investment property, including capital assets. 1. Capital Assets Almost everything an individual or business owns and uses for personal purposes or investment is a capital asset. Examples include stocks and bonds, a home and car or a stamp or coin collection. 2. Personal-Use Property Property held for personal use is a capital asset. Gain from a sale or exchange of that property is a capital gain. Loss from the sale or exchange of that property is not deductible. A taxpayer can deduct a loss relating to personal-use property only if it results from a casualty or theft. 3. Investment Property Investment property (such as stocks and bonds) is a capital asset, and a gain or loss from its sale or exchange is a capital gain or loss. This treatment does not apply to property used to produce rental income. 4. Noncapital Assets A noncapital asset is property that is not a capital asset. The following kinds of property are not capital assets: Property held mainly for sale to customers or property that will physically become part of merchandise for sale to customers. This includes stock in trade, inventory, and other property held mainly for sale to customers in a trade or business; Accounts or notes receivable acquired in the ordinary course of a trade or business for services rendered or from the sale of any properties described in above; Depreciable property used in a trade or business or as rental property, even if the property is fully depreciated (or amortized); Dispositions of Business Property 5-25

157 Real property used in a trade or business or as rental property, even if the property is fully depreciated; A copyright; a literary, musical, or artistic composition; a letter; a memorandum; or similar property (such as drafts of speeches, recordings, transcripts, manuscripts, drawings, or photographs): a. Created by your personal efforts, b. Prepared or produced for you (in the case of a letter, memorandum, or similar property), or c. Acquired from a person who created the property or for whom the property was prepared under circumstances (for example, by gift) entitling you to the basis of the person who created the property, or for whom it was prepared or produced. U.S. Government publications received from the government for free or for less than the normal sales price or that was acquired under circumstances entitling the recipient to the basis of someone who got the publications for free or for less than the normal sales price; Any commodities derivative financial instrument held by a commodities derivatives dealer unless it meets both the following requirements; a. It is established to the satisfaction of the IRS that the instrument has no connection to the activities of the dealer as a dealer. b. The instrument is clearly identified in the dealer's records as meeting (a) by the end of the day on which it was acquired, originated, or entered into. Any hedging transaction that is clearly identified as a hedging transaction by the end of the day on which it was acquired, originated, or entered into; or Supplies of a type regularly used or consumed in the ordinary course of a trade or business. 5. Property Held Mainly for Sale to Customers Stock in trade, inventory, and other property held mainly for sale to customers in a trade or business are not capital assets. 6. Business Assets Real property and depreciable property used in a trade or business or as rental property (including 197 intangibles) are not capital assets. 7. Commodities Derivative Financial Instrument A commodities derivative financial instrument is a commodities contract or other financial instrument for commodities (other than a share of corporate stock, a beneficial interest in a partnership or trust, a note, bond, debenture, or other evidence of indebtedness, or a 1256 contract) the value or settlement price of which is calculated or determined by reference to a specified index (as defined in 1221(b) of the Internal Revenue Code). Dispositions of Business Property 5-26

158 A commodities derivative dealer is a person who regularly offers to enter into, assume, offset, assign, or terminate positions in commodities derivative financial instruments with customers in the ordinary course of a trade or business. 8. Hedging Transaction A hedging transaction is any transaction an individual or business enters into in the normal course of a trade or business primarily to manage any of the following: Risk of price changes or currency fluctuations involving ordinary property it holds or will hold; or Risk of interest rate or price changes or currency fluctuations for borrowings the individual or entity made or will make, or ordinary obligations the individual or entity did or will incur. C. DETERMINING WHETHER A GAIN OR LOSS IS LONG OR SHORT TERM If a business has a capital gain or loss, it must determine whether it is long term or short term. Whether a gain or loss is long or short term depends on how long the business owned the property before it was disposed of. The length of time that the property was owned before being sold is referred to as the holding period. If the entity holds a capital asset one year or less, the gain or loss from its disposition is short term. If it holds a capital asset longer than one year, the gain or loss from its disposition is long term. Table 5.2 Determining Short and Long Term Gain or Loss IF you hold the property... THEN you have a... One year or less Short-term gain or loss. More than one year Long-term capital gain or loss. This distinction is essential to correctly arrive at a business s net capital gain or loss. Capital losses are allowed in full against capital gains plus up to $3,000 of ordinary income. 1. Holding Period To figure if the business held the property longer than one year, start counting on the day following the day it acquired the property. The day it disposed of the property is part of its holding period. Example. If Kwame bought an asset on June 19, 2012, he should start counting on June 20, If he sold the asset on June 19, 2013, his holding period is not longer than one year, but if he sold it on June 20, 2013, his holding period is longer than one year. Dispositions of Business Property 5-27

159 a. Patent property. If a business disposes of patent property, it generally is considered to have held the property longer than one year, no matter how long it actually was held. b. Inherited property. If a business inherits property, it is considered to have held the property longer than one year, regardless of how long it was actually held. c. Installment sale. The gain from an installment sale of an asset qualifying for longterm capital gain treatment in the year of sale continues to be long-term in later tax years. If it is short-term in the year of sale, it continues to be short-term when payments are received in later tax years. The date the installment payment is received determines the capital gains rate that should be applied, not the date the asset was sold under an installment contract. d. Nontaxable exchange. If a business acquires an asset in exchange for another asset and the basis for the new asset is figured, in whole or in part, by using the basis in the old property, the holding period of the new property includes the holding period of the old property. That is, it begins on the same day as the business s holding period for the old property. Example. Troy bought machinery on December 4, On June 4, 2012, he traded this machinery for other machinery in a nontaxable exchange. On December 5, 2012, Troy sold the machinery he got in the exchange. Troy s holding period for this machinery began on December 5, Therefore, he held it longer than one year. e. Corporate liquidation. The holding period for property received in a liquidation generally starts on the day after it is received if gain or loss is recognized. f. Profit-sharing plan. The holding period of common stock withdrawn from a qualified contributory profit-sharing plan begins on the day following the day the plan trustee delivered the stock to the transfer agent with instructions to reissue the stock in the individual s name. g. Gift. If a business receives a gift of property and its basis in it is figured using the donor's basis, its holding period includes the donor's holding period. h. Real property. To figure how long a business held real property, start counting on the day after it received title to it or, if earlier, the day after it took possession of it and assumed the burdens and privileges of ownership. However, taking possession of real property under an option agreement is not enough to start the holding period. The holding period cannot start until there is an actual contract of sale. The holding period of the seller cannot end before that time. i. Repossession. If an individual sells real property but keeps a security interest in it and then later repossesses it, his holding period for a later sale includes the period he held the property before the original sale, as well as the period after the repossession. The individual s holding period does not include the time between the original sale and the repossession. That is, it does not include the period during which the first buyer held the property. Dispositions of Business Property 5-28

160 j. Non-business bad debts. Non-business bad debts are short-term capital losses. D. REPORTING GAINS AND LOSSES Taxpayers should report gains and losses from the following dispositions on the forms indicated. The instructions for the forms explain how to fill them out. The following table includes some of the more common reporting requirements. Table 5.3 Common Reporting Requirements Dispositions of business property and depreciable property Like-kind exchanges Installment sales Casualties and thefts Use Form If you have taxable gain, Schedule D (Form 1040) may also be required. Use Form 8824, Like-Kind Exchanges. Form 4797 and Schedule D (Form 1040) may also be required. Use Form 6252, Installment Sale Income. Form 4797 and Schedule D (Form 1040) may also be required. Use Form 4684, Casualties and Thefts. Form 4797 may also be required. Condemned property Use Form Schedule D (Form 1040) may also be required. Dispositions of Business Property 5-29

161 Chapter 5 Review Questions The following questions are designed to ensure that you have a complete understanding of the information presented in the chapter. They do not need to be submitted in order to receive CPE credit. They are included as an additional tool to enhance your learning experience. We recommend that you answer each review question and then compare your response to the suggested solution before answering the final exam questions related to this chapter. 1. For tax purposes, dispositions of property are limited to the sale of property for cash. a) true b) false 2. Which of the following are requirements of a like-kind exchange: a) property with a value of $100,000 or above b) commercial real estate c) business or investment property d) property that has been owned for at least 10 years 3. An exchange of personal property for real property qualifies as a like-kind exchange. a) true b) false 4. How long does an individual or business have to identify the property to be received as part of a like-kind exchange: a) 30 days b) 45 days c) 90 days d) 180 days 5. Special rules limit the disposition of property in like-kind exchanges between related persons. One such rule requires a year holding period to avoid the disqualification of previously claimed non-recognition treatment. a) one b) two c) three d) five Dispositions of Business Property 5-30

162 6. Which of the following is the most accurate definition of an installment sale: a) an installment sale occurs when the seller finances 100 percent of the purchase price b) an installment sale occurs when the buyer requires financing to complete the transaction c) an installment sale occurs when the seller receives at least one payment from the buyer in the tax year following the transaction d) an installment sale occurs when the seller receives at least three payments from the buyer following the transaction 7. The IRS has no requirements mandating sellers to report installment sales. a) true b) false 8. When a business is sold, it is not necessary to determine the gain or loss on each individual asset. a) true b) false 9. Which of the following is the most accurate definition of the basis of a copyright: a) copyrights are not real property, so there is no basis b) the basis of the value of the time spent by the author in creating the intellectual property c) the fair market value of the copyright at the time of disposition d) the cost of securing the copyright 10. Which of the following factors is used in determining whether a gain is long or short term: a) the amount of the gain and how long the asset was held b) only the amount of the gain c) only the amount of time the asset was held d) there is no such distinction Dispositions of Business Property 5-31

163 Chapter 5 Solutions and Suggested Responses 1. A: True is incorrect. There are many types of dispositions of property including, but not limited to, the sale of property for cash. B: False is correct. The disposition of property includes, among other things, selling property for cash or other property, exchanging property for other property, receiving money as a tenant for the cancellation of a lease, or receiving money for granting the exclusive use of a copyright throughout its life in a particular medium. (See page 5-1 of the course material.) 2. A: Incorrect. There is no minimum value for like-kind exchange property. B: Incorrect. Property is not limited to commercial real estate. For example, apartments can be like-kind property. C: Correct. The asset must be business or investment property to qualify for a likekind exchange. D: Incorrect. There is no such requirement. (See page 5-1 of the course material.) 3. A: True is incorrect. To be subject to an exchange, the property in question must be of like kind. B: False is correct. An exchange of personal property for real property does not qualify as a like-kind exchange. There must be an exchange of like-kind property. Like-kind properties are properties of the same nature or character, even if they differ in grade or quality. (See pages 5-2 to 5-3 of the course material.) 4. A: Incorrect. The period for making the identification is actually 45 days. B: Correct. This is the period of time an individual or entity has to identify the property to be received in an exchange. C: Incorrect. The actual time period is shorter. D: Incorrect. The actual time period is shorter. (See page 5-4 of the course material.) Dispositions of Business Property 5-32

164 5. A: Incorrect. This period is too short. B: Correct. Under these special rules, if either person disposes of the property within two years after the exchange, the exchange is disqualified from nonrecognition treatment. The gain or loss on the original exchange must then be recognized as of the date of the later disposition. The two-year holding period begins on the date of the last transfer of property that was part of the like-kind exchange. C: Incorrect. This number of years is too long. D: Incorrect. This period too is longer than required to avoid disqualification of nonrecognition treatment. (See pages 5-11 to 5-12 of the course material.) 6. A: Incorrect. Only some kind of note is required, not 100 percent financing. B: Incorrect. Financing from a third party does not create an installment sale. C: Correct. Only a single payment after the tax year of the sale is sufficient to constitute an installment sale. D: Incorrect. Only one payment after the tax year is required to constitute an installment sale. (See page 5-12 of the course material.) 7. A: True is incorrect. The IRS has a number of reporting requirements for installment sales. B: False is correct. Generally, sellers will use Form 6252 to report installment sale income. (See page 5-16 of the course material.) 8. A: True is incorrect. Each asset must be treated separately in determining whether there was a gain or a loss. B: False is correct. A business usually has many assets. When sold, these assets must be classified as capital assets, depreciable property used in the business, real property used in the business, or property held for sale to customers, such as inventory or stock in trade. The gain or loss on each asset is figured separately. (See page 5-17 of the course material.) Dispositions of Business Property 5-33

165 9. A: Incorrect. A copyright is true intellectual property, and therefore has both value and a basis. B: Incorrect. The time spent by the author is not computed in calculating the basis of a copyright. C: Incorrect. The fair market value is not relevant to the determination of basis. D: Correct. It is the actual cost of securing the copyright, including filing fees and attorney s fees, that is used to determine the basis of the asset. (See page 5-21 of the course material.) 10. A: Incorrect. The amount of time the asset is held is determinative, but not its value. B: Incorrect. The amount of the gain has no impact on whether or not the gain was long or short term. C: Correct. Assets held for more than one year are considered long term gain or loss. Less than that is considered short term gain or loss. D: Incorrect. There is an important distinction because it affects the amount of tax owed. (See page 5-27 of the course material.) Dispositions of Business Property 5-34

166 Chapter 6: General Business Credit I. Overview A business s general business credit for the year consists of the carry-forward of business credits from prior years plus the total of the current year business credits. In addition, a business s general business credit for the current year may be increased later by the carry-back of business credits from later years. This credit is subtracted directly from a business s tax liability. All of the following credits are part of the general business credit. The form used to figure each credit is shown in parentheses. Form 3800 will also have to be completed. For reference purposes, the forms are provided at the end of this chapter. A. MISCELLANEOUS CREDITS The following are some of the miscellaneous credits available for the 2012 tax year. 1. Alcohol and Cellulosic Biofuel Fuels Credit (Form 6478) This credit applies to alcohol a business sold or used as fuel. Alcohol, for purposes of this credit, includes ethanol and methanol. It does not include alcohol produced from petroleum, natural gas, coal, or peat. Nor does it include alcohol of less than 150 proof. For more information, see Form 6478 provided at the end of this chapter. 2. Certain Employment Taxes (Form 8846) The credit is generally equal to a business s (employer's) portion of social security and Medicare taxes paid on tips received by employees of a food and beverage establishment where tipping is customary. The credit applies regardless of whether the food is consumed on or off the business premises. However, the business cannot get credit for its part of social security and Medicare taxes on those tips that are used to meet the federal minimum wage rate that applies to the employee under the Fair Labor Standards Act. For more information, see Form 8846 provided at the end of this chapter. 3. Employer-Provided Childcare Facilities (Form 8882) This credit applies to the qualified expenses a business paid for employee childcare and qualified expenses it paid for childcare resource and referral services. The credit is 25% of qualified expenses the business paid for employee childcare and 10% of qualified expenses it paid for childcare resource and referral services. This credit is limited to $150,000 each year. For more information, see Form 8882 provided at the end of this chapter. 4. Low-Income Housing Credit (Form 8586) This credit generally applies to qualified low-income housing buildings placed in service after For more information, see Form General Business Credit 6-1

167 5. Orphan Drug Credit (Form 8820) The orphan drug credit applies to qualified expenses incurred in testing certain drugs, known as orphan drugs for rare diseases and conditions. For more information, see Form Small Employer Health Insurance Premium Credit (Form 8941) This is available to eligible small employers, generally those with 25 full-time equivalent employees (FTEs) or less. The maximum credit is a percentage of premiums the employer paid during the tax year for certain health insurance coverage the employer provided to certain employees. For more information, see Form B. WORK OPPORTUNITY TAX CREDIT (FORM 5884) 1. General Statement of Law The work opportunity tax credit (WOTC) is available on an elective basis for employers hiring individuals from one of a list of targeted groups. The amount of the credit available to an employer is determined by the amount of qualified wages paid by the employer. Generally, qualified wages consist of wages attributable to service rendered by a member of a targeted group during the one-year period beginning with the day the individual begins work for the employer (two years in the case of an individual in the long-term family assistance recipient category). The American Recovery and Reinvestment Act ( ARRA ) adds two categories of targeted groups that make employers eligible for the credit: (1) certain military veterans, and (2) certain people aged referred to as disconnected youth. This section discusses the credit, including changes made by the ARRA. 2. Targeted Groups Eligible for Credit Generally an employer is eligible for the credit only for qualified wages paid to members of a targeted group. a. Families Receiving TANF An eligible recipient is an individual certified by a designated local employment agency (e.g., a state employment agency) as being a member of a family eligible to receive benefits under the Temporary Assistance for Needy Families Program ( TANF ) for a period of at least nine months, part of which is during the 18-month period ending on the hiring date. For these purposes, members of the family are defined to include only those individuals taken into account for purposes of determining eligibility for the TANF. b. Qualified Veteran There are two subcategories of qualified veterans related to eligibility for food stamps and compensation for a service-connected disability. General Business Credit 6-2

168 i. Food stamps A qualified veteran is a veteran who is certified by the designated local agency as a member of a family receiving assistance under a food stamp program under the Food Stamp Act of ii. Entitled to compensation for a service-connection disability A qualified veteran also includes an individual who is certified as entitled to compensation for a service-connected disability and: (1) having a hiring date which is not more than one year after having been discharged or released from active duty in the Armed Forces of the United States; or (2) having been unemployed for six months or more (whether or not consecutive) during the one-year period ending on the date of hiring. iii. Definitions For these purposes, being entitled to compensation for a service-connected disability is defined with reference to section 101 of Title 38, U.S. Code, which means having a disability rating of 10 percent or higher for service connected injuries. For these purposes, a veteran is an individual who has served on active duty (other than for training) in the Armed Forces for more than 180 days or who has been discharged or released from active duty in the Armed Forces for a service-connected disability. However, any individual who has served for a period of more than 90 days during which the individual was on active duty (other than for training) is not a qualified veteran if any of this active duty occurred during the 60-day period ending on the date the individual was hired by the employer. This latter rule is intended to prevent employers who hire current members of the armed services (or those departed from service within the last 60 days) from receiving the credit. c. Qualified Ex-Felon A qualified ex-felon is an individual certified as: (1) having been convicted of a felony under any state or federal law; and (2) having a hiring date within one year of release from prison or the date of conviction. d. Designated Community Residents A designated community resident is an individual certified as being at least age 18 but not yet age 40 on the hiring date and as having a principal place of abode within an empowerment zone, enterprise community, renewal community or a rural renewal community. For these purposes, a rural renewal county is a county outside a metropolitan statistical area (as defined by the Office of Management and Budget) which had a net population loss during the five-year periods and Qualified wages do not include wages paid or incurred for services performed after the individual moves outside an empowerment zone, enterprise community, renewal community or a rural renewal community. General Business Credit 6-3

169 e. Vocational Rehabilitation Referral A vocational rehabilitation referral is an individual who is certified by a designated local agency as an individual who has a physical or mental disability that constitutes a substantial handicap to employment and who has been referred to the employer while receiving, or after completing: (a) vocational rehabilitation services under an individualized, written plan for employment under a state plan approved under the Rehabilitation Act of 1973; (b) under a rehabilitation plan for veterans carried out under Chapter 31 of Title 38, U.S. Code; or (c) an individual work plan developed and implemented by an employment network pursuant to subsection (g) of section 1148 of the Social Security Act. Certification will be provided by the designated local employment agency upon assurances from the vocational rehabilitation agency that the employee has met the above conditions. f. Qualified Summer Youth Employee A qualified summer youth employee is an individual: (a) who performs services during any 90-day period between May 1 and September 15; (b) who is certified by the designated local agency as being 16 or 17 years of age on the hiring date; (c) who has not been an employee of that employer before; and (d) who is certified by the designated local agency as having a principal place of abode within an empowerment zone, enterprise community, or renewal community (as defined under Subchapter U of Subtitle A, Chapter 1 of the Internal Revenue Code). As with designated community residents, no credit is available on wages paid or incurred for service performed after the qualified summer youth moves outside of an empowerment zone, enterprise community, or renewal community. If, after the end of the 90-day period, the employer continues to employ a youth who was certified during the 90-day period as a member of another targeted group, the limit on qualified first year wages will take into account wages paid to the youth while a qualified summer youth employee. g. Qualified Food Stamp Recipient A qualified food stamp recipient is an individual at least age 18 but not yet age 40 certified by a designated local employment agency as being a member of a family receiving assistance under a food stamp program under the Food Stamp Act of 1977 for a period of at least six months ending on the hiring date. In the case of families that cease to be eligible for food stamps under section 6(o) of the Food Stamp Act of 1977, the six-month requirement is replaced with a requirement that the family has been receiving food stamps for at least three of the five months ending on the date of hire. For these purposes, members of the family are defined to include only those individuals taken into account for purposes of determining eligibility for a food stamp program under the Food Stamp Act of h. Qualified SSI Recipient A qualified SSI recipient is an individual designated by a local agency as receiving supplemental security income ( SSI ) benefits under Title XVI of the Social Security Act for any month ending within the 60-day period ending on the hiring date. General Business Credit 6-4

170 i. Long-Term Family Assistance Recipients A qualified long-term family assistance recipient is an individual certified by a designated local agency as being: (a) a member of a family that has received family assistance for at least 18 consecutive months ending on the hiring date; (b) a member of a family that has received such family assistance for a total of at least 18 months (whether or not consecutive) after August 5, 1997 (the date of enactment of the welfare-to-work tax credit if the individual is hired within two years after the date that the 18-month total is reached; or (c) a member of a family who is no longer eligible for family assistance because of either federal or state time limits, if the individual is hired within two years after the federal or state time limits made the family ineligible for family assistance. 3. Qualified Wages Generally, qualified wages are defined as cash wages paid by the employer to a member of a targeted group. The employer s deduction for wages is reduced by the amount of the credit. For purposes of the credit, generally, wages are defined by reference to the FUTA definition of wages contained in sec. 3306(b) (without regard to the dollar limitation therein contained). Special rules apply in the case of certain agricultural labor and certain railroad labor. 4. Calculation of the Credit The credit available to an employer for qualified wages paid to members of all targeted groups except for long-term family assistance recipients equals 40 percent (25 percent for employment of 400 hours or less) of qualified first-year wages. Generally, qualified first-year wages are qualified wages (not in excess of $6,000) attributable to service rendered by a member of a targeted group during the one-year period beginning with the day the individual began work for the employer. Therefore, the maximum credit per employee is $2,400 (40 percent of the first $6,000 of qualified first-year wages). With respect to qualified summer youth employees, the maximum credit is $1,200 (40 percent of the first $3,000 of qualified first-year wages). Except for long-term family assistance recipients, no credit is allowed for second-year wages. In the case of long-term family assistance recipients, the credit equals 40 percent (25 percent for employment of 400 hours or less) of $10,000 for qualified first-year wages and 50 percent of the first $10,000 of qualified second-year wages. Generally, qualified second-year wages are qualified wages (not in excess of $10,000) attributable to service rendered by a member of the long-term family assistance category during the one-year period beginning on the day after the one-year period beginning with the day the individual began work for the employer. Therefore, the maximum credit per employee is $9,000 (40 percent of the first $10,000 of qualified first-year wages plus 50 percent of the first $10,000 of qualified second-year wages). 5. Certification Rules An individual is not treated as a member of a targeted group unless: (1) on or before the day on which an individual begins work for an employer, the employer has received a certification from a designated local agency that such individual is a member of a targeted group; or (2) on or before the day an individual is offered employment with the employer, a pre-screening notice is completed by the employer with respect to such individual, and not later than the 28th day after the individual begins work for the General Business Credit 6-5

171 employer, the employer submits such notice, signed by the employer and the individual under penalties of perjury, to the designated local agency as part of a written request for certification. For these purposes, a pre-screening notice is a document (in such form as the Secretary may prescribe) which contains information provided by the individual on the basis of which the employer believes that the individual is a member of a targeted group. 6. Minimum Employment Period No credit is allowed for qualified wages paid to employees who work less than 120 hours in the first year of employment. 7. Other Rules The work opportunity tax credit is not allowed for wages paid to a relative or dependent of the taxpayer. No credit is allowed for wages paid to an individual who is a more than fifty percent owner of the entity. Similarly, wages paid to replacement workers during a strike or lockout are not eligible for the work opportunity tax credit. Wages paid to any employee during any period for which the employer received on-the-job training program payments with respect to that employee are not eligible for the work opportunity tax credit. The work opportunity tax credit generally is not allowed for wages paid to individuals who had previously been employed by the employer. In addition, many other technical rules apply. 8. Expiration The American Taxpayer Relief Act of 2012 (the Act) extends the Work Opportunity Tax Credit (WOTC) for taxable employers hiring members of targeted groups before January 1, 2014, and for tax-exempt employers hiring qualified veterans before January 1, In 2012, the WOTC was available for employers hiring qualified veterans, and not for hiring members of other targeted groups. Therefore, the Act retroactively extends the availability of the WOTC for taxable employers who hired individuals from targeted groups, other than qualified veterans, in Vow to Hire Heroes Act of 2011 On November 21, 2011, President Obama signed into law the Vow to Hire Heroes Act of Section 261 of the Act, the Returning Heroes and Wounded Warriors Work Opportunity Tax Credits, amends and expands the definition of WOTC s Veteran target groups originally found in ARRA. The changes and new provisions in this Act apply to individuals who begin to work for an employer the day after its enactment, November 22, The credits from this Act have been extended until December 31, The Act includes the following provisions: Extends the current target group for Veterans receiving Supplemental Nutrition Assistance Program (SNAP) benefits with the same qualified wages cap ($6,000) and maximum tax credit of ($2,400). Extends the current target group for Veterans with a service-connected disability with the same qualified wages cap ($12,000) and maximum tax credit ($4,800). General Business Credit 6-6

172 Extends the current target group for Veterans with a service-connected disability unemployed for at least six months with the qualified wages cap increased to $24,000 and the maximum tax credit increased to $9,600. Establishes a new target group for unemployed Veterans, similar to the Recovery Act of 2009 unemployed Veteran group that expired on December 31, 2010: o o o Veterans unemployed for at least four weeks with a qualified wages cap of $6,000 and maximum tax credit of $2,400. Veterans unemployed for at least six months with qualified wages cap of $14,000 and maximum tax credit of $5,600. State Workforce Agencies will certify Veterans as meeting the required periods of unemployment based on receipt of unemployment insurance compensation. Note: The five-year period ending on the hiring day requirement that was part of the Recovery Act unemployed Veteran group was rescinded. Qualified tax-exempt (i.e., 501(c)) organizations can now participate by hiring qualified Veterans and are now eligible to claim the WOTC. See new IRS Form 5884-C for more information. C. INVESTMENT CREDIT (FORM 3468) 1. Credit for Investment in Advanced Energy Property a. General Rule Pre-ARRA An income tax credit is allowed for the production of electricity from qualified energy resources at qualified facilities. 1 Qualified energy resources comprise wind, closed-loop biomass, open-loop biomass, geothermal energy, solar energy, small irrigation power, municipal solid waste, qualified hydropower production, and marine and hydrokinetic renewable energy. Qualified facilities are, generally, facilities that generate electricity using qualified energy resources. An income tax credit is also allowed for certain energy property placed in service. Qualifying property includes certain fuel cell property, solar property, geothermal power production property, small wind energy property, combined heat and power system property, and geothermal heat pump property. In addition to these, numerous other credits are available to taxpayers to encourage renewable energy production and energy conservation, including, among others, credits for certain biofuels, plug-in electric vehicles, and energy efficient appliances, and for improvements to heating, air conditioning, and insulation. 1 Sec. 45. In addition to the electricity production credit, section 45 also provides income tax credits for the production of Indian coal and refined coal at qualified facilities. General Business Credit 6-7

173 No credit is specifically designed under present law to encourage the development of a domestic manufacturing base to support the industries described above. b. Provisions of the American Recovery and Reinvestment Act The Act establishes a 30 percent credit for investment in qualified property used in a qualified advanced energy manufacturing project. Only tangible personal property and other tangible property (not including a building or its structural components) is crediteligible. A qualified advanced energy project is a project that re-equips, expands, or establishes a manufacturing facility for the production of: (1) property designed to be used to produce energy from the sun, wind, or geothermal deposits (within the meaning of section 613(e)(2)), or other renewable resources; (2) fuel cells, microturbines, or an energy storage system for use with electric or hybrid-electric motor vehicles; (3) electric grids to support the transmission of intermittent sources of renewable energy, including storage of such energy; (4) property designed to capture and sequester carbon dioxide; (5) property designed to refine or blend renewable fuels (but not fossil fuels) or to produce energy conservation technologies (including energy-conserving lighting technologies and smart grid technologies); or (6) other advanced energy property designed to reduce greenhouse gas emissions as may be determined by the Secretary. Qualifying advance energy projects also include projects designed to manufacture any new qualified plug-in electric drive motor vehicle (as defined by section 30D(c)), any specified vehicle (as defined by section 30D(f)(2)), or any component which is designed specifically for use with such vehicles, including any electric motor, generator, or power control unit. Qualified property must be depreciable (or amortizable) property used in a qualified advanced energy project. Qualified property does not include property designed to manufacture equipment for use in the refining or blending of any transportation fuel other than renewable fuels. The basis of qualified property must be reduced by the amount of credit received. Credits are available only for projects certified by the Secretary of Treasury, in consultation with the Secretary of Energy. The Secretary of Treasury must establish a certification program no later than 180 days after date of enactment, and may allocate up to $2.3 billion in credits. In selecting projects, the Secretary may consider only those projects where there is a reasonable expectation of commercial viability. In addition, the Secretary must consider other selection criteria, including which projects (1) will provide the greatest domestic job creation; (2) will provide the greatest net impact in avoiding or reducing air pollutants or anthropogenic emissions of greenhouse gases; (3) have the lowest levelized cost of generated or stored energy, or of measured reduction in energy consumption or greenhouse gas emission; and (4) have the shortest project time from certification to completion. In addition, the Secretary must consider projects that have the greatest potential for technological innovation and commercial deployment. Each project application must be submitted during the two-year period beginning on the date such certification program is established. An applicant for certification has one year from the date the Secretary accepts the application to provide the Secretary with evidence that the requirements for certification have been met. Upon certification, the applicant has three years from the date of issuance of the certification to place the General Business Credit 6-8

174 project in service. Not later than four years after the date of enactment of the credit, the Secretary is required to review the credit allocations and redistribute any credits that were not used either because of a revoked certification or because of an insufficient quantity of credit applications. The provision became effective on the date of enactment. 2. Modification of the Energy Credit a. In general A nonrefundable, 10-percent business energy credit is allowed for the cost of new property that is equipment that either: (1) uses solar energy to generate electricity, to heat or cool a structure, or to provide solar process heat, or (2) is used to produce, distribute, or use energy derived from a geothermal deposit, but only, in the case of electricity generated by geothermal power, up to the electric transmission stage. Property used to generate energy for the purposes of heating a swimming pool is not eligible solar energy property. The energy credit is a component of the general business credit. An unused general business credit generally may be carried back one year and carried forward 20 years. The taxpayer s basis in the property is reduced by one-half of the amount of the credit claimed. For projects whose construction time is expected to equal or exceed two years, the credit may be claimed as progress expenditures are made on the project, rather than during the year the property is placed in service. The credit is allowed against the alternative minimum tax for credits determined in taxable years beginning after October 3, Property financed by subsidized energy financing or with proceeds from private activity bonds is subject to a reduction in basis for purposes of claiming the credit. The basis reduction is proportional to the share of the basis of the property that is financed by the subsidized financing or proceeds. The term subsidized energy financing means financing provided under a federal, state, or local program, a principal purpose of which is to provide subsidized financing for projects designed to conserve or produce energy. b. Special Rules for Solar Energy Property The credit for solar energy property is increased to 30 percent in the case of periods prior to January 1, Additionally, equipment that uses fiber-optic distributed sunlight to illuminate the inside of a structure is solar energy property eligible for the 30 percent credit. c. Fuel Cells and Microturbines The energy credit applies to qualified fuel cell power plants, but only for periods prior to January 1, The credit rate is 30 percent. A qualified fuel cell power plant is an integrated system composed of a fuel cell stack assembly and associated balance of plant components that (1) converts a fuel into electricity using electrochemical means, and (2) has an electricity-only generation efficiency of greater than 30 percent and a capacity of at least one-half kilowatt. The credit may not exceed $1,667 for each 0.5 kilowatt of capacity. General Business Credit 6-9

175 The energy credit applies to qualifying stationary microturbine power plants for periods prior to January 1, The credit is limited to the lesser of 10 percent of the basis of the property or $200 for each kilowatt of capacity. A qualified stationary microturbine power plant is an integrated system comprised of a gas turbine engine, a combustor, a recuperator or regenerator, a generator or alternator, and associated balance of plant components that converts a fuel into electricity and thermal energy. Such system also includes all secondary components located between the existing infrastructure for fuel delivery and the existing infrastructure for power distribution, including equipment and controls for meeting relevant power standards, such as voltage, frequency and power factors. Such system must have an electricityonly generation efficiency of not less than 26 percent at International Standard Organization conditions and a capacity of less than 2,000 kilowatts. d. Geothermal Heat Pump Property The energy credit applies to qualified geothermal heat pump property placed in service prior to January 1, The credit rate is 10 percent. Qualified geothermal heat pump property is equipment that uses the ground or ground water as a thermal energy source to heat a structure or as a thermal energy sink to cool a structure. e. Small Wind Property The energy credit applies to qualified small wind energy property placed in service prior to January 1, The credit rate is 30 percent. The credit is limited to $4,000 per year with respect to all wind energy property of any taxpayer. Qualified small wind energy property is property that uses a qualified wind turbine to generate electricity. A qualifying wind turbine means a wind turbine of 100 kilowatts of rated capacity or less. f. Combined Heat and Power Property The energy credit applies to combined heat and power ( CHP ) property placed in service prior to January 1, The credit rate is 10 percent. CHP property is property: (1) that uses the same energy source for the simultaneous or sequential generation of electrical power, mechanical shaft power, or both, in combination with the generation of steam or other forms of useful thermal energy (including heating and cooling applications); (2) that has an electrical capacity of not more than 50 megawatts or a mechanical energy capacity of no more than 67,000 horsepower or an equivalent combination of electrical and mechanical energy capacities; (3) that produces at least 20 percent of its total useful energy in the form of thermal energy that is not used to produce electrical or mechanical power, and produces at least 20 percent of its total useful energy in the form of electrical or mechanical power (or a combination thereof); and (4) the energy efficiency percentage of which exceeds 60 percent. CHP property does not include property used to transport the energy source to the generating facility or to distribute energy produced by the facility. The otherwise allowable credit with respect to CHP property is reduced to the extent the property has an electrical capacity or mechanical capacity in excess of any applicable limits. Property in excess of the applicable limit (15 megawatts or a mechanical energy capacity of more than 20,000 horsepower or an equivalent combination of electrical and mechanical energy capacities) is permitted to claim a fraction of the otherwise allowable General Business Credit 6-10

176 credit. The fraction is equal to the applicable limit divided by the capacity of the property. For example, a 45 mega-watt property would be eligible to claim 15/45ths, or one third, of the otherwise allowable credit. Again, no credit is allowed if the property exceeds the 50 megawatt or 67,000 horsepower limitations described above. Additionally, the provision provides that systems whose fuel source is at least 90 percent open-loop biomass and that would qualify for the credit but for the failure to meet the efficiency standard are eligible for a credit that is reduced in proportion to the degree to which the system fails to meet the efficiency standard. For example, a system that would otherwise be required to meet the 60-percent efficiency standard, but which only achieves 30-percent efficiency, would be permitted a credit equal to one-half of the otherwise allowable credit (i.e., a 5 percent credit). g. Provisions of the American Recovery and Reinvestment Act The Act eliminates the credit cap applicable to qualified small wind energy property. It also removes the rule that reduces the basis of the property for purposes of claiming the credit if the property is financed in whole or in part by subsidized energy financing or with proceeds from private activity bonds. The provision applies to periods after December 31, 2008, under rules similar to the rules of section 48(m) of the Code (as in effect on the day before the enactment of the Revenue Reconciliation Act of 1990). D. EMPOWERMENT ZONE EMPLOYMENT CREDIT (FORM 8844) A business may qualify for this credit if it has employees and is engaged in a business in an empowerment zone for which the credit is available. The empowerment zone employment credit provides businesses with an incentive to hire individuals who both live and work in an empowerment zone. (An exception applies to the Washington, DC empowerment zone. Individuals who work in the Washington, DC empowerment zone may live anywhere in the District of Columbia.) An employer can claim the credit if it pays or incurs qualified zone wages to a qualified zone employee. The credit is 20% of the qualified zone wages paid or incurred during a calendar year. The amount of qualified zone wages that can be used to figure the credit cannot be more than $15,000 for each employee for each calendar year. As a result, the credit can be as much as $3,000 (20% of $15,000) per qualified zone employee each year. 1. Expiration The empowerment zone designations generally expired at the end of However, the American Taxpayer Relief Act of 2012 provides for an extension of the designations to the end of General Business Credit 6-11

177 2. Qualified Zone Employee A qualified zone employee is any employee who meets both of the following tests: The employee performs substantially all of his or her services for the employer within an empowerment zone and in its trade or business; and While performing those services, the employee's main home is within that empowerment zone (for services performed within the DC Zone, the employee's main home may be anywhere within the District of Columbia). Both full-time and part-time employees may qualify. The pay-period method or the calendar-year method can be used to determine the period of time the employee has performed services in the zone. 3. Unqualified Employees The following individuals are not qualified zone employees: An individual employed for less than 90 calendar days. However, this 90-day requirement does not apply in either of the following situations: a. The taxpayer terminates the employee because of misconduct as determined under the state unemployment compensation law that applies. b. The employee becomes disabled before the 90th day. However, if the disability ends before the 90th day, the taxpayer must offer to reemploy the former employee. Certain related taxpayers; Certain dependents; Any 5% owner; An individual employed at any: a. Private or commercial golf course, b. Country club, c. Massage parlor, d. Hot tub facility, e. Suntan facility, f. Racetrack, or other facility used for gambling, or g. Store whose principal business is the sale of alcoholic beverages for offpremise consumption; and Any individual employed in a farming trade or business if, at the close of the tax year, the sum of the following amounts is more than $500,000: General Business Credit 6-12

178 a. The larger of the unadjusted bases or fair market value of the farm assets owned; and b. The value of the farm assets leased. 4. Qualified Zone Wages Qualified zone wages are any wages paid or incurred for services performed by an employee while the employee is a qualified zone employee (defined earlier). Wages are generally defined as wages (excluding tips) subject to the Federal Unemployment Tax Act (FUTA) without regard to the FUTA dollar limit. A taxpayer can also treat as qualified zone wages certain training and education expenses paid or incurred on behalf of a qualified zone employee. 5. Effect of Other Credits Qualified zone wages do not include any amount taken into account in figuring the welfare-to-work credit, the work opportunity credit, or the New York Liberty Zone business employee credit. In addition, a taxpayer must reduce the $15,000 maximum qualified zone wages for each qualified zone employee by the amount of wages used to figure any of those credits for that employee. 6. Fiscal Year Taxpayers If an entity uses a fiscal tax year, the amount of qualified zone wages used to figure the credit is the amount paid or incurred during the calendar year that ends during its tax year. Example. Protege Corporation s tax year begins on February 1 and ends on January 31 of the next year. Protege uses the cash method of accounting and has one employee, whom it hired in March 2012 and pays $1,000 a month. Protege paid that employee qualified zone wages of $10,000 in calendar year 2012 and $1,000 in January When Protege figures its credit for the tax year ending January 31, 2013, it uses the $10,000 paid in 2012 but cannot use the $1,000 paid in January That amount will be used to figure the credit on its next tax return. 7. Claiming the Credit Taxpayers use Form 8844 to claim this credit. Although the empowerment zone employment credit is a component of the general business credit, a special tax liability limit applies to this credit. The allowable credit is figured in Part II of Form 3800, General Business Credit. 8. Effect on Salary and Wage Deduction In general, a taxpayer must reduce the deduction on its income tax return for salaries and wages and certain education and training costs by the amount of its current year empowerment zone employment credit (before applying the tax liability limit). General Business Credit 6-13

179 E. INCREASED SECTION 179 DEDUCTION Section 179 of the Internal Revenue Code allows a taxpayer to choose to deduct all or part of the cost of certain qualifying property in the year it is placed in service. A taxpayer can do this instead of recovering the cost by taking depreciation deductions over a specified recovery period. There are limits, however, on the amount a taxpayer can deduct in a tax year. A taxpayer may be able to claim an increased 179 deduction if the business qualifies as an enterprise zone business. The increase can be as much as $35,000. This increased 179 deduction applies to qualified zone property placed in service in an empowerment zone. 1. Enterprise Zone Business For the increased 179 deduction, a corporation, partnership, or sole proprietorship is an enterprise zone business if all the following statements are true for the tax year: Every trade or business of the corporation or partnership is the active conduct of a qualified business (defined later) within an empowerment zone. (This rule does not apply to a sole proprietorship.); At least 50% of its total gross income is from the active conduct of a qualified business within a zone; A substantial part of the use of its tangible property is within a zone; A substantial part of its intangible property is used in the active conduct of the business; A substantial part of the employees' services are performed within a zone; At least 35% of the employees are residents of an empowerment zone. (This rule does not apply to businesses in the DC Zone.); and Less than 5% of the average of the total unadjusted bases of the property owned by the business is from: a. Nonqualified financial property (generally, debt, stock, partnership interests, options, futures contracts, forward contracts, warrants, notional principal contracts, and annuities), or b. Collectibles not held primarily for sale to customers. For a sole proprietorship, the term employee used above includes the proprietor. 2. Qualified Business A qualified business is generally any trade or business except one that consists primarily of the development or holding of intangibles for sale or license. However, the rental to others of real property located in an empowerment zone is a qualified business only if the property is not residential rental property and at least 50% of the gross rental income from the property is from enterprise zone businesses. General Business Credit 6-14

180 The rental to others of tangible personal property is a qualified business only if at least 50% of the rentals of the property are to enterprise zone businesses or zone residents. 3. Qualified Zone Property For the increased 179 deduction, qualified zone property is any depreciable tangible property if all the following are true: The business acquired the property after the zone designation took effect; The business did not acquire the property from a related person or member of a controlled group of which the owner is a member; The basis in the property is not determined either by its adjusted basis in the hands of the person from whom you acquired it or under the stepped-up basis rules for property acquired from a decedent; The taxpayer was the first person to use the property in an empowerment zone; and At least 85% of the property s use is in an empowerment zone and in the active conduct of a qualified trade or business in the zone. Buildings are qualified zone property, but they do not qualify for the 179 deduction. Used property may be qualified zone property if it has not previously been used within an empowerment zone. Property will be treated as having met the above requirements if the taxpayer substantially renovated the property. A taxpayer will be deemed to have substantially renovate property if, during any 24-month period beginning after the zone designation took effect, its additions to the property's basis are more than the greater of the following amounts: 100% of the adjusted basis of the property at the beginning of the 24-month period; or $5, Section 179 Deduction Limits There are limits on the amount a taxpayer can deduct under 179. The total cost of 179 property that a taxpayer can deduct for a tax year generally cannot be more than the maximum 179 dollar limit. However, if the taxpayer placed 179 property that is qualified zone property in service during the year, this maximum dollar limit is increased by the smaller of the following amounts: The cost of that property; or $35,000. General Business Credit 6-15

181 F. CLAIMING BUSINESS CREDITS To claim a general business credit, a taxpayer will first have to get the forms needed to claim current year credits. In addition to the credit form, the business will also need to file Form Who Must File Form 3800? You must file Form 3800 to claim any of the general business credits. 2. Alternative Minimum Tax (AMT) Although a business may not owe AMT, it must still figure its tentative minimum tax on Form 6251 in order to claim a general business credit. Form 6251 must be attached to the business s tax return. General Business Credit 6-16

182 Chapter 6 Review Questions The following questions are designed to ensure that you have a complete understanding of the information presented in the chapter. They do not need to be submitted in order to receive CPE credit. They are included as an additional tool to enhance your learning experience. We recommend that you answer each review question and then compare your response to the suggested solution before answering the final exam questions related to this chapter. 1. The employer tax credit for providing childcare facilities is capped at: a) $50,000 per year b) $75,000 per year c) $150,000 per year d) $250,000 per year 2. Employers are never entitled to a tax credit for hiring ex-felons. a) true b) false 3. How is the work opportunity tax credit calculated: a) it is a flat amount for all employers b) it is based on the size of the employer c) it is determined by qualified wages paid by the employer d) both b and c above 4. Businesses that seek to take advantage of a general business tax credit have to file IRS Form a) true b) false General Business Credit 6-17

183 Chapter 6 Solutions and Suggested Responses 1. A: Incorrect. The annual limit is much higher. B: Incorrect. The annual limit is twice this. C: Correct. This is the most an employer can take as a tax credit each year for providing childcare services for employees. D: Incorrect. The maximum annual credit is half of this. (See page 6-1 of the course material.) 2. A: True is incorrect. Hiring certain ex-felons will make employers entitled to a tax credit. B: False is correct. The credit applies where the employee was released from state or federal prison within one year of being hired. (See page 6-3 of the course material.) 3. A: Incorrect. The work opportunity credit is determined by the amount of wages paid by the employer. B: Incorrect. The credit varies depending on the amount of qualified wages paid. C: Correct. The credit is based on wages paid to workers in qualified groups during the tax year. D: Incorrect. Only one of the responses is correct. (See page 6-5 of the course material.) 4. A: True is correct. To claim a general business tax credit, a taxpayer will first have to get the forms needed to claim current year credits. In addition to the credit form, a business also needs to file Form B: False is incorrect. Businesses are required to file Form 3800 to claim the general business tax credits available. (See page 6-16 of the course material.) General Business Credit 6-18

184 Form 3468 Department of the Treasury Internal Revenue Service (99) Name(s) shown on return Investment Credit OMB No Attach to your tax return Information about Form 3468 and its separate instructions is at Attachment Sequence No. 174 Identifying number Part I Information Regarding the Election To Treat the Lessee as the Purchaser of Investment Credit Property If you are claiming the investment credit as a lessee based on a section 48(d) (as in effect on November 4, 1990) election, provide the following information. If you acquired more than one property as a lessee, attach a statement showing the information below. 1 Name of lessor 2 Address of lessor 3 Description of property 4 Amount for which you were treated as having acquired the property $ Part II Qualifying Advanced Coal Project Credit, Qualifying Gasification Project Credit, and Qualifying Advanced Energy Project Credit 5 Qualifying advanced coal project credit (see instructions): a Qualified investment in integrated gasification combined cycle property placed in service during the tax year for projects described in section 48A(d)(3)(B)(i) $ 20% (.20) 5a b Qualified investment in advanced coal-based generation technology property placed in service during the tax year for projects described in section 48A(d)(3)(B)(ii)..... $ 15% (.15) 5b c Qualified investment in advanced coal-based generation technology property placed in service during the tax year for projects described in section 48A(d)(3)(B)(iii)..... $ 30% (.30) 5c d Total. Add lines 5a, 5b, and 5c d 6 Qualifying gasification project credit (see instructions): a Qualified investment in qualified gasification property placed in service during the tax year for which credits were allocated or reallocated after October 3, 2008, and that includes equipment that separates and sequesters at least 75% of the project s carbon dioxide emissions $ 30% (.30) 6a b Qualified investment in property other than in a above placed in service during the tax year $ 20% (.20) 6b c Total. Add lines 6a and 6b c 7 Qualifying advanced energy project credit (see instructions): Qualified investment in advanced energy project property placed in service during the tax year $ 30% (.30) 7 8 Reserved Enter the applicable unused investment credit from cooperatives (see instructions) Add lines 5d, 6c, 7, and 9. Report this amount on Form 3800, line 1a Part III Rehabilitation Credit and Energy Credit 11 Rehabilitation credit (see instructions for requirements that must be met): a Check this box if you are electing under section 47(d)(5) to take your qualified rehabilitation expenditures into account for the tax year in which paid (or, for self-rehabilitated property, when capitalized). See instructions. Note. This election applies to the current tax year and to all later tax years. You may not revoke this election without IRS consent b Enter the dates on which the 24- or 60-month measuring period begins and ends c Enter the adjusted basis of the building as of the beginning date above (or the first day of your holding period, if later) $ d Enter the amount of the qualified rehabilitation expenditures incurred, or treated as incurred, during the period on line 11b above..... $ Enter the amount of qualified rehabilitation expenditures and multiply by the percentage shown: e Pre-1936 buildings located in the Gulf Opportunity Zone. $ 13% (.13) 11e f Pre-1936 buildings affected by a Midwestern disaster.. $ 13% (.13) 11f g Other pre-1936 buildings $ 10% (.10) 11g h Certified historic structures located in the Gulf Opportunity Zone $ 26% (.26) 11h For Paperwork Reduction Act Notice, see separate instructions. Cat. No E Form 3468 (2012)

185 Form 3468 (2012) Page 2 Part III Rehabilitation Credit and Energy Credit (continued) i Certified historic structures affected by a Midwestern disaster $ 26% (.26) 11i j Other certified historic structures $ 20% (.20) 11j For properties identified on lines 11h, 11i, or 11j, complete lines 11k and 11l. k Enter the assigned NPS project number or the pass-through entity s employer identification number (see instructions) l Enter the date that the NPS approved the Request for Certification of Completed Work (see instructions) m Rehabilitation credit from an electing large partnership (Schedule K-1 (Form 1065-B), box 9).. 11m 12 Energy credit: a Basis of property using geothermal energy or solar energy (acquired before January 1, 2006, and the basis attributable to construction, reconstruction, or erection by the taxpayer before January 1, 2006) placed in service during the tax year (see instructions) $ 10% (.10) 12a b Basis of property using solar illumination or solar energy placed in service during the tax year that was acquired after December 31, 2005, and the basis attributable to construction, reconstruction, or erection by the taxpayer after December 31, 2005 (see instructions) $ 30% (.30) 12b Qualified fuel cell property (see instructions): c Basis of property placed in service during the tax year that was acquired after December 31, 2005, and before October 4, 2008, and the basis attributable to construction, reconstruction, or erection by the taxpayer after December 31, 2005, and before October 4, $ 30% (.30) 12c d Applicable kilowatt capacity of property on line 12c (see instructions) $1,000 12d e Enter the lesser of line 12c or line 12d e f Basis of property placed in service during the tax year that was acquired after October 3, 2008, and the basis attributable to construction, reconstruction, or erection by the taxpayer after October 3, $ 30% (.30) 12f g Applicable kilowatt capacity of property on line 12f (see instructions) $3,000 12g h Enter the lesser of line 12f or line 12g h i Qualified microturbine property (see instructions): Basis of property placed in service during the tax year that was acquired after December 31, 2005, and the basis attributable to construction, reconstruction, or erection by the taxpayer after December 31, $ 10% (.10) 12i j Kilowatt capacity of property on line 12i $200 12j k Enter the lesser of line 12i or line 12j k Form 3468 (2012)

186 Form 3468 (2012) Page 3 Part III Rehabilitation Credit and Energy Credit (continued) Combined heat and power system property (see instructions): Caution. You cannot claim this credit if the electrical capacity of the property is more than 50 megawatts or 67,000 horsepower. l Basis of property placed in service during the tax year that was acquired after October 3, 2008, and the basis attributable to construction, reconstruction, or erection by the taxpayer after October 3, $ 10% (.10) 12l m If the electrical capacity of the property is measured in: Megawatts, divide 15 by the megawatt capacity. Enter 1.0 if the capacity is 15 megawatts or less. Horsepower, divide 20,000 by the horsepower. Enter 1.0 if the capacity is 20,000 horsepower or less m. n Multiply line 12l by line 12m n Qualified small wind energy property (see instructions): o Basis of property placed in service during the tax year that was acquired after October 3, 2008, and before January 1, 2009, and the basis attributable to the construction, reconstruction, or erection by the taxpayer after October 3, 2008, and before January 1, $ 30% (.30) 12o p Enter the smaller of line 12o or $4, p q Basis of property placed in service during the tax year that was acquired after December 31, 2008, and the basis attributable to construction, reconstruction, or erection by the taxpayer after December 31, $ 30% (.30) 12q Geothermal heat pump systems (see instructions): r Basis of property placed in service during the tax year that was acquired after October 3, 2008, and the basis attributable to construction, reconstruction, or erection by the taxpayer after October 3, $ 10% (.10) 12r Qualified investment credit facility property (see instructions): s Basis of property placed in service during the tax year... $ 30% (.30) 12s 13 Enter the applicable unused investment credit from cooperatives (see instructions) Add lines 11e through 11j, 11m, 12a, 12b, 12e, 12h, 12k, 12n, 12p, 12q, 12r, 12s, and 13. Report this amount on Form 3800, line 4a Form 3468 (2012)

187 2012 Instructions for Form 3468 Investment Credit Department of the Treasury Internal Revenue Service Section references are to the Internal Revenue Code unless otherwise noted. Future Developments For the latest information about developments related to Form 3468 and its instructions, such as legislation enacted after they were published, go to What's New The qualifying therapeutic discovery project credit has been removed since the credit has expired. General Instructions Purpose of Form Use Form 3468 to claim the investment credit. The investment credit consists of the rehabilitation, energy, qualifying advanced coal project, qualifying gasification project, and qualifying advanced energy project credits. If you file electronically, you must send in a paper Form 8453, U.S. Individual Income Tax Transmittal for an IRS e-file Return, if attachments are required to Form Investment Credit Property Investment credit property is any depreciable or amortizable property that qualifies for the rehabilitation credit, energy credit, qualifying advanced coal project credit, qualifying gasification project credit, or qualifying advanced energy project credit. You cannot claim a credit for property that is: Used mainly outside the United States (except for property described in section 168(g)(4)); Used by a governmental unit or foreign person or entity (except for a qualified rehabilitated building leased to that unit, person, or entity; and property used under a lease with a term of less than 6 months); Used by a tax-exempt organization (other than a section 521 farmers' cooperative) unless the property is used mainly in an unrelated trade or business or is a qualified rehabilitated building leased by the organization; Used for lodging or in the furnishing of lodging (see section 50(b)(2) for exceptions); or Certain MACRS business property to the extent it has been expensed under section 179 of the Internal Revenue Code. Qualified Progress Expenditures Qualified progress expenditures are those expenditures made before the property is placed in service and for which the taxpayer has made an election to treat the expenditures as progress expenditures. Qualified progress expenditure property is any property that is being constructed by or for the taxpayer and which (a) has a normal construction period of two years or more, and (b) it is reasonable to believe that the property will be new investment credit property in the hands of the taxpayer when it is placed in service. The placed in service requirement does not apply to qualified progress expenditures. Qualified progress expenditures for: Self-constructed property means the amount that is properly chargeable (during the tax year) to capital account with respect to that property; or Non-self-constructed property means the lesser of: (a) the amount paid (during the tax year) to another person for the construction of the property, or (b) the amount that represents the proportion of the overall cost to the taxpayer of the construction by the other person which is properly attributable to that portion of the construction which is completed during the tax year. For more information on qualified progress expenditures, see section 46(d) (as in effect on November 4, 1990). For details on qualified progress expenditures for the rehabilitation credit, see section 47(d). At-Risk Limit for Individuals and Closely Held Corporations The cost or basis of property for investment credit purposes may be limited if you borrowed against the property and are protected against loss, or if you borrowed money from a person who is related or who has an interest (other than as a creditor) in the business activity. The cost or basis must be reduced by the amount of the nonqualified nonrecourse financing related to the property as of the close of the tax year in which the property is placed in service. If, at the close of a tax year following the year property was placed in service, the nonqualified nonrecourse financing for any property has increased or decreased, then the credit base for the property changes accordingly. The changes may result in an increased credit or a recapture of the credit in the year of the change. See sections 49 and 465 for details. Recapture of Credit You may have to refigure the investment credit and recapture all or a portion of it if: You dispose of investment credit property before the end of 5 full years after the property was placed in service (recapture period); You change the use of the property before the end of the recapture period so that it no longer qualifies as investment credit property; The business use of the property decreases before the end of the recapture period so that it no longer qualifies (in whole or in part) as investment credit property; Any building to which section 47(d) applies will no longer be a qualified rehabilitated building when placed in service; Any property to which section 48(b) applies will no longer qualify as investment credit property when placed in service; Before the end of the recapture period, your proportionate interest is reduced by more than one-third in an S corporation, partnership (other than an electing large partnership), estate, or trust that allocated the cost or basis of property to you for which you claimed a credit; You return leased property (on which you claimed a credit) to the lessor before the end of the recapture period; A net increase in the amount of nonqualified nonrecourse financing occurs for any property to which section 49(a)(1) applied; or A grant under section 1603 of the American Recovery and Reinvestment Tax Act of 2009 was made for section 48 property Jan 18, 2013 Cat. No P

188 for which a credit was allowed for progress expenditures before the grant was made. Recapture is applicable to those amounts previously included in the qualified basis for an energy credit, including progress expenditures, that are also the basis for the 1603 grant; A grant under section 9023 of the Patient Protection and Affordable Care Act was made for investment for which a credit was determined under section 48D before the grant was made. Exceptions to recapture. Recapture of the investment credit does not apply to any of the following. 1. A transfer due to the death of the taxpayer. 2. A transfer between spouses or incident to divorce under section However, a later disposition by the transferee is subject to recapture to the same extent as if the transferor had disposed of the property at the later date. 3. A transaction to which section 381(a) applies (relating to certain acquisitions of the assets of one corporation by another corporation). 4. A mere change in the form of conducting a trade or business if: a. The property is retained as investment credit property in that trade or business, and b. The taxpayer retains a substantial interest in that trade or business. A mere change in the form of conducting a trade or business includes a corporation that elects to be an S corporation and a corporation whose S election is revoked or terminated. For more information, see the Instructions for Form See section 46(g)(4) (as in effect on November 4,! 1990), and related regulations, if you made a CAUTION withdrawal from a capital construction fund set up under the Merchant Marine Act of 1936 to pay the principal of any debt incurred in connection with a vessel on which you claimed investment credit. Any required recapture is reported on Form For details, see Form 4255, Recapture of Investment Credit. Specific Instructions Do not attach this form to your tax return if you are (a)! an estate or trust whose entire qualified rehabilitation CAUTION expenditures or bases in energy property are allocated to the beneficiaries, (b) an S corporation, or (c) a partnership (other than an electing large partnership). However, you must complete lines 11k and 11l of this form and attach it if you are the owner of a certified historic structure. Shareholders of S Corporations, Partners of Partnerships, and Beneficiaries of Estates and Trusts If you are a shareholder, partner (other than a partner in an electing large partnership), or beneficiary of the designated pass-through entity, the entity will provide to you the information necessary to complete the following: The qualified investment in qualifying advanced coal project property for lines 5a through 5c. The qualified investment in qualifying gasification project property for lines 6a and 6b. The qualified investment in qualifying advanced energy project property for line 7. The information for lines 11b through 11j and 11m for the rehabilitation credit. The basis of energy property for lines 12a, 12b, 12c, 12f, 12i, 12l, 12o, 12q, 12r, and 12s. The kilowatt capacity for lines 12d, 12g, and 12j. The megawatt capacity or horsepower for line 12m. Part I. Information Regarding the Election To Treat the Lessee as the Purchaser of Investment Credit Property If you lease property to someone else, you may elect to treat all or part of your investment in new property as if it were made by the person who is leasing it from you. Once the election is made, the lessee will be entitled to an investment credit for that property for the tax year in which the property is placed in service and the lessor will generally not be entitled to such a credit. If the leased property is disposed of, or otherwise ceases to be section 38 property, the property will generally be subject to the recapture rules for early dispositions. For information on making the election, see section 48(d) (as in effect on November 4, 1990) and related regulations. For limitations, see sections 46(e)(3) and 48(d) (as in effect on November 4, 1990). Line 2 Enter the lessor's full address. Enter the address of the lessor's principal office or place of business. Include the suite, room, or other unit number after the street address. If the post office does not deliver mail to the street address and the lessor has a P.O. box, show the box number instead. Note. Do not use the address of the registered agent for the state in which the lessor is incorporated. For example, if a business is incorporated in Delaware or Nevada and the lessor's principal place of business is located in Little Rock, AR, you should enter the Little Rock address. If the lessor receives its mail in care of a third party (such as an accountant or attorney), enter on the street address line C/O followed by the third party's name and street address or P.O. box. Qualifying Advanced Coal Project Credit A qualifying advanced coal project is a project that: Uses advanced coal-based generation technology (as defined in section 48A(f)) to power a new electric generation unit or to refit or repower an existing electric generation unit (including an existing natural gas-fired combined cycle unit), Has fuel input which, when completed, will be at least 75 percent coal, Has an electric generation unit or units at the site that will generate at least 400 megawatts, Has a majority of the output that is reasonably expected to be acquired or utilized, Is to be constructed and operated on a long-term basis when the taxpayer provides evidence of ownership or control of a site of sufficient size, Will be located in the United States, and Includes equipment that separates and sequesters at least 65 percent (70 percent in the case of an application for reallocated credits) of the project's total carbon dioxide emissions for project applications described in section 48A(d)(2)(A)(ii). Basis. Qualified investment for any tax year is the basis of eligible property placed in service by the taxpayer during the tax year which is part of a qualifying advanced coal project. Eligible property is limited to property which can be depreciated or amortized and which was constructed, reconstructed, or erected -2- Instructions for Form 3468 (2012)

189 and completed by the taxpayer; or which is acquired by the taxpayer if the original use of such property commences with the taxpayer. Basis reduction for certain financing. If property is financed in whole or in part by subsidized energy financing or by tax-exempt private activity bonds, the amount that you can claim as basis is the basis that would otherwise be allowed multiplied by a fraction that is 1 reduced by a second fraction, the numerator of which is that portion of the basis allocable to such financing or proceeds, and the denominator of which is the basis of the property. For example, if the basis of the property is $100,000 and the portion allocable to such financing or proceeds is $20,000, the fraction of the basis that you may claim the credit on is 4 5 (that is, 1 minus $20,000/$100,000). Subsidized energy financing means financing provided under a federal, state, or local program, a principal purpose of which is to provide subsidized financing for projects designed to conserve or produce energy. Line 5a Enter the qualified investment in integrated gasification combined cycle property placed in service during the tax year for projects described in section 48A(d)(3)(B)(i). Eligible property is any property which is part of a qualifying advanced coal project using an integrated gasification combined cycle and is necessary for the gasification of coal, including any coal handling and gas separation equipment. Integrated gasification combined cycle is an electric generation unit which produces electricity by converting coal to synthesis gas, which in turn is used to fuel a combined-cycle plant to produce electricity from both a combustion turbine (including a combustion turbine/fuel cell hybrid) and a steam turbine. Line 5b Enter the qualified investment in advanced coal-based generation technology property placed in service during the tax year for projects described in section 48A(d)(3)(B)(ii). Eligible property is any property which is part of a qualifying advanced coal project (defined earlier) not using an integrated gasification combined cycle. Line 5c Enter the qualified investment in advanced coal-based generation technology property placed in service during the tax year for projects described in section 48A(d)(3)(B)(iii). Eligible property is any certified property located in the United States and which is part of a qualifying advanced coal project (defined earlier) which has equipment that separates and sequesters at least 65 percent of the project's total carbon dioxide emissions. This percentage increases to 70 percent if the credits are later reallocated by the IRS. The credit will be recaptured if a project fails to attain or maintain the carbon dioxide separation and sequestration requirements. For details, see section 48A(i) and Notice , I.R.B Qualifying Gasification Project Credit A qualifying gasification project is a project that: Employs gasification technology (as defined in section 48B(c) (2)), Is carried out by an eligible entity (as defined in section 48B(c) (7)), and Includes a qualified investment of which an amount not to exceed $650 million is certified under the qualifying gasification program as eligible for credit. The total amount of credits that may be allocated under the qualifying gasification project program may not exceed $600 million. For more information on the qualifying gasification project and the qualifying gasification program, see Notice , I.R.B. 802 and Notice , I.R.B Basis reduction. If property is financed in whole or in part by subsidized energy financing or by tax-exempt private activity bonds, figure the credit by using the basis of such property reduced under the rules described in Basis reduction for certain financing, earlier. Line 6a Enter the qualified investment in qualifying gasification project property (defined above) placed in service during the tax year for which credits were allocated or reallocated after October 3, 2008, and that includes equipment that separates and sequesters at least 75% of the project's carbon dioxide emissions. Qualified investment is the basis of eligible property placed in service during the tax year that is part of a qualifying gasification project. For purposes of this credit, eligible property includes any property that is part of a qualifying gasification project and necessary for the gasification technology of such project. The IRS is required to recapture the benefit of any allocated credit if a project fails to attain or maintain these carbon dioxide separation and sequestration requirements. See section 48B(f) and Notice , I.R.B Line 6b Enter the qualified investment, other than line 6a, in qualifying gasification project property (defined above) placed in service during the tax year. Qualifying Advanced Energy Project Credit To be eligible for the qualifying advanced energy project credit, some or all of the qualified investment in the qualifying advanced energy project must be certified by the IRS under section 48C(d). For more information on certification, see Notice , I.R.B Line 7 Enter the qualified investment in qualifying advanced energy project property placed in service during the tax year, that is part of a qualifying advanced energy project. Qualified investment is the basis of eligible property placed in service during the tax year that is part of a qualifying advanced energy project. Qualifying advanced energy project means a project that re-equips, expands, or establishes a manufacturing facility for the production of: Property designed to be used to produce energy from the sun, wind, geothermal deposits (within the meaning of section 613(e) (2)), or other renewable resources, Fuel cells, microturbines, or an energy storage system for use with electric or hybrid-electric motor vehicles, Electric grids to support the transmission of intermittent sources of renewable energy, including storage of the energy, Property designed to capture and sequester carbon dioxide emissions, Instructions for Form 3468 (2012) -3-

190 Property designed to refine or blend renewable fuels or to produce energy conservation technologies (including energy-conserving lighting technologies and smart grid technologies), New qualified plug-in electric drive motor vehicles (as defined in section 30D), qualified plug-in electric vehicles (as defined in section 30(d)), or components which are designed specifically for use with those vehicles, including electric motors, generators, and power control units, and Other advanced energy property designed to reduce greenhouse gas emissions. A qualifying advanced energy project does not include any portion of a project for the production of any property that is used in the refining or blending of any transportation fuel (other than renewable fuels). Eligible property. Eligible property is property that is necessary for the production of property described in section 48C(c)(1)(A)(i), for which depreciation or amortization is available and is tangible personal property or other tangible property (not including a building or its structural components), but only if the property is used as an integral part of the qualifying advanced energy project. Transitional rule. Enter only the basis: Attributable to constructed, reconstruction, or erection by the taxpayer after February 17, 2009, Of property acquired and placed in service after February 17, 2009, and Only to the extent of the qualified investment (as determined under section 46(c) and (d) as in effect on November 4, 1990) with respect to qualified progress expenditures made after February 17, Line 8 Line 8 is reserved for future use. Credit from Cooperatives Line 9 Patrons, including cooperatives that are patrons in other cooperatives, enter the unused investment credit from the qualifying advanced coal project credit, qualifying gasification project credit, or qualifying advanced energy project credit allocated from cooperatives. If you are a cooperative, see the Instructions for Form 3800, line 1a, for allocating the investment credit to your patrons. Rehabilitation Credit You are allowed a credit for qualified rehabilitation expenditures made for any qualified rehabilitated building. You must reduce your basis by the amount of the credit determined for the tax year. If the adjusted basis of the building is determined in whole or in part by reference to the adjusted basis of a person other than the taxpayer, see Regulations section (b)(2)(viii) for additional information that must be attached. Qualified Rehabilitated Building To be a qualified rehabilitated building, your building must meet all five of the following requirements. 1. The building must have been placed in service (see requirement 4) prior to 1936 unless it is a certified historic structure. A certified historic structure is any building (a) listed in the National Register of Historic Places, or (b) located in a registered historic district (as defined in section 47(c)(3)(B)) and certified by the Secretary of the Interior as being of historic significance to the district. Certification requests are made through your State Historic Preservation Officer on National Park Service (NPS) Form a, Historic Preservation Certification Application. The request for certification should be made prior to physical work beginning on the building. 2. The building must be substantially rehabilitated. A building is considered substantially rehabilitated if your qualified rehabilitation expenditures during a self-selected 24-month period that ends with or within your tax year are more than the greater of $5,000 or your adjusted basis in the building and its structural components. Figure adjusted basis on the first day of the 24-month period or the first day of your holding period, whichever is later. If you are rehabilitating the building in phases under a written architectural plan and specifications that were completed before the rehabilitation began, substitute 60-month period for 24-month period. If the building is in one of the designated counties or parishes in the GO Zone, Rita GO Zone, or Wilma GO Zone, the 24-month period and 60-month period is extended by 12 months. However, the rehabilitation must have begun, but not been completed, and the building placed in service prior to the following dates. States Date GO Zone Florida August 24, 2005 GO Zone Louisiana, Mississippi, and Alabama August 29, 2005 Rita GO Zone Louisiana and Texas September 23, 2005 Wilma GO Zone Florida October 23, Depreciation must be allowable with respect to the building. Depreciation is not allowable if the building is permanently retired from service. If the building is damaged, it is not considered permanently retired from service where the taxpayer repairs and restores the building and returns it to actual service within a reasonable period of time. For a building damaged in the GO Zone, Rita GO Zone, or Wilma GO Zone, that reasonable period is deemed to be up to 36 months, subject to the following qualifications. The building must have been placed in service prior to the date as given in the table above. The relevant 36-month period for that building starts on the same date as given in the table above. Beginning no later than August 15, 2006, for GO Zone, Rita GO Zone, or Wilma GO Zone property, the taxpayer must be engaged in the repair or restoration of building, defined as: a. Ongoing physical repairs, b. Written contracts in place for the repair or restoration to be completed within the designated 36-month period, or c. Active negotiation of contracts for the repair or restoration to be completed within the designated 36-month period, but only if the contracts are finalized prior to January 1, The building must have been placed in service before the beginning of rehabilitation. This requirement is met if the building was placed in service by any person at any time before the rehabilitation began. 5. For a building other than a certified historic structure (a) at least 75% of the external walls must be retained with 50% or more kept in place as external walls, and (b) at least 75% of the existing internal structural framework of the building must be retained in place. Qualified Rehabilitation Expenditures To be qualified rehabilitation expenditures, your expenditures must meet all six of the following requirements. -4- Instructions for Form 3468 (2012)

191 1. The expenditures must be for (a) nonresidential rental property, (b) residential rental property (but only if a certified historic structure see Regulations section (h)), or (c) real property that has a class life of more than 12 years. 2. The expenditures must be incurred in connection with the rehabilitation of a qualified rehabilitated building. 3. The expenditures must be capitalized and depreciated using the straight line method. 4. The expenditures cannot include the costs of acquiring or enlarging any building. 5. If the expenditures are in connection with the rehabilitation of a certified historic structure or a building in a registered historic district, the rehabilitation must be certified by the Secretary of the Interior as being consistent with the historic character of the property or district in which the property is located. This requirement does not apply to a building in a registered historic district if (a) the building is not a certified historic structure, (b) the Secretary of the Interior certifies that the building is not of historic significance to the district, and (c) if the certification in (b) occurs after the rehabilitation began, the taxpayer certifies in good faith that he or she was not aware of that certification requirement at the time the rehabilitation began. 6. The expenditures cannot include any costs allocable to the part of the property that is (or may reasonably expect to be) tax-exempt use property (as defined in section 168(h) except that 50 percent shall be substituted for 35 percent in paragraph (1)(B)(iii)). This exclusion does not apply for line 11d. Line 11 For credit purposes, the expenditures are generally taken into account for the tax year in which the qualified rehabilitated building is placed in service. However, with certain exceptions, you may elect to take the expenditures into account for the tax year in which they were paid (or, for a self-rehabilitated building, when capitalized) if (a) the normal rehabilitation period for the building is at least 2 years, and (b) it is reasonable to expect that the building will be a qualified rehabilitated building when placed in service. For details, see section 47(d). To make this election, check the box on line 11a. The credit, as a percent of expenditures paid or incurred during the tax year for any qualified rehabilitated building, depends on the type of structure and its location. Note. The credit is increased for qualified rehabilitated expenditures made on or after the applicable disaster date for qualified rehabilitated buildings or structures damaged or destroyed as a result of the severe storms, tornados, or flooding in the Midwestern disaster area. For details on the affected counties and the applicable disaster dates in the Midwestern disaster area, see Tables 1 and 2 in Publication 4492-B, Information for Affected Taxpayers in the Midwestern Disaster Areas. If the structure is.. Located Report on Line Other than a certified historic structure Other than a certified historic structure Other than a certified historic structure In the GO Zone 11e In the Midwestern disaster area Elsewhere than in the GO Zone or Midwestern disaster area 11f 11g Certified historic structure In the GO Zone 11h Certified historic structure Certified historic structure In the Midwestern disaster area Elsewhere than in the GO Zone or Midwestern disaster area If you are claiming a credit for a certified historic structure on lines 11h, 11i, or 11j, enter the assigned NPS project number on line 11k. If the qualified rehabilitation expenditures are from an S corporation, partnership, estate, or trust, enter on line 11k the employer identification number of the pass-through entity instead of the assigned NPS project number, and skip line 11l and the instructions below. Enter the date of the final certification of completed work received from the Secretary of the Interior on line 11l. If the final certification has not been received by the time the tax return is filed for a year in which the credit is claimed, attach a copy of the first page of NPS Form a, Historic Preservation Certification Application (Part 2 Description of Rehabilitation), with an indication that it was received by the Department of the Interior or the State Historic Preservation Officer, together with proof that the building is a certified historic structure (or that such status has been requested). After the final certification of completed work has been received, file Form 3468 with the first income tax return filed after receipt of the certification and enter the assigned NPS project number and the date of the final certification of completed work on the appropriate lines on the form. Also attach an explanation, and indicate the amount of credit claimed in prior years. If you fail to receive final certification of completed work prior to the date that is 30 months after the date that you filed the tax return on which the credit was claimed, you must submit a written statement to the IRS stating that fact before the last day of the 30th month. You will be asked to consent to an agreement under section 6501(c)(4) extending the period of assessment for any tax relating to the time for which the credit was claimed. Mail to: Internal Revenue Service 2970 Market Street 4-E LIH Unit - Mail Stop E Philadelphia, PA i 11j You must retain a copy of the final certification of completed work as long as its contents may be needed for the administration of any provision of the Internal Revenue Code. If the final certification is denied by the Department of Interior, the credit is disallowed for any tax year in which it was claimed, and you must file an amended return if necessary. See Regulations section (d)(7)(ii) for details. Energy Credit To qualify as energy property, property must: Instructions for Form 3468 (2012) -5-

192 1. Meet the performance and quality standards, if any, that have been prescribed by regulations and are in effect at the time the property is acquired; 2. Be property for which depreciation (or amortization in lieu of depreciation) is allowable; and 3. Be property either: a. The construction, reconstruction, or erection of which is completed by the taxpayer; or b. Acquired by the taxpayer if the original use of such property must begin with the taxpayer. Energy property does not include any property acquired before February 14, 2008, or to the extent of basis attributable to construction, reconstruction, or erection before February 14, 2008, that is public utility property, as defined by section 46(f)(5) (as in effect on November 4, 1990), and related regulations. You must reduce the basis of energy property by 50% of the energy credit determined. You must reduce the basis of energy property used for figuring the credit by any amount attributable to qualified rehabilitation expenditures. Energy property that qualifies for a grant under section 1603 of the American Recovery and Reinvestment Tax Act of 2009 is not eligible for the energy credit for the tax year that the grant is made or any subsequent tax year. Basis reduction. If energy property (acquired before January 1, 2009, or to the extent of its basis attributable to construction, reconstruction, or erection before January 1, 2009) is financed in whole or in part by subsidized energy financing or by tax-exempt private activity bonds, reduce the basis of such property under the rules described in Basis reduction for certain financing, earlier. For property acquired after December 31, 2008, and for basis attributable to construction, reconstruction, or erection after December 31, 2008, there is no basis reduction for property financed by subsidized energy financing or by tax-exempt private activity bonds. Line 12a Enter the basis of any property placed in service during the tax year that uses geothermal energy. Geothermal energy property is equipment that uses geothermal energy to produce, distribute, or use energy derived from a geothermal deposit (within the meaning of section 613(e)(2)). For electricity produced by geothermal power, equipment qualifies only up to, but not including, the electrical transmission stage. Also enter the basis, attributable to periods before January 1, 2006, of property placed in service during the tax year that uses solar energy to: 1. Generate electricity, 2. Heat or cool (or provide hot water for use in) a structure, or 3. Provide solar process heat (but not to heat a swimming pool). Basis is attributable to periods before January 1, 2006, if the property was acquired before January 1, 2006, or to the extent of basis attributable to construction, reconstruction, or erection by the taxpayer before January 1, Line 12b Enter the basis, attributable to periods after December 31, 2005, of any property using solar energy placed in service during the tax year. There are two types of property. 1. Equipment that uses solar energy to illuminate the inside of a structure using fiber-optic distributed sunlight. 2. Equipment that uses solar energy to: a. Generate electricity, b. Heat or cool (or provide hot water for use in) a structure, or c. Provide solar process heat (but not to heat a swimming pool). Basis is attributable to periods after December 31, 2005, if the property was acquired after December 31, 2005, or to the extent of basis attributable to construction, reconstruction, or erection by the taxpayer after December 31, Line 12c Enter the basis, attributable to periods after December 31, 2005, and before October 4, 2008, of any qualified fuel cell property placed in service during the tax year. Qualified fuel cell property is a fuel cell power plant that generates at least 0.5 kilowatt of electricity using an electrochemical process and has electricity-only generation efficiency greater than 30 percent. See section 48(c)(1) for further details. Basis is attributable to periods after December 31, 2005, and before October 4, 2008, if the property was acquired after December 31, 2005, and before October 4, 2008, or to the extent of basis attributable to construction, reconstruction, or erection by the taxpayer after December 31, 2005, and before October 4, Line 12d Enter the applicable number of kilowatts of capacity attributable to the basis on line 12c. Transitional Rule. The increase in the kilowatt limit from $1,000 to $3,000 per kilowatt applies only to: property (other than property for which you have elected to treat expenditures as qualified progress expenditures) the construction, reconstruction, or erection of which is completed by the taxpayer after October 3, 2008, but only to the extent of the basis thereof attributable to the construction, reconstruction, or erection during such period; property (other than property for which you have elected to treat expenditures as qualified progress expenditures) acquired and placed in service after October 3, 2008; and property for which you have elected to treat expenditures as qualified progress expenditures but only to the extent of the qualified investment with respect to qualified progress expenditures made after October 3, Line 12f Enter the basis, attributable to periods after October 3, 2008, of any qualified fuel cell property placed in service during the tax year. For a definition of qualified fuel cell property, see Line 12c above. Basis is attributable to periods after October 3, 2008, if the property was acquired after October 3, 2008, or to the extent of basis attributable to construction, reconstruction, or erection by the taxpayer after October 3, Instructions for Form 3468 (2012)

193 Line 12g Enter the applicable number of kilowatts of capacity attributable to the basis on line 12f. Transitional Rule. For transitional rules, see Line 12d. Line 12i Enter the basis, attributable to periods after December 31, 2005, of any qualified microturbine property placed in service during the tax year. Qualified microturbine property is a stationary microturbine power plant which generates less than 2,000 kilowatts and has an electricity-only generation efficiency of not less than 26 percent at International Standard Organization conditions. See section 48(c)(2) for further details. Basis is attributable to periods after December 31, 2005, if the property was acquired after December 31, 2005, or to the extent of basis attributable to construction, reconstruction, or erection by the taxpayer after December 31, Line 12l Enter the basis, attributable to periods after October 3, 2008, of any qualified combined heat and power system property placed in service during the tax year. Combined heat and power system property is property that uses the same energy source for the simultaneous or sequential generation of electrical power, mechanical shaft power, or both; in combination with the generation of steam or other forms of useful thermal energy (including heating and cooling applications); the energy efficiency percentage of which exceeds 60 percent; and it produces: At least 20 percent of its total useful energy in the form of thermal energy that is not used to produce electrical or mechanical power (or a combination thereof), and At least 20 percent of its total useful energy in the form of electrical or mechanical power (or a combination thereof). For details, see section 48(c)(3). Basis is attributable to periods after October 3, 2008, if the property was acquired after October 3, 2008, or to the extent of basis attributable to construction, reconstruction, or erection by the taxpayer after October 3, Energy efficiency percentage. The energy efficiency percentage of a combined heat and power system property is the fraction the numerator of which is the total useful electrical, thermal, and mechanical power produced by the system at normal operating rates, and expected to be consumed in its normal application, and the denominator of which is the lower heating value of the fuel sources for the system. The energy efficiency percentage is determined on a Btu basis. Combined heat and power system property does not include property used to transport the energy source to the facility or to distribute energy produced by the facility. Biomass systems. Systems designed to use biomass for at least 90 percent of the energy source are eligible for a credit that is reduced in proportion to the degree to which the system fails to meet the efficiency standard. For more information, see section 48(c)(3)(D). Line 12o Enter the basis, attributable to periods after October 3, 2008, and before January 1, 2009, of any qualified small wind energy property placed in service during the tax year. Qualified small wind energy property means property that uses a qualifying small wind turbine to generate electricity. For this purpose, a qualifying small wind turbine means a wind turbine which has a nameplate capacity of not more than 100 kilowatts. For details, see section 48(c)(4). Basis is attributable to periods after October 3, 2008, and before January 1, 2009, if the property was acquired after October 3, 2008, and before January 1, 2009, or to the extent of basis attributable to construction, reconstruction, or erection by the taxpayer after October 3, 2008, and before January 1, Line 12p Enter the smaller of the basis you entered on line 12o or $4,000. Line 12q Enter the basis, attributable to periods after December 31, 2008, of any qualified small wind energy property placed in service during the tax year. For the definition of qualified small wind energy property, see the instruction to line 12o, above. Basis is attributable to periods after December 31, 2008, if the property was acquired after December 31, 2008, or to the extent of basis attributable to construction, reconstruction, or erection by the taxpayer after December 31, Line 12r Enter the basis, attributable to periods after October 3, 2008, of any geothermal heat pump system placed in service during the tax year. Geothermal heat pump systems constitute equipment which uses the ground or ground water as a thermal energy source to heat a structure or as a thermal energy sink to cool a structure. For details, see section 48(a)(3)(A)(vii). Basis is attributable to periods after October 3, 2008, if the property was acquired after October 3, 2008, or to the extent of basis attributable to construction, reconstruction, or erection by the taxpayer after October 3, Line 12s Enter the basis of any qualified investment credit facility property placed in service during the tax year. Qualified investment credit facility property is property that: Is tangible personal property or other tangible property (not including a building or its structural components), but only if the property is used as an integral part of the qualified investment credit facility; Is constructed, reconstructed, erected, or acquired by the taxpayer; Depreciation or amortization is allowable; and The original use begins with the taxpayer. See section 48(a)(5) for details. A qualified investment credit facility is a facility that: Is a qualified facility under section 45(d)(1), (2), (3), (4), (6), (7), (9), or (11) that is placed in service after 2008 and the construction of which begins before January 1, 2014; No credit has been allowed under section 45 for that facility; and An irrevocable election was made to treat the facility as energy property. The election to treat a qualified facility as energy property is made by claiming the energy credit with respect to qualified investment credit facility property by completing Form 3468 and attaching it to your timely filed income tax return (including extensions) for the tax year that the property is placed in service. Instructions for Form 3468 (2012) -7-

194 You must make a separate election for each qualified facility that is to be treated as a qualified investment credit facility. You must also attach a statement to the Form 3468 that includes the following information: 1. Your name, address, taxpayer identification number, and telephone number. 2. For each qualified investment credit facility: a. A detailed technical description of the facility, including generating capacity. b. A detailed technical description of the energy property placed in service during the tax year as an integral part of the facility, including a statement that the property is an integral part of such facility. c. The date that the energy property was placed in service. d. An accounting of your basis in the energy property. e. A depreciation schedule reflecting your remaining basis in the energy property after the energy credit is claimed. 3. A statement that you have not and will not claim a grant under section 1603 of the American Recovery and Reinvestment Tax Act of 2009 for property for which you are claiming the energy credit. 4. A declaration, applicable to the statement and any accompanying documents, signed by you, or signed by a person currently authorized to bind you in such matters, in the following form: Under penalties of perjury, I declare that I have examined this statement, including accompanying documents, and to the best of my knowledge and belief, the facts presented in support of this statement are true, correct, and complete. Line 13 Patrons, including cooperatives that are patrons in other cooperatives, enter the unused investment credit from the rehabilitation credit or energy credit allocated from cooperatives. If you are a cooperative, see the Instructions for Form 3800, line 1a, for allocating the investment credit to your patrons. Paperwork Reduction Act Notice. We ask for the information on this form to carry out the Internal Revenue laws of the United States. You are required to give us the information. We need it to ensure that you are complying with these laws and to allow us to figure and collect the right amount of tax. You are not required to provide the information requested on a form that is subject to the Paperwork Reduction Act unless the form displays a valid OMB control number. Books or records relating to a form or its instructions must be retained as long as their contents may become material in the administration of any Internal Revenue law. Generally, tax returns and return information are confidential, as required by section The time needed to complete and file this form will vary depending on individual circumstances. The estimated burden for individual taxpayers filing this form is approved under OMB control number and is included in the estimates shown in the instructions for their individual income tax return. The estimated burden for all other taxpayers who file this form is shown below: Recordkeeping hrs., 13 min. Learning about the law or the form hrs., 21 min. Preparing and sending the form to the IRS hrs., 31 min. If you have comments concerning the accuracy of these time estimates or suggestions for making this form simpler, we would be happy to hear from you. See the instructions for the tax return with which this form is filed. -8- Instructions for Form 3468 (2012)

195 Form 3800 Department of the Treasury Internal Revenue Service (99) Name(s) shown on return General Business Credit Information about Form 3800 and its separate instructions is at Attach to your tax return. Identifying number OMB No Attachment Sequence No. 22 Part I Current Year Credit for Credits Not Allowed Against Tentative Minimum Tax (TMT) (See instructions and complete Part(s) III before Parts I and II) 1 General business credit from line 2 of all Parts III with box A checked Passive activity credits from line 2 of all Parts III with box B checked 2 3 Enter the applicable passive activity credits allowed for 2012 (see instructions) Carryforward of general business credit to Enter the amount from line 2 of Part III with box C checked. See instructions for statement to attach Carryback of general business credit from Enter the amount from line 2 of Part III with box D checked (see instructions) Add lines 1, 3, 4, and Part II Allowable Credit 7 Regular tax before credits: Individuals. Enter the amount from Form 1040, line 44, or Form 1040NR, line 42. Corporations. Enter the amount from Form 1120, Schedule J, Part I, line 2; or the applicable line of your return Estates and trusts. Enter the sum of the amounts from Form 1041, Schedule G, lines 1a and 1b; or the amount from the applicable line of your return Alternative minimum tax: Individuals. Enter the amount from Form 6251, line Corporations. Enter the amount from Form 4626, line Estates and trusts. Enter the amount from Schedule I (Form 1041), line 56.. }. } Add lines 7 and a Foreign tax credit a b Certain allowable credits (see instructions) b c Add lines 10a and 10b c 11 Net income tax. Subtract line 10c from line 9. If zero, skip lines 12 through 15 and enter -0- on line 16a Net regular tax. Subtract line 10c from line 7. If zero or less, enter Enter 25% (.25) of the excess, if any, of line 12 over $25,000 (see instructions) Tentative minimum tax: Individuals. Enter the amount from Form 6251, line Corporations. Enter the amount from Form 4626, line Estates and trusts. Enter the amount from Schedule I } 14 (Form 1041), line Enter the greater of line 13 or line a Subtract line 15 from line 11. If zero or less, enter a b Reserved b c Reserved c 17a Enter the smaller of line 6 or line 16a a C corporations: See the line 17a instructions if there has been an ownership change, acquisition, or reorganization. b Reserved b c Reserved c For Paperwork Reduction Act Notice, see separate instructions. Cat. No F Form 3800 (2012)

196 Form 3800 (2012) Page 2 Part II Allowable Credit (Continued) Note. If you are not required to report any amounts on lines 22 or 24 below, skip lines 18 through 25 and enter -0- on line Multiply line 14 by 75% (.75) (see instructions) Enter the greater of line 13 or line Subtract line 19 from line 11. If zero or less, enter Subtract line 17a from line 20. If zero or less, enter Combine the amounts from line 3 of all Parts III with box A, C, or D checked Passive activity credit from line 3 of all Parts III with box B checked Enter the applicable passive activity credit allowed for 2012 (see instructions) Add lines 22 and Empowerment zone and renewal community employment credit allowed. Enter the smaller of line 21 or line Subtract line 13 from line 11. If zero or less, enter Add lines 17a and Subtract line 28 from line 27. If zero or less, enter Enter the general business credit from line 5 of all Parts III with box A checked Enter the total eligible small business credit from line 6 of all Parts III with box E checked Passive activity credits from line 5 of all Parts III with box B checked and line 6 of all Parts III with box F checked Enter the applicable passive activity credits allowed for 2012 (see instructions) Carryforward of business credit to Enter the amount from line 5 of Part III with box C checked and line 6 of Part III with box G checked. See instructions for statement to attach Carryback of business credit from Enter the amount from line 5 of Part III with box D checked and line 6 of Part III with box H checked (see instructions) Add lines 30, 31, 33, 34, and Enter the smaller of line 29 or line Credit allowed for the current year. Add lines 28 and 37. Report the amount from line 38 (if smaller than the sum of Part I, line 6, and Part II, lines 25 and 36, see instructions) as indicated below or on the applicable line of your return: Individuals. Form 1040, line 53, or Form 1040NR, line Corporations. Form 1120, Schedule J, Part I, line 5c Estates and trusts. Form 1041, Schedule G, line 2b } Form 3800 (2012)

197 Form 3800 (2012) Page 3 Name(s) shown on return Identifying number Part III General Business Credits or Eligible Small Business Credits (see instructions) Complete a separate Part III for each box checked below. (see instructions) A General Business Credit From a Non-Passive Activity E Eligible Small Business Credit From a Non-Passive Activity B General Business Credit From a Passive Activity F Eligible Small Business Credit From a Passive Activity C General Business Credit Carryforwards G Eligible Small Business Credit Carryforwards D General Business Credit Carrybacks H Eligible Small Business Credit Carrybacks I If you are filing more than one Part III with box A, B, E, or F checked, complete and attach first an additional Part III combining amounts from all Parts III with box A, B, E, or F checked. Check here if this is the consolidated Part III (a) Description of credit (b) (c) If claiming the credit Note. On any line where the credit is from more than one source, a separate Part III is needed for each from a pass-through Enter the appropriate pass-through entity. entity, enter the EIN amount 1a Investment (Form 3468, Part II only) (attach Form 3468) a b Reserved b c Increasing research activities (Form 6765) c d Low-income housing (Form 8586, Part I only) d e Disabled access (Form 8826) (see instructions for limitation) e f Renewable electricity, refined coal, and Indian coal production (Form 8835) 1f g Indian employment (Form 8845) g h Orphan drug (Form 8820) h i New markets (Form 8874) i j Small employer pension plan startup costs (Form 8881) (see instructions for limitation) 1j k Employer-provided child care facilities and services (Form 8882) (see instructions for limitation) k l Biodiesel and renewable diesel fuels (attach Form 8864) l m Low sulfur diesel fuel production (Form 8896) m n Distilled spirits (Form 8906) n o Nonconventional source fuel (Form 8907) o p Energy efficient home (Form 8908) p q Energy efficient appliance (Form 8909) q r Alternative motor vehicle (Form 8910) r s Alternative fuel vehicle refueling property (Form 8911) s t Reserved t u Mine rescue team training (Form 8923) u v Agricultural chemicals security (Form 8931) (see instructions for limitation). 1v w Employer differential wage payments (Form 8932) w x Carbon dioxide sequestration (Form 8933) x y Qualified plug-in electric drive motor vehicle (Form 8936) y z Qualified plug-in electric vehicle (Form 8834, Part I only) z aa New hire retention (Form 5884-B) aa bb General credits from an electing large partnership (Schedule K-1 (Form 1065-B)) 1bb zz Other zz 2 Add lines 1a through 1zz and enter here Enter the amount from Form a Investment (Form 3468, Part III) (attach Form 3468) a b Work opportunity (Form 5884) b c Alcohol and cellulosic biofuel fuels (Form 6478) c d Low-income housing (Form 8586, Part II) d e Renewable electricity, refined coal, and Indian coal production (Form 8835) 4e f Employer social security and Medicare taxes paid on certain employee tips (Form 8846) 4f g Qualified railroad track maintenance (Form 8900) g h Small employer health insurance premiums (Form 8941) h i Reserved i j Reserved j z Other z 5 Add lines 4a through 4z and enter here Add lines 2, 3, and Form 3800 (2012)

198 2012 Instructions for Form 3800 General Business Credit Department of the Treasury Internal Revenue Service Section references are to the Internal Revenue Code unless otherwise noted. Future Developments For the latest information about developments related to Form 3800 and its instructions, such as legislation enacted after they were published, go to General Instructions Generally, you are not required to TIP complete the source credit form or attach it to Form 3800 if you are a taxpayer that is not a partnership or S corporation, and your only source for a credit listed in Form 3800, Part III, is from a partnership, S corporation, estate, trust, or cooperative. The following exceptions apply: You are claiming the investment credit (Form 3468) or the biodiesel and renewable diesel fuels credit (Form 8864) in Part III with box A, B, E, or F checked. The taxpayer is an estate or trust and the source credit can be allocated to beneficiaries. For more details, see the Instructions for Form 1041, U.S. Income Tax Return for Estates and Trusts, Schedule K-1, box 13. The taxpayer is a cooperative and the source credit can or must be allocated to patrons. For more details, see the Instructions for Form 1120-C, U.S. Income Tax Return for Cooperative Associations, Schedule J, line 5c. Who Must File You must file Form 3800 to claim any of the general business credits. Special Rules for Eligible Small Business Credits (ESBCs) ESBCs. ESBCs determined in tax year 2010 can offset both regular tax and AMT. Any unused ESBCs determined in tax year 2010 are carried back five years and are used to offset regular tax and AMT in the carryback years. Generally, ESBCs mean the sum of the general business credits determined for the tax year with respect to an eligible small business. However, the new hire retention credit (reported on Part III, line 1aa) is not an ESBC. Eligible small business defined. For purposes of the Small Business Jobs Act of 2010, an eligible small business is: A corporation whose stock is not publicly traded, A partnership, or A sole proprietorship. The average annual gross receipts of the corporation, partnership, or sole proprietorship for the 3-tax-year period preceding the tax year of the credits cannot exceed $50 million. Gross receipts for any tax year must be reduced by returns and allowances made during the year. Any reference to your business also includes a reference to any predecessor of your business. If your business was not in existence for the entire 3-year period, base your average annual gross receipts on the period your business existed. Also, if your business had a tax year of less than 12 months, your gross receipts must be annualized by multiplying the gross receipts for the short period by 12 and dividing the result by the number of months in the short period. Member of controlled group, business under common control, or affiliated group. For purposes of the gross receipts test, all members of a controlled group of corporations (as defined in section 52(a)) and all members of a group of businesses under common control (as defined in section 52(b)), are treated as a single person; and all employees of the members of an affiliated service group (as defined in sections 414(m) and (o)) shall be treated as employed by a single person. Treatment of partners and S corporation shareholders. General business credits determined for a partnership or S corporation cannot be treated as ESBCs unless both the partnership or corporation and partner or shareholder meet the gross receipts test as discussed under Eligible small business defined, earlier, for the tax year that the credits are treated as current year general business credits. Carryback and Carryforward of Unused Credit! CAUTION The carryforward may have to be reduced in the event of any recapture event (change in ownership, change in use of property, etc.). If a section 1603 grant is received, the carryforward must be reduced to zero. For further information, see Form 4255, Recapture of Investment Credit. If you cannot use part or all of your general business credit because of the tax liability limit (line 38 is less than the sum of Part I, line 6, and Part II, lines 25 and 36), carry the unused credit back one year (see Special 5-year carryback rule for ESBCs below). To carry back an unused credit, file an amended return (Form 1040X, Amended U.S. Individual Income Tax Return, Form 1120X, Amended U.S. Corporation Income Tax Return, or other amended return) for the prior tax year or an application for tentative refund (Form 1045, Application for Tentative Refund, or Form 1139, Corporation Application for Tentative Refund). Generally, if you file an application for a tentative refund, it must be filed by the end of the tax year following the tax year in which the credit arose. TIP The new hire retention credit cannot be carried back to tax years beginning before March 18, Special 5 year carryback rule for ESBCs. File an amended return (Form 1040X, Form 1120X, or other amended return) for the prior tax year or an application for tentative refund (Form 1045 or Form 1139) to carry back unused ESBCs determined in the first tax year beginning in Write SBJA 2012 at the top of the form you use to file the amended return. Carry back any unused ESBC by reporting it on the 2007 Form 6478, Credit for Alcohol Used as a Fuel, line 10. Any carryback of the ESBC not used in 2007 can be carried to 2008 (the next earliest carryback year), and so on, by including any remaining unused ESBC on the following forms Form 6478, Alcohol and Cellulosic Biofuel Fuels Credit, line Form 6478, line Form 6478, line 14. Enter SBJA 2012 to the left of the entry space used to include the unused ESBC on each Form Note. Except for ESBCs, no part of the unused credit for any year attributable to any credit can be carried back to any tax Jan 23, 2013 Cat. No Q

199 year before the first tax year for which that credit was first allowable. See Credit Ordering Rule, later, to determine which credits are allowed first. If you have an unused credit after carrying it back 1 year (to each of the 5 preceding tax years, beginning with the earliest, for ESBCs), carry it forward to each of the 20 tax years after the year of the credit. Any qualified business credits (as defined in section 196(c)) that are unused after the last tax year of the 20-year carryforward period (or at the time an individual taxpayer dies or other taxpayer, such as a corporation or partnership, ceases to exist) may be taken as a deduction in the earlier of: The tax year following the last tax year of the 20-year carryforward period, or The tax year in which the individual taxpayer dies or other taxpayer ceases to exist. Carryforward of the energy credit and the renewable electricity credit. The energy credit must be recaptured in full if a grant is paid under Public Law 111-5, section 1603, for investment in energy property that an energy credit was previously claimed or for investment in renewable energy property that an election was made to treat the property as energy property. Recapture is applicable to those amounts previously constituting the qualified basis for an energy credit, including progress expenditures, that are also the basis for the 1603 grant. Recapture is accomplished as follows: 1. Any portion of the energy credit related to that property that was used to offset tax in a prior tax year must be added to tax in the tax year the 1603 grant is received. Recaptured tax is calculated on Form Any carryforward of the energy credit related to that property is reduced to zero to recapture the unused portion of the credit. See Form 4255 for any other recapture event (change in ownership or change in use of property, etc.). Change in Filing or Marital Status Your general business credit is limited to your tax liability. Therefore, if you filed a joint return in a carryback or carryforward year and your marital status or filing status has changed, you may need to figure your separate tax liability in that carryback or carryforward year. This would apply if: You filed as single in the credit year, but filed a joint return in the carryback or carryforward year; You filed a joint return in the credit year, but filed a joint return with a different spouse in the carryback or carryforward year; or You were married and filed a separate return in the credit year, but filed a joint return with the same or a different spouse in the carryback or carryforward year. Determine your separate tax liability in the carryback or carryforward year as follows. 1. Figure your tax for the carryback or carryforward year as though you were married filing a separate return. 2. Figure your spouse's tax in that year as though he or she was married filing a separate return. 3. Add the amounts in steps (1) and (2). 4. Divide the amount in step (1) by the amount in step (3). The result should be rounded to at least three decimal places. 5. Multiply the decimal in step (4) by the total tax shown on your joint return for the carryback or carryforward year. The result is your separate tax liability and a carryback or carryforward credit is applied against this amount only. Although your carryback or carryforward of the credit is limited to your separate tax liability, the amount of your refund resulting from the carryback or carryforward is further limited to your share of the joint overpayment. This is found by subtracting your separate tax liability (as determined above) from your contribution toward the payment. Unless you have an agreement or clear evidence of each spouse's contribution toward the payment of the joint liability, your contribution includes the tax withheld on your wages and your share of the joint estimated tax or tax paid with the return. Your share of these payments is found by using the same formula used in determining your separate tax liability. Substitute the joint estimated tax, or tax paid with the return, for the tax in step (5). If the original return for the carryback year resulted in an overpayment, reduce your contribution by your share of the refund. Attach a copy of the computation to your amended return or application for tentative refund. Credit Ordering Rule General business credits reported on Form 3800 are treated as used on a first-in, first-out basis by offsetting the earliest-earned credits first. Therefore, the order in which the credits are used in any tax year is: Carryforwards to that year, the earliest ones first; The general business credit earned in that year; and The carryback to that year. If your general business credits exceed your tax liability limit, the credits are used in the following order and based on the 2 order shown under Order in which credits are used next. Credits reported on line 2 of all Parts III with boxes A, B, C, and D checked. Credits reported on Part II, line 25. Non-ESBC credits reported on line 5 of all Parts III with boxes A, B, C, and D checked. ESBC credits reported on line 6 of all Parts III with boxes E, F, G, and H checked. Order in which credits are used. When relevant, the components of the general business credit reported on Form 3800 arising in a single tax year are used in the following order. Investment credit (in the following order rehabilitation credit, energy credit, qualifying advanced coal project credit, qualifying gasification project credit, qualifying advanced energy project credit, and qualifying therapeutic discovery project credit) (Form 3468). Work opportunity credit (Form 5884). Alcohol and cellulosic biofuel fuels credit (Form 6478). Credit for increasing research activities (Form 6765). Low-income housing credit (Form 8586, Part I only). Disabled access credit (Form 8826). Renewable electricity, refined coal, and Indian coal production credit (Form 8835). Empowerment zone employment credit (Form 8844). Indian employment credit (Form 8845). Employer social security and Medicare taxes paid on certain employee tips (Form 8846). Orphan drug credit (Form 8820). New markets credit (Form 8874). Credit for small employer pension plan startup costs (Form 8881). Credit for employer-provided child care facilities and services (Form 8882). Qualified railroad track maintenance credit (Form 8900). Biodiesel and renewable diesel fuels credit (Form 8864). Low sulfur diesel fuel production credit (Form 8896). Distilled spirits credit (Form 8906). Nonconventional source fuel credit (Form 8907). Energy efficient home credit (Form 8908). Energy efficient appliance credit (Form 8909). Alternative motor vehicle credit (Form 8910). Alternative fuel vehicle refueling property credit (Form 8911). Mine rescue team training credit (Form 8923). Agricultural chemicals security credit (Form 8931).

200 Credit for employer differential wage payments (Form 8932). Carbon dioxide sequestration credit (Form 8933). Qualified plug-in electric drive motor vehicle credit (Form 8936). Qualified plug-in electric vehicle credit (Form 8834, Part I only). Credit for small employer health insurance premiums (Form 8941). New hire retention credit (Form 5884-B). General credits from an electing large partnership (Schedule K-1 (Form 1065-B)). Although these credits are TIP aggregated on Form 3800, keep a separate record of each credit, including whether the credit was an eligible small business credit, to ensure proper accounting of the credits. Specific Instructions Complete and attach the appropriate credit forms used to figure your current year credit. See exceptions under General Instructions, earlier. Assembling Form To ensure Form 3800 is correctly processed, assemble Form 3800 in the following order. 1. Page Page Part III with box I checked. 4. All Parts III with box A checked. 5. All Parts III with box B checked. 6. Part III with box C checked. 7. Part III with box D checked. 8. All Parts III with box E checked. 9. All Parts III with box F checked. 10. Part III with box G checked. 11. Part III with box H checked. Part I. Current Year Credit for Credits Not Allowed Against Tentative Minimum Tax (TMT) Complete all Parts III before! completing Part I and Part II. See CAUTION Part III. General Business Credits or Eligible Small Business Credits for more information. Line 3 Enter the applicable passive activity credit amount allowed from Form 8582-CR, Passive Activity Credit Limitations, or Form 8810, Corporate Passive Activity Loss and Credit Limitations. The passive activity credit amount allowed on line 3 only applies to the general business credits not allowed against TMT from Part I, line 2, plus any prior year unallowed passive activity credit from general business credits not allowed against TMT. Generally, a passive activity is a trade or business in which you did not materially participate. Generally, rental activities are passive activities, whether or not you materially participated. See Form 8582-CR or Form 8810 for details. Line 4 Enter the amount of all carryforwards to 2012 of unused credits that are reported from line 2 of Part III with box C checked. For each credit, attach a statement with the following information. Show the tax year the credit originated, the amount of the credit as reported on the original return, and the amount allowed for that year. Also state whether the total carryforward amount was changed from the originally reported amount and identify the type of credit(s) involved. If the revised carryforward amount relates to unused additional research credits, attach an additional statement detailing the changes to the originally reported Form 6765 information for all originating credit years applicable. For each carryback year, show the year and the amount of the credit allowed after you applied the carryback. For each carryforward year, show the year and the amount of the credit allowed after you applied the carryforward. Note. Individuals claiming the research credit from a sole proprietorship or pass-through entity do not include any carryforward of that credit on line 4. Instead, include the carryforward when figuring the research credit limitation on line 1c of any Parts III with the applicable box A or B checked and attach the statement required above. Line 5 Use line 5 only when you amend your 2012 return to carry back unused credits from Enter the amount that is reported from line 2 of Part III with box D checked. Note. Individuals claiming the research credit from a sole proprietorship or pass-through entity do not include any carryback of that credit on line 5. Instead, include the carryback when figuring the research credit limitation on line 1c of any Parts III with the applicable box A or B checked. Part II. Allowable Credit Line 10b Enter the total allowable credit, if any, from your tax return as follows. 3 Individuals. The amount from Form 1040 lines 48 through 53 (Form 1040-NR lines 46 through 50). Do not include any general business credit claimed on Form 3800, any prior year minimum tax, or any credit claimed on Form 8912, Credit to Holders of Tax Credit Bonds. Estates and trusts. Enter the total of any write-in credits from Form 1041, Schedule G, line 3. Corporations. Enter the amount from Form 1120, Schedule J, line 5b (or the applicable line of your return). Line 13 See section 38(c)(6) for special rules that apply to married couples filing separate returns, controlled corporate groups, regulated investment companies, real estate investment trusts, estates, and trusts. Line 16b When using this line to figure amounts on other tax forms or worksheets, this line should be considered to be zero. Line 16c When using this line to figure amounts on other tax forms or worksheets, this line should be considered to be zero. Line 17a Corporations. If the corporation has undergone a post-1986 ownership change (as defined in section 382(g)), section 383 may limit the amount of tax that may be offset by pre-change general business credits. Also, if a corporation acquires control of another corporation (or acquires its assets in a reorganization), section 384 may limit the amount of tax attributable to recognized built-in gains that may be offset by pre-acquisition general business credits. If either of these limitations apply, attach a computation of the allowable general business credit, enter the amount on line 17a, and write Sec. 383 or Sec. 384 in the margin next to your entry on line 17a. Line 17b When using this line to figure amounts on other tax forms or worksheets, this line should be considered to be zero. Line 17c When using this line to figure amounts on other tax forms or worksheets, this line should be considered to be zero. Line 18 Note. Complete lines 18 through 26 if you have any prior year unallowed passive activity credit carryover from Form 8844, Empowerment Zone and Renewal Community Employment Credit, that does not appear on Part III, line 3, but would be included on line 24.

201 If you entered an amount on line 3 (for the empowerment zone or renewal community employment credit) on any Parts III with box A, B, C, or D checked, or if you have prior year unallowed passive activity credit carryover for this credit, multiply line 14 by 75% (.75). All others skip lines 18 through 25 and enter zero on line 26. Line 24 Enter the applicable passive activity credit amount for the empowerment zone and renewal community employment credit allowed from Form 8582-CR or Form The passive activity credit amount allowed on line 24 only applies to the empowerment zone and renewal community employment credit reported on Part III, line 3, plus any prior year unallowed passive activity empowerment zone and renewal community employment credit. See the instructions for the applicable form for details. See the instructions for Part I, line 3, for the definition of a passive activity. Line 33 Enter the applicable passive activity credit amount for general business credits allowed against TMT and eligible small business credits allowed from Form 8582-CR or Form See the instructions for the applicable form for details. The passive activity credit amount allowed on line 33 only applies to the general business credits from Part II, line 32, plus any prior year unallowed passive activity credit from general business credits reported on Part III, line 4, and eligible small business credit. See the instructions for Part I, line 3, for the definition of a passive activity. Line 34 Enter the amount of all carryforwards to 2012 of unused credits that are reported from line 5 of Part III with box C checked and line 6 of Part III with box G checked. Note. Individuals claiming the research credit from a sole proprietorship or pass-through entity do not include any carryforward of that credit on line 34. Instead, include the carryforward when figuring the research credit limitation on line 1c of any Parts III with the applicable box A, B, E, or F checked. See the instructions for Part I, line 4, for the required statement that must be attached to your tax return. Line 35 Use line 35 only when you amend your 2012 return to carry back unused credits from Enter the amount that is reported from line 5 of Part III with box D checked and line 6 of Part III with box H checked. Note. Individuals claiming the research credit from a sole proprietorship or pass-through entity do not include any carryback of that credit on line 35. Instead, include the carryback when figuring the research credit limitation on line 1c of any Parts III with the applicable box A, B, E, or F checked. Line 38 If line 38 is smaller than the sum of Part I, line 6, and Part II, lines 25 and 36, see Carryback and Carryforward of Unused Credit, earlier. Part III. General Business Credits or Eligible Small Business Credits Complete a separate Part III for each box checked. In addition, for each box A, B, E, or F checked, if you have a credit from more than one source and one of the sources is a pass-through entity, including a cooperative (see Column (b), later), a separate Part III is needed for each pass-through entity for which you received the same credit. As a result, one checkbox could have multiple Parts III if you receive a single credit from multiple pass-through entities. Box A Through H Check the box that identifies the credit being reported. For boxes E and F, eligible small business credits only apply to qualifying credits determined in See Special Rules for Eligible Small Business Credits (ESBCs), earlier. You may be able to claim an eligible small business credit that was determined in 2010 if you received the credit from a pass-through entity. Box I Check box I if you are reporting credits on more than one Part III with box A, B, E, or F checked. Part III with box I checked is used to consolidate the amounts from all Parts III with box A, B, E, or F by combining the amounts of each credit line from the Parts III with these boxes checked. A consolidated Part III is needed if there is more than one Part III with box A, B, E, or F checked. More than one box A, B, E, or F means more than one individual letter box (for example, if there is more than one Parts III with box B checked, a consolidated Part III is needed to reflect the total of all the boxes B checked) or more than one combination of letters (for example, if there is a box A checked and a box B checked, a consolidated Part III is needed to reflect the total of boxes A and B). Column (b) If you are reporting a credit from a pass-through entity, you must enter that 4 pass-through entity's EIN under column (b) for that credit. If you are reporting a credit reported to you on Form 1099-PATR, Taxable Distributions Received From Cooperatives, you must enter that cooperative's EIN under column (b) for that credit. A separate Part III will be needed to report the EIN of the pass-through entity, including cooperatives, and the amount of credit from that entity, if a credit is received from more than one source and one of the sources is a pass-through entity, including a cooperative. Column (b) is only completed for any Part III with box A, B, E, or F checked. Limitation on Certain Credits The aggregate amount from each credit form is usually reported on the appropriate line of Form 3800, Part III, for the applicable boxes A, B, E, and F, to reflect self-generated credit sources and all pass-through entity sources. However, certain credits have limitations imposed. They include: Form 3468, Part III, line 12p $4,000 limitation for qualified small wind energy property (reported on line 4a); Form 8826, line 8 $5,000 limitation for the overall credit (reported on line 1e); Form 8881, line 5 $500 limitation for the overall credit (reported on line 1j); Form 8882, line 7 $150,000 limitation for the overall credit (reported on line 1k); Form 8909, line 23. See the Form 8909 instructions for information on the limitation that applies (reported on line 1q); and Form 8931, line 8 $2 million limitation for the overall credit (reported on line 1v). In situations where there is a limitation on the credit amount, the limited amount allowed is allocated pro-rata and anything above the limitation is lost. Line Changes From Source Forms The credit from the following source forms are reported on Form 3800, Part III, as indicated. Source Form Line Number Form 8826 Line 8 Line 1e Form 8881 Line 5 Line 1j Form 8882 Lines 7 or 9 Line 1k Form 3800, Part III Form 8896 Lines 8 or 10 Line 1m Lines 1a and 4a If you are a cooperative described in section 1381(a), you must allocate to your patrons the investment credit in excess of your tax liability limit. Allocate to your

202 patrons the portion, if any, of the investment credit on line 6 or line 36 in excess of line 16a or line 29, respectively. While any excess is allocated to patrons, any credit recapture applies as if you as the cooperative had claimed the entire credit. Line 1c Research credit limitation. If you are an individual, the amount of the research credit that may be included on line 1c is limited to the amount of tax attributable to your taxable income from the sole proprietorship or your interest in the pass-through entity (partnership, S corporation, estate, or trust) generating the credit. Figure the research credit limitation separately for each sole proprietorship or pass-through entity by using the following formula: Line 11 Taxable income attributable to the sole proprietorship or your interest in the pass-through entity Your taxable income for the year The sum of the fractions used for determining the limits cannot exceed one. The research credit used to determine the limitation is the sum of the current year credit (determined without regard to the limitation), any carryforwards of the credit not used in prior years, and any carryback of the credit from For information on how to compute your taxable income for the year, your taxable income attributable to the sole proprietorship, or your interest in the pass-through entity, see Regulations sections (c) and If in the current tax year you had no taxable income attributable to a particular business interest, you cannot claim any research credit this year related to that business. If any of your research credit is not allowed to be used because of this limitation, see Carryback and Carryforward of Unused Credit, earlier. Line 1e When reporting the disabled access credit from Form 8826 on line 1e, do not enter more than $5,000 in column (c) of Parts III with box A, B, E, or F checked, combined. Line 1f Cooperatives, estates, and trusts: enter the amount from Form 8835, line 12, and the applicable part of the amount from Form 8835, line 32. All others: enter the amount from Form 8835, line 10, and the applicable part of the amount from Form 8835, line 30. Do not enter an amount from Form 8835 that is included on Form 3800, line 4e. Line 1j When reporting the credit for small employer pension plan startup costs from Form 8881 on line 1j, do not enter more than $500 in column (c) of Parts III with box A, B, E, or F checked, combined. Line 1k When reporting the credit for employer-provided childcare facilities and services from Form 8882 on line 1k, do not enter more than $150,000 in column (c) of Parts III with box A, B, E, or F checked, combined. Line 1v When reporting the agricultural chemicals security credit from Form 8931 on line 1v, do not enter more than $2 million in column (c) of Parts III with box A, B, E, or F checked, combined. Line 1bb Enter the total of the amounts shown in box 7 of the Schedules K-1 (Form 1065-B), Partner's Share of Income (Loss) From an Electing Large Partnership, you received from electing large partnerships (ELPs). Line 1zz Enter any carryforward to 2012 of any unused credit from: Form 3468 (for years prior to 2008 for the rehabilitation credit) (for tax years beginning before October 4, 2008, for the energy credit); Form 5884 for years prior to 2007; Form 6478 for years prior to 2005; Form 8846 for years prior to 2007; or Form 8900 for years prior to Also use line 1zz to enter any carryforward to 2012 of any unused credit from general business credits no longer covered on Form 3800 due to, and not limited to, expiration of a tax provision. The following list identifies these credits. Trans-Alaska pipeline liability fund credit. Credit for employers affected by Hurricane Katrina, Rita, or Wilma (Form 5884-A, Section A only). Hurricane Katrina housing credit (Form 5884-A, Section B only). Credit for affected Midwestern disaster area employers (Form 5884-A, Section A only). Employer housing credit (Form 5884-A, Section B only). Enhanced oil recovery credit (Form 8830). Credit for contributions to selected community development corporations (Form 8847). Welfare-to-work credit (Form 8861). New York Liberty Zone business employee credit (Form 8884). Renewal community employee credit (previously reported on Form 8844). Only Part III with box C checked is to be used with a line 1zz credit entry under column (c). No EINs are required under column (b). Note. If an amount is entered on line 1zz, see the instructions for Part I, line 4 for the statement to attach. Line 4h Credit for Small Employer Health Insurance Premiums (Form 8941): Tax-exempt eligible small employers, other than certain farmers' cooperatives, do not report the credit for small employer health insurance premiums on line 4h. Eligible tax-exempt small employers will report this credit on Form 990-T, Exempt Organization Business Income Tax Return. If your only source of credit listed on line 4h is from pass-through entities, you are not required to complete or attach Form Instead enter the credit directly on line 4h. Eligible small employers (other than tax-exempt eligible small employers) will enter the credit from Form 8941, line 16 or line 18. See the Instructions for Form 8941 for more information. 5

203 Paperwork Reduction Act Notice. We ask for the information on this form to carry out the Internal Revenue laws of the United States. You are required to give us the information. We need it to ensure that you are complying with these laws and to allow us to figure and collect the right amount of tax. You are not required to provide the information requested on a form that is subject to the Paperwork Reduction Act unless the form displays a valid OMB control number. Books or records relating to a form or its instructions must be retained as long as their contents may become material in the administration of any Internal Revenue law. Generally, tax returns and return information are confidential, as required by Internal Revenue Code section The time needed to complete and file this form will vary depending on individual circumstances. The estimated burden for individual taxpayers filing this form is approved under OMB control number and is included in the estimates shown in the instructions for their individual income tax return. The estimated burden for all other taxpayers who file this form is shown below. Recordkeeping Learning about the law or the form hr., 53 min. 1 hr. Preparing, copying, assembling, and sending the form to the IRS hr., 20 min. If you have comments concerning the accuracy of these time estimates or suggestions for making this form simpler, we would be happy to hear from you. See the instructions for the tax return with which this form is filed. 6

204 Form 5884 Department of the Treasury Internal Revenue Service Name(s) shown on return Work Opportunity Credit OMB No Attach to your tax return Attachment Information about Form 5884 and its instructions is at Sequence No. 77 Identifying number 1 Enter on the applicable line below the total qualified first- or second-year wages paid or incurred during the tax year, and multiply by the percentage shown, for services of employees who are certified as members of a targeted group. a Qualified first-year wages of employees who worked for you at least 120 hours but fewer than 400 hours. $ 25% (.25) 1a b Qualified first-year wages of employees who worked for you at least 400 hours $ 40% (.40) 1b c Qualified second-year wages of employees certified as long-term family assistance recipients $ 50% (.50) 1c 2 Add lines 1a, 1b, and 1c. See instructions for the adjustment you must make to salaries and wages Work opportunity credit from partnerships, S corporations, cooperatives, estates, and trusts Add lines 2 and 3. Cooperatives, estates, and trusts, go to line 5. Partnerships and S corporations, stop here and report this amount on Schedule K. All others, stop here and report this amount on Form 3800, line 4b Amount allocated to patrons of the cooperative or beneficiaries of the estate or trust (see instructions) Cooperatives, estates, and trusts, subtract line 5 from line 4. Report this amount on Form 3800, line 4b For Paperwork Reduction Act Notice, see instructions. Cat. No D Form 5884 (2012)

205 Form 5884 (2012) Page 2 General Instructions Section references are to the Internal Revenue Code unless otherwise noted. Future Developments For the latest information about developments related to Form 5884 and its instructions, such as legislation enacted after they were published, go to form5884. What's New The work opportunity credit was extended to cover employees not certified as qualified veterans who begin work after 2011 and before 2014 and employees certified as qualified veterans who begin work after 2012 and before Empowerment zone designations were extended to cover 2012 and This extension may allow employers to use certain wages paid to summer youth employees and designated community residents for services performed in 2012 and 2013 to figure the credit. See Qualified Wages for details. Purpose of Form Use Form 5884 to claim the work opportunity credit for qualified first- or second-year wages you paid to or incurred for targeted group employees during the tax year. Your business does not have to be located in an empowerment zone or rural renewal county to qualify for this credit. You can claim or elect not to claim the work opportunity credit any time within 3 years from the due date of your return on either your original return or an amended return. Taxpayers, other than partnerships, S corporations, cooperatives, estates, or trusts, whose only source of this credit is from those pass-through entities, are not required to complete or file this form. Instead, they can report this credit directly on Form How To Claim the Credit You must request and be issued a certification for each employee from the state employment security agency (SESA). The certification proves that the employee is a member of a targeted group. You must receive the certification by the day the individual begins work or complete Form 8850, Pre-Screening Notice and Certification Request for the Work Opportunity Credit, on or before the day you offer the individual a job. If you complete Form 8850, it must be signed by you and the individual and submitted to the SESA by the 28th calendar day after the individual begins work. If the SESA denies the request, it will provide a written explanation of the reason for denial. If a certification is revoked because it was based on false information provided by the worker, wages paid or incurred after the date you receive the notice of revocation do not qualify for the credit. Targeted group employee. An employee is a member of a targeted group if he or she is a: Long-term family assistance recipient, Qualified recipient of Temporary Assistance for Needy Families (TANF), Qualified veteran, Qualified ex-felon, Designated community resident, Vocational rehabilitation referral, Summer youth employee, SNAP recipient, or SSI recipient. See the Instructions for Form 8850 and section 51(d) for details and restrictions. Qualified Wages Wages qualifying for the credit generally have the same meaning as wages subject to the Federal Unemployment Tax Act (FUTA). If the work performed by any employee during more than half of any pay period qualifies under FUTA as agricultural labor, that employee s wages subject to social security and Medicare taxes are qualified wages. For a special rule that applies to railroad employees, see section 51(h)(1)(B). Qualified wages for any employee must be reduced by the amount of any work supplementation payments you received under the Social Security Act for the employee. The amount of qualified wages for any employee is zero if: The employee did not work for you for at least 120 hours, The employee worked for you previously, The employee is your dependent, The employee is related to you (see section 51(i)(1)), or 50% or less of the wages the employee received from you were for working in your trade or business. Qualified wages do not include: Wages paid to or incurred for any employee during any period for which you received payment for the employee from a federally funded on-the-job training program; Wages paid to or incurred for a summer youth employee for services performed while the employee lived outside an empowerment zone; Wages paid to or incurred for a designated community resident for services performed while the employee lived outside an empowerment zone or rural renewal county; Wages paid to or incurred for services performed by a summer youth employee before or after any 90-day period between May 1 and September 15; and Wages for services of replacement workers during a strike or lockout.

206 Form 5884 (2012) Page 3 Member of Controlled Group or Business Under Common Control For purposes of figuring the credit, all members of a controlled group of corporations (as defined in section 52(a)) and all members of a group of businesses under common control (as defined in section 52(b)), are treated as a single taxpayer. As a member, compute your credit based on your proportionate share of qualified wages giving rise to the group s work opportunity credit. Enter your share of the credit on line 2. Attach a statement showing how your share of the credit was figured, and enter See attached next to the entry space for line 2. Specific Instructions Current Year Credit Lines 1a, 1b, and 1c Enter on the applicable line and multiply by the percentage shown the total qualified first- or second-year wages paid to or incurred for employees who are members of a targeted group. Qualified first-year wages are qualified wages you paid to or incurred for work performed during the 1-year period beginning on the date the individual begins work for you. Qualified second-year wages are qualified wages you paid to or incurred for certified long-term family assistance recipients for work performed during the 1-year period beginning on the day after the last day of the 1-year wage period. The amount of qualified first-year wages and the amount of qualified second-year wages that may be taken into account for any employee certified as a longterm family assistance recipient is limited to $10,000 per year. The amount of qualified first-year wages that may be taken into account for an employee certified as a qualified veteran is limited to the following amounts. $6,000 for a qualified veteran certified as being either (a) a member of a family receiving assistance under the Supplemental Nutrition Assistance Program (SNAP) (food stamps) for at least a 3-month period during the 15- month period ending on the hiring date, or (b) unemployed for a period or periods totaling at least 4 weeks (whether or not consecutive) but less than 6 months in the 1-year period ending on the hiring date. $12,000 for a qualified veteran certified as being entitled to compensation for a service-connected disability and either (a) hired not more than 1 year after being discharged or released from active duty in the U.S. Armed Forces, or (b) began work before November 22, 2011, and was unemployed for a period or periods totaling at least 6 months (whether or not consecutive) in the 1-year period ending on the hiring date. $14,000 for a qualified veteran who began work after November 21, 2011, and was certified as being unemployed for a period or periods totaling at least 6 months (whether or not consecutive) in the 1-year period ending on the hiring date. $24,000 for a qualified veteran who began work after November 21, 2011, and was certified as being entitled to compensation for a service-connected disability, and unemployed for a period or periods totaling at least 6 months (whether or not consecutive), in the 1-year period ending on the hiring date. The amount of qualified first-year wages that may be taken into account for any employee certified as a summer youth employee is limited to $3,000. The amount of qualified first-year wages that may be taken into account for an employee certified as a member of any other targeted group is $6,000. Successor employer. For successor employers, the 1- or 2-year period begins on the date the employee began work for the previous employer and any qualified first- or second-year wages paid or incurred by the successor employer are reduced by the qualified first- or secondyear wages paid or incurred by the previous employer. See section 51(k)(1) and Regulations section (h). A successor employer is an employer that acquires substantially all of the property used in a trade or business (or a separate unit thereof) of another employer (the previous employer) and immediately after the acquisition, the successor employs in his or her trade or business an individual who was employed immediately prior to the acquisition in the trade or business of the previous employer. Line 2 In general, you must reduce your deduction for salaries and wages by the amount on line 2. This is required even if you cannot take the full credit this year and must carry part of it back or forward. If you capitalized any costs on which you figured the credit, reduce the amount capitalized by the credit attributable to these costs. Line 3 Enter the amount of credit that was allocated to you as a partner, shareholder, patron of a cooperative, or beneficiary. Line 5 Cooperatives. A cooperative described in section 1381(a) must allocate to its patrons the credit in excess of its tax liability limit. Therefore, to figure the unused amount of the credit allocated to patrons, the cooperative must first figure its tax liability. While any excess is allocated to patrons, any credit recapture applies as if the cooperative had claimed the entire credit. If the cooperative is subject to the passive activity rules, include on line 3 any work opportunity credit from passive activities disallowed for prior years and carried forward to this year. Complete Form 8810, Corporate Passive Activity Loss and Credit Limitations, to determine the allowed credit that must be allocated to patrons. For details, see the Instructions for Form Estates and trusts. Allocate the work opportunity credit on line 4 between the estate or trust and the beneficiaries in the same proportion as income was allocated and enter the beneficiaries' share on line 5.

207 Form 5884 (2012) Page 4 If the estate or trust is subject to the passive activity rules, include on line 3 any work opportunity credit from passive activities disallowed for prior years and carried forward to this year. Complete Form 8582-CR, Passive Activity Credit Limitations, to determine the allowed credit that must be allocated between the estate or trust and the beneficiaries. For details, see the Instructions for Form 8582-CR. Paperwork Reduction Act Notice. We ask for the information on this form to carry out the Internal Revenue laws of the United States. You are required to give us the information. We need it to ensure that you are complying with these laws and to allow us to figure and collect the right amount of tax. You are not required to provide the information requested on a form that is subject to the Paperwork Reduction Act unless the form displays a valid OMB control number. Books or records relating to a form or its instructions must be retained as long as their contents may become material in the administration of any Internal Revenue law. Generally, tax returns and return information are confidential, as required by section The time needed to complete and file this form will vary depending on individual circumstances. The estimated burden for individual taxpayers filing this form is approved under OMB control number and is included in the estimates shown in the instructions for their individual income tax return. The estimated burden for all other taxpayers who file this form is shown below. Recordkeeping hr., 6 min. Learning about the law or the form hr., 15 min. Preparing and sending the form to the IRS hr., 34 min. If you have comments concerning the accuracy of these time estimates or suggestions for making this form simpler, we would be happy to hear from you. See the instructions for the tax return with which this form is filed.

208 Form 6478 Department of the Treasury Internal Revenue Service Name(s) shown on return Alcohol and Cellulosic Biofuel Fuels Credit (Including Second Generation Biofuel) Attach to your tax return. Information about Form 6478 and its instructions is at Identifying number OMB No Attachment Sequence No. 83 Reserved Type of Fuel (a) Number of Gallons Sold or Used (b) Rate (c) Column (a) x Column (b) 1 Reserved Reserved Reserved Reserved Qualified cellulosic biofuel production for fuel sold or used before January 3, 2013 (see instructions for election) Qualified second generation biofuel production for fuel sold or used after January 2, 2013 (see instructions for election).. 6 $1.01 $ Add the amounts in column (c) on lines 5 and 6. Include this amount in your income for 2012, and enter your IRS registration number (see instructions) Alcohol and cellulosic biofuel fuels credit from partnerships, S corporations, cooperatives, estates, and trusts (see instructions) Add lines 7 and 8. Cooperatives, estates, and trusts, go to line 10. Partnerships and S corporations, stop here and report this amount on Schedule K. All others, stop here and report this amount on Form 3800, line 4c Amount allocated to patrons of the cooperative or beneficiaries of the estate or trust (see instructions) Cooperatives, estates, and trusts, subtract line 10 from line 9. Report this amount on Form 3800, line 4c Reserved For Paperwork Reduction Act Notice, see instructions. Cat. No J Form 6478 (2012)

209 Form 6478 (2012) Page 2 General Instructions Section references are to the Internal Revenue Code unless otherwise noted. Future Developments For the latest information about developments related to Form 6478 and its instructions, such as legislation enacted after they were published, go to What's New The alcohol mixture, alcohol, and small ethanol producer credits expired for fuels sold or used after The cellulosic biofuel producer credit was extended to cover fuel sold or used through January 2, A second generation biofuel producer credit adds algae-based fuel and covers fuel sold or used after January 2, 2013, and before January 1, Purpose of Form Use Form 6478 to figure your alcohol and cellulosic biofuel fuels credit. You claim the credit for the tax year in which the sale or use occurs. This credit consists of the: Cellulosic biofuel producer credit, and Second generation biofuel producer credit. You may claim or elect not to claim the alcohol and cellulosic biofuel fuels credit at any time within 3 years from the due date of your return (determined without regard to extensions) on either an original or an amended return for the tax year of the sale or use. Taxpayers, other than partnerships, S corporations, cooperatives, estates, or trusts, whose only source of this credit is from those pass-through entities, are not required to complete or file this form. Instead, they can report this credit directly on Form Qualified Cellulosic Biofuel Production This is cellulosic biofuel which during the tax year: 1. Is sold by the producer to another person a. For use by the buyer in the buyer s trade or business to produce a qualified cellulosic biofuel mixture (other than casual off-farm production), b. For use by the buyer as a fuel in a trade or business, or c. Who sells the cellulosic biofuel at retail to another person and puts the cellulosic biofuel in the retail buyer s fuel tank; or 2. Is used or sold by the producer for any purpose described in (1) above. Qualified cellulosic biofuel production does not include purchasing alcohol and increasing the proof of the alcohol through additional distillation. Nor does it include cellulosic biofuel that is not both produced in the United States or a U.S. possession and used as a fuel in the United States or a U.S. possession. A qualified cellulosic biofuel mixture combines cellulosic biofuel with gasoline or a special fuel. The producer of the mixture either: Used it as a fuel, or Sold it as fuel to another person. Cellulosic Biofuel Generally, cellulosic biofuel, for credit purposes, is any liquid fuel, which: Is produced from any lignocellulosic or hemicellulosic matter that is available on a renewable or recurring basis, Meets the registration requirements for fuels and fuel additives established by the Environmental Protection Agency under section 211 of the Clean Air Act (42 U.S.C. 7545), and Is not alcohol of less than 150 proof. In figuring the proof of any alcohol, disregard any added denaturants (additives that make the alcohol unfit for human consumption). However, cellulosic biofuel does not include any fuel if: More than 4% of the fuel (determined by weight) is any combination of water and sediment, The ash content of the fuel is more than 1% (determined by weight), or The fuel has an acid number greater than 25. Qualified Second Generation Biofuel Production This is second generation biofuel which during the tax year: 1. Is sold by the producer to another person a. For use by the buyer in the buyer s trade or business to produce a qualified second generation biofuel mixture (other than casual off-farm production), b. For use by the buyer as a fuel in a trade or business, or c. Who sells the second generation biofuel at retail to another person and puts the second generation biofuel in the retail buyer s fuel tank; or 2. Is used or sold by the producer for any purpose described in (1) above. Qualified second generation biofuel production does not include purchasing alcohol and increasing the proof of the alcohol through additional distillation. Nor does it include second generation biofuel that is not both produced in the United States or a U.S. possession and used as a fuel in the United States or a U.S. possession. A qualified second generation biofuel mixture combines second generation biofuel with gasoline or a special fuel. The producer of the mixture either: Used it as a fuel, or Sold it as fuel to another person. Second Generation Biofuel Generally, second generation biofuel, for credit purposes, is any liquid fuel, which: Is derived by, or from, qualified feedstocks,

210 Form 6478 (2012) Page 3 Meets the registration requirements for fuels and fuel additives established by the Environmental Protection Agency under section 211 of the Clean Air Act (42 U.S.C. 7545), and Is not alcohol of less than 150 proof. In figuring the proof of any alcohol, disregard any added denaturants (additives that make the alcohol unfit for human consumption). A qualified feedstock is: Any lignocellulosic or hemicellulosic matter that is available on a renewable or recurring basis, and Any cultivated algae, cyanobacteria, or lemna. However, second generation biofuel does not include any fuel if: More than 4% of the fuel (determined by weight) is any combination of water and sediment, The ash content of the fuel is more than 1% (determined by weight), or The fuel has an acid number greater than 25. Special rules for algae. For sales described in (1) under Qualified Second Generation Biofuel Production, earlier, second generation biofuel also includes certain liquid fuel, which: Is derived by, or from, any cultivated algae, cyanobacteria, or lemna, and Is not alcohol of less than 150 proof (disregard any added denaturants). But only if this fuel is sold by the producer to another person for refining by such other person into a liquid fuel which will meet the registration requirements for fuels and fuel additives established by the Environmental Protection Agency under section 211 of the Clean Air Act (42 U.S.C. 7545), and not include any fuel if: More than 4% of the fuel (determined by weight) is any combination of water and sediment, The ash content of the fuel is more than 1% (determined by weight), or The fuel has an acid number greater than 25. Also, once this fuel is sold by the producer to another person for refining by such person into a fuel which will meet these requirements, neither the producer nor any other person can use such fuel (or any fuel derived from such fuel) to figure a second credit for qualified second generation biofuel production. Registration All producers of cellulosic or second generation biofuel must be registered with the IRS. See Form 637, Application for Registration. Recapture of Credit You must pay a tax on each gallon of cellulosic or second generation biofuel at the rate you used to figure the credit if you do not use the fuel for the purposes described under Qualified Cellulosic Biofuel Production or Qualified Second Generation Biofuel Production, earlier. Report the tax on Form 720. Specific Instructions Lines 1 Through 4 These lines are reserved for future use. Line 5 Enter the number of gallons of cellulosic biofuel sold or used before January 3, 2013, that meets the conditions listed under Qualified Cellulosic Biofuel Production, earlier. Multiply by the rate of $1.01 per gallon. Line 6 Enter the number of gallons of second generation biofuel sold or used after January 2, 2013, that meets the conditions listed under Qualified Second Generation Biofuel Production, earlier. Multiply by the rate of $1.01 per gallon. Line 7 The total credit shown in column (c) on lines 5 and 6 must be included in income under other income on the applicable line of your income tax return, even if you cannot use all of the credit because of the tax liability limit. However, if you are subject to the alternative minimum tax (AMT), this amount is not income in figuring AMT and must be subtracted when figuring your alternative minimum taxable income. Do this by including this amount on line 27 of Form 6251, line 23 of Schedule I (Form 1041), or line 2o of Form Registration number. To claim a cellulosic or second generation biofuel producer credit on line 5 or line 6, you must be registered with the IRS. Enter your CB registration number in the space provided. For more information, see Form 637 and Publication 510, Excise Taxes. Line 8 Enter the amount of credit that was allocated to you as a partner, shareholder, patron of a cooperative, or beneficiary. If your credit from a pass-through entity includes the small ethanol producer credit, you, as a partner, shareholder, patron, or beneficiary, are subject to the 15- million-gallon production limitation and the 60-milliongallon productive capacity limitation for an eligible small ethanol producer. If you receive a small ethanol producer credit from more than one entity, your credit may be limited. Line 10 Estate or trust. Allocate the alcohol and cellulosic biofuel fuels credit on line 9 between the estate or trust and the beneficiaries in the same proportion as income was allocated and enter the beneficiaries share on line 10. If the estate or trust is subject to the passive activity rules, include on line 8 any alcohol and cellulosic biofuel fuels credits from passive activities disallowed for prior years and carried forward to this year. Complete Form 8582-CR, Passive Activity Credit Limitations, to determine the allowed credit that must be allocated between the estate or trust and the beneficiaries. For details, see the Instructions for Form 8582-CR.

211 Form 6478 (2012) Page 4 Cooperative election to allocate the cellulosic or second generation biofuel producer credit to patrons. A cooperative described in section 1381(a) can elect to allocate any part of the cellulosic or second generation biofuel producer credit to patrons of the cooperative. To make the election, attach a statement to the effect that the cooperative elects to allocate the credit pro rata among the patrons eligible to share in patronage dividends on the basis of the quantity or value of business done with or for the patrons for the tax year. If the cooperative is subject to the passive activity rules, include on line 8 any small ethanol or cellulosic biofuel producer credits from passive activities disallowed for prior years and carried forward to this year. Complete Form 8810, Corporate Passive Activity Loss and Credit Limitations, to determine the allowed producer credits that can be allocated to patrons. For details, see the Instructions for Form The election is not effective unless: The statement described above is attached to the timely filed tax return (including extensions) for the tax year associated with the election, and The cooperative designates the apportionment in a written notice mailed to its patrons during the payment period described in section 1382(d). If you timely filed your return without making an election, you can still make the election by filing an amended return within 6 months of the due date of the return (excluding extensions). Write Filed pursuant to section on the amended return. Once made, the election cannot be revoked. Paperwork Reduction Act Notice. We ask for the information on this form to carry out the Internal Revenue laws of the United States. You are required to give us the information. We need it to ensure that you are complying with these laws and to allow us to figure and collect the right amount of tax. You are not required to provide the information requested on a form that is subject to the Paperwork Reduction Act unless the form displays a valid OMB control number. Books or records relating to a form or its instructions must be retained as long as their contents may become material in the administration of any Internal Revenue law. Generally, tax returns and return information are confidential, as required by section The time needed to complete and file this form will vary depending on individual circumstances. The estimated burden for individual taxpayers filing this form is approved under OMB control number and is included in the estimates shown in the instructions for their individual income tax return. The estimated burden for all other taxpayers who file this form is shown below. Recordkeeping hr., 32 min. Learning about the law or the form min. Preparing and sending the form to the IRS hr. If you have comments concerning the accuracy of these time estimates or suggestions for making this form simpler, we would be happy to hear from you. See the instructions for the tax return with which this form is filed.

212 Form 8586 (Rev. December 2011) Department of the Treasury Internal Revenue Service (99) Name(s) shown on return Low-Income Housing Credit Attach to your tax return. Identifying number OMB No Attachment Sequence No. 36a Part I Buildings Placed in Service Before Number of Forms 8609-A attached for buildings placed in service before Has there been a decrease in the qualified basis of any buildings accounted for on line 1 since the close of the preceding tax year? Yes No If Yes, enter the building identification numbers (BINs) of the buildings that had a decreased basis. If you need more space, attach a schedule. (i) (ii) (iii) (iv) 3 Current year credit from attached Form(s) 8609-A for buildings placed in service before 2008 (see instructions) Low-income housing credit for buildings placed in service before 2008 from partnerships, S corporations, estates, and trusts Add lines 3 and 4. Estates and trusts, go to line 6. Partnerships and S corporations, stop here and report this amount on Schedule K. All others, stop here and report this amount on Form 3800, line 1d Amount allocated to beneficiaries of the estate or trust (see instructions) Estates and trusts, subtract line 6 from line 5. Report this amount on Form 3800, line 1d... 7 Part II Buildings Placed in Service After Number of Forms 8609-A attached for buildings placed in service after Has there been a decrease in the qualified basis of any buildings accounted for on line 8 since the close of the preceding tax year? Yes No If Yes, enter the building identification numbers (BINs) of the buildings that had a decreased basis. If you need more space, attach a schedule. (i) (ii) (iii) (iv) 10 Current year credit from attached Form(s) 8609-A for buildings placed in service after 2007 (see instructions) Low-income housing credit for buildings placed in service after 2007 from partnerships, S corporations, estates, and trusts Add lines 10 and 11. Estates and trusts, go to line 13. Partnerships and S corporations, stop here and report this amount on Schedule K. All others, stop here and report this amount on Form 3800, line 4d Amount allocated to beneficiaries of the estate or trust (see instructions) Estates and trusts, subtract line 13 from line 12. Report this amount on Form 3800, line 4d.. 14 For Paperwork Reduction Act Notice, see instructions. Cat. No I Form 8586 (Rev )

213 Form 8586 (Rev ) Page 2 General Instructions Section references are to the Internal Revenue Code unless otherwise noted. What's New Credit carryforwards, carrybacks, and passive activity limitations for buildings placed in service after 2007 are no longer reported on this form; instead, they must be reported on Form 3800, General Business Credit. The IRS has created a page on IRS.gov for information about Form 8586 and its instructions, at Information about any future developments affecting Form 8586 (such as legislation enacted after we release it) will be posted on that page. Purpose of Form Use Form 8586 to claim the low-income housing credit. This general business credit is allowed for each new qualified low-income building placed in service after Generally, it is taken over a 10-year credit period. The portion of the low-income housing credit attributable to buildings placed in service after 2007 is not limited by tentative minimum tax. Taxpayers, other than partnerships, S corporations, estates, or trusts, whose only source of this credit is from those pass-through entities, are not required to complete or file this form. Instead, they can report this credit directly on Form Qualified Low-Income Housing Project The credit cannot exceed the amount allocated to the building. See section 42(h)(1) for details. The low-income housing credit can only be claimed for residential rental buildings in low-income housing projects that meet one of the minimum set-aside tests. For details, see the Instructions for Form 8609, Part II, line 10c. Except for buildings financed with certain tax-exempt bonds, you may not take a low-income housing credit on a building if it has not received an allocation from the housing credit agency. No allocation is needed when 50% or more of the aggregate basis of the building and the land on which the building is located is financed with certain tax-exempt bonds. The owner still must get a Form 8609 from the appropriate housing credit agency (with the applicable items completed, including an assigned BIN). Land on which the building is located includes only land that is functionally related and subordinate to the qualified low-income building (see Regulations sections (a)(3) and (b)(4)(iii)). Recapture of Credit There is a 15-year compliance period during which the residential rental building must continue to meet certain requirements. If, as of the close of any tax year in this period, there is a reduction in the qualified basis of the building from the previous year, you may have to recapture a part of the credit you have taken. Similarly, you may have to recapture part of the credits taken in previous years upon certain dispositions of the building or interests therein, unless you follow the procedures to prevent recapture. See Recapture and building dispositions in the Instructions for Form 8609-A, Annual Statement for Low-Income Housing Credit, for details. If you must recapture credits, use Form 8611, Recapture of Low-Income Housing Credit. See section 42(j) for details. Recordkeeping Keep a copy of this Form 8586 together with all Forms 8609, Schedules A (Form 8609) (and successor Forms 8609-A), and Forms 8611 for 3 years after the 15-year compliance period ends. Specific Instructions Line 2. A decrease in qualified basis will result in recapture if the qualified basis at the close of the tax year is less than the qualified basis at the close of the first year of the credit period. If the reduction in qualified basis at the close of the tax year also results in a violation of the minimum set-aside requirement, then no credit is allowable for the year. Line 3. The credit for the year is figured on Form 8609-A for each building. Attach a copy of each Form 8609-A you completed for the tax year to Form Enter on line 3 the total credit from attached Form(s) 8609-A for buildings placed in service before Line 6. Estates or trusts. Allocate the low-income housing credit on line 5 between the estate or trust and the beneficiaries in the same proportion as income was allocated and enter the beneficiaries share on line 6. If the estate or trust is subject to the passive activity rules, include on line 4 any low-income housing credits attributable to buildings placed in service before 2008 from passive activities disallowed for prior years and carried forward to this year. Complete Form CR, Passive Activity Credit Limitations, to determine the allowed credit that must be allocated between the estate or trust and the beneficiaries. For details, see the Instructions for Form 8582-CR. Line 9. A decrease in qualified basis will result in recapture if the qualified basis at the close of the tax year is less than the qualified basis at the close of the first year of the credit period. If the reduction in qualified basis at the close of the tax year also results in a violation of the minimum set-aside requirement, then no credit is allowable for the year. Line 10. The credit for the year is figured on Form 8609-A for each building. Attach a copy of each Form 8609-A you completed for the tax year to Form Enter on line 10 the total credit for attached Form(s) 8609-A for buildings placed in service after Line 13. Estates or trusts. Allocate the low-income housing credit on line 12 between the estate or trust and the beneficiaries in the same proportion as income was allocated and enter the beneficiaries share on line 13. If the estate or trust is subject to the passive activity rules, include on line 11 any low-income housing credits attributable to buildings placed in service after 2007 from passive activities disallowed for prior years and carried forward to this year. Complete Form CR, Passive Activity Credit Limitations, to determine the allowed credit that must be allocated between the estate or trust and the beneficiaries. For details, see the Instructions for Form 8582-CR. Paperwork Reduction Act Notice. We ask for the information on this form to carry out the Internal Revenue laws of the United States. You are required to give us the information. We need it to ensure that you are complying with these laws and to allow us to figure and collect the right amount of tax. You are not required to provide the information requested on a form that is subject to the Paperwork Reduction Act unless the form displays a valid OMB control number. Books or records relating to a form or its instructions must be retained as long as their contents may become material in the administration of any Internal Revenue law. Generally, tax returns and return information are confidential, as required by section The time needed to complete and file this form will vary depending on individual circumstances. The estimated burden for individual taxpayers filing this form is approved under OMB control number and is included in the estimates shown in the instructions for their individual income tax return. The estimated burden for all other taxpayers who file this form is shown below. Recordkeeping hr., 44 min. Learning about the law or the form min. Preparing and sending the form to the IRS... 2 hr., 11 min. If you have comments concerning the accuracy of these time estimates or suggestions for making this form simpler, we would be happy to hear from you. See the instructions for the tax return with which this form is filed.

214 Form 8820 (Rev. December 2012) Department of the Treasury Internal Revenue Service Name(s) shown on return Orphan Drug Credit Information about Form 8820 and its instructions is available at Attach to your tax return. OMB No Attachment Sequence No. 103 Identifying number Part I Current Year Credit 1 Qualified clinical testing expenses paid or incurred during the tax year (see instructions) a Current year credit. Multiply line 1 by 50% (.50) (see instructions) a b Enter the portion of the credit from Form 8932, line 2, that is attributable to wages that were also used to figure the credit on line 2a above b c Subtract line 2b from line 2a. If zero or less, enter c 3 Orphan drug credit from partnerships, S corporations, estates, or trusts Add lines 2c and 3. Estates and trusts go to line 5. Partnerships and S corporations, report this amount on Schedule K. All others, report this amount on Form 3800, line 1h Amount allocated to the beneficiaries of the estate or trust (see instructions) Estates and trusts. Subtract line 5 from line 4. Report this amount on Form 3800, line 1h For Paperwork Reduction Act Notice, see instructions. Cat. No S Form 8820 (Rev )

215 Form 8820 (Rev ) Page 2 Part II Orphan Drug Information (see instructions) (a) 7a (b) Name of orphan drug (c) Designation application number (d) Date drug designated (mm/dd/yyyy) b c d e f g h i j k l m n o p q r s t u v w x y z Form 8820 (Rev )

216 Form 8820 (Rev ) Page 3 General Instructions Section references are to the Internal Revenue Code unless otherwise noted. Future developments. For the latest information about developments related to Form 8820 and its instructions, such as legislation enacted after this form and instructions were published, go to Purpose of Form Use Form 8820 to claim the orphan drug credit. The credit is 50% of qualified clinical testing expenses paid or incurred during the tax year. See section 45C and Regulations section for details. Taxpayers that are not partnerships, S corporations, estates, or trusts, and whose only source of this credit is from those pass-through entities, are not required to complete or file this form. Instead, they can report this credit directly on Form Definitions Qualified clinical testing expenses. Generally, qualified clinical testing expenses are amounts paid or incurred by the taxpayer that would be described as qualified research expenses under section 41, with two modifications: In sections 41(b)(2) and (3), clinical testing is substituted for qualified research and 100% (instead of 65% or 75%) of contract research expenses are treated as clinical testing expenses. Qualified clinical testing expenses do not include expenses to the extent they are funded by a grant, contract, or otherwise by a governmental entity or another person. Clinical testing. Generally, clinical testing means any human clinical testing that meets all four of the following conditions. 1. The testing is carried out under an exemption for a drug being tested for a rare disease or condition under section 505(i) of the Federal Food, Drug, and Cosmetic Act (Act). 2. The testing occurs after the date the drug is designated under Act section 526 and before the date on which an application for the drug is approved under Act section 505(b) (or, if the drug is a biological product, before the date the drug is licensed under section 351 of the Public Health Service Act). 3. The testing is conducted by or for the taxpayer to whom the designation under Act section 526 applies. 4. The testing relates to the use of the drug for the rare disease or condition for which it was designated under Act section 526. Rare disease or condition. A rare disease or condition is one which afflicts: 200,000 or fewer persons in the United States or More than 200,000 persons in the United States, but for which there is no reasonable expectation of recovering the cost of developing and making available a drug in the United States for the disease from sales of the drug in the United States. The above determinations are made as of the date the drug is designated under Act section 526. Testing Not Eligible for the Credit The credit is not allowed for clinical testing conducted outside the United States unless there is an insufficient U.S. testing population and the testing is conducted by a U. S. person or by another person not related to the taxpayer. Testing conducted either inside or outside the United States by a corporation to which section 936 applies is not eligible for the orphan drug credit. Coordination With the Research Credit Qualified clinical testing expenses used to figure the orphan drug credit cannot also be used to figure the credit for increasing research activities. However, any of these expenses that are also qualified research expenses must be included in base period research expenses when figuring the credit for increasing research activities in a later tax year. Member of Controlled Group or Business Under Common Control For purposes of figuring the credit, all members of a controlled group of corporations (as defined in section 41(f)(1)(A) and (f)(5)) and all members of a group of businesses under common control (as defined in section 41(f)(1)(B)), are treated as a single taxpayer. As a member, your credit is determined on a proportionate basis to your share of the aggregate clinical testing expenses taken into account by the group for the orphan drug credit. Enter your share of the credit on line 2a. Attach a statement showing how your share of the credit was figured, and write See Attached next to the entry space for line 2a. Specific Instructions Figure any orphan drug credit from your own trade or business on lines 1 and 2a. Line 1 Complete Part II for each orphan drug for which qualified clinical testing expenses are paid or incurred during the tax year and included in line 1. Line 2a Reduce the deduction for qualified clinical testing expenses otherwise allowable on your income tax return by the amount of the credit shown on line 2a. If the credit exceeds the amount allowed as a deduction for the tax year, reduce the amount chargeable to the capital account for the year for such expenses by the amount of the excess. See section 280C(b) for special rules. Line 2b If the credit on line 2a includes wages paid to employees, and you are also claiming a credit for employer differential wage payments based on wages paid to the same employees, enter on line 2b the portion of the credit from the employer differential wage credit line (e.g., line 2 of Form 8932 (Rev. December 2012)) that is attributable to wages that were also used to figure the credit on line 2a. See Form 8932, Credit for Employer Differential Wage Payments, for information on the credit.

217 Form 8820 (Rev ) Page 4 Line 5 Allocate the orphan drug credit on line 4 between the estate or trust and the beneficiaries in the same proportion as income was allocated and enter the beneficiaries share on line 5. If the estate or trust is subject to the passive activity rules, include on line 3 any orphan drug credit from passive activities disallowed for prior years and carried forward to this year. Complete Form 8582-CR, Passive Activity Credit Limitations, to determine the allowed credit that must be allocated between the estate or trust and the beneficiaries. For details, see the Instructions for Form 8582-CR. Part II For each drug for which qualified clinical testing expenses are included on line 1, enter the generic name of the orphan drug, the Designation application number, and the date the drug was designated under section 526 of the Federal Food, Drug, and Cosmetic Act. Attach as many Part II pages as needed to show all orphan drugs. Paperwork Reduction Act Notice. We ask for the information on this form to carry out the Internal Revenue laws of the United States. You are required to give us the information. We need it to ensure that you are complying with these laws and to allow us to figure and collect the right amount of tax. You are not required to provide the information requested on a form that is subject to the Paperwork Reduction Act unless the form displays a valid OMB control number. Books or records relating to a form or its instructions must be retained as long as their contents may become material in the administration of any Internal Revenue law. Generally, tax returns and return information are confidential, as required by section The time needed to complete and file this form will vary depending on individual circumstances. The estimated burden for individual taxpayers filing this form is approved under OMB control number and is included in the estimates shown in the instructions for their individual income tax return. The estimated burden for all other taxpayers who file this form is shown below. Recordkeeping.. 1 hr., 54 min. Learning about the law or the form hr. Preparing and sending the form to the IRS.. 1 hr., 4 min. If you have comments concerning the accuracy of these time estimates or suggestions for making this form simpler, we would be happy to hear from you. See the instructions for the tax return with which this form is filed.

218 Form 8844 Department of the Treasury Internal Revenue Service Name(s) shown on return Empowerment Zone Employment Credit Attach to your tax return. Information about Form 8844 and its instructions is at Identifying number OMB No Attachment Sequence No Enter the total qualified wages paid or incurred during calendar year 2012 only (see instructions) a Qualified empowerment zone wages $ 20% (.20) 1a b Reserved b 2 Enter the amount from line 1a. See instructions for the adjustment you must make to salaries and wages Empowerment zone employment credit from partnerships, S corporations, cooperatives, estates, and trusts Add lines 2 and 3. Cooperatives, estates, and trusts, go to line 5. Partnerships and S corporations, stop here and report this amount on Schedule K. All others, stop here and report this amount on Form 3800, Part III, line Amount allocated to patrons of the cooperative or beneficiaries of the estate or trust (see instructions) Cooperatives, estates, and trusts, subtract line 5 from line 4. Report this amount on Form 3800, Part III, line For Paperwork Reduction Act Notice, see instructions. Cat. No S Form 8844 (2012)

219 Form 8844 (2012) Page 2 General Instructions Section references are to the Internal Revenue Code. Future Developments For the latest information about developments related to Form 8844 and its instructions, such as legislation enacted after this form and instructions were published, go to form8844. What's New The empowerment zone designations generally expired at the end of However, the American Taxpayer Relief Act of 2012 provides for an extension of the designations to the end of To extend the designations, state and local governments must amend their nominations for designation to change the termination date to December 31, The IRS is working with HUD and USDA to provide guidance on amending nominations for designation. The treatment of parts of Washington, DC, as an empowerment zone ended at the end of Purpose of Form Use Form 8844 to claim the empowerment zone employment credit. For tax years that include December 31, 2012, the credit is 20% of the employer's qualified wages (up to $15,000) paid or incurred during calendar year 2012 on behalf of qualified empowerment zone employees. The credit is a component of the general business credit, and a special tax liability limit applies. The allowable credit is figured in Part II of Form 3800, General Business Credit. Empowerment Zones Urban areas. Parts of the following urban areas were empowerment zones. You can find out if your business or an employee s residence is located within an urban empowerment zone by using the RC/EZ/EC Address Locator at or by calling Pulaski County, AR Tucson, AZ Fresno, CA Los Angeles, CA (city and county) Santa Ana, CA New Haven, CT Jacksonville, FL Miami/Dade County, FL Chicago, IL Gary/Hammond/East Chicago, IN Boston, MA Baltimore, MD Detroit, MI Minneapolis, MN St. Louis, MO/East St. Louis, IL Cumberland County, NJ New York, NY Syracuse, NY Yonkers, NY Cincinnati, OH Cleveland, OH Columbus, OH Oklahoma City, OK Philadelphia, PA/Camden, NJ Columbia/Sumter, SC Knoxville, TN El Paso, TX San Antonio, TX Norfolk/Portsmouth, VA Huntington, WV/Ironton, OH Rural areas. Parts of the following rural areas were empowerment zones. You can find out if your business or an employee s residence is located within a rural empowerment zone by using the RC/EZ/EC Address Locator at or by calling Desert Communities, CA (part of Riverside County) Southwest Georgia United, GA (part of Crisp County and all of Dooly County) Southernmost Illinois Delta, IL (parts of Alexander and Johnson Counties and all of Pulaski County) Kentucky Highlands, KY (part of Wayne County and all of Clinton and Jackson Counties) Aroostook County, ME (part of Aroostook County) Mid-Delta, MS (parts of Bolivar, Holmes, Humphreys, Leflore, Sunflower, and Washington Counties) Griggs-Steele, ND (part of Griggs County and all of Steele County) Oglala Sioux Tribe, SD (parts of Jackson and Bennett Counties and all of Shannon County) Middle Rio Grande FUTURO Communities, TX (parts of Dimmit, Maverick, Uvalde, and Zavala Counties) Rio Grande Valley, TX (parts of Cameron, Hidalgo, Starr, and Willacy Counties) Qualified empowerment zone employee. A qualified empowerment zone employee is any employee (full-time or part-time) of the employer who: Performs substantially all of the services for that employer within an empowerment zone in the employer s trade or business and Has his or her principal residence within that empowerment zone while performing those services (employees who work in the Washington, DC, empowerment zone may live anywhere in the District of Columbia). See Qualified Employees below for a list of persons who are not qualified employees. Qualified Employees Any person may be a qualified employee except the following. Any relative of the employer described in sections 152(d)(2)(A) through 152(d)(2)(G). A dependent of the employer described in section 152(d)(2)(H). If the employer is a corporation, any individual who bears any of the relationships described in sections 152(d)(2)(A) through 152(d)(2)(G), or is a dependent, as described in section 152(d)(2)(H), of an individual who owns (or is considered to own under section 267(c)) more than 50% in value of the outstanding stock of the corporation. If the employer is an entity other than a corporation, any individual who owns directly or indirectly more than 50% of the capital and profits interest, including constructive ownership, in the entity. If the employer is an estate or trust, any individual who is a grantor, beneficiary, or fiduciary of the estate or trust (or a dependent, as described in section 152(d)(2)(H), of such an individual), or any individual who is a relative, as described in sections 152(d)(2)(A) through 152(d)(2)(G), of the grantor, beneficiary, or fiduciary of the estate or trust. Any person who owns (or is considered to own under section 318) more than 5% of the outstanding or voting stock of the employer, or if not a corporate employer, more than 5% of the capital or profits interest in the employer. Any individual employed by the employer for less than 90 days. For exceptions, see Early termination of employee, later. Any individual employed by the employer at any private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises. Any individual employed by the employer in a trade or business of which the principal activity is farming (see Note below), but only if at the close of the tax year the sum of the following amounts exceeds $500, The larger of the unadjusted bases or fair market value of the farm assets owned by the employer. 2. The value of the farm assets leased by the employer.

220 Form 8844 (2012) Page 3 Note. Certain farming activities are described in section 2032A(e)(5)(A) or (B). Early termination of employee. Generally, an individual is not a qualified zone employee unless employed for at least 90 days. The 90-day requirement does not apply in the following situations. The employee is terminated because of misconduct as determined under the applicable state unemployment compensation law. The employee becomes disabled before the 90th day. However, if the disability ends before the 90th day, the employer must offer to reemploy the former employee. An employee is not treated as terminated if the corporate employer is acquired by another corporation under section 381(a) and the employee continues to be employed by the acquiring corporation. Nor is a mere change in the form of conducting the trade or business treated as a termination if the employee continues to be employed in such trade or business and the taxpayer retains a substantial interest therein. Wages Wages are defined in section 51(c) and generally are wages (excluding tips) subject to the Federal Unemployment Tax Act (FUTA), without regard to the FUTA dollar limitation. The following are also treated as wages. Amounts paid or incurred by the employer as educational assistance payments excludable from the employee s gross income under section 127. However, this does not apply if the employee has a relationship to the employer described in section 267(b) or 707(b)(1) (substituting 10 percent for 50 percent in those sections) or the employer and employee are engaged in trades or businesses under common control (within the meaning of sections 52(a) and (b)). Amounts paid or incurred by the employer on behalf of an employee under age 19 for a youth training program operated by that employer in conjunction with local education officials. Specific Instructions Complete lines 1 and 2 to figure the current year credit for your trade or business. Skip lines 1 and 2 if you are only claiming a credit that was allocated to you from a pass-through entity. Line 1a Qualified Empowerment Zone Wages Enter the total qualified empowerment zone wages paid or incurred during the calendar year The credit must be figured using only the wages that you paid or incurred in the calendar year that ended with or within your tax year. For example, if your tax year began on April 1, 2012, and ended on March 31, 2013, you must figure wages based on the calendar year that began on January 1, 2012, and ended on December 31, Wages paid after the end of the calendar year may be used only to figure the credit claimed on the following year s tax return. Qualified empowerment zone wages are qualified wages paid or incurred by an employer for services performed by an employee while the employee is a qualified empowerment zone employee (defined earlier). The maximum wages that may be taken into account for each employee is limited to $15,000. The $15,000 amount for any employee is reduced by the amount of wages paid or incurred during the calendar year on behalf of that employee that are used in figuring the work opportunity credit (Form 5884). Line 2 In general, you must reduce your deduction for salaries and wages and certain educational and training costs by the line 2 credit amount. You must make this reduction even if you cannot take the full credit this year because of the tax liability limit. If you capitalized any costs on which you figured the credit, reduce the amount capitalized by the amount of the credit attributable to these costs. Members of a controlled group of corporations and businesses under common control are treated as a single employer in determining the credit. The members share the credit in the same proportion that they paid or incurred qualifying wages. Line 5 Cooperatives. A cooperative described in section 1381(a) must allocate to its patrons the credit in excess of its tax liability limit. Therefore, to figure the unused amount of the credit allocated to patrons, the cooperative must first figure its tax liability. While any excess is allocated to patrons, any credit recapture applies as if the cooperative had claimed the entire credit. If the cooperative is subject to the passive activity rules, include on line 3 any empowerment zone and renewal community employment credits from passive activities disallowed for prior years and carried forward to this year. Complete Form 8810, Corporate Passive Activity Loss and Credit Limitations, to determine the allowed credit that must be allocated between the cooperative and the patrons. For details, see the Instructions for Form Estates and trusts. If the estate or trust is subject to the passive activity rules, include on line 3 any empowerment zone and renewal community employment credits from passive activities disallowed for prior years and carried forward to this year. Complete Form 8582-CR, Passive Activity Credit Limitations, to determine the allowed credit that must be allocated between the estate or trust and the beneficiaries. For details, see the Instructions for Form 8582-CR. Paperwork Reduction Act Notice. We ask for the information on this form to carry out the Internal Revenue laws of the United States. You are required to give us the information. We need it to ensure that you are complying with these laws and to allow us to figure and collect the right amount of tax. You are not required to provide the information requested on a form that is subject to the Paperwork Reduction Act unless the form displays a valid OMB control number. Books or records relating to a form or its instructions must be retained as long as their contents may become material in the administration of any Internal Revenue law. Generally, tax returns and return information are confidential, as required by section The time needed to complete and file this form will vary depending on individual circumstances. The estimated burden for individual taxpayers filing this form is approved under OMB control number and is included in the estimates shown in the instructions for their individual income tax return. The estimated burden for all other taxpayers who file this form is shown below. Recordkeeping hr., 4 min. Learning about the law or the form hr., 22 min. Preparing and sending the form to the IRS.. 2 hr., 33 min. If you have comments concerning the accuracy of these time estimates or suggestions for making this form simpler, we would be happy to hear from you. See the instructions for the tax return with which this form is filed.

221 Form 8846 Department of the Treasury Internal Revenue Service Name(s) shown on return Credit for Employer Social Security and Medicare Taxes Paid on Certain Employee Tips Attach to your tax return. Information about Form 8846 and its instructions is at OMB No Attachment Sequence No. 98 Identifying number Note. Claim this credit only for social security and Medicare taxes paid by a food or beverage establishment where tipping is customary for providing food or beverages. See the instructions for line 1. 1 Tips received by employees for services on which you paid or incurred employer social security and Medicare taxes during the tax year (see instructions) Tips not subject to the credit provisions (see instructions) Creditable tips. Subtract line 2 from line Multiply line 3 by 7.65% (.0765). If you had any tipped employees whose wages (including tips) exceeded $110,100, see instructions and check here Credit for employer social security and Medicare taxes paid on certain employee tips from partnerships and S corporations Add lines 4 and 5. Partnerships and S corporations, report this amount on Schedule K. All others, report this amount on Form 3800, line 4f For Paperwork Reduction Act Notice, see instructions. Cat. No Z Form 8846 (2012)

222 Form 8846 (2012) Page 2 General Instructions Section references are to the Internal Revenue Code. Future Developments For the latest information about developments related to Form 8846 and its instructions, such as legislation enacted after they were published, go to Purpose of Form Certain food and beverage establishments (see Who Should File, below) use Form 8846 to claim a credit for social security and Medicare taxes paid or incurred by the employer on certain employees tips. The credit is part of the general business credit. You can claim or elect not to claim the credit any time within 3 years from the due date of your return on either your original return or on an amended return. Taxpayers, other than partnerships or S corporations, whose only source of this credit is from those pass-through entities, are not required to complete or file this form. Instead, report this credit directly on the applicable line of Form 3800, General Business Credit. Who Should File File Form 8846 if you meet both of the following conditions. 1. You had employees who received tips from customers for providing, delivering, or serving food or beverages for consumption if tipping of employees for delivering or serving food or beverages is customary. 2. During the tax year, you paid or incurred employer social security and Medicare taxes on those tips. How the Credit Is Figured Generally, the credit equals the amount of employer social security and Medicare taxes paid or incurred by the employer on tips received by the employee. However, the amount of tips for any month that are used to figure the credit must be reduced by the amount by which the wages that would have been payable during that month at $5.15 an hour exceed the wages (excluding tips) paid by the employer during that month. For example, an employee worked 100 hours and received $450 in tips for October The worker received $375 in wages (excluding tips) at the rate of $3.75 an hour. If the employee had been paid $5.15 an hour, the employee would have received wages, excluding tips, of $515. For credit purposes, the $450 in tips is reduced by $140 (the difference between $515 and $375), and only $310 of the employee s tips for October 2012 is taken into account. Specific Instructions Figure the current year credit from your trade or business on lines 1 through 4. Line 1 Enter the tips received by employees for services on which you paid or incurred employer social security and Medicare taxes during the tax year. Include tips received from customers for providing, delivering, or serving food or beverages for consumption if tipping of employees for delivering or serving food or beverages is customary. Line 2 If you pay each tipped employee wages (excluding tips) equal to or more than $5.15 an hour, enter zero on line 2. Figure the amount of tips included on line 1 that are not creditable for each employee on a monthly basis. This is the total amount that would be payable to the employee at $5.15 an hour reduced by the wages (excluding tips) actually paid to the employee during the month. Enter on line 2 the total amounts figured for all employees. Line 4 If any tipped employee s wages and tips exceeded the 2012 social security tax wage base of $110,100 subject to the 6.2% rate, check the box on line 4 and attach a separate computation showing the amount of tips subject to only the Medicare tax rate of 1.45%. Subtract these tips from the line 3 tips, and multiply the difference by Then, multiply the tips subject only to the Medicare tax by Enter the sum of these amounts on line 4. Reduce the income tax deduction for employer social security and Medicare taxes by the amount on line 4. Paperwork Reduction Act Notice. We ask for the information on this form to carry out the Internal Revenue laws of the United States. You are required to give us the information. We need it to ensure that you are complying with these laws and to allow us to figure and collect the right amount of tax. You are not required to provide the information requested on a form that is subject to the Paperwork Reduction Act unless the form displays a valid OMB control number. Books or records relating to a form or its instructions must be retained as long as their contents may become material in the administration of any Internal Revenue law. Generally, tax returns and return information are confidential, as required by section The time needed to complete and file this form will vary depending on individual circumstances. The estimated burden for individual taxpayers filing this form is approved under OMB control number and is included in the estimates shown in the instructions for their individual income tax return. The estimated burden for all other taxpayers who file this form is shown below. Recordkeeping.. 3 hr., 35 min. Learning about the law or the form min. Preparing and sending the form to the IRS min. If you have comments concerning the accuracy of these time estimates or suggestions for making this form simpler, we would be happy to hear from you. See the instructions for the tax return with which this form is filed.

223 8882 Form (Rev. December 2006) Department of the Treasury Internal Revenue Service Name(s) shown on return Credit for Employer-Provided Childcare Facilities and Services Attach to your tax return. OMB No Attachment Sequence No.131 Identifying number 1 Qualified childcare facility expenditures paid or incurred 1 2 Enter 25% (.25) of line Qualified childcare resource and referral expenditures paid or incurred 3 4 Enter 10% (.10) of line Credit for employer-provided childcare facilities and services from partnerships, S corporations, estates, and trusts Add lines 2, 4, and 5 Enter the smaller of line 6 or $150,000. Estates and trusts, go to line 8. All others report this amount as follows: partnerships and S corporations, report this amount on Schedule K; all others, report the credit on the applicable line of Form 3800, (e.g., line 1n of the 2006 Form 3800) Amount allocated to beneficiaries of the estate or trust (see instructions) Estates and trusts. Subtract line 8 from line 7. Report the credit on the applicable line of Form 3800 (e.g., line 1n of the 2006 Form 3800) General Instructions Section references are to the Internal Revenue Code. What s New The tax liability limit is no longer figured on this form. Instead, it must be figured on Form 3800, General Business Credit. Taxpayers that are not partnerships, S corporations, estates, or trusts, and whose only source of this credit is from those pass-through entities, are not required to complete or file this form. Instead, they can report this credit directly on line 1n of Form The IRS will revise this December 2006 version of the form only when necessary. Continue to use this version for tax years beginning after 2005 until a new revision is issued. Purpose of Form Employers use Form 8882 to claim the credit for qualified childcare facility and resource and referral expenditures. The credit is part of the general business credit. You may claim the credit any time within 3 years from the due date of your return on either an original or amended return. For details, see section 45F. How To Figure the Credit The credit is 25% of the qualified childcare facility expenditures plus 10% of the qualified childcare resource and referral expenditures paid or incurred during the tax year. The credit is limited to $150,000 per tax year. Qualified childcare expenditures are amounts paid or incurred: To acquire, construct, rehabilitate, or expand property that: 1. Is to be used as part of a qualified childcare facility of the taxpayer, 2. Is depreciable (or amortizable) property, and 3. Is not part of the principal residence of the taxpayer or any employee of the taxpayer; For the operating expenses of a qualified childcare facility of the taxpayer, including expenses for training of employees, scholarship programs, and providing increased compensation to employees with higher levels of childcare training; or Under a contract with a qualified childcare facility to provide childcare services to employees of the taxpayer. Note. Any expenses for childcare included in qualified childcare facility expenditures may not exceed the fair market value of such care. A qualified childcare facility is a facility that meets the requirements of all applicable laws and regulations of the state or local government in which it is located, including the licensing of the facility as a childcare facility. The following conditions must also be met. The principal use of the facility must be to provide childcare (unless the facility is also the personal residence of the person operating the facility). Enrollment in the facility must be open to employees of the taxpayer during the tax year. 9 For Paperwork Reduction Act Notice, see back of form. Cat. No Y Form 8882 (Rev )

224 Form 8882 (Rev ) If the facility is the principal trade or business of the taxpayer, at least 30% of the enrollees of the facility must be dependents of employees of the taxpayer. The use of the facility (or the eligibility to use the facility) must not discriminate in favor of highly compensated employees. Qualified childcare resource and referral expenditures are amounts paid or incurred under a contract to provide childcare resource and referral services to employees of the taxpayer. The provision of the services (or the eligibility to use the services) must not discriminate in favor of highly compensated employees. No Double Benefit Allowed You must reduce: The basis of any qualified childcare facility by the amount of the credit on line 7 allocable to capital expenditures related to the facility, Any otherwise allowable deductions used to figure the credit by the amount of the credit on line 7 allocable to those deductions, and Any expenditures used to figure any other credit by the amount of the credit on line 7 allocable to those expenditures (for purposes of figuring the other credit). Note. For credits entered on line 5, only the pass-through entity is required to make this reduction. Recapture of Credit You may have to recapture part or all of the credit if, before the 10th tax year after the tax year in which your qualified childcare facility is placed in service, the facility ceases to operate as a qualified childcare facility or there is a change in ownership of the facility. However, a change in ownership will not require recapture if the person acquiring the interest in the facility agrees, in writing, to assume the recapture liability. See section 45F(d) for details. Any recapture tax is reported on the line of your tax return where other recapture taxes are reported (or, if no such line, on the total tax line). The recapture tax may not be used in figuring the amount of any credit or in figuring the alternative minimum tax. Member of Controlled Group or Business Under Common Control For purposes of figuring the credit, all members of a controlled group of corporations (as defined in section 52(a)) and all members of a group of businesses under common control (as defined in section 52(b)), are treated as a single taxpayer. As a member, compute your credit for lines 2 and 4 as follows: Specific Instructions Page 2 Compute your credit for line 2 based on your proportionate share of qualified childcare facility expenditures giving rise to the group s credit for line 2. Enter your share of the credit on line 2. Attach a statement showing how your share of the credit was figured, and write See Attached next to the entry space for line 2. Compute your credit for line 4 based on your proportionate share of qualified resource and referral expenditures giving rise to the group s credit for line 4. Enter your share of the credit on line 4. Attach a statement showing how your share of the credit was figured, and write See Attached next to the entry space for line 4. Line 8 Estates and trusts. Allocate the credit for employer-provided childcare facilities and services on line 7 between the estate or trust and the beneficiaries in the same proportion as income was allocated, and enter the beneficiaries share on line 8. Paperwork Reduction Act Notice. We ask for the information on this form to carry out the Internal Revenue laws of the United States. You are required to give us the information. We need it to ensure that you are complying with these laws and to allow us to figure and collect the right amount of tax. You are not required to provide the information requested on a form that is subject to the Paperwork Reduction Act unless the form displays a valid OMB control number. Books or records relating to a form or its instructions must be retained as long as their contents may become material in the administration of any Internal Revenue law. Generally, tax returns and return information are confidential, as required by section The time needed to complete and file this form will vary depending on individual circumstances. The estimated burden for individual taxpayers filing this form is approved under OMB control number and is included in the estimates shown in the instructions for their individual income tax return. The estimated burden for all other taxpayers who file this form is shown below. Recordkeeping 2 hr., 37 min. Learning about the law or the form 30 min. Preparing and sending the form to the IRS 34 min. If you have comments concerning the accuracy of these time estimates or suggestions for making this form simpler, we would be happy to hear from you. See the instructions for the tax return with which this form is filed.

225 Form 8941 Department of the Treasury Internal Revenue Service Name(s) shown on return Credit for Small Employer Health Insurance Premiums Attach to your tax return. OMB No Attachment Information about Form 8941 and its separate instructions is at Sequence No. 63 Identifying number 1 a Enter the number of individuals you employed during the tax year who are considered employees for purposes of this credit (see instructions) a b Enter the employer identification number (EIN) used to report employment taxes for individuals included on line 1a (see instructions) b 2 Enter the number of full-time equivalent employees you had for the tax year (see instructions). If you entered 25 or more, skip lines 3 through 11 and enter -0- on line Average annual wages you paid for the tax year (see instructions). If you entered $50,000 or more, skip lines 4 through 11 and enter -0- on line Premiums you paid during the tax year for employees included on line 1a for health insurance coverage under a qualifying arrangement (see instructions) Premiums you would have entered on line 4 if the total premium for each employee equaled the average premium for the small group market in which you offered health insurance coverage (see instructions) Enter the smaller of line 4 or line Multiply line 6 by the applicable percentage: Tax-exempt small employers, multiply line 6 by 25% (.25) All other small employers, multiply line 6 by 35% (.35) If line 2 is 10 or less, enter the amount from line 7. Otherwise, see instructions If line 3 is $25,000 or less, enter the amount from line 8. Otherwise, see instructions Enter the total amount of any state premium subsidies paid and any state tax credits available to you for premiums included on line 4 (see instructions) Subtract line 10 from line 4. If zero or less, enter Enter the smaller of line 9 or line If line 12 is zero, skip lines 13 and 14 and go to line 15. Otherwise, enter the number of employees included on line 1a for whom you paid premiums during the tax year for health insurance coverage under a qualifying arrangement (see instructions) Enter the number of full-time equivalent employees you would have entered on line 2 if you only included employees included on line Credit for small employer health insurance premiums from partnerships, S corporations, cooperatives, estates, and trusts (see instructions) Add lines 12 and 15. Cooperatives, estates, and trusts, go to line 17. Tax-exempt small employers, skip lines 17 and 18 and go to line 19. Partnerships and S corporations, stop here and report this amount on Schedule K. All others, stop here and report this amount on Form 3800, line 4h Amount allocated to patrons of the cooperative or beneficiaries of the estate or trust (see instructions) Cooperatives, estates, and trusts, subtract line 17 from line 16. Stop here and report this amount on Form 3800, line 4h Enter the amount you paid in 2012 for taxes considered payroll taxes for purposes of this credit (see instructions) Tax-exempt small employers, enter the smaller of line 16 or line 19 here and on Form 990-T, line 44f For Paperwork Reduction Act Notice, see separate instructions. Cat. No S Form 8941 (2012)

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236 I. Business Income: Defined Chapter 7: Business Income This chapter primarily explains business income and how to account for it on a tax return. It also explains what items are not considered income. If there is a connection between any income the owner receives and his business, the income is business income. A connection exists if it is clear that the payment of income would not have been made if the owner did not have the business. A person can have business income even if he is not involved in the activity on a regular full-time basis. Income from work done on the side in addition to a regular job can be business income. Most business income, such as income from the sale of products or services, must be reported on Schedule C or C EZ. However, income from the sale of business assets, such as land and office buildings, is reported on other forms. II. Specific Types of Income Individuals must report on their tax return all income received from business enterprises unless it is excluded by law. In most cases, a person s business income will be in the form of cash, checks, and credit card charges. But business income can be in other forms, such as property or services. These and other types of income are explained next. A. ROYALTIES Royalties from copyrights, patents, and oil, gas, and mineral properties are taxable as ordinary income. An individual will generally report royalties in Part I of Schedule E (Form 1040), Supplemental Income and Loss. However, if an individual holds an operating oil, gas, or mineral interest or is in business as a self-employed writer, inventor, artist, etc., he should report income and expenses on Schedule C or Schedule C EZ (Form 1040). 1. Copyrights and Patents Royalties from copyrights on literary, musical, or artistic works, and similar property, or from patents on inventions, are amounts paid for the right to use an individual s work over a specified period of time. Royalties generally are based on the number of units sold, such as the number of books, tickets to a performance, or machines sold. 2. Oil, Gas, and Minerals Royalty income from oil, gas, and mineral properties is the amount received when natural resources are extracted from the owner s property. The royalties are based on units, such as barrels, tons, etc., and are paid to the owner by a person or company who leases the property. Business Income 7-1

237 3. Depletion If an individual is the owner of an economic interest in mineral deposits or oil and gas wells, he can recover the investment through the depletion allowance. 4. Coal and Iron Ore Under certain circumstances, an individual or business can treat amounts received from the disposal of coal and iron ore as payments from the sale of a capital asset, rather than as royalty income. 5. Sale of Property Interest If an individual sells his complete interest in oil, gas, or mineral rights, the amount received is considered payment for the sale of 1231 property, not royalty income. Under certain circumstances, the sale is subject to capital gain or loss treatment on Schedule D (Form 1040). If the seller retains a royalty, an overriding royalty, or a net profit interest in a mineral property for the life of the property, he has made a lease or a sublease, and any cash received for the assignment of other interests in the property is ordinary income subject to a depletion allowance. 6. Part of Future Production Sold If an individual owns mineral property but sells part of the future production, he generally treats the money received from the buyer at the time of the sale as a loan from the buyer. The owner should not include it in his income or take depletion based on it. When production begins, the owner should include all the proceeds in his income, deduct all the production expenses, and deduct depletion from that amount to arrive at his taxable income from the property. B. BARTERING Bartering is an exchange of property or services. Individuals must include in their gross receipts, at the time received, the fair market value of property or services they received in bartering. If an individual exchanges services with another person and they both have agreed ahead of time on the value of the services, that value will be accepted as the fair market value unless the value can be shown to be otherwise. Generally, an individual must report this income on Schedule C or Schedule C EZ (Form 1040). However, if the barter involves an exchange of something other than services, such as in Example 4 below, an individual may have to use another form or schedule instead. Example 1. Sam is a self-employed lawyer. He performs legal services for a client, a small corporation. In payment for his services, Sam receives shares of stock in the corporation. Sam must include the fair market value of the shares in income. Business Income 7-2

238 Example 2. Nick is an artist and creates a work of art to compensate his landlord for the rent-free use of his apartment. Nick must include the fair rental value of the apartment in his gross receipts. His landlord must include the fair market value of the work of art in his rental income. Example 3. Heidi is a self-employed accountant. Both Heidi and a house painter are members of a barter club, an organization that each year gives its members a directory of members and the services each member provides. Members get in touch with other members directly and bargain for the value of the services to be performed. In return for accounting services Heidi provided for the house painter's business, the house painter painted her home. She must include in gross receipts the fair market value of the services she received from the house painter. The house painter must include the fair market value of Heidi s accounting services in his gross receipts. Example 4. Amy is a member of a barter club that uses credit units to credit or debit members' accounts for goods or services provided or received. As soon as units are credited to her account, Amy can use them to buy goods or services or sell or transfer the units to other members. Amy must include the value of credit units she received in her gross receipts for the tax year in which the units are credited to her account. The dollar value of units received for services by an employee of the club, who can use the units in the same manner as other members, must be included in the employee's gross income for the tax year in which received. It is wages subject to social security and Medicare taxes (FICA), federal unemployment taxes (FUTA), and income tax withholding. Example 5. Troy operates a plumbing business and uses the cash method of accounting. He joins a barter club and agrees to provide plumbing services to any member for a specified number of hours. Each member has access to a directory that lists the members of the club and the services available. Members contact each other directly and request services to be performed. Members are not required to provide services unless requested by another member, but they can use as many of the offered services as they wish without paying a fee. Troy must include the fair market value of any services he receives from club members in his gross receipts when he receives them even if he has not provided any services to club members. Business Income 7-3

239 1. Form 1099-B from Barter Exchange If an individual exchanged property or services through a barter exchange, Form B, Proceeds from Broker and Barter Exchange Transactions, or a similar statement from the barter exchange should be provided. It should show the value of cash, property, services, credits, or scrip received from exchanges during the year. The IRS will also receive a copy of Form 1099-B. 2. Backup Withholding The income received from bartering generally is not subject to regular income tax withholding. However, backup withholding will apply in certain circumstances to ensure that income tax is collected on this income. Under backup withholding, the barter exchange must withhold, as income tax, 28% of the income if: The individual does not give the barter exchange his taxpayer identification number (generally a social security number or an employer identification number); or The IRS notifies the barter exchange that the individual gave it an incorrect identification number. If an individual joins a barter exchange, he must certify under penalty of perjury that his taxpayer identification number is correct and that he is not subject to backup withholding. If he does not make this certification, backup withholding may begin immediately. The barter exchange will give him a Form W-9, Request for Taxpayer Identification Number and Certification, or a similar form, for him to make this certification. The barter exchange will withhold tax only up to the amount of any cash paid to the individual or deposited in their account and any scrip or credit issued to the individual (and converted to cash). If tax is withheld from an individual s barter income, the barter exchange will report the amount of tax withheld on Form 1099-B, or similar statement. C. REAL ESTATE RENTS If an individual is a real estate dealer that receives income from renting real property or an owner of a hotel, motel, etc., who provides services (maid services, etc.) for guests, he must report the rental income and expenses on Schedule C or C-EZ. If an individual is not a real estate dealer or the kind of owner described in the preceding sentence, he should report the rental income and expenses on Schedule E, instead of on Schedule C or C-EZ. 1. Prepaid Rent Advance payments received under a lease that do not put any restriction on the use or enjoyment are income in the year they are received. This is true no matter what accounting method or period the owner uses. Business Income 7-4

240 2. Lease Bonus A bonus an owner receives from a lessee for granting a lease is an addition to the rent. It is included in gross income in the year it is received. 3. Lease Cancellation Payments Payments received from a lessee for canceling a lease are included in the owner s gross receipts in the year they are received. 4. Payments to Third Parties If an owner s lessee makes payments to someone else under an agreement to pay the owner s debts or obligations, the owner should include the payments in his gross receipts when the lessee makes the payments. A common example of this kind of income is a lessee's payment of the owner s property taxes on leased real property. 5. Settlement Payments Payments received in settlement of a lessee's obligation to restore the leased property to its original condition are income in the amount that the payments exceed the adjusted basis of the leasehold improvements destroyed, damaged, removed, or disconnected by the lessee. D. RENTS FROM PERSONAL PROPERTY If a taxpayer rents out personal property, such as equipment or vehicles, how income and expenses from such sources is reported is generally determined by whether or not the rental activity is a business, and whether or not the rental activity is conducted for profit. Generally, if the taxpayer s primary purpose is income or profit and he is involved in the rental activity with continuity and regularity, such rental activity is a business. 1. Reporting Business Income and Expenses If a taxpayer is in the business of renting personal property, he should report income and expenses on Schedule C or Schedule C-EZ (Form 1040). 2. Reporting Nonbusiness Income If an individual is not in the business of renting personal property, he must report rental income on line 21 of Form He should list the type and amount of the income on the dotted line next to line Reporting Nonbusiness Expenses If an individual rents personal property for profit, he must include his rental expenses in the total amount on Form If the individual does not rent personal property for profit, his deductions are limited and he cannot report a loss to offset other income. Business Income 7-5

241 E. INTEREST AND DIVIDEND INCOME Interest and dividends may be considered business income. Interest received on notes receivable that an individual has accepted in the ordinary course of business is business income. Interest received on loans is business income if the lender is in the business of lending money. F. CANCELED SALES CONTRACT If an individual sells property (such as land or a residence) under a contract, but the contract is canceled and the individual returns the buyer's money in the same tax year as the original sale, such seller has no income from the sale. If the contract is canceled and the seller returns the buyer's money in a later tax year, the seller must include its gain in income for the year of the sale. When the seller returns the money and takes back the property in the later year, he will treat the transaction as a purchase that gives him a new basis in the property equal to the funds which were returned to the buyer. G. UNCOLLECTIBLE LOANS If a loan payable to an individual becomes uncollectible during the tax year and the individual uses the accrual method of accounting, he must include in gross income interest accrued up to the time the loan became uncollectible. If the accrued interest later becomes uncollectible, the individual may be able to take a bad debt deduction. H. DIVIDENDS Generally, dividends are business income to dealers in securities. For most sole proprietors and statutory employees, however, dividends are non-business income. If an individual holds stock as a personal investment separately from his business activity, the dividends from the stock are non-business income. If an individual receives dividends from business insurance premiums he deducted in an earlier year, he must report all or part of the dividend as business income on his return. I. CANCELED DEBT Generally, if a debt is canceled or forgiven other than as a gift or bequest the debtor must include the canceled amount in his gross income for tax purposes. If the debt was incurred in business, it should be reported on line 6 of Schedule C. If the debt is a nonbusiness debt, the canceled amount should be reported on line 21 of Form The following are some of the exceptions to the general rule for canceled debt: 1. Price Reduced After Purchase If an individual owes a debt to the seller for property he bought and the seller reduces the amount owed, the buyer generally does not have income from the reduction. Unless the individual is bankrupt or insolvent, he should treat the amount of the reduction as a purchase price adjustment and reduce his basis in the property. Business Income 7-6

242 2. Deductible Debt An individual does not realize income from a canceled debt to the extent the payment of the debt would have led to a deduction. Example. 3. Exclusions Steve gets accounting services for his business on credit. Later, Steve has trouble paying his business debts, but he is not bankrupt or insolvent. Steve s accountant forgives part of the amount he owes for the accounting services. How Steve treats the canceled debt depends on his method of accounting. If Steve uses the cash method, he does not include the canceled debt in income because the payment of the debt would have been deductible as a business expense. If Steve follows the accrual method, he will include the canceled debt in income because the expense was deductible when he incurred the debt. Individuals should not include canceled debt in income in the following situations; however, the individual may be required to file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness): a. The cancellation takes place in a bankruptcy case under title 11 of the U.S. Code (relating to bankruptcy); b. The cancellation takes place when the individual was insolvent. The individual can exclude the canceled debt to the extent he is insolvent; c. The canceled debt is a qualified farm debt owed to a qualified person; d. The canceled debt is a qualified real property business debt. This situation is explained later; e. The canceled debt is qualified principal residence indebtedness which is discharged after 2006 and before 2011; or f. The discharge of certain indebtedness of a qualified individual because of Midwestern disasters. If a canceled debt is excluded from income because it takes place in a bankruptcy case, the exclusions in situations (b)-(f) do not apply. If it takes place when the individual is insolvent, the exclusions in situations (c) and (d) do not apply to the extent the individual is insolvent. For purposes of this discussion, debt includes any debt for which an individual is liable or which attaches to property he holds. Business Income 7-7

243 4. Qualified Real Property Business Debt An individual can choose to exclude (up to certain limits) the cancellation of qualified real property business debt. If he makes the choice, he must reduce the basis of his depreciable real property by the amount excluded. This reduction must be made at the beginning of the tax year following the tax year in which the cancellation occurs. However, if the individual disposes of the property before that time, he must reduce the property s basis immediately before the disposition. 5. Cancellation of Qualified Real Property Business Debt Qualified real property business debt is debt (other than qualified farm debt) that meets all the following conditions: a. It was incurred or assumed in connection with real property used in a trade or business; b. It was secured by such real property; c. It was incurred or assumed at either of the following times: i. Before January 1, ii. After December 31, 1992, if incurred or assumed to acquire, construct, or substantially improve the real property; and d. It is debt to which an individual chooses to apply these rules. Qualified real property business debt includes refinancing of debt described in (c) above, but only to the extent it does not exceed the debt being refinanced. An individual cannot exclude more than either of the following amounts: The excess (if any) of: a. The outstanding principal of qualified real property business debt (immediately before the cancellation), over b. The fair market value (immediately before the cancellation) of the business real property that is security for the debt, reduced by the outstanding principal amount of any other qualified real property business debt secured by this property immediately before the cancellation. The total adjusted bases of depreciable real property held immediately before the cancellation. These adjusted bases are determined after any basis reduction due to a cancellation in bankruptcy, insolvency, or of qualified farm debt. Do not take into account depreciable real property acquired in contemplation of the cancellation. To make this choice, an individual must complete Form 982 and attach it to his income tax return for the tax year in which the cancellation occurs. He must file his return by the due date (including extensions). If an individual timely files his return for the year without making the choice, he can still make the choice by filing an amended return within six months of the due date of the return (excluding extensions). Business Income 7-8

244 III. Other Income A. GAINS AND LOSSES Taxpayers should not report on Schedule C or C EZ a gain or loss from the disposition of property that is neither stock in trade nor held primarily for sale to customers. Instead, they must report these gains and losses on other forms. B. PROMISSORY NOTES An individual should report promissory notes and other evidences of debt issued to him in a sale or exchange of property that is stock in trade or held primarily for sale to customers on Schedule C or C-EZ. In general, they should be reported at their stated principal amount (minus any unstated interest) when they are received. C. LOST INCOME PAYMENTS If an individual reduces or stops its business activities, he should report on Schedule C or C EZ any payment received for the lost income of his business from insurance or other sources. It should be reported on Schedule C or C EZ even if the business is inactive when the payment was received. D. DAMAGES Individuals must include in gross income compensation he receives during the tax year as a result of any of the following injuries connected with his business: Patent infringement; Breach of contract or fiduciary duty; or Antitrust injury. 1. Economic Injury An individual may be entitled to a deduction against the income if it compensates him for actual economic injury. The deduction is the smaller of the following amounts: The amount received or accrued for damages in the tax year reduced by the amount paid or incurred in the tax year to recover that amount; or His loss from the injury that he has not yet deducted. 2. Punitive Damages Punitive damages must be included in income. Business Income 7-9

245 E. KICKBACKS Persons who receive kickbacks must include them in their income on Schedule C or C EZ. However, they should not be included if the individual properly treats them as a reduction of a related expense item, a capital expenditure, or cost of goods sold. F. RECOVERY OF ITEMS PREVIOUSLY DEDUCTED If an individual recovers a bad debt or any other item deducted in a previous year, he should include the recovery in income on Schedule C or C-EZ. However, if all or part of the deduction in earlier years did not reduce his tax, the individual can exclude the part that did not reduce his tax. If the taxpayer excludes part of the recovery from income, he must include with his return a computation showing how the exclusion was figured. Example. Joe Smith, a sole proprietor, had gross income of $8,000, a bad debt deduction of $300, and other allowable deductions of $7,700. He also had 2 personal exemptions of $6,100. He would not pay income tax even if he did not deduct the bad debt. Therefore, he will not report as income any part of the $300 he may recover in any future year. This rule does not apply to depreciation. Taxpayers recover depreciation using other rules, discussed next. G. RECAPTURE OF DEPRECIATION In the following situations, taxpayers are required to recapture the depreciation deduction. This means they include in income part or all of the depreciation that was deducted in previous years. 1. Listed Property If a business use of listed property falls to 50% or less in a tax year after the tax year the property was placed in service, the taxpayer may have to recapture part of the depreciation deduction. This is done by including in income on Schedule C part of the depreciation that was deducted in previous years. Use Part IV of Form 4797, Sales of Business Property, to figure the amount to include on Schedule C. 2. Section 179 Property Under 179 of the Internal Revenue Code, taxpayers can elect to recover all or part of the cost of certain qualifying property, up to a limit, by deducting it in the year the property is placed in service. This is the 179 deduction. Taxpayers can elect the 179 deduction instead of recovering the cost by taking depreciation deductions. If a taxpayer takes a 179 deduction for an asset and before the end of the asset's recovery period the percentage of business use drops to 50% or less, they must recapture part of the 179 deduction. This is done by including in income on Schedule C part of the deduction that was taken. 3. Sale or Exchange of Depreciable Property If a taxpayer sells or exchanges depreciable property at a gain, he may have to treat all or part of the gain due to depreciation as ordinary income. Business Income 7-10

246 IV. Items that Are Not Income In some cases the property or money that an individual receives is not income, as noted below: A. LOANS Money borrowed through a bona fide loan is not income. B. SALES TAX State and local sales taxes imposed on the buyer, that a business owner was required to collect and pay over to state or local governments, are not income. C. APPRECIATION Increases in value of property are not income until the owner realizes the increases through a sale or other taxable disposition. D. LEASEHOLD IMPROVEMENTS If a tenant erects buildings or makes improvements to an individual s property, the increase in the value of the property due to the improvements is not income to the individual. However, if the facts indicate that the improvements are a payment of rent to the individual, then the increase in value would be income. E. EXCHANGE OF LIKE-KIND PROPERTY If an individual exchanges his business property or property held for investment solely for property of a like kind to be used in his business or to be held for investment, no gain or loss is recognized. This means that the gain is not taxable and the loss is not deductible. A common type of nontaxable exchange is the trade-in of a business automobile for another business automobile. F. CONSIGNMENTS Consignments of merchandise to others to sell for an individual are not sales. The title of merchandise remains with the individual, the consignor, even after the consignee possesses the merchandise. Therefore, if a business owner ships goods on consignment, he has no profit or loss until the consignee sells the merchandise. Merchandise shipped out on consignment is included in the owner s inventory until it is sold. However, a business owner should not include merchandise he receives on consignment in his inventory. Profit or commission on merchandise consigned will be included as income when the individual sells the merchandise or when he receives his profit or commission, depending upon the method of accounting that is used. G. CONSTRUCTION ALLOWANCES If an individual enters into a lease after August 5, 1997, he can exclude from income the construction allowance received (in cash or as a rent reduction) from the landlord if it was received under both the following conditions: Business Income 7-11

247 Under a short-term lease of retail space; and For the purpose of constructing or improving qualified long-term real property for use in his business at that retail space. The individual can exclude the construction allowance to the extent it does not exceed the amount he spent for construction or improvements. 1. Short-Term Lease A short-term lease is a lease (or other agreement for occupancy or use) of retail space for 15 years or less. The following rules apply in determining whether the lease is for 15 years or less. Take into account options to renew when figuring whether the lease is for 15 years or less. But do not take into account any option to renew at fair market value determined at the time of renewal; and Two or more successive leases that are part of the same transaction (or a series of related transactions) for the same or substantially similar retail space are treated as one lease. 2. Retail Space Retail space is real property leased, occupied, or otherwise used by a taxpayer as a tenant in his business of selling tangible personal property or services to the general public. 3. Qualified Long-Term Real Property Qualified long-term real property is nonresidential real property that is part of, or otherwise present at, a retail space and that reverts to the landlord when the lease ends. V. Accounting for Income Accounting for income for tax purposes differs at times from accounting for financial purposes. This section discusses some of the more common differences that may affect business transactions. A. INCOME PAID TO A THIRD PARTY All income earned by a taxpayer is taxable to that taxpayer. Taxpayers cannot avoid tax liability by having the income paid to a third party. For example, if an individual rents out his property and the rental agreement directs the lessee to pay the rent to his son, the amount paid to his son is gross income to the individual (not the son). Business Income 7-12

248 B. CASH DISCOUNTS These are amounts a seller permits a buyer to deduct from the invoice price for prompt payment. For income tax purposes, a taxpayer can use either of the following two methods to account for cash discounts: (1) Deduct the cash discount from purchases (see Line 36, Purchases Less Cost of Items Withdrawn for Personal Use in chapter 8); or (2) Credit the cash discount to a discount income account. Taxpayers must use the chosen method every year for all purchase discounts. If a taxpayer uses the second method listed above, the credit balance in the account at the end of his tax year will be considered business income. Under this method, the taxpayer may not reduce the cost of goods sold by the cash discounts he received. When valuing his closing inventory, the taxpayer also cannot reduce the invoice price of merchandise on hand at the close of the tax year by the average or estimated discounts received on the merchandise. C. TRADE DISCOUNTS These are reductions from list or catalog prices and usually are not written into the invoice or charged to the customer. Taxpayers should not enter these discounts on their books of account. Instead, they should use only the net amount as the cost of the merchandise purchased. D. PAYMENT PLACED IN ESCROW If the buyer of a taxpayer s property places part or all of the purchase price in escrow, the taxpayer should not include any part of it in gross sales until he actually or constructively receives it. However, upon completion of the terms of the contract and the escrow agreement, the taxpayer will have taxable income, even if he does not accept the money until the next year. E. SALES RETURNS AND ALLOWANCES Credits a firm allows customers for returned merchandise and any other allowances made on sales are deductions from gross sales in figuring net sales. F. INSURANCE PROCEEDS If an individual receives insurance or another type of reimbursement for a casualty or theft loss, he must subtract it from the loss when he figures his deduction. He may not deduct the reimbursed part of a casualty or theft loss. Business Income 7-13

249 Chapter 7 Review Questions The following questions are designed to ensure that you have a complete understanding of the information presented in the chapter. They do not need to be submitted in order to receive CPE credit. They are included as an additional tool to enhance your learning experience. We recommend that you answer each review question and then compare your response to the suggested solution before answering the final exam questions related to this chapter. 1. Royalties from copyrights, patents and certain mineral rights are, based on their unique nature, not taxed as ordinary income. a) true b) false 2. How does the IRS treat bartering for income tax purposes: a) businesses that barter must include as gross receipts their costs of the goods or services provided in the barter b) goods or services received through barter are not subject to income tax because no money changed hands c) businesses that barter must include as gross receipts the value of the goods or services received in the barter d) businesses that barter include as gross receipts 50 percent of the fair market value of the goods or services received 3. When backup withholding for bartering applies, what percentage of the income does the barter exchange withhold: a) 12% b) 28% c) 35% d) 52% 4. For most sole proprietors, dividends are not considered to be business income. a) true b) false 5. Under what circumstances must kickbacks be reported in a tax return: a) never; since they are probably illegal, it would be stupid to report them to the government b) in cases where the kickback is received as a normal part of the individual s job c) in all cases except where they are included as part of the cost of the goods sold d) where the kickback exceeds $10,000 Business Income 7-14

250 6. Neither sales tax collected for a government agency nor proceeds received from a bona fide loan are considered income to the business. a) true b) false Business Income 7-15

251 Chapter 7 Solutions and Suggested Responses 1. A: True is incorrect. This type of income is considered ordinary income. B: False is correct. Because royalties from copyrights, patents, and oil, gas, and mineral properties are taxable as ordinary income, individuals will generally report royalties in Part I of Schedule E (Form 1040), Supplemental Income and Loss. However, if an individual holds an operating oil, gas, or mineral interest or is in business as a self-employed writer, inventor, artist, etc., he should report income and expenses on Schedule C or Schedule C-EZ (Form 1040). (See page 7-1 of the course material.) 2. A: Incorrect. It is the value of what is received that is included as gross income. B: Incorrect. The fact that no money is exchanged does not insulate the transactions from taxation. C: Correct. The value of what is received is included in the recipient s gross income. D: Incorrect. There is no such formula. The recipient includes the value of what is received as part of their gross receipts. Actual taxable income is then calculated later. (See page 7-2 of the course material.) 3. A: Incorrect. The actual amount is more. B: Correct. A barter exchange must withhold, as income tax, 28% of the income if the individual or entity does not give the barter exchange its taxpayer identification number or the IRS notifies the barter exchange that the individual gave it an incorrect identification number. C: Incorrect. The actual amount is less. D: Incorrect. The actual amount is less. (See page 7-4 of the course material.) Business Income 7-16

252 4. A: True is correct. Generally, dividends are business income to dealers in securities. For most sole proprietors and statutory employees, however, dividends are non-business income. If an individual holds stock as a personal investment separately from his business activity, the dividends from the stock are non-business income. B: False is incorrect. For most sole proprietors, dividends are not business income. (See page 7-6 of the course material.) 5. A: Incorrect. As a general rule, kickbacks must be reported whether they are legal or not, because they are in fact income. B: Incorrect. Regardless of whether they are routine or unexpected, as a general rule a kickback must be reported. C: Correct. This is the general rule. D: Incorrect. There is no minimum. All kickbacks must generally be reported. (See page 7-10 of the course material.) 6. A: True is correct. In some cases, the property or money that a business receives is not income. This category includes both money borrowed through a bona fide loan and state and local sales taxes imposed on the buyer that a business owner was required to collect and pay over to state or local governments. B: False is incorrect. Neither is considered to be business income. (See page 7-11 of the course material.) Business Income 7-17

253 I. Introduction Chapter 8: How to Figure Cost of Goods Sold If a sole proprietor or other type of business entity is engaged in making or buying goods to sell, it can deduct the cost of goods sold from its gross receipts (a sole proprietor would do this on Schedule C of Form 1040). However, to determine these costs, the business must value its inventory at the beginning and end of each tax year. This chapter applies to business entities that are a manufacturer, wholesaler, or retailer or if it is engaged in any business that makes, buys, or sells goods to produce income. This chapter does not apply to a personal service business, such as the business of a doctor, lawyer, carpenter, or painter. However, if the individual works in a personal service business and also sells or charges for the materials and supplies normally used in the business, this chapter does apply. If an entity must account for inventory in its business, it must generally use the accrual method of accounting for its purchases and sales. Accounting methods are discussed in more detail in Chapter 4. II. Figuring Cost of Goods Sold Schedule C Lines A sole proprietor can figure the cost of goods sold by filling out lines of Schedule C of Form 1040 (Profit or Loss from Business). These lines are reproduced below and are explained in the discussion that follows. However, while the focus of this discussion is on Form 1040, business entities other than sole proprietors, such as partnerships or corporations, determine the cost of goods sold according to the same formula on their applicable IRS form. The principles set forth in this chapter, therefore, apply to all small businesses regardless of how they are structured. Table 8.1 Figuring Cost of Goods Sold Schedule C Figure the cost of goods sold by filling out lines of Schedule C (reproduced in full at the end of this chapter). 35 Inventory at the beginning of the year. If different from last year s closing inventory, attach explanation 36 Purchases less cost of items withdrawn for personal use 37 Cost of labor. Do not include any amounts paid to yourself 38 Materials and supplies 39 Other costs 40 Add lines 35 through Inventory at end of year 42 Cost of goods sold. Subtract line 41 from line 40. Enter the result here on page 1, line 4 Cost of Goods Sold 8-1

254 A. LINE 35 INVENTORY AT BEGINNING OF YEAR If a business is a merchant, beginning inventory is the cost of merchandise on hand at the beginning of the year that it will sell to customers. If the business is a manufacturer or producer, it includes the total cost of raw materials, work in process, finished goods, and materials and supplies used in manufacturing the goods. Opening inventory usually will be identical to the closing inventory of the year before. The owner must explain any difference in a schedule attached to his return. 1. Donation of Inventory If a business owner contributes inventory (property that he sells in the course of his business), the amount the owner can claim as a contribution deduction is the smaller of its fair market value on the day it is contributed or its basis. The basis of donated inventory is any cost incurred for the inventory in an earlier year that the owner would otherwise include in his opening inventory for the year of the contribution. The owner must remove the amount of his contribution deduction from his opening inventory. It is not part of the cost of goods sold. If the cost of donated inventory is not included in the opening inventory, the inventory's basis is zero and the owner cannot claim a charitable contribution deduction. The owner would therefore treat the inventory's cost as he would ordinarily treat it under his method of accounting. For example, the owner would include the purchase price of inventory bought and donated in the same year in the cost of goods sold for that year. Example 1. You are a calendar year taxpayer who uses an accrual method of accounting. In 2013, you contributed property from inventory to a church. It had a fair market value of $600. The closing inventory at the end of 2012 properly included $400 of costs due to the acquisition of the property, and in 2012, you properly deducted $50 of administrative and other expenses attributable to the property as business expenses. The charitable contribution allowed for 2013 is $400. The cost of goods sold you use in determining gross income for 2013 must not include the $400. You remove that amount from opening inventory for Example 2. If, in Example 1, you acquired the contributed property in 2013 at a cost of $400, you would include the $400 cost of the property in figuring the cost of goods sold for 2013 and deduct the $50 of administrative and other expenses attributable to the property for that year. You would not be allowed any charitable contribution deduction for the contributed property. Cost of Goods Sold 8-2

255 B. LINE 36 PURCHASES LESS COST OF ITEMS WITHDRAWN FOR PERSONAL USE If a business owner is a merchant, he will use the cost of all merchandise he bought for sale. If the owner is a manufacturer or producer, this includes the cost of all raw materials or parts purchased for manufacture into a finished product. 1. Trade Discounts The differences between the stated prices of articles and the actual prices the owner paid for them are called trade discounts. A business owner must use the prices actually paid (not the stated prices) in figuring his cost of purchases. The owner should not show the discount amount separately as an item in gross income. An automobile dealer must record the cost of a car in inventory reduced by a manufacturer's rebate that represents a trade discount. 2. Cash Discounts Cash discounts are amounts a business s suppliers let them deduct from the purchase invoices for prompt payments. There are two methods of accounting for cash discounts. The business may either credit them to a separate discount account or deduct them from total purchases for the year. Whichever method is selected must be used consistently. If the business wants to change its method of figuring inventory cost, the owner must file Form 3115, Application for Change in Accounting Method. If a business owner credits cash discounts to a separate account, the owner must include this credit balance in his business income at the end of the tax year. If the owner uses this method, he should not reduce his cost of goods sold by the cash discounts. A business owner must deduct all returns and allowances from his total purchases during the year. In addition, if an owner withdraws merchandise for personal or family use, he must exclude this cost from the total amount of merchandise he bought for sale. He should do this by crediting the purchases or sales account with the cost of merchandise he withdrew for personal use. He should also charge the amount to his drawing account. A drawing account is a separate account a business owner should keep to record the business income withdrawn to pay for personal and family expenses. As stated above, the owner should also use it to record withdrawals of merchandise for personal or family use. This account is also known as a withdrawals account or personal account. C. LINE 37 COST OF LABOR Labor costs are usually an element of cost of goods sold only in a manufacturing or mining business. Small merchandisers (wholesalers, retailers, etc.) usually do not have labor costs that can properly be charged to cost of goods sold. In a manufacturing business, labor costs properly allocable to the cost of goods sold include both the direct and indirect labor used in fabricating the raw material into a finished, saleable product. Cost of Goods Sold 8-3

256 1. Direct Labor Direct labor costs are the wages a business pays to those employees who spend all their time working directly on the product being manufactured. They also include a part of the wages paid to employees who work directly on the product part time if the business can determine that part of their wages. 2. Indirect Labor Indirect labor costs are the wages paid to employees who perform a general factory function that does not have any immediate or direct connection with making the saleable product, but that is a necessary part of the manufacturing process. 3. Other Labor Other labor costs not properly chargeable to the cost of goods sold may be deducted as selling or administrative expenses. Generally, the only kinds of labor costs properly chargeable to the cost of goods sold are the direct or indirect labor costs and certain other costs treated as overhead expenses properly charged to the manufacturing process, as discussed later under Line 39 Other Costs. D. LINE 38 MATERIALS AND SUPPLIES Materials and supplies, such as hardware and chemicals, used in manufacturing goods are charged to cost of goods sold. Those that are not used in the manufacturing process are treated as deferred charges. The owner can deduct them as a business expense when they are used. E. LINE 39 OTHER COSTS Examples of other costs incurred in a manufacturing or mining process that a business can charge to its cost of goods sold are as follows: 1. Containers Containers and packages that are an integral part of the product manufactured are a part of the cost of goods sold. If they are not an integral part of the manufactured product, their costs are shipping or selling expenses. 2. Freight-in Freight-in, express-in, and cartage-in on raw materials, supplies used in production, and merchandise purchased for sale are all part of cost of goods sold. 3. Overhead Expenses Overhead expenses include expenses such as rent, heat, light, power, insurance, depreciation, taxes, maintenance, labor, and supervision. The overhead expenses which are direct and necessary expenses of the manufacturing operation are included in the cost of goods sold. Cost of Goods Sold 8-4

257 F. LINE 40 ADD LINES 35 THROUGH 39 The total of lines 35 through 39 equals the cost of the goods available for sale during the year. G. LINE 41 INVENTORY AT END OF YEAR Subtract the value of the closing inventory (including, as appropriate, the allocable parts of the cost of raw materials and supplies, direct labor, and overhead expenses) from line 40. Inventory at the end of the year is also known as closing or ending inventory. The ending inventory will usually become the beginning inventory of the next tax year. H. LINE 42 COST OF GOODS SOLD When closing inventory is subtracted from the cost of goods available for sale, the remainder is the cost of goods sold during the tax year. Cost of Goods Sold 8-5

258 Chapter 8 Review Questions The following questions are designed to ensure that you have a complete understanding of the information presented in the chapter. They do not need to be submitted in order to receive CPE credit. They are included as an additional tool to enhance your learning experience. We recommend that you answer each review question and then compare your response to the suggested solution before answering the final exam questions related to this chapter. 1. The inventory at the opening of a year for a merchant is usually equal to which of the following: a) the fair market value of the goods b) the closing inventory of the prior year c) the amount for which the merchant is insured d) the lesser of a or b 2. There is only one method to account for cash discounts. a) true b) false 3. Which of the following are examples of costs that can be considered part of a manufacturer s cost of goods sold: a) containers b) labor c) overhead expenses d) all of the above 4. Containers and packages that are part of the product manufactured are never a part of the cost of goods sold. a) true b) false Cost of Goods Sold 8-6

259 Chapter 8 Solutions and Suggested Responses 1. A: Incorrect. The fair market value of the goods is not relevant in determining the value of the inventory. B: Correct. The inventory of the prior year should be equal to the inventory of the opening of the following year as one literally follows the other. Any difference must be explained to the IRS. C: Incorrect. This is not relevant to this determination. D: Incorrect. Because A is not correct, this cannot possibly be correct either. (See page 8-2 of the course material.) 2. A: True is incorrect. There are actually two ways a business can account for cash discounts. B: False is correct. There are two methods of accounting for cash discounts. The business may either credit them to a separate discount account or deduct them from total purchases for the year. Whichever method is selected must be used consistently. If the business wants to change its method of figuring inventory cost, the owner must file Form 3115, Application for Change in Accounting Method. (See page 8-3 of the course material.) 3. A: Incorrect. Containers and other packaging that are integral to the product are part of the cost of goods sold. However, this is not the best answer. B: Incorrect. Direct and indirect labor costs are part of the cost of goods sold. However, this is not the best answer. C: Incorrect. Certain overhead expenses can be considered part of the cost of goods sold. These include rent and utilities. However, this is not the best answer. D: Correct. All of the above are part of the cost of goods sold calculated for a manufacturer. (See pages 8-3 to 8-4 of the course material.) 4. A: True is incorrect. They are a part of the cost of the goods sold under certain circumstances. B: False is correct. Containers and packages that are an integral part of the product manufactured are a part of the cost of goods sold. If they are not an integral part of the manufactured product, their costs are shipping or selling expenses. (See page 8-4 of the course material.) Cost of Goods Sold 8-7

260 SCHEDULE C (Form 1040) Department of the Treasury Internal Revenue Service (99) Name of proprietor Profit or Loss From Business (Sole Proprietorship) OMB No Attachment Sequence No. 09 For information on Schedule C and its instructions, go to Attach to Form 1040, 1040NR, or 1041; partnerships generally must file Form Social security number (SSN) A Principal business or profession, including product or service (see instructions) B Enter code from instructions C Business name. If no separate business name, leave blank. D Employer ID number (EIN), (see instr.) E Business address (including suite or room no.) City, town or post office, state, and ZIP code F Accounting method: (1) Cash (2) Accrual (3) Other (specify) G Did you materially participate in the operation of this business during 2012? If No, see instructions for limit on losses. Yes No H If you started or acquired this business during 2012, check here I Did you make any payments in 2012 that would require you to file Form(s) 1099? (see instructions) Yes No J If "Yes," did you or will you file required Forms 1099? Yes No Part I Income 1 Gross receipts or sales. See instructions for line 1 and check the box if this income was reported to you on Form W-2 and the Statutory employee box on that form was checked Returns and allowances (see instructions) Subtract line 2 from line Cost of goods sold (from line 42) Gross profit. Subtract line 4 from line Other income, including federal and state gasoline or fuel tax credit or refund (see instructions) Gross income. Add lines 5 and Part II Expenses Enter expenses for business use of your home only on line Advertising Office expense (see instructions) 18 9 Car and truck expenses (see 19 Pension and profit-sharing plans. 19 instructions) Rent or lease (see instructions): 10 Commissions and fees. 10 a Vehicles, machinery, and equipment 20a 11 Contract labor (see instructions) 11 b Other business property... 20b 12 Depletion Repairs and maintenance Depreciation and section Supplies (not included in Part III). 22 expense deduction (not included in Part III) (see 23 Taxes and licenses instructions) Travel, meals, and entertainment: 14 Employee benefit programs a Travel a (other than on line 19).. 14 b Deductible meals and 15 Insurance (other than health) 15 entertainment (see instructions). 24b 16 Interest: 25 Utilities a Mortgage (paid to banks, etc.) 16a 26 Wages (less employment credits). 26 b Other b 27 a Other expenses (from line 48).. 27a 17 Legal and professional services 17 b Reserved for future use... 27b 28 Total expenses before expenses for business use of home. Add lines 8 through 27a Tentative profit or (loss). Subtract line 28 from line Expenses for business use of your home. Attach Form Do not report such expenses elsewhere Net profit or (loss). Subtract line 30 from line 29. If a profit, enter on both Form 1040, line 12 (or Form 1040NR, line 13) and on Schedule SE, line 2. (If you checked the box on line 1, see instructions). Estates and trusts, enter on Form 1041, line 3. } 31 If a loss, you must go to line If you have a loss, check the box that describes your investment in this activity (see instructions). } If you checked 32a, enter the loss on both Form 1040, line 12, (or Form 1040NR, line 13) and on Schedule SE, line 2. (If you checked the box on line 1, see the line 31 instructions). Estates and 32a All investment is at risk. trusts, enter on Form 1041, line 3. 32b Some investment is not at risk. If you checked 32b, you must attach Form Your loss may be limited. For Paperwork Reduction Act Notice, see your tax return instructions. Cat. No P Schedule C (Form 1040) 2012

261 Schedule C (Form 1040) 2012 Page 2 Part III Cost of Goods Sold (see instructions) 33 Method(s) used to value closing inventory: a Cost b Lower of cost or market c Other (attach explanation) 34 Was there any change in determining quantities, costs, or valuations between opening and closing inventory? If Yes, attach explanation Yes No 35 Inventory at beginning of year. If different from last year s closing inventory, attach explanation Purchases less cost of items withdrawn for personal use Cost of labor. Do not include any amounts paid to yourself Materials and supplies Other costs Add lines 35 through Inventory at end of year Cost of goods sold. Subtract line 41 from line 40. Enter the result here and on line Part IV Information on Your Vehicle. Complete this part only if you are claiming car or truck expenses on line 9 and are not required to file Form 4562 for this business. See the instructions for line 13 to find out if you must file Form When did you place your vehicle in service for business purposes? (month, day, year) / / 44 Of the total number of miles you drove your vehicle during 2012, enter the number of miles you used your vehicle for: a Business b Commuting (see instructions) c Other 45 Was your vehicle available for personal use during off-duty hours? Yes No 46 Do you (or your spouse) have another vehicle available for personal use? Yes No 47a Do you have evidence to support your deduction? Yes No b If Yes, is the evidence written? Yes No Part V Other Expenses. List below business expenses not included on lines 8 26 or line Total other expenses. Enter here and on line 27a Schedule C (Form 1040) 2012

262 Chapter 9: Figuring Gross Profit I. Overview After a business has calculated its gross receipts and the cost of goods sold, it is ready to figure its gross profit. Gross profit must be determined before a business can deduct any allowable expenses. These expenses are discussed in Chapter 10, next. A. TYPES OF BUSINESSES If a business owner is filing Schedule C-EZ, the gross profit is gross receipts plus certain other amounts, discussed below. 1. Businesses That Sell Products If a business is a sole proprietorship filing Schedule C, the owner will figure his gross profit by first figuring his net receipts. Net receipts are figured on Schedule C by subtracting any returns and allowances (line 2) from gross receipts (line 1). Returns and allowances include cash or credit refunds made to customers, rebates, and other allowances off the actual sales price. Next, the cost of goods sold (line 4) is subtracted from net receipts (line 3). The result is the gross profit from the business. 2. Businesses That Sell Services An owner does not have to figure the cost of goods sold if the sale of merchandise is not an income-producing factor for the business. The gross profit is the same as the net receipts (gross receipts minus any refunds, rebates, or other allowances). Most professions and businesses that sell services rather than products can figure gross profit directly from net receipts in this way. Illustration. This illustration of the gross profit section of the income statement of a retail business shows how gross profit is figured: Gross Receipts $400,000 Minus: Returns and Allowances $14,940 Net Receipts $385,060 Minus: Cost of Goods Sold $288,140 GROSS PROFIT $96,920 Figuring Gross Profit 9-1

263 The cost of goods sold for this business is figured as follows: Inventory at beginning of year $37,845 Plus: Purchases $285,900 Minus: Items withdrawn $2,650 $283,250 for personal use Goods available for sale $321,095 Minus: Inventory at the $32,955 end of year COST OF GOODS SOLD $288,140 B. ITEMS TO CHECK Consider the following items before figuring gross profit. 1. Gross Receipts At the end of each business day, a business owner should make sure his records balance with actual cash and credit receipts for the day. It may also be helpful to use cash registers to keep track of receipts. It is also recommended a business use a proper invoicing system and keep a separate bank account for the business. 2. Sales Tax Collected Records should be checked so that they show the correct sales tax collected. If a business collects state and local sales taxes imposed on the seller of goods or services from the buyer, the amount collected should be included in gross receipts. Businesses that are required to collect state and local taxes imposed on the buyer and turn them over to state or local governments generally do not include these amounts in income. 3. Inventory at Beginning of Year Compare this figure with last year's ending inventory. The two amounts should usually be the same. 4. Purchases If a business owner takes any inventory items for personal use used for personal consumption, provided to family, or given as gifts, etc. they should be removed from the cost of goods sold. Figuring Gross Profit 9-2

264 5. Inventory at End of Year Procedures for taking inventory should be checked for adequacy. These procedures should ensure all items have been included in inventory and proper pricing techniques have been used. Inventory forms and adding machine tapes should be used as the only evidence for the inventory. Inventory forms are available at office supply stores. These forms have columns for recording the description, quantity, unit price, and value of each inventory item. Each page has space to record who made the physical count, who priced the items, who made the extensions, and who proofread the calculations. These forms will provide a permanent record to support its validity. C. TESTING GROSS PROFIT ACCURACY If a business is engaged in retail or wholesale, it can check the accuracy of its gross profit figure. First, gross profit is divided by net receipts. The resulting percentage measures the average spread between the merchandise cost of goods sold and the selling price. Next, this percentage is compared to the business s markup policy. Little or no difference between these two percentages shows that the gross profit figure is accurate. A large difference between these percentages may show that it did not accurately figure sales, purchases, inventory, or other items of cost. The business should determine the reason for the difference. Example. Joe Able operates a retail business. On the average, he marks up his merchandise so that he will realize a gross profit of 33⅓% on its sales. The net receipts (gross receipts minus returns and allowances) shown on his income statement is $300,000. His cost of goods sold is $200,000. This results in a gross profit of $100,000 ($300,000 $200,000). To test the accuracy of this year's results, Joe divides gross profit ($100,000) by net receipts ($300,000). The resulting 33⅓% confirms his markup percentage of 33⅓%. D. ADDITIONS TO GROSS PROFIT If a business has income from a source other than its regular business operations, the income is entered on line 6 of Schedule C and added to gross profit. The result is gross business income. If an owner uses Schedule C-EZ, the income is included on line 1 of the schedule. Some examples include income from an interest-bearing checking account, income from scrap sales, and amounts recovered from bad debts. Figuring Gross Profit 9-3

265 Chapter 9 Review Questions The following questions are designed to ensure that you have a complete understanding of the information presented in the chapter. They do not need to be submitted in order to receive CPE credit. They are included as an additional tool to enhance your learning experience. We recommend that you answer each review question and then compare your response to the suggested solution before answering the final exam questions related to this chapter. There are no review questions associated with this chapter. Figuring Gross Profit 9-4

266 I. Introduction and Overview Chapter 10: Business Expenses Owners can deduct the costs of running their business. These costs are known as business expenses. These are costs the owner does not have to capitalize or include in the cost of goods sold. A. ORDINARY AND NECESSARY To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in a particular field of business. A necessary expense is one that is helpful and appropriate for a particular business. An expense does not have to be indispensable to be considered necessary. In this context, it is important to separate business expenses from the following expenses: The expenses used to figure the cost of goods sold; Capital expenses; and Personal expenses. If a business owner has an expense that is partly for business and partly personal, he should separate the personal part from the business part. B. COST OF GOODS SOLD If a business manufactures products or purchases them for resale, some of the business s expenses may be included in figuring cost of goods sold. The owner can deduct the cost of goods sold from the business s gross receipts to figure his gross profit for the year. If the business uses an expense to figure the cost of goods sold, it cannot deduct it again as a business expense. The following are types of expenses that go into figuring cost of goods sold: The cost of products or raw materials, including the cost of having them shipped to the business; The cost of storing the products the business sells; Direct labor costs (including contributions to pension or annuity plans) for workers who produce the products; and Factory overhead expenses. Under the uniform capitalization rules, businesses must capitalize the direct costs and part of the indirect costs for production or resale activities. Indirect costs include the following: Business Expenses 10-1

267 Rent; Interest; Taxes; Storage; Purchasing; Processing; Repackaging; Handling; and Administrative costs. This rule does not apply to personal property acquired for resale if the company s average annual gross receipts (or those of their predecessor) for the preceding three tax years are not more than $10 million. C. CAPITAL EXPENSES A taxpayer generally must capitalize the cost of property used in a trade or business and recover such cost over time through annual deductions for depreciation or amortization. Tangible property generally is depreciated under the modified accelerated cost recovery system ( MACRS ), which determines depreciation by applying specific recovery periods, placed-in-service conventions, and depreciation methods to the cost of various types of depreciable property (Internal Revenue Code 168). The cost of nonresidential real property is recovered using the straight-line method of depreciation and a recovery period of 39 years. Nonresidential real property is subject to the mid-month placed-in-service convention. Under the mid-month convention, the depreciation allowance for the first year property is placed in service is based on the number of months the property was in service, and property placed in service at any time during a month is treated as having been placed in service in the middle of the month. Depreciation allowances for improvements made on leased property are determined under MACRS, even if the MACRS recovery period assigned to the property is longer than the term of the lease. This rule applies regardless of whether the lessor or the lessee places the leasehold improvements in service. If a leasehold improvement constitutes an addition or improvement to nonresidential real property already placed in service, the improvement is depreciated using the straight-line method over a 39-year recovery period, beginning in the month the addition or improvement was placed in service. Qualified property includes qualified leasehold improvement property. For this purpose, qualified leasehold improvement property is any improvement to an interior portion of a building that is nonresidential real property, provided certain requirements are met. The Business Expenses 10-2

268 improvement must be made under or pursuant to a lease either by the lessee (or sublessee), or by the lessor, of that portion of the building to be occupied exclusively by the lessee (or sublessee). The improvement must be placed in service more than three years after the date the building was first placed in service. Qualified leasehold improvement property does not include any improvement for which the expenditure is attributable to the enlargement of the building, any elevator or escalator, any structural component benefiting a common area, or the internal structural framework of the building. A lessor of leased property that disposes of a leasehold improvement that was made by the lessor for the lessee of the property may take the adjusted basis of the improvement into account for purposes of determining gain or loss if the improvement is irrevocably disposed of or abandoned by the lessor at the termination of the lease. This rule conforms the treatment of lessors and lessees with respect to leasehold improvements disposed of at the end of a term of lease. The American Jobs Creation Act of 2004 provides a statutory 15-year recovery period for qualified leasehold improvement property placed in service before January 1, The provision requires that qualified leasehold improvement property be recovered using the straight-line method. Qualified leasehold improvement property is defined as under present law for purposes of the additional first-year depreciation deduction, with the following modification. If a lessor makes an improvement that qualifies as qualified leasehold improvement property, such improvement does not qualify as qualified leasehold improvement property to any subsequent owner of such improvement. An exception to the rule applies in the case of death and certain transfers of property that qualify for nonrecognition treatment. There are, in general, three types of costs that must be capitalized: Going into business; Business assets; and Improvements. Although businesses generally cannot take a current deduction for a capital expense, they may be able to take deductions for the amount spent through depreciation, amortization, or depletion. These allow the business to deduct part of the cost each year over a number of years. 1. Going Into Business The costs of getting started in business, before actually beginning business operations, are capital expenses. These costs may include expenses for advertising, travel, or wages for training employees. Business Expenses 10-3

269 If an individual attempts to go into business but is not successful, the expenses incurred in trying to establish the business fall into one of two categories: The costs the individual had before making a decision to acquire or begin a specific business. These costs are personal and nondeductible. They include any costs incurred during a general search for, or preliminary investigation of, a business or investment possibility; and The costs the individual had in his attempt to acquire or begin a specific business. These costs are capital expenses and an individual can deduct them as a capital loss. If a corporation attempts to go into a new trade or business and is unsuccessful, it may be able to deduct all investigatory costs as a loss. The costs of any assets acquired during an unsuccessful attempt to go into business are a part of the owner s basis in the assets. The owner cannot take a deduction for these costs; the costs of these assets will be recovered when they are disposed of. 2. Business Assets The cost of any asset used in a business is a capital expense. There are many different kinds of business assets, such as land, buildings, machinery, furniture, trucks, patents, and franchise rights. The business must capitalize the full cost of the asset, including freight and installation charges. 3. Improvements The costs of making improvements to a business asset are capital expenses if the improvements add to the value of the asset, appreciably lengthen the time it can be used, or adapt it to a different use. Businesses can deduct repairs that keep their property in a normal efficient operating condition as a business expense. Improvements include new electric wiring, a new roof, a new floor, new plumbing, bricking up windows to strengthen a wall, and lighting improvements. D. PERSONAL EXPENSES Generally, a business cannot deduct personal, living, or family expenses. However, if an individual has an expense for something that is used partly for business and partly for personal purposes, he may divide the total cost between the business and personal parts. He can deduct as a business expense only the business part. Business Expenses 10-4

270 Table 10.1 Capital or Deductible Expenses The following chart is designed to help readers understand how to differentiate a capital expense from a deductible expense through specific example. Type of Expense Repairs made to a business vehicle Cost of building a private road on business property and the cost of replacing a gravel driveway with a concrete one Purchase of tools Machinery parts Heating equipment Treatment They are deductible expenses. However, amounts paid to recondition and overhaul a business vehicle are capital expenses. These are capital expenses the business may be able to depreciate. The cost of maintaining a private road on business property is a deductible expense. Unless the uniform capitalization rules apply, amounts spent for tools used in a business are deductible expenses if the tools have a life expectancy of less than 1 year. Unless the uniform capitalization rules apply, the cost of replacing short-lived parts of a machine to keep it in good working condition and not add to its life is a deductible expense. The cost of changing from one heating system to another is a capital expense. II. Timing and Amount of Deductions A. HOW MUCH CAN BE DEDUCTED An individual or business cannot deduct more for a business expense than the amount actually spent. There is usually no other limit on how much can be deducted if the amount is reasonable. However, if the deductions are large enough to produce a net business loss for the year, the tax loss may be limited. For example, if an individual provides services to pay a business expense, the amount that can be deducted is the amount actually spent to provide the services. It is not what would have been paid in cash. Similarly, if a business expense is paid in goods or other property, the business can deduct only the amount the property actually cost. If these costs are included in the cost of goods sold, they cannot be deducted as a business expense. B. LIMITS ON LOSSES If deductions for an investment or business activity are more than the income it brings in, the result is a net loss. There may be limits on how much, if any, of the loss can be used to offset income from other sources. Business Expenses 10-5

271 1. At-Risk Limits Generally, a deductible loss from a trade or business or other income-producing activity is limited to the investment the individual has at risk in the activity. An individual is at risk in any activity for the following items: The money and adjusted basis of property contributed to the activity; and Amounts borrowed for use in the activity if: 2. Passive Activities a. The individual is personally liable for repayment; or b. The individual pledges property (other than property used in the activity) as security for the loan. Generally, an individual is in a passive activity if he has a trade or business activity in which he does not materially participate during the year, or a rental activity. In general, deductions for losses from passive activities only offset an individual s income from passive activities. Individuals cannot use any excess deductions to offset their other income. In addition, passive activity credits can only offset the tax on net passive income. Any excess loss or credits are carried over to later years. 3. Net Operating Loss If a business s deductions are more than its income for the year, it may have a net operating loss. It can use a net operating loss to lower its taxes in other years. 4. Not-for-Profit Activities If a individual does not carry on his business or investment activity to make a profit, there is a limit on the deductions he can take. He cannot use a loss from the activity to offset other income. Activities done as a hobby, or mainly for sport or recreation fall under this limit. So does an investment activity intended only to produce tax losses for the investors. The limit on not-for-profit losses applies to individuals, partnerships, estates, trusts, and S corporations. It does not apply to corporations other than S corporations. In determining whether an activity is being carried on for profit, all the facts are taken into account. No one factor alone is decisive. Among the factors to consider are whether: The activity is carried on in a business-like manner; The time and effort put into the activity indicates the individual intends to make it profitable; Whether the individual depends on income from the activity for his livelihood; Business Expenses 10-6

272 The losses are due to circumstances beyond his control (or are normal in the start-up phase of their type of business); The owner changes his methods of operation in an attempt to improve profitability; The individual, or his advisors, have the knowledge needed to carry on the activity as a successful business; The individual was successful in making a profit in similar activities in the past; The activity makes a profit in some years, and how much profit it makes; and The individual can expect to make a future profit from the appreciation of the assets used in the activity. An activity is presumed carried on for profit if it produced a profit in at least three of the last five tax years, including the current year. Activities that consist primarily of breeding, training, showing, or racing horses are presumed carried on for profit if they produced a profit in at least two of the last seven tax years, including the current year. The activity must be substantially the same for each year within this period. An individual has a profit when the gross income from an activity is more than the deductions for it. C. WHEN EXPENSES CAN BE DEDUCTED When an expense can be deducted depends on the individual s or business s accounting method. An accounting method is a set of rules used to determine when and how income and expenses are reported. The two basic methods are the cash method and the accrual method. 1. Cash Method Under the cash method of accounting, an individual or business generally deducts business expenses in the tax year the expenses were actually paid, even if the expenses were incurred in an earlier year. 2. Accrual Method Under the accrual method of accounting, an individual or business generally deducts business expenses when both of the following apply: The all-events test has been met. The test is met when: All events have occurred that fix the fact of liability; and The liability can be determined with reasonable accuracy. Economic performance has occurred. An individual or business generally cannot deduct or capitalize a business expense until economic performance occurs. If the expense is for property or services provided to the Business Expenses 10-7

273 business, or for its use of property, economic performance occurs as the property or services are provided, or the property is used. If the expense is for property or services provided to others, economic performance occurs as the individual or business provides the property or services. Example. Kwame Jackson, CPA, a sole proprietor, uses the calendar year as his tax year. In December 2012, the Field Plumbing Company did some repair work at his place of business and sent him a bill for $150. Kwame paid it by check in January If Kwame uses an accrual method of accounting, he can deduct the $150 on his tax return for 2012 because all events occurred to fix the fact of liability, the liability can be determined, and economic performance occurred in that year. If he uses the cash method of accounting, Kwame can deduct the expense on his 2013 return. 3. Prepaid Expenses An individual or business generally cannot deduct expenses in advance, even if they are paid in advance. This rule applies to both the cash and accrual methods. It applies to prepaid interest, prepaid insurance premiums, and any other expense paid far enough in advance to, in effect, create an asset with a useful life extending substantially beyond the end of the current tax year. Example. In 2013, two partners sign a 10-year lease and immediately pay their rent for the first three years. Even though the partnership paid the rent for 2013, 2014, and 2015, the partners can deduct only the rent for 2013 on their current tax return. They can deduct on their 2014 and 2015 tax returns the rent for those years. III. Selected Categories of Generally Deductible Expenses A. BAD DEBTS A business bad debt is generally one that comes from operating a trade or business. The individual may be able to deduct business bad debts as an expense on his business tax return. A business bad debt is a loss from the worthlessness of a debt that was either of the following: (1) created or acquired in a business; (2) or closely related to the business when it became partly or totally worthless. A debt is closely related to a business if the primary motive for incurring the debt is a business reason. Business bad debts are mainly the result of credit sales to customers. They can also be the result of loans to suppliers, clients, employees, or distributors. Goods and services customers have not paid for are shown in the books as either accounts receivable or notes receivable. If an entity is unable to collect any part of these accounts or notes receivable, the uncollectible part is a business bad debt. Business Expenses 10-8

274 A business can take a bad debt deduction for these accounts and notes receivable only if the amount owed was included in the business s gross income either for the year the deduction is claimed or for a prior year. All other bad debts are non-business bad debts and are deductible as short-term capital losses on Schedule D (Form 1040). B. CAR AND TRUCK EXPENSES If an individual uses his car or truck in business, he may be able to deduct the costs of operating and maintaining his vehicle. He may also be able to deduct other costs of local transportation and traveling away from home overnight on business. In addition, a business may be entitled to a tax credit for an alternative motor vehicle it places in service during the year. The vehicle must meet certain requirements and it does not have to be used in business to qualify for the credit. 1. Local Transportation Expenses Local transportation expenses include the ordinary and necessary costs of all the following: Getting from one workplace to another in the course of the business or profession when the individual is traveling within the city or general area that is his tax home, as defined later; Visiting clients or customers; Going to a business meeting away from a regular workplace; and Getting from home to a temporary workplace when the individual has one or more regular places of work. These temporary workplaces can be either within the area of his tax home or outside that area. Local business transportation does not include expenses incurred while traveling away from home overnight. Those expenses are deductible as travel expenses, which are discussed later. However, if an individual uses his car while traveling away from home overnight, he can use the rules in this section to figure his car expense deduction. Generally, an individual s tax home is his regular place of business, regardless of where he maintains his family home. It includes the entire city or general area in which his business or work is located. Example. William operates a printing business out of rented office space. William uses his van to deliver completed jobs to his customers. William can deduct the cost of round-trip transportation between his customers and his print shop. Business Expenses 10-9

275 William cannot deduct the costs of driving his car or truck between his home and main or regular workplace. These costs are personal commuting expenses. An individual s workplace can be his home if he has an office in his home that qualifies as his principal place of business. Example. Lucille is a graphics designer. She operates her business out of her home. Lucille s home qualifies as her principal place of business. She occasionally has to drive to her clients to deliver completed work. Lucille can deduct the cost of the round-trip transportation between her home and her clients. 2. Methods for Deducting Car and Truck Expenses For local transportation or overnight travel by car or truck, one of the following methods can generally be used to figure expenses: (1) the standard mileage rate, or (2) actual expenses. For 2013, for example, the standard mileage rate is 56.5 cents a mile for all business miles. If an individual chooses to use the standard mileage rate for a year, he cannot deduct his actual expenses for that year except for business-related parking fees and tolls. If an individual wants to use the standard mileage rate for a car or truck of his own, he must choose to use it in the first year the car is available for use in his business. In later years, he can choose to use either the standard mileage rate or actual expenses. If an individual uses the standard mileage rate for a car he leases, he must choose to use it for the entire lease period (including renewals). The standard mileage rate cannot be used if the individual: Operates five or more cars at the same time; Claimed a depreciation deduction using any method other than straight line, for example, ACRS or MACRS; Claimed a 179 deduction on the car; Claimed the special depreciation allowance on the car; Claimed actual car expenses for a leased car; or Is a rural mail carrier who received a qualified reimbursement. Business Expenses 10-10

276 3. Parking Fees and Tolls In addition to using the standard mileage rate, an individual can deduct any businessrelated parking fees and tolls. (Parking fees paid to park a car at the individual s place of work are nondeductible commuting expenses.) 4. Actual Expenses If an individual does not choose to use the standard mileage rate, he may be able to deduct his actual car or truck expenses. Actual car expenses include the costs of the following items: Depreciation Lease payments Registration Garage rent Licenses Repairs Gas Oil Tires Insurance Parking fees Tolls 5. Reimbursing Employee Expenses Entities generally can deduct the amount they reimburse their employees for car and truck expenses. C. EMPLOYEE WAGES An individual (a sole proprietor) can generally deduct on Schedule C the pay he gives his employees for the services they perform for the business. The pay may be in cash, property, or services. It may include wages, salaries, vacation allowances, bonuses, commissions, and fringe benefits. An employer can also claim the following employment credits if he hires individuals who meet certain requirements: Empowerment zone and renewal community employment credit; Welfare-to-work credit; and Work opportunity credit. However, the employer must reduce his deduction for employee wages by the amount of any employment credits he claims. In addition, individuals cannot deduct their own salary or any personal withdrawals they make from their business. A sole proprietor is not an employee of the business. Business Expenses 10-11

277 1. Rule for Deductibility To be deductible, the employees' pay must be an ordinary and necessary expense and the individual or business must pay or incur it in the tax year. In addition, the pay must meet both the following tests: The pay must be reasonable; and The pay must be for services performed. If these tests are met, the form or method of figuring the pay does not affect its deductibility. For example, bonuses and commissions based on sales or earnings and paid under an agreement made before the services were performed are generally deductible. Test 1: Reasonable Determine the reasonableness of pay by the facts. Generally, reasonable pay is the amount that like enterprises ordinarily would pay for the services under similar circumstances. The employer must be able to prove the pay is reasonable. This is based on the circumstances that exist when the employee is hired, not those existing when the reasonableness is questioned. If the pay is excessive, the employer can deduct only the part that is reasonable. To determine if pay is reasonable, the following items and any other pertinent facts are considered: The duties performed by the employee; The volume of business handled; The character and amount of responsibility; The complexities of the business; The amount of time required; The general cost of living in the locality; The ability and achievements of the individual employee performing the service; The pay compared with the gross and net income of the business, as well as with distributions to shareholders if the business is a corporation; The employer s policy regarding pay for all its employees; and The history of pay for each employee. Business Expenses 10-12

278 In addition, the employer must base the test of whether an individual's pay is reasonable on each individual's pay and the service performed, not on the total amount paid to all officers or all employees. For example, even if the total amount paid to all officers is reasonable, the employer cannot deduct the part of an individual officer's pay that is not reasonable based on the items listed above. Consider, for example, the case of an employee-shareholder. If a corporation pays an employee who is also a shareholder a salary that is unreasonably high considering the services actually performed, the excessive part of the salary may be treated as a constructive distribution of earnings to the employee-shareholder. Test 2: For Services Performed The employer must be able to prove the payment was made for services actually performed. This is a purely factual showing whereby the employer must show that each employee did actually perform the services contracted for. 2. Awards Employee compensation often comes in a number of forms, including the following: a. Awards. Employers can generally deduct amounts paid to employees as awards, whether paid in cash or property. If property is given to an employee as an employee achievement award, the deduction may be limited. b. Achievement Awards. An achievement award is an item of tangible personal property that meets all the following requirements: It is given to an employee for length of service or safety achievement; It is awarded as part of a meaningful presentation; and It is awarded under conditions and circumstances that do not create a significant likelihood of disguised pay. c. Length-of-Service Award. An award will not qualify as a length-of-service award if either of the following applies: The employee receives the award during his or her first five years of employment; or The employee received another length-of-service award (other than one of very small value) during the same year or in any of the prior four years. d. Deduction Limit. The deduction for the cost of employee achievement awards given to any one employee during the tax year is limited to the following amounts: Business Expenses 10-13

279 $400 for awards that are not qualified plan awards; and $1,600 for all awards, whether or not qualified plan awards. A qualified plan award is an achievement award given as part of an established written plan or program that does not favor highly compensated employees as to eligibility or benefits. A highly compensated employee for 2012 tax return filing year is an employee who meets either of the following tests: The employee was a 5% owner at any time during the year or the preceding year; or The employee received more than $115,000 in pay for the preceding year. Employers can choose to ignore the second test if the employee was not also in the top 20% of employees ranked by pay for the preceding year. An award is not a qualified plan award if the average cost of the entire employee achievement awards given during the tax year (that would be qualified plan awards except for this limit) is more than $400. To figure this average cost, account awards of very small value are not included. 3. Bonuses Employers can generally deduct a bonus paid to an employee if they intended the bonus as additional pay for services, not as a gift, and the services were actually performed. However, the total bonuses, salaries, and other pay must be reasonable for the services performed. If, to promote employee goodwill, an employer distributes turkeys, hams, or other merchandise of nominal value to employees at holidays, they can deduct the cost of these items as a non-wage business expense. The deduction for de minimis gifts of food or drink are not subject to the deduction limit that generally applies to meals. 4. Fringe Benefits A fringe benefit is a form of pay provided to any person for the performance of services by that person. The following are examples of fringe benefits: Benefits under employee benefit programs; Meals and lodging; Use of a car; Flights on airplanes; Discounts on property or services; Memberships in country clubs or other social clubs; and Business Expenses 10-14

280 Tickets to entertainment or sporting events. Employers can generally deduct the cost of fringe benefits they provide on their tax return or business schedule in whatever category the cost falls. For example, if they allow an employee to use a car or other property they lease, they can deduct the cost of the lease as a rent or lease expense. If they own the property, they should include their deduction for its cost or other basis as a 179 deduction or a depreciation deduction. They may not owe employment taxes on the value of the fringe benefits they provide to an employee. 5. Employee Benefit Programs Employee benefit programs include the following: Accident and health plans; Adoption assistance; Cafeteria plans; Dependent care assistance; Educational assistance; Group-term life insurance coverage; and Welfare benefit funds. Employers can generally deduct amounts they spend on employee benefit programs on the employee benefit programs line of their tax return or business schedule. However, they may deduct certain costs on other lines. For example, an employer provides dependent care by operating a dependent care facility for its employees, and deducts the costs in whatever categories they fall (depreciation, utilities, salaries, etc.). Employers cannot deduct the cost of group-term life insurance coverage if they are directly or indirectly the beneficiary of the policy. A welfare benefit fund is a funded plan (or a funded arrangement having the effect of a plan) that provides welfare benefits to the employees, independent contractors, or their beneficiaries. Welfare benefits are any benefits other than deferred compensation or transfers of restricted property. The deduction for contributions to a welfare benefit fund is limited to the fund's qualified cost for the tax year. If an employer s contributions to the fund are more than its qualified cost, it can carry the excess over to the next tax year. Generally, the fund's qualified cost is the total of the following amounts, reduced by the after-tax income of the fund: The cost the employer would have been able to deduct using the cash method of accounting if it had paid for the benefits directly; and Business Expenses 10-15

281 The contributions added to a reserve account that are needed to fund claims incurred but not paid as of the end of the year for supplemental unemployment benefits, severance pay, or disability, medical, or life insurance benefits. 6. Meals and Lodging Employers can usually deduct the cost of furnishing meals and lodging to their employees. Generally, a business can deduct only 50% of its business-related meal expenses while traveling away from its tax home for business purposes. Also, a business owner can generally deduct only 50% of certain reimbursements made to his employees for meal expenses they incur while traveling away from home on business. Employers should deduct the cost on their tax return or business schedule in whatever category the expense falls. For example, if the employer operates a restaurant, he should deduct the cost of the meals he furnishes to his employees as part of the cost of goods sold. If the employer operates a nursing home, motel, or rental property, he should deduct the cost of furnishing lodging to an employee as expenses for utilities, linen service, salaries, depreciation, etc. While employers can generally deduct only 50% of the cost of furnishing meals to employees, the full cost of the following meals is deductible: Meals whose value is included in an employee's wages; Meals that qualify as a de minimis fringe benefit. This generally includes meals furnished to employees at the employer s place of business if more than half of these employees are provided the meals for the employer s convenience; Meals an employer furnishes to its employees at the work site when the employer operates a restaurant or catering service; Meals furnished to employees as part of the expense of providing recreational or social activities, such as a company picnic; Meals employers are required by federal law to furnish to crew members of certain commercial vessels (or would be required to furnish if the vessels were operated at sea). This does not include meals furnished on vessels primarily providing luxury water transportation; and Meals furnished on an oil or gas platform or drilling rig located offshore or in Alaska. This includes meals furnished at a support camp that is near and integral to an oil or gas-drilling rig located in Alaska. 7. Loans or Advances Employers generally can deduct as wages a loan or advance made to an employee that they do not expect the employee to repay if it is for personal services actually performed. The total must be reasonable when the loan or advance is added to the employee's other pay. However, if the employee performs no services, the amount advanced is treated as a loan to the employee, which cannot be deducted unless it becomes a bad debt. Business Expenses 10-16

282 On certain loans made to an employee or shareholder, the employer is treated as having received interest income and as having paid compensation or dividends equal to that interest. 8. Property If an employer transfers property (including the company's stock) to an employee as payment for services, it can generally deduct it as wages. The amount the employer can deduct is its fair market value on the date of the transfer minus any amount the employee paid for the property. An employer can claim the deduction only for the tax year in which its employee includes the property's value in income. The employee is deemed to have included the value in income if the employer reports it on Form W-2 in a timely manner. The employer treats the deductible amount as received in exchange for the property, and must recognize any gain or loss realized on the transfer. The employer s gain or loss is the difference between the fair market value of the property and its adjusted basis on the date of transfer. A corporation recognizes no gain or loss when it pays for services with its own stock. These rules also apply to property transferred to an independent contractor, generally reported on Form 1099-MISC. If the property transferred for services is subject to restrictions that affect its value, the employer generally cannot deduct it and does not report gain or loss until it is substantially vested in the recipient. However, if the recipient pays for the property, the employer must report any gain at the time of the transfer up to the amount paid. Substantially vested means the property is not subject to a substantial risk of forfeiture. The recipient is not likely to have to give up his or her rights in the property in the future. 9. Reimbursement for Business Expenses Employers can generally deduct the amount paid or reimbursed to employees for business expenses they incur on behalf of the employer for items such as travel and entertainment. However, the deduction for meal and entertainment expenses is usually limited to 50% of the payment. If an employer makes the payment under an accountable plan, it should deduct it in the category of the expense paid. For example, if an employer pays an employee for travel expenses incurred on its behalf, it should deduct this payment as a travel expense on its tax return or business schedule. If the payment is made under a non-accountable plan, the employer should deduct it as wages on its tax return or business schedule. 10. Sick Pay Employers can deduct amounts paid to their employees for sickness and injury, including lump-sum amounts, as wages. However, the deduction is limited to amounts not compensated by insurance or other means. Business Expenses 10-17

283 11. Vacation Pay Vacation pay is an amount paid to an employee while the employee is on vacation. It includes an amount an employer pays an employee for unused vacation leave. Vacation pay does not include any sick pay or holiday pay. Employers can deduct vacation pay only in the tax year in which the employee actually receives it. This rule applies regardless of whether the employer uses the cash method or an accrual method of accounting. D. INSURANCE 1. Deductible Premiums A business can generally deduct premiums paid for the following kinds of insurance related to the business: Fire, theft, flood, or similar insurance; Credit insurance that covers losses from business bad debts; Group hospitalization and medical insurance for employees, including long-term care insurance; Liability insurance; Malpractice insurance that covers the personal liability for professional negligence resulting in injury or damage to patients or clients; Workers' compensation insurance set by state law that covers any claims for bodily injuries or job-related diseases suffered by employees in the owner s business, regardless of fault; Contributions to a state unemployment insurance fund are deductible as taxes if they are considered taxes under state law; Overhead insurance that pays for business overhead expenses the business has during long periods of disability caused by the owner s injury or sickness; Car and other vehicle insurance that covers vehicles used in the business for liability, damages, and other losses. If the owner operates a vehicle partly for personal use, he may deduct only the part of the insurance premium that applies to the business use of the vehicle. If he uses the standard mileage rate to figure his car expenses, he cannot deduct any car insurance premiums; Business Expenses 10-18

284 Life insurance covering the owner s employees if they are not directly or indirectly the beneficiary under the contract; and Business interruption insurance that pays for lost profits if the business is shut down due to a fire or other cause. 2. Nondeductible Premiums Businesses cannot deduct premiums on the following kinds of insurance: Self-insurance reserve funds. Businesses cannot deduct amounts credited to a reserve set up for self-insurance. This applies even if the business cannot get business insurance coverage for certain business risks. However, actual losses may be deductible; Loss of earnings. Businesses cannot deduct premiums for a policy that pays for its lost earnings due to sickness or disability; Certain life insurance and annuities: For contracts issued before June 9, 1997, businesses cannot deduct the premiums on a life insurance policy covering the owner, an employee, or any person with a financial interest in the business if the owner is directly or indirectly a beneficiary of the policy. The owner is included among possible beneficiaries of the policy if the policy owner is obligated to repay a loan from them using the proceeds of the policy. A person has a financial interest in a business if the person is an owner or part owner of the business or has lent money to the business. For contracts issued after June 8, 1997, a business owner generally cannot deduct the premiums on any life insurance policy, endowment contract, or annuity contract if they are directly or indirectly a beneficiary. The disallowance applies without regard to whom the policy covers. Insurance to secure a loan. If a business owner takes out a policy on his life or on the life of another person with a financial interest in the business to get or protect a business loan, he cannot deduct the premiums as a business expense. Nor can he deduct the premiums as interest on business loans or as an expense of financing loans. In the event of death, the proceeds of the policy are not taxed as income even if they are used to liquidate the debt. 3. Self-employed Health Insurance Deduction A business may be able to deduct 100% of the amount it paid for medical and dental insurance and qualified long-term care insurance for the owner and his or her family. Business Expenses 10-19

285 4. Prepayment A business owner cannot deduct expenses in advance, even if he pays them in advance. This rule applies to any expense paid far enough in advance to, in effect, create an asset with a useful life extending substantially beyond the end of the current tax year. Example. In 2013, Luke signed a three-year insurance contract. Even though he paid the premiums for 2013, 2014, and 2015 when he signed the contract, Luke can only deduct the premium for 2013 on his 2013 tax return. Luke can deduct in 2014 and 2015 the premium allocable to those years. E. INTEREST PAYMENTS A business owner can generally deduct as a business expense all interest he pays or accrues during the tax year on debts related to the business. Interest relates to the business if the proceeds of the loan are used for a business expense. It does not matter what type of property secures the loan. The owner can deduct interest on a debt only if all of the following requirements are met: The owner is legally liable for that debt; Both the owner and the lender intend that the debt be repaid; and The owner and the lender have a true debtor-creditor relationship. A business owner cannot deduct on Schedule C or C-EZ the interest he paid on personal loans. If a loan is part business and part personal, he must divide the interest between the personal part and the business part. Example. In 2013, John Smith, a sole proprietor, paid $600 interest on a car loan. During 2013, John used the car 60% for business and 40% for personal purposes. John is claiming actual expenses on the car. He can only deduct $360 (60% $600) for interest for 2013 on Schedule C or C-EZ. The remaining interest of $240 is a nondeductible personal expense. F. LEGAL AND PROFESSIONAL FEES Legal and professional fees, such as fees charged by accountants, that are ordinary and necessary expenses directly related to operating a business are deductible on Schedule C or C-EZ. However, a business owner usually cannot deduct legal fees he pays to acquire business assets. Rather, they must be added to the basis of the property. If the fees include payments for work of a personal nature (such as making a will), the owner can take a business deduction only for the part of the fee related to the business. The personal part of legal fees for producing or collecting taxable income, doing or Business Expenses 10-20

286 keeping his job, or for tax advice may be deductible on Schedule A (Form 1040) if he itemizes deductions. A business owner can also deduct on Schedule C or C-EZ the cost of preparing that part of his tax return relating to his business as a sole proprietor or statutory employee. He can deduct the remaining cost on Schedule A (Form 1040) if he itemizes his deductions. He can also deduct on Schedule C or C-EZ the amount paid or incurred in resolving asserted tax deficiencies for his business as a sole proprietor or statutory employee. G. PENSION PLANS A business owner can set up and maintain the following small business retirement plans for himself and his employees: SEP (Simplified Employee Pension) plans; SIMPLE (Savings Incentive Match Plan for Employees) plans; and Qualified plans (including Keogh or H.R. 10 plans). SEP, SIMPLE, and qualified plans offer a business owner and his employees a tax favored way to save for retirement. The owner can deduct contributions he makes to the plan for his employees on line 19 of Schedule C. If the owner is a sole proprietor, he can deduct contributions made to the plan for himself on line 28 of Form The owner can also deduct trustees' fees if contributions to the plan do not cover him. Earnings on the contributions are generally tax free until the owner or his employees receive distributions from the plan. The owner may also be able to claim a tax credit of 50% of the first $1,000 of qualified startup costs if he begins a new qualified defined benefit or defined contribution plan (including a 401(k) plan), SIMPLE plan, or simplified employee pension. Under certain plans, employees can have their employer contribute limited amounts of their before-tax pay to a plan. These amounts (and earnings on them) are generally tax free until the employees receive distributions from the plan. H. RENT EXPENSES Rent is any amount a business pays for the use of property it does not own. In general, a business owner can deduct rent as a business expense only if the rent is for property he uses in his business. If the owner has or will receive equity in or title to the property, he cannot deduct the rent. 1. Unreasonable Rent A business cannot take a rental deduction for unreasonable rents. Ordinarily, the issue of reasonableness arises only if the business owner and the lessor are related. Rent paid to a related person is reasonable if it is the same amount the owner would pay to a stranger for use of the same property. Rent is not unreasonable just because it is figured as a percentage of gross receipts. Business Expenses 10-21

287 Related persons include members of the owner s immediate family, including only brothers and sisters (either whole or half), his spouse, ancestors, and lineal descendants. 2. Rent on the Owner s Home If a business rents the owner s home and uses part of it as its place of business, the business may be able to deduct the rent paid for that part. However, the owner must meet the requirements for business use of a home, discussed later in this chapter. 3. Rent Paid in Advance Generally, rent paid in a business is deductible in the year paid or accrued. If the owner pays rent in advance, he can deduct only the amount that applies to his use of the rented property during the tax year. He can deduct the rest of his payment only over the period to which it applies. I. TAXES A business owner can deduct on Schedule C or C-EZ various federal, state, local, and foreign taxes directly attributable to his business. 1. Income Taxes Owners can deduct on Schedule C or C-EZ a state tax on gross income (as distinguished from net income) directly attributable to his business. An owner can deduct other state and local income taxes on Schedule A (Form 1040) if he itemizes his deductions. Federal income tax is not deductible. 2. Employment Taxes Employers can deduct the social security, Medicare, and federal unemployment (FUTA) taxes paid out of their own funds as an employer. Employers can also deduct payments made as an employer to a state unemployment compensation fund or to a state disability benefit fund. These payments are deductible as taxes. 3. Self-Employment Tax A business owner can deduct one-half of his self-employment tax on line 27 of Form Personal Property Tax Business owners can deduct on Schedule C or C-EZ any tax imposed by a state or local government on personal property used in their business. They can also deduct registration fees for the right to use property within a state or local area. Business Expenses 10-22

288 Example. May and Julius Winter drove their car 7,000 business miles out of a total of 10,000 miles. They had to pay $25 for their annual state license tags and $20 for their city registration sticker. They also paid $235 in city personal property tax on the car, for a total of $280. They are claiming their actual car expenses. Because they used the car 70% for business, they can deduct 70% of the $280, or $196, as a business expense. 5. Real Estate Taxes A business owner can deduct on Schedule C or C-EZ the real estate taxes paid on business property. Deductible real estate taxes are any state, local, or foreign taxes on real estate levied for the general public welfare. The taxing authority must base the taxes on the assessed value of the real estate and charge them uniformly against all property under its jurisdiction. 6. Sales Tax A business should treat any sales tax paid on a service or on the purchase or use of property as part of the cost of the service or property. If the service or the cost or use of the property is a deductible business expense, the owner can deduct the tax as part of that service or cost. If the property is merchandise bought for resale, the sales tax is part of the cost of the merchandise. If the property is depreciable, the sales tax is added to the basis for depreciation. A business owner may not deduct state and local sales taxes imposed on the buyer that he must collect and pay over to the state or local government. These taxes should not be included in gross receipts or sales. 7. Excise Taxes A business can deduct on Schedule C or C-EZ all excise taxes that are ordinary and necessary expenses of carrying on a business. 8. Fuel Taxes Taxes on gasoline, diesel fuel, and other motor fuels used in business are usually included as part of the cost of the fuel. These taxes should not be deducted as a separate item. A business owner may be entitled to a credit or refund for federal excise tax paid on fuels used for certain purposes. Credits are discussed in Chapter 6. J. OTHER COMMON DEDUCTIBLE BUSINESS EXPENSES A business may also be able to deduct the following expenses: Advertising; Donations to business organizations; Business Expenses 10-23

289 Education expenses; Environmental cleanup costs; Impairment-related expenses; Interview expense allowances; Licenses and regulatory fees; Moving machinery; Outplacement services; Penalties and fines paid for late performance or nonperformance of a contract; Repairs that keep the property in a normal efficient operating condition; Repayments of income; Subscriptions to trade or professional publications; Supplies and materials; and Utilities. Following is a discussion about some of these categories. 1. Subscriptions A business can deduct as a business expense subscriptions to professional, technical, and trade journals that deal with its business field. 2. Supplies and Materials Unless the business has deducted the cost in any earlier year, it generally can deduct the cost of materials and supplies actually consumed and used during the tax year. If a business keeps incidental materials and supplies on hand, it can deduct the cost of the incidental materials and supplies it bought during the tax year if all the following requirements are met: It does not keep a record of when they are used; It does not take an inventory of the amount on hand at the beginning and end of the tax year; and This method does not distort its income. Business Expenses 10-24

290 A business can also deduct the cost of books, professional instruments, equipment, etc., if it normally uses them up within a year. However, if the usefulness of these items extends substantially beyond the year they are placed in service, the business generally must recover their costs through depreciation. 3. Utilities A business s expenses for heat, lights, power, and telephone service are deductible. However, any part due to personal use is not deductible. An individual cannot deduct the cost of basic local telephone service (including any taxes) for the first telephone line he has in his home, even though he maintains a home office. However, charges for business long-distance phone calls on that line, as well as the cost of a second line into the home used exclusively for business, are deductible business expenses. 4. Advertising A business generally can deduct reasonable advertising expenses if they relate to business activities. Generally, it cannot deduct the cost of advertising to influence legislation. A business can usually deduct as a business expense the cost of institutional or goodwill advertising to keep the firm s name before the public if it relates to business the owner reasonably expects to gain in the future. For example, the cost of advertising that encourages people to contribute to the Red Cross, to buy U.S. Savings Bonds, or to participate in similar causes is usually deductible. 5. Anticipated Liabilities Anticipated liabilities or reserves for anticipated liabilities are not deductible. For example, assume a business sold 1-year TV service contracts this year totaling $50,000. From experience, the owner knows it will have expenses of about $15,000 in the coming year for these contracts. The business cannot deduct any of the $15,000 this year by charging expenses to a reserve or liability account. It can deduct the expenses only when it actually pays or accrues them, depending on the business s accounting method. IV. Travel, Meals and Entertainment Expenses This section explains the kinds of travel and entertainment expenses that a business owner can deduct on Schedule C or C-EZ. Business Expenses 10-25

291 Table 10.2 When Are Entertainment Expenses Deductible? (The following is a summary of the rules for deducting entertainment expense). General Rule A business can deduct ordinary and necessary expenses to entertain a client, customer or employee if the expense meets the directly-related test or the associated test. Definitions Entertainment includes any activity generally considered to provide entertainment, amusement, or recreation, and includes meals provided to a customer or client. An ordinary expense is one that is common and accepted in your field of business, trade, or profession. A necessary expense is one that is helpful and appropriate, Directly-Related Test although not necessarily required, for your business. Entertainment took place in a clear business setting, or Main purpose of entertainment was the active conduct of business, and 1. You did engage in business with the person during the entertainment period, and 2. You had more than a general expectation of getting income or some other specific business benefit. Associated Test Entertainment is associated with your trade or business, and Entertainment directly precedes or follows a substantial business discussion. Other Rules You cannot deduct the cost of your meal as an entertainment expense if you are claiming the meal as a travel expense. You cannot deduct expenses that are lavish or extravagant under the circumstances. You generally can deduct only 50% of your unreimbursed entertainment expenses. A. TRAVEL EXPENSES These are the ordinary and necessary expenses of traveling away from home for business. An individual is traveling away from home if both the following conditions are met: His duties require him to be away from the general area of his tax home (defined later) substantially longer than an ordinary day's work; and He needs to get sleep or rest to meet the demands of his work while away from home. 1. Tax Home Generally, a person s tax home is his regular place of business, regardless of where he maintains his family home. It includes the entire city or general area in which a business is located. Business Expenses 10-26

292 2. Deductible Expenses The following is a brief summary of the expenses that can be deducted: The cost of travel by airplane, train, bus, or car between home and business destination; Fares for taxis, commuter buses and other types of transportation between the airport or station and a hotel, or between the hotel and a work location away from home; The cost of sending baggage and sample or display material between a regular and temporary work location; The costs of operating and maintaining a vehicle when traveling away from home on business. The individual can deduct actual expenses or the standard mileage rate (discussed earlier), as well as business-related tolls and parking. If an individual rents a car while away from home on business, he can deduct only the business-use portion of the expenses; The cost of meals and lodging if a business trip is overnight or long enough that an individual needs to stop for sleep or rest to properly perform his duties. In most cases, the individual can deduct only 50% of his meal expenses; The costs of dry cleaning and laundry while on a business trip; The cost of business calls while on a business trip, including business communication by fax machine or other communication devices; and The tips paid for any expense in this list. B. ENTERTAINMENT EXPENSES An individual may be able to deduct business-related entertainment expenses for entertaining a client, customer, or employee. In most cases, the individual can deduct only 50% of these expenses. The following are examples of entertainment expenses: Entertaining guests at nightclubs, athletic clubs, theaters, or sporting events; and Providing meals, a hotel suite, or a car to business customers or their families. An employer generally can deduct the amount it reimburses employees for travel and entertainment expenses. The reimbursement deducted and the manner in which it is deducted depend in part on whether the employer reimburses the expenses under an accountable plan or a nonaccountable plan. Business Expenses 10-27

293 V. Business Use of the Home A. TEST FOR DEDUCTIBILITY If an individual uses part of his home for business, he may be able to deduct expenses for the business use of his home. These expenses may include mortgage interest, insurance, utilities, repairs, and depreciation. To qualify to claim expenses for the business use of his home, the individual must meet the following tests: The business part of his home must be used exclusively and regularly for his trade or business; and The business part of his home must be one of the following: a. His principal place of business; b. A place where he meets or deals with patients, clients, or customers in the normal course of his trade or business; or c. A separate structure (not attached to his home) he uses in connection with his trade or business. A person generally does not have to meet the exclusive use test for the part of his home that he regularly uses in either of the following ways: (a) for the storage of inventory or product samples; or (b) as a daycare facility. 1. Exclusive Use Test An individual s home office qualifies as his principal place of business if the following requirements are met: He uses the office exclusively and regularly for administrative or management activities of his trade or business; and He has no other fixed location where he conducts substantial administrative or management activities of his trade or business. Alternatively, if an individual uses his home exclusively and regularly for his business, but his home office does not qualify as the principal place of business based on the previous rules, the individual can determine his principal place of business based on the following factors: The relative importance of the activities performed at each location; and If the relative importance factor does not determine his principal place of business, he also can consider the time spent at each location. Business Expenses 10-28

294 Example. Jack is an attorney and uses a den in his home to write legal briefs and prepare clients' tax returns. His family also uses the den for recreation. The den is not used exclusively in Jack s profession, so he cannot claim a business deduction for its use. 2. Exceptions to Exclusive Use An individual does not have to meet the exclusive use test if he uses part of his home in either of the following ways: For the storage of inventory or product samples; or As a daycare facility. 3. Regular Use To qualify under the regular use test, an individual must use a specific area of his home for business on a continuing basis. He does not meet the test if his business use of the area is only occasional or incidental, even if he does not use that area for any other purpose. 4. Principal Place of Business An individual can have more than one business location, including his home, for a single trade or business. To qualify to deduct the expenses for the business use of one s home under the principal place of business test, the individual s home must be his principal place of business for that business. To determine his principal place of business, all the facts and circumstances must be considered. A home office will qualify as a principal place of business for deducting expenses for its use if an individual meets the following requirements: He uses it exclusively and regularly for administrative or management activities of his business; and He has no other fixed location where he conducts substantial administrative or management activities of his business. Alternatively, if the individual uses his home exclusively and regularly for his business, but his home office does not qualify as his principal place of business based on the previous rules, he must determine his principal place of business based on the following factors: The relative importance of the activities performed at each location; and If the relative importance factor does not determine an individual s principal place of business, he can also consider the time spent at each location. Business Expenses 10-29

295 If, after considering the different business locations, an individual s home cannot be identified as his principal place of business, he cannot deduct home office expenses. B. DEDUCTION LIMIT If an individual s gross income from the business use of his home equals or exceeds his total business expenses (including depreciation), he can deduct all of his business expenses related to the use of his home. If the individual s gross income from the business use is less than his total business expenses, his deduction for certain expenses for the business use of the home is limited. The deduction of otherwise nondeductible expenses, such as insurance, utilities, and depreciation (with depreciation taken last), allocable to the business is limited to the gross income from the business use of an individual s home minus the sum of the following: The business part of expenses the individual could deduct even if he did not use his home for business (such as mortgage interest, real estate taxes, and casualty and theft losses that are allowable as itemized deductions on Schedule A (Form 1040)); and The business expenses that relate to the business activity in the home (for example, business phone, supplies, and depreciation on equipment), but not to the use of the home itself. VI. Limits and Exclusions for Deduction of Expenses A business usually cannot deduct the following as business expense: Bribes and kickbacks; Charitable contributions; Demolition expenses or losses; Dues to business, social, athletic, luncheon, sporting, airline, and hotel clubs; Lobbying expenses; Penalties and fines paid to a governmental agency or instrumentality because it broke the law; Political contributions; and Repairs that add to the value of its property or significantly increase its life. A. CHARITABLE CONTRIBUTIONS Cash payments to charitable, religious, educational, scientific, or similar organizations may be deductible as business expenses if the payments are not charitable contributions or gifts. If the payments are charitable contributions or gifts, the business cannot deduct Business Expenses 10-30

296 them as business expenses. However, corporations (other than S corporations) can deduct charitable contributions on their income tax returns. Sole proprietors, partners in a partnership, or shareholders in an S corporation may be able to deduct charitable contributions made by their business on Schedule A (Form 1040). Example. Bill paid $15 to a local church for a half-page ad in a program for a concert it is sponsoring. The purpose of the ad was to encourage readers to buy his products. Since Bill s payment is not a contribution, he cannot deduct it as such. However, he can deduct it as an advertising expense. B. BRIBES AND KICKBACKS A business cannot deduct bribes, kickbacks, or similar payments if they are either of the following: Paid directly or indirectly to an official or employee of any government or an agency or instrumentality of any government in violation of the law. If the government is a foreign government, the payments are not deductible if they are unlawful under the Foreign Corrupt Practices Act of 1977; or Paid directly or indirectly to a person in violation of any federal or state law (but only if that state law is generally enforced) that provides for a criminal penalty or for the loss of a license or privilege to engage in a trade or business. A state law is considered generally enforced unless it is never enforced or enforced only for infamous persons or persons whose violations are extraordinarily flagrant. For example, a state law is generally enforced unless proper reporting of a violation of the law results in enforcement only under unusual circumstances. 1. Types of Kickbacks Prohibited A kickback includes a payment for referring a client, patient, or customer. The common kickback situation occurs when money or property is given to someone as payment for influencing a third party to purchase from, use the services of, or otherwise deal with the person who pays the kickback. In many cases, the person whose business is being sought or enjoyed by the person who pays the kickback does not know of the payment. Example 1. Mr. Green, an insurance broker, pays part of the insurance commissions he earns to car dealers who refer insurance customers to him. The car dealers are not licensed to sell insurance. Mr. Green cannot deduct these payments if they are in violation of any federal or state law. Example 2. The Yard Corporation is in the business of repairing ships. It returns 10% of the repair bills as kickbacks to the captains and chief officers of vessels it repairs. It considers kickbacks necessary to get business. The owners Business Expenses 10-31

297 of the ships do not know of these payments. In the state where the corporation operates, it is unlawful to attempt to influence the actions of any employee, private agent, or fiduciary in relation to the principal's or employer's affairs by giving or offering anything of value without the knowledge and consent of the principal or employer. The state generally enforces the law. The kickbacks paid by the Yard Corporation are not deductible. 2. Reporting Kickbacks If a business pays kickbacks during its tax year, whether or not they are deductible on its income tax return, it may have to report them on an information return, Form 1099 MISC. C. CLUB DUES AND MEMBERSHIP FEES Generally, neither a business nor an individual can deduct amounts paid or incurred for membership in any club organized for business, pleasure, recreation, or any other social purpose. This includes country clubs, golf and athletic clubs, hotel clubs, sporting clubs, airline clubs, and clubs operated to provide meals under circumstances generally considered to be conducive to business discussions. None of the following organizations will be treated as a club organized for business, pleasure, recreation, or other social purpose unless one of the main purposes is to conduct entertainment activities for members or their guests or to provide members or their guests with access to entertainment facilities: Boards of trade; Business leagues; Chambers of commerce; Civic or public service organizations; Professional organizations such as bar associations and medical associations; Real estate boards; and Trade associations. D. DONATED INVENTORY If an individual contributes inventory (property he sells in the course of his business), the amount he can claim as a contribution deduction is the smaller of its fair market value on the day it is contributed or its basis. The basis of donated inventory is any cost incurred for the inventory in an earlier year that the individual would otherwise include in his opening inventory for the year of the contribution. He must remove the amount of his contribution deduction from his opening inventory. It is not part of the cost of goods sold. Business Expenses 10-32

298 A corporation (other than an S corporation) can deduct its basis in the property plus onehalf of the gain that would have been realized if the property had been sold at its fair market value on the date of contribution. But the deduction cannot be more than twice the property's basis. For more information on the charitable contribution of property by a corporation, see 170(e)(3) of the Internal Revenue Code. Example 1. Heidi owns an auto repair shop and in 2013 she donated auto parts to her local school for its auto repair class. The fair market value of the parts at the time of the contribution was $600 and she had included $400 for the parts in her opening inventory for Heidi s charitable contribution is $400. She reduces her opening inventory by the $400 for the donated property. Example 2. Assume the same facts as Example 1, except Heidi purchased the auto parts in 2013 for $400 (not part of the opening inventory). The $400 is included as part of the cost of goods sold for 2013 but not in figuring the basis of the property. Her charitable contribution is $0. E. DAMAGES RECOVERED Special rules apply to compensation an individual or entity receives for damages sustained as a result of patent infringement, breach of contract or fiduciary duty, or antitrust violations. This compensation must be included as income. However, an individual may be able to take a special deduction. The deduction applies only to amounts recovered for actual injury, not any additional amount. The deduction is the smaller of the following: The amount received or accrued for damages in the tax year reduced by the amount paid or incurred in the year to recover that amount; or The losses from the injury that have not been deducted. F. DEMOLITION EXPENSES OR LOSSES A business cannot deduct any amount paid or incurred to demolish a structure or any loss for the undepreciated basis of a demolished structure. These amounts must be added to the basis of the land where the demolished structure was located. G. DEPRECIATION If property an individual buys to use in his business has a useful life that extends substantially beyond the year it is placed in service, the individual generally cannot deduct the entire cost as a business expense in the year it is purchased. Rather, the cost must be spread over more than one tax year and deduct part of it each year. This method of deducting the cost of business property is called depreciation. Business Expenses 10-33

299 However, an owner may be able to elect to deduct a limited amount of the cost of certain depreciable property in the year it is placed in service in the business. This deduction is known as the 179 deduction, described immediately below. H. SECTION 179 DEDUCTION Under 179 of the Internal Revenue Code, a business can elect to recover all or part of the cost of certain qualifying property, up to a limit, by deducting it in the year the property is placed in service. This is referred to as a 179 deduction. Taxpayers can elect the 179 deduction in lieu of recovering the cost through depreciation deductions. Estates and trusts cannot elect the 179 deduction. 1. Eligible Property To qualify for the 179 deduction, the property must be one of the following types of depreciable property: Tangible personal property; Other tangible property (except buildings and their structural components) used as: a. An integral part of manufacturing, production, or extraction or of furnishing transportation, communications, electricity, gas, water, or sewage disposal services; b. A research facility used in connection with any of the activities in (a) above; or c. A facility used in connection with any of the activities in (a) for the bulk storage of fungible commodities; Single purpose agricultural (livestock) or horticultural structures; Storage facilities (except buildings and their structural components) used in connection with distributing petroleum or any primary product of petroleum; or Off-the-shelf computer software. 2. Property Acquired for Business Use To qualify for the 179 deduction, the property must have been acquired for use in the owner s trade or business. Property acquired only for the production of income, such as investment property, rental property (if renting property is not their trade or business), and property that produces royalties, does not qualify. 3. Partial Business Use When property is used for both business and nonbusiness purposes, the owner can elect the 179 deduction only if the property is used more than 50% for business in the year it is placed in service. If the property is used more than 50% for business, multiply Business Expenses 10-34

300 the cost of the property by the percentage of business use. Use the resulting business cost to figure the 179 deduction. Example. May Oak bought and placed in service an item of section 179 property costing $11,000. She used the property 80% for her business and 20% for personal purposes. The business part of the cost of the property is $8,800 (80% $11,000). 4. Property Acquired by Purchase To qualify for the 179 deduction, the property must have been acquired by purchase. For example, property acquired by gift or inheritance does not qualify. Property is not considered acquired by purchase in the following situations: It is acquired by one member of a controlled group from another member of the same group; Its basis is determined either In whole or in part by its adjusted basis in the hands of the person from whom it was acquired; or Under the stepped-up basis rules for property acquired from a decedent; or It is acquired from a related person. 5. Excepted Property Even if the requirements explained in the preceding discussions are met, an owner cannot elect the 179 deduction for the following property: Certain property leased to others (if the owner is a noncorporate lessor); Certain property used predominantly to furnish lodging or in connection with the furnishing of lodging; Air conditioning or heating units; Property used predominantly outside the United States (except property described in 168(g)(4) of the Internal Revenue Code); Property used by certain tax-exempt organizations (except property used in connection with the production of income subject to the tax on unrelated trade or business income); or Property used by governmental units or foreign persons or entities (except property used under a lease with a term of less than six months). Business Expenses 10-35

301 6. Dollar Limit The total amount a taxpayer can elect to deduct under 179 is limited. The Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) of 2003 increased the amount a taxpayer could deduct, for taxable years beginning in 2003 through 2005, to $100,000 of the cost of qualifying property placed in service for the taxable year. The $100,000 amount was reduced dollar-for-dollar (but not below zero) by the amount by which the cost of qualifying property placed in service during the taxable year exceeded $400,000. These amounts were indexed for inflation. In 2007, section 179 allowed taxpayers to expense up to $125,000 on qualifying property placed in service during the tax year, and the phase out began for amounts spent over $500,000 in that tax year, adding to the small business tax incentive. In 2008, the Economic Stimulus Act increased the previous section 179 deduction to $250,000, and increased the dollar-for-dollar phase out on total property purchased to $800,000. The American Recovery and Reinvestment Act of 2009 extended these amounts for another year (2009). For 2013, Congress again extended the previous years section 179 deduction limits. They currently equal a $500,000 (maximum) first year deduction with total phaseout beginning at $2,000,000 and ending at $2,500,000. If more than one qualifying property is placed in service during the year, the taxpayer can allocate the section 179 deduction among the items in any way, as long as the total does not exceed $500,000. The full deduction does not need to be claimed. Also, see the latest IRS guidance on section 179 deduction limits for luxury vehicles and those with gross vehicle weight (GVW) exceeding 6,000 pounds. The amount that can be elected to deduct is not affected if the taxpayer places qualifying property in service in a short tax year or if he places qualifying property in service for only a part of a 12-month tax year. After applying the dollar limit to determine a tentative deduction, a taxpayer must apply the business income limit (described later) to determine their actual 179 deduction. 7. Business Income Limit The total cost a taxpayer can deduct each year after applying the dollar limit is limited to the taxable income from the active conduct of any trade or business during the year. Generally, a taxpayer is considered to actively conduct a trade or business if he meaningfully participates in the management or operations of the trade or business. Any cost not deductible in one year under 179 because of this limit can be carried to the next year. 8. Electing the Deduction To elect a 179 deduction, a taxpayer must file Form 4562 with either of the following: His original tax return filed for the year the property was placed in service (whether or not it is filed timely); or An amended return filed no later than the due date (including extensions) for the return for the year the property was placed in service. Business Expenses 10-36

302 If a taxpayer timely filed his return for the year without making the election, he still can make the election by filing an amended return within six months of the due date of the return (excluding extensions). Taxpayers must keep records that show the specific identification of each piece of qualifying 179 property. These records must show how the property was acquired, the person it was acquired from and when it was placed in service. 9. Revoking an Election If a taxpayer elected a 179 deduction, he can revoke his election (or his selection of qualifying property subject to a deduction) by filing an amended return without IRS approval. Once made, the revocation is irrevocable. Prior to the enactment of JGTRRA (and for taxable years beginning in 2006 and thereafter), an expensing election could be revoked only with consent of the Commissioner of the IRS. JGTRRA permits taxpayers to revoke expensing elections on amended returns without the consent of the Commissioner with respect to a taxable year beginning after 2002 and before The American Jobs Creation Act of 2004 permits taxpayers to revoke expensing elections on amended returns without the consent of the Commissioner with respect to a taxable year beginning before For years after 2008, see IRS Publication 946 for latest guidance on revoking prior 179 deduction elections. I. DONATIONS TO BUSINESS ORGANIZATIONS An individual can deduct donations to business organizations as business expenses if all the following conditions are met: The donation relates directly to the donor s trade or business; The donor reasonably expects a financial return in line with his donation; and The donation is not a nondeductible lobbying expense (discussed later). For example, a donation made to a committee organized by the Chamber of Commerce to bring a national convention to the donor s city may be deductible. J. EDUCATION EXPENSES An individual can deduct the ordinary and necessary expenses paid for the education and training of his employees. An individual can also deduct his own education expenses (including certain related travel) related to his trade or business. The individual must be able to show the education maintains or improves skills required in his trade or business, or it is required by law or regulations, for keeping his license, status, or job. Individuals cannot deduct education expenses incurred to meet the minimum requirements of their present trade or business, or those that qualify them for a new trade or business. This is true even if the education maintains or improves skills presently required in the individual s business. Business Expenses 10-37

303 Example 1. Dr. Carter, who is a psychiatrist, begins a program of study at an accredited psychoanalytic institute to qualify as a psychoanalyst. She can deduct the cost of the program because the study maintains or improves skills required in her profession and does not qualify her for a new one. Example 2. Herb Jones owns a repair shop for electronic equipment. The bulk of the business is television repairs, but occasionally he fixes tape decks and disc players. To keep up with the latest technical changes, he takes a special course to learn how to repair disc players. Since the course maintains and improves skills required in his trade, he can deduct its cost. K. ENVIRONMENTAL CLEANUP COSTS An owner can deduct certain costs to clean up land and to treat groundwater it contaminated with hazardous waste from business operations. The costs incurred to restore the land and groundwater to the same physical condition that existed prior to contamination are deductible. The owner cannot deduct costs for the construction of groundwater treatment facilities. Likewise, the owner must capitalize those costs and they are recoverable through depreciation. L. FRANCHISE, TRADEMARK, TRADE NAME If an individual buys a franchise, trademark, or trade name, he can deduct the amount paid or incurred as a business expense only if the payments are part of a series of payments that are: Contingent on productivity, use, or disposition of the item; Payable at least annually for the entire term of the transfer agreement; and Substantially equal in amount (or payable under a fixed formula). A franchise includes an agreement that gives one of the parties to the agreement the right to distribute, sell, or provide goods, services, or facilities within a specified area. 1. Property Acquired After August 10, 1993 (or after July 25, 1991, if elected) Any amounts paid or incurred that are not described above must be charged to a capital account. These are 197 intangibles and are amortized over 15 years. The taxpayer can elect to apply this treatment to any franchise, trademark, or trade name acquired after July 25, This election is binding and cannot be revoked without approval of the IRS. Business Expenses 10-38

304 2. Property Acquired Before August 11, 1993 For a transfer not treated as a sale or exchange of a capital asset, a taxpayer can deduct a lump-sum payment of an agreed upon principal amount ratably over the shorter of the following: 10 years; or The period of the transfer agreement. For a transfer not treated as a sale or exchange of a capital asset, a taxpayer can deduct, in the year made, a payment that is one of a series of approximately equal payments payable over either of the following: The period of the transfer agreement; or A period of more than 10 years, regardless of the period of the agreement. The above business deductions do not apply to transfers after October 2, 1989, and before August 11, 1993, if the principal sum is over $100,000. Any payment not deductible because of these rules should be charged to a capital account. However, the taxpayer can deduct the payments charged to a capital account over the life of the asset if he can determine the useful life of the asset. Otherwise, he can choose to amortize the payment over a 25-year period beginning with the tax year the transfer occurs. 3. Contracts Entered Into Before October 3, 1989 For contracts to buy a franchise, trademark, or trade name entered into before October 3, 1989, a taxpayer can deduct payments contingent on productivity, use, or disposition. The rules discussed earlier for annual and substantially equal payments do not apply. 4. Disposition of Franchise, Trademark, or Trade Name If a business transfers, sells, or otherwise disposes of a franchise, trademark, or trade name, it must recapture as ordinary income (up to any gain realized) the payments it deducted as any of the following: A lump-sum or serial payment of a principal amount not treated as a sale or exchange of a capital asset; An amortized payment deducted over 25 years; and The amortization claimed on 197 intangibles. M. IMPAIRMENT-RELATED EXPENSES If an individual is disabled, he can deduct expenses necessary for him to be able to work (impairment-related expenses) as a business expense, rather than as a medical expense. Business Expenses 10-39

305 An individual is considered disabled if he has either of the following: A physical or mental disability (for example, blindness or deafness) that functionally limits his being employed; or A physical or mental impairment that substantially limits one or more of his major life activities. The expenses can be deducted as a business expense if all the following apply: The individual s work clearly requires the expense for him to satisfactorily perform the work; The goods or services purchased are clearly not needed or used, other than incidentally, in the individual s personal activities; and His treatment is not specifically provided for under other tax law provisions. Example. Roger is blind. He must use a reader to do his work, both at and away from his place of work. The reader's services are only for Roger s work. He can deduct this expense for the reader as a business expense. N. LICENSE AND REGULATORY FEES Licenses and regulatory fees for an individual s trade or business paid each year to state or local governments generally are deductible. Some licenses and fees may have to be amortized. O. LOBBYING EXPENSES Generally, a business cannot deduct lobbying expenses. 1. Lobbying Defined Lobbying expenses include amounts paid or incurred for any of the following activities: Influencing legislation; Participating in or intervening in any political campaign for, or against, any candidate for public office; Attempting to influence the general public, or segments of the public, about elections, legislative matters, or referendums; Communicating directly with covered executive branch officials (defined later) in any attempt to influence the official actions or positions of those officials; and Researching, preparing, planning, or coordinating any of the preceding activities. Business Expenses 10-40

306 Expenses for influencing legislation and communicating directly with a covered executive branch official include a portion of a business s labor costs and general and administrative costs of the business. A business cannot take a charitable or business expense deduction for amounts paid to an organization if both the following apply: The organization conducts lobbying activities on matters of direct financial interest to the business; and A principal purpose of the contribution is to avoid the rules that prohibit a business deduction for lobbying expenses. If a tax-exempt organization, other than a 501(c)(3) organization, provides a business with a notice on the part of dues that is allocable to nondeductible lobbying and political expenses, the business cannot deduct that part of the dues. 2. Covered Executive Branch Official For purposes of this discussion, a covered executive branch official is any of the following: The President; The Vice President; Any officer or employee of the White House Office of the Executive Office of the President and the two most senior level officers of each of the other agencies in the Executive Office; or Any individual who: Is serving in a position in Level I of the Executive Schedule under section 5312 of title 5, United States Code; Has been designated by the President as having Cabinet-level status; or Is an immediate deputy of an individual listed above. 3. Exceptions to Denial of Deduction The general denial of the deduction does not apply to the following: Expenses of appearing before, or communicating with, any local council or similar governing body concerning its legislation (local legislation) if the legislation is of direct interest to the individual or entity and an organization of which they are a member. An Indian tribal government is treated as a local council or similar governing body; Any in-house expenses for influencing legislation and communicating directly with a covered executive branch official if those expenses for the tax year do not exceed $2,000 (excluding overhead expenses); and Business Expenses 10-41

307 Expenses incurred by taxpayers engaged in the trade or business of lobbying (professional lobbyists) on behalf of another person (but does apply to payments by the other person to the lobbyist for lobbying activities). P. MOVING MACHINERY Generally, the cost of moving machinery from one city to another is a deductible expense. So is the cost of moving machinery from one plant to another, or from one part of a plant to another. A business can deduct the cost of installing the machinery in the new location. However, it must capitalize the costs of installing or moving newly purchased machinery. Q. OUTPLACEMENT SERVICES A business can deduct the costs of outplacement services it provides to its employees to help them find new employment, such as career counseling, resumé assistance, skills assessment, etc. The costs of outplacement services may cover more than one deduction category. For example, deduct as a utilities expense the cost of telephone calls made under this service and deduct as rental expense the cost of renting machinery and equipment for this service. R. PENALTIES AND FINES Penalties a business pays for late performance or nonperformance of a contract are generally deductible. For instance, if a partnership contracted to construct a building by a certain date and had to pay an amount for each day the building was not finished after that date, the partners can deduct the amounts paid or incurred. On the other hand, a business cannot deduct penalties or fines paid to any government agency or instrumentality because of a violation of any law. These fines or penalties include the following amounts: Paid because of a conviction for a crime or after a plea of guilty or no contest in a criminal proceeding; Paid as a penalty imposed by federal, state, or local law in a civil action, including certain additions to tax and additional amounts and assessable penalties imposed by the Internal Revenue Code; Paid in settlement of actual or possible liability for a fine or penalty, whether civil or criminal; or Forfeited as collateral posted for a proceeding that could result in a fine or penalty. Business Expenses 10-42

308 Examples of nondeductible penalties and fines include the following: Fines for violating city housing codes; Fines paid by truckers for violating state maximum highway weight laws; Fines for violating air quality laws; and Civil penalties for violating federal laws regarding mining safety standards and discharges into navigable waters. A fine or penalty does not include any of the following: Legal fees and related expenses to defend oneself in a prosecution or civil action for a violation of the law imposing the fine or civil penalty; Court costs or stenographic and printing charges; or Compensatory damages paid to a government. S. POLITICAL CONTRIBUTIONS A business cannot deduct contributions or gifts to political parties or candidates as business expenses. In addition, it cannot deduct expenses paid or incurred to take part in any political campaign of a candidate for public office. A business cannot deduct indirect political contributions and costs of taking part in political activities as business expenses. Examples of nondeductible expenses include the following: Advertising in a convention program of a political party, or in any other publication if any of the proceeds from the publication are for, or intended for, the use of a political party or candidate; Admission to a dinner or program (including, but not limited to, galas, dances, film presentations, parties, and sporting events) if any of the proceeds from the function are for, or intended for, the use of a political party or candidate; or Admission to an inaugural ball, gala, parade, concert, or similar event if identified with a political party or candidate. T. REPAIRS The cost of repairing or improving property used in a trade or business is either a deductible or capital expense. The business can deduct repairs that keep its property in a normal efficient operating condition, but that do not add to its value or usefulness or appreciably lengthen its life. If the repairs add to the value or usefulness of property or significantly increase its life, the business must capitalize them. Although a business cannot deduct capital expenses as current expenses, it can usually deduct them over a period of time as depreciation. Business Expenses 10-43

309 The cost of repairs includes the costs of labor, supplies, and certain other items. A business cannot deduct the value of the owner s own labor. Examples of repairs include the following: Patching and repairing floors; Repainting the inside and outside of a building; Repairing roofs and gutters; and Mending leaks. A business cannot deduct the cost of repairs added to the cost of goods sold as a separate business expense. Business Expenses 10-44

310 Chapter 10 Review Questions The following questions are designed to ensure that you have a complete understanding of the information presented in the chapter. They do not need to be submitted in order to receive CPE credit. They are included as an additional tool to enhance your learning experience. We recommend that you answer each review question and then compare your response to the suggested solution before answering the final exam questions related to this chapter. 1. An ordinary expense is one that a business owner feels he must make in order to improve the economic outlook of the enterprise. a) true b) false 2. The cost of products or raw materials is used to determine the cost of goods sold. a) true b) false 3. Which of the following business expenses must be capitalized: a) improvements b) the cost of going into business c) business assets d) all of the above 4. A business owner cannot deduct personal living expenses as a business expense. a) true b) false 5. There is generally no limit to deductions that a not-for-profit enterprise can take. a) true b) false 6. A bad debt is typically the result of which of the following: a) poor management b) credit sales to customers c) employee theft d) bad products Business Expenses 10-45

311 7. What is the general rule regarding the deductibility of employee wages: a) employers may deduct employee wages in all cases, regardless of how much the employee is being paid and what his job entails b) employers may deduct wages that are reasonable for services actually performed c) employers may deduct 50 percent of employee wages as a business expense d) employers may deduct employee wages so long as they do not exceed 75 percent of the employer s gross income 8. What percentage of the cost of meals for employees or owners while traveling can a business deduct: a) 25 percent b) 50 percent c) 75 percent d) 100 percent 9. A business owner can generally deduct as a business expense all interest he pays or accrues during the tax year on debts related to the business. a) true b) false 10. The expense of advertising a specific product or service is generally deductible, while the cost of so-called institutional advertising is severely limited. a) true b) false 11. Which of the following are requirements for an individual to deduct the use of his home for business: a) the home must be used regularly for business b) the home must be used more than occasionally for business c) the part of the home being considered business use must be used regularly and exclusively for business d) the business must pay rent to the homeowner 12. Charitable contributions are generally not deductible as business expenses. a) true b) false 13. A business can deduct membership dues in which of the following types of clubs or social organizations: a) country clubs b) public service organizations c) trade associations d) both b and c above Business Expenses 10-46

312 14. Under which of the following circumstances can a business owner deduct education expenses: a) when they are incurred for the education of his employees b) under any circumstances, as it is good public policy to encourage education c) when it is incurred for himself and is related to his business or trade d) either a or c above 15. Taxpayers may deduct certain costs associated with cleaning up contaminated land or groundwater. a) true b) false 16. Which of the following statements about expenses incurred in lobbying government agencies and officials is most correct: a) expenses incurred in lobbying are always deductible to the extent the lobbying efforts are directly related to the business b) the IRS allows businesses to deduct 50 percent of their expenses incurred in lobbying to the extent those lobbying efforts are directly related to the business c) lobbying expenses are generally not deductible d) lobbying expenses are only deductible to the extent they involve an integral part of the business Business Expenses 10-47

313 Chapter 10 Solutions and Suggested Responses 1. A: True is incorrect. While an ordinary expense may fall into this category, it is not the definition which the IRS uses to determine whether the business may properly deduct an expense. B: False is correct. To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in a particular field of business. (See page 10-1 of the course material.) 2. A: True is correct. Other expenses that go into calculating the cost of goods sold are the cost of having raw materials shipped to the business, the cost of storing the products the business sells, direct labor costs for workers who produce the goods, and factory overhead expenses. B: False is incorrect. Expenses that go into calculating the cost of goods sold do include the cost of the raw materials. (See page 10-1 of the course material.) 3. A: Incorrect. The cost associated with making improvements to a business asset are generally required to be capitalized. However, this is not the most correct answer. B: Incorrect. The costs associated with starting a business, including wages and advertising, generally must be capitalized. However, this is not the best answer. C: Incorrect. The cost of business assets such as property, machinery and the like must generally be capitalized. However, this is not the best answer. D: Correct. Each of the above types of business expenses must generally be capitalized, meaning the full cost cannot be deducted in the year the expense was incurred. (See page 10-3 of the course material.) 4. A: True is correct. Generally, a business cannot deduct personal, living, or family expenses. B: False is incorrect. While such expenses are generally not deductible, if an individual has an expense for something that is used partly for business and partly for personal purposes, he may divide the total cost between the business and personal parts. He can deduct as a business expense only the business part. (See page 10-4 of the course material.) Business Expenses 10-48

314 5. A: True is incorrect. If an individual does not carry on his business or investment activity to make a profit, there is a limit on the deductions he can take. He cannot use a loss from the activity to offset other income. B: False is correct. The limit on not-for-profit losses applies to individuals, partnerships, estates, trusts, and S corporations. It does not apply to corporations other than S corporations. (See page 10-6 of the course material.) 6. A: Incorrect. Poor management can lead to bad decisions, but this is not the direct cause of a bad debt. B: Correct. The most common way a business will incur a bad debt is through extending credit to a customer who does not pay. C: Incorrect. This can account for loss, but is not considered bad debt. D: Incorrect. It is failure to pay for goods or services that results in the creation of bad debt. (See page 10-8 of the course material.) 7. A: Incorrect. Wages must be reasonable and ordinary to be deductible and must be paid for services actually performed. B: Correct. This is the general test for deductibility. Employers therefore cannot deduct as a business expense unreasonable wages based on industry standards or wages for employees who did not actually perform work. C: Incorrect. There is no such rule. D: Incorrect. There is no such cap. All reasonable and ordinary wages are deductible. (See page of the course material.) Business Expenses 10-49

315 8. A: Incorrect. The actual percentage is higher. B: Correct. Employers can usually deduct the cost of furnishing meals and lodging to their employees. However, employers can generally deduct only 50% of the cost of furnishing meals. The theory is that the employee has to eat anyway, so the cost is not completely business related. C: Incorrect. The actual percentage is lower. D: Incorrect. The actual percentage is lower. (See page of the course material.) 9. A: True is correct. Interest relates to their business if the proceeds of the loan are used for a business expense. It does not matter what type of property secures the loan. The owner can deduct interest on a debt only if he meets all of the following requirements: 1) he is legally liable for that debt; 2) both the owner and the lender intend that the debt be repaid; and 3) the owner and the lender have a true debtorcreditor relationship. B: False is incorrect. Such expenses are generally deductible, subject to the rules above. (See page of the course material.) 10. A: True is incorrect. Both types of advertising are normally deductible. B: False is correct. A business can usually deduct as a business expense the cost of institutional or goodwill advertising to keep the firm s name before the public if it relates to business the owner reasonably expects to gain in the future. (See page of the course material.) 11. A: Incorrect. The standard for deducting part of a home for business is much more stringent than this. B: Incorrect. The home must be used regularly, not just sporadically or occasionally. Other requirements apply as well. C: Correct. Both requirements must be met. The test to deduct use of a home for business is a difficult one to meet. D: Incorrect. This is not one of the requirements for deductibility. (See page of the course material.) Business Expenses 10-50

316 12. A: True is correct. If the payments are charitable contributions or gifts, the business cannot deduct them as business expenses. B: False is incorrect. Cash payments to charitable, religious, educational, scientific, or similar organizations may be deductible as business expenses if the payments are not charitable contributions or gifts. However, corporations (other than S corporations) can deduct charitable contributions on their income tax returns. Sole proprietors, partners in a partnership, or shareholders in an S corporation may be able to deduct charitable contributions made by their business on Schedule A (Form 1040). (See pages to of the course material.) 13. A: Incorrect. Membership in a country club, even if primarily for business purposes, is not deductible. B: Incorrect. Membership dues in public service organizations such as Rotary can be deducted unless one of the main purposes is to conduct entertainment activities, but this is not the best answer. C: Incorrect. Membership dues in a trade association are deductible business expenses, as long as they do not have as one of their main purposes to conduct entertainment activities, but this is not the best answer. D: Correct. Both dues for public service organizations and trade associations are deductible expenses if they help the taxpayer carry out his duties. (See page of the course material.) 14. A: Incorrect. A business may deduct as a business expense education and training programs for its employees. However, this is not the best answer. B: Incorrect. While it certainly is good public policy to encourage education, there are limits to what a business can deduct. C: Incorrect. A business owner can deduct as a business expense educational costs incurred for himself if such program is related to their business or trade. However, this is not the best answer. D: Correct. Because both A and C are correct, D is the best answer. (See page of the course material.) Business Expenses 10-51

317 15. A: True is correct. Such expenses are deductible if the contamination is caused by the taxpayer s business operations. B: False is incorrect. This is deemed to be a valid business expense. (See page of the course material.) 16. A: Incorrect. To the contrary, lobbying expenses are not deductible regardless of what they are related to. B: Incorrect. No part of lobbying expenses is deductible regardless of their purpose. C: Correct. The general rule is that expenses incurred in lobbying cannot be deducted. D: Incorrect. It does not matter whether or not the issue is integral to the business. Lobbying expenses are not deductible. (See pages to of the course material.) Business Expenses 10-52

318 Chapter 11: Figuring Net Profit or Loss I. Overview After figuring business income and expenses, the next step is to figure the net profit or net loss from the business. This is done by subtracting business expenses from business income. If expenses are less than income, the difference is net profit and becomes part of income on page 1 of Form If expenses are more than the business s income, the difference is a net loss. The loss can usually be deducted from gross income on page 1 of Form But in some situations the loss is limited. This chapter briefly explains two of those situations. Other situations that may limit a business s loss are explained in the instructions for line G and line 32 of Schedule C. If an individual has more than one business, he must figure his net profit or loss for each business on a separate Schedule C. A. NET OPERATING LOSSES (NOLs) If deductions for the year are more than the business s income for the year, the business may have a net operating loss (NOL). A business can use an NOL by deducting it from its income in another year or years. Examples of typical losses that may produce an NOL include, but are not limited to, losses incurred from the following: The taxpayer s trade or business; The taxpayer s work as an employee (unreimbursed employee business expenses); A casualty or theft; Moving expenses; or Rental property. A loss from operating a business is the most common reason for an NOL. B. NOT-FOR-PROFIT ACTIVITIES If an individual does not carry on his business to make a profit, there is a limit on the deductions that can be taken. The individual cannot use a loss from the activity to offset other income. Activities conducted as a hobby, or mainly for sport or recreation, come under this limit. Figuring Net Profit or Less 11-1

319 Chapter 11 Review Questions The following questions are designed to ensure that you have a complete understanding of the information presented in the chapter. They do not need to be submitted in order to receive CPE credit. They are included as an additional tool to enhance your learning experience. We recommend that you answer each review question and then compare your response to the suggested solution before answering the final exam questions related to this chapter. There are no review questions associated with this chapter. Figuring Net Profit or Less 11-2

320 Chapter 12: Maintaining Business Records I. General Record Keeping Requirements A. THE VALUE OF BUSINESS RECORDS This chapter explains why small businesses must keep records, what kinds of records they must keep, and how to keep them. It also explains how long a business must keep its records for federal tax purposes. Everyone in business must keep records. The following are advantages of maintaining good records: A business owner needs good records to monitor the progress of his or her business. Records can show whether the business is improving, which items are selling, or what changes need to be made; Good records can increase the likelihood of business success; Businesses need good records to prepare accurate financial statements. These include income statements and balance sheets. These statements can help the business in dealing with its bank or creditors and help manage the business; A business will generally receive money or property from many sources. Accurate records can identify the source of the receipts. This information is necessary to separate business from non-business receipts and taxable from nontaxable income; Good records can help a business to keep track of deductible expenses; Good records are necessary to prepare tax returns. These records must support the income, expenses, and credits that are reported; and Support items reported on tax returns. Businesses must have records available at all times for inspection by the IRS. B. TYPES OF RECORDS TO KEEP Except in a few cases, the law does not require any specific kind of records. Owners can choose any record-keeping system suited to their business that clearly shows their income and expenses. The business a particular owner is in affects the type of records he will need to keep for federal tax purposes. Owners should set up their record-keeping system using an accounting method that clearly shows their income for their chosen tax year. If an owner is in more than one business, he should keep a complete and separate set of records for each business. A corporation, for example, should keep minutes of board of directors' meetings. Maintaining Business Records 12-1

321 A good record-keeping system should include a summary of all business transactions. This summary is ordinarily made in the business s books (for example, accounting journals and ledgers). The books must show the business s gross income, as well as its deductions and credits. For most small businesses, the business checkbook is the main source for entries in the business books. In addition, supporting documents, discussed immediately below, should be retained. 1. Supporting Documents Purchases, sales, payroll, and other transactions made in a business generate supporting documents. Supporting documents include sales slips, paid bills, invoices, receipts, deposit slips, and canceled checks. These documents contain information a business needs to record in its books. It is important to keep these documents because they support the entries in the business s books and on its tax return. 2. Gross Receipts Gross receipts are the income an owner receives from his business. Supporting documents that show the amounts and sources of a company s gross receipts should be retained. Documents that show gross receipts include the following: Cash register tapes; Bank deposit slips; Receipt books; Invoices; Credit card charge slips; and Forms 1099 MISC. 3. Purchases Purchases are the items a business buys and resells to customers. If a business is a manufacturer or producer, this includes the cost of all raw materials or parts purchased for manufacture into finished products. The supporting documents should show the amount paid and that the amount was for purchases. Documents for purchases include the following: Canceled checks; Cash register tape receipts; Credit card sales slips; and Invoices. Maintaining Business Records 12-2

322 These records will help the business determine the value of its inventory at the end of the year. 4. Expenses Expenses are the costs incurred (other than purchases) to carry on the business. Supporting documents should show the amount paid and that the amount was for a business expense. Documents for expenses include the following: Canceled checks; Cash register tapes; Account statements; Credit card sales slips; Invoices; and Petty cash slips for small cash payments. A petty cash fund allows a business to make small payments without having to write checks for small amounts. Each time a payment is made from this fund, the responsible person should make out a petty cash slip and attach it to the receipt as proof of payment. 5. Assets Assets are the property, such as machinery and furniture that a business owns and uses. An owner must keep records to verify certain information about his business assets. Records are needed to figure the annual depreciation and the gain or loss when assets are sold. These records should show the following information: When and how an asset was acquired; Purchase price; Cost of any improvements; Section 179 deduction taken; Deductions taken for depreciation; Deductions taken for casualty losses, such as losses resulting from fires or storms; How the asset was used; When and how the asset was disposed of; Selling price; and Maintaining Business Records 12-3

323 Expenses of sale. The following types of documents may show this information: Purchase and sales invoices; Real estate closing statements; or Canceled checks. C. RECORDING BUSINESS TRANSACTIONS A good record-keeping system includes a summary of all business transactions. Business transactions are ordinarily summarized in books called journals and ledgers. Whether a business keeps journals and ledgers and how they are kept depends on the type of business. For example, a record-keeping system for a small business might include the following items: Business checkbook; Daily summary of cash receipts; Monthly summary of cash receipts; Check disbursements journal; Depreciation worksheet; and Employee compensation record. 1. Business Checkbook One of the first things an individual should do when he starts a business is to open a business checking account. The business account should be separate from the owner s personal checking account. The business checkbook is a basic source of information for recording business expenses. All daily receipts should be deposited in the business checking account. All payments should be made by check to document business expenses. Owners should write checks payable to themselves only when making withdrawals from the business for personal use. The business account should be used for business purposes only. The source of deposits and the type of expense should be indicated in the checkbook. Maintaining Business Records 12-4

324 D. BOOKKEEPING SYSTEM A business must decide whether to use a single-entry or a double-entry bookkeeping system. The single-entry system of bookkeeping is the simplest to maintain, but it may not be suitable for everyone. Some people may find the double-entry system better because it has built-in checks and balances to assure accuracy and control. 1. Single-Entry A single-entry system is based on the income statement (profit or loss statement). It can be a simple and practical system if an individual is starting a small business. The system records the flow of income and expenses through the use of: A daily summary of cash receipts; and Monthly summaries of cash receipts and disbursements. 2. Double-Entry A double-entry bookkeeping system uses journals and ledgers. Transactions are first entered in a journal and then posted to ledger accounts. These accounts show income, expenses, assets (property a business owns), liabilities (debts of a business), and net worth (excess of assets over liabilities). Income and expense accounts are closed at the end of each tax year. Asset, liability, and net worth accounts, on the other hand, are kept open on a permanent basis. In the double-entry system, each account has a left side for debits and a right side for credits. It is self-balancing because every transaction is recorded as a debit entry in one account and as a credit entry in another. Under this system, the total debits must equal the total credits after the journal entries have been posted into the ledger accounts. If the amounts do not balance, an error has been made and must be corrected. 3. Computerized System There are computer software packages that can be used for record-keeping. They can be purchased in many retail stores. These packages are very helpful and relatively easy to use; they require very little knowledge of bookkeeping and accounting. Businesses that use a computerized system must be able to produce sufficient legible records to support and verify entries made on a tax return and determine the business s correct tax liability. To meet this qualification, the machine-sensible records must reconcile with the business s books and return. These records must provide enough detail to identify the underlying source documents. The business must also keep all machine-sensible records and a complete description of the computerized portion of its record-keeping system. This documentation must be sufficiently detailed to show all of the following items: Maintaining Business Records 12-5

325 Functions being performed as the data flows through the system; Controls used to ensure accurate and reliable processing; Controls used to prevent the unauthorized addition, alteration, or deletion of retained records; and Charts of accounts and detailed account descriptions. 4. Microfilm Microfilm and microfiche reproductions of general books of accounts, such as cash books, journals, voucher registers, and ledgers, are accepted for record-keeping purposes if they comply with Revenue Procedure in Cumulative Bulletin Electronic Storage System Records maintained in an electronic storage system are accepted for record-keeping purposes if the system complies with Revenue Procedure in Cumulative Bulletin An electronic storage system is one that either images hardcopy (paper) books and records or transfers computerized books and records to an electronic storage media, such as an optical disk. E. HOW LONG MUST RECORDS BE MAINTAINED A business must keep its records as long as they may be needed for the administration of any provision of the Internal Revenue Code. Generally, this means the business must keep records that support an item of income or deduction on a return until the period of limitations for that return runs out. The period of limitations is the period of time in which the business can amend its return to claim a credit or refund, or the IRS can assess additional tax. Table 12.1 contains the periods of limitations that apply to income tax returns. Unless otherwise stated, the years refer to the period after the return was filed. Returns filed before the due date are treated as filed on the due date. 1. Tax Returns A business should keep copies of its filed tax returns. They help in preparing future tax returns and making computations if an amended return must be filed. 2. Employment Taxes If a business has employees, it must keep all employment tax records for at least four years after the date the tax becomes due or is paid, whichever is later. Maintaining Business Records 12-6

326 3. Assets A business should keep records relating to property until the period of limitations expires for the year in which it disposes of the property in a taxable disposition. It must keep these records to figure any depreciation, amortization, or depletion deduction, and to figure the basis for computing gain or loss when it sells or otherwise disposes of the property. Generally, if a business has received property in a nontaxable exchange, its basis in that property is the same as the basis of the property it gave up, increased by any money it paid. The business must keep the records on the old property, as well as on the new property, until the period of limitations expires for the year in which it disposes of the new property in a taxable disposition. 4. Records for Non-Tax Purposes There may be other, non-tax reasons to maintain certain business records. For example, an insurance company or creditors may require the business to keep them longer than the IRS does. Table 12.1 Period of Limitations IF you... THEN the period is Owe additional tax and situations (2), (3) 3 years and (4) below do not apply to you 2. Do not report income that you should 6 years report and it is more than 25% of the gross income shown on your return 3. File a fraudulent return Not limited 4. Do not file a return Not limited 5. File a claim for credit or refund after you Later of 3 years or 2 years after tax was filed your return paid 6. File a claim for a loss from worthless 7 years securities or a bad debt deduction II. Records for Certain Types of Business Expenses Certain types of business expenses often require heightened record-keeping to fulfill IRS requirements. Below are a few common examples. A. BUSINESS GIFTS Taxpayers must generally be able to show that the gift was ordinary and necessary to their business in order for the cost to be a deductible business expense. The following must often be shown: The cost of the gift; The date of the gift; Maintaining Business Records 12-7

327 A description of the gift; and The business purpose or reason for the gift, or nature of the business benefit expected to be derived out of the gift. The occupation or other information relating to the recipient of the gift, including their name, title or other description sufficient to establish a business relationship to the taxpayer may be required. B. TRAVEL, ENTERTAINMENT AND CAR EXPENSES A business or individual should keep adequate records to prove its expenses or have sufficient evidence that will support its own statement. In general, a taxpayer must prepare a written record for it to be considered adequate. This is because written evidence is more reliable than oral evidence alone. However, if a record is prepared in a computer memory device with the aid of a logging program, it is considered an adequate record. Persons should keep the proof they need in an account book, diary, statement of expense, or similar record. They should also keep documentary evidence that, together with their record, will support each element of an expense. 1. Documentary Evidence A taxpayer must generally have documentary evidence, such as receipts, canceled checks, or bills, to support his expenses. Documentary evidence is not needed, however, if any of the following conditions apply: The individual had meals or lodging expenses while traveling away from home which are accounted to his employer under an accountable plan, and he uses a per diem allowance method that includes meals and/or lodging; The expense, other than lodging, is less than $75; or He has a transportation expense for which a receipt is not readily available. Documentary evidence ordinarily will be considered adequate if it shows the amount, date, place, and essential character of the expense. For example, a hotel receipt is enough to support expenses for business travel if it has all of the following information: The name and location of the hotel; The dates the individual stayed there; and Separate amounts for charges such as lodging, meals, and telephone calls. A restaurant receipt is generally enough to prove an expense for a business meal if it has all of the following information: The name and location of the restaurant; Maintaining Business Records 12-8

328 The number of people served; and The date and amount of the expense. If a charge is made for items other than food and beverages, the receipt must show that this is the case. A canceled check, together with a bill from the payee, ordinarily establishes the cost. However, a canceled check by itself does not prove a business expense without other evidence to show that it was for a business purpose. 2. Duplicate Information An individual does not have to record information in his account book or other record that duplicates information shown on a receipt as long as the records and receipts complement each other in an orderly manner. 3. Proving Business Purpose An individual must generally provide a written statement of the business purpose of an expense. However, the degree of proof varies according to the circumstances in each case. If the business purpose of an expense is clear from the surrounding circumstances, then the individual does not need to give a written explanation. Example. If you are a sales representative who calls on customers on an established sales route, you do not have to give a written explanation of the business purpose for traveling that route. You can satisfy the requirements by recording the length of the delivery route once, the date of each trip at or near the time of the trips, and the total miles you drove the car during the tax year. You could also establish the date of each trip with a receipt, record of delivery, or other documentary evidence. 4. Confidential Information An individual does not need to put confidential information relating to an element of a deductible expense (such as the place, business purpose, or business relationship) in his account book, diary, or other record. However, he does have to record the information elsewhere at or near the time of the expense and have it available to fully prove that element of the expense. C. INCOMPLETE RECORDS If an individual does not have complete records to prove an element of an expense, then he must prove the element with: His own written or oral statement containing specific information about the element; and Maintaining Business Records 12-9

329 Other supporting evidence that is sufficient to establish the element. If the element is the description of a gift, or the cost, time, place, or date of an expense, the supporting evidence must be either direct evidence or documentary evidence. Direct evidence can be written statements, or the oral testimony of guests or other witnesses setting forth detailed information about the element. Documentary evidence can be receipts, paid bills, or similar evidence. If the element is either the business relationship of the guests or the business purpose of the amount spent, the supporting evidence can be circumstantial, rather than direct. For example, the nature of the work, such as making deliveries, provides circumstantial evidence of the use of a car for business purposes. Invoices of deliveries establish when the car was used for business. 1. Exceptional Circumstances An individual can satisfy the substantiation requirements with other evidence if, because of the nature of the situation in which an expense is made, he cannot get a receipt. This applies if all the following are true: He was unable to obtain evidence for an element of the expense or use that completely satisfies the requirements; He was unable to obtain evidence for an element that completely satisfies the two rules listed earlier; and He has presented other evidence for the element that is the best proof possible under the circumstances. 2. Destroyed Records If an individual cannot produce a receipt because of reasons beyond his control, he can prove a deduction by reconstructing his records or expenses. Reasons beyond his control include fire, flood, and other casualty. D. SEPARATING AND COMBINING EXPENSES This section explains when expenses must be kept separate and when expenses can be combined. 1. Separating Expenses Each separate payment is generally considered a separate expense. For example, if a business owner entertains a customer or client at dinner and then goes to the theater, the dinner expense and the cost of the theater tickets are two separate expenses. The owner must record them separately in his records. Maintaining Business Records 12-10

330 If a business buys season or series tickets for business use, it must treat each ticket in the series as a separate item. To determine the cost of individual tickets, divide the total cost (but not more than face value) by the number of games or performances in the series. The business must keep records to show whether it uses each ticket as a gift or entertainment. Also, it must be able to prove the cost of non-luxury box seat tickets if it rents a skybox or other private luxury box for more than one event. 2. Combining Items A business can make one daily entry in its records for reasonable categories of expenses. Examples are taxi fares, telephone calls, or other incidental travel costs. Meals should be in a separate category. The business can include tips for meal-related services with the costs of the meals. Expenses of a similar nature occurring during the course of a single event are considered a single expense. For example, if during entertainment at a cocktail lounge, a business owner pays separately for each serving of refreshments, the total expense for the refreshments is treated as a single expense. Maintaining Business Records 12-11

331 Chapter 12 Review Questions The following questions are designed to ensure that you have a complete understanding of the information presented in the chapter. They do not need to be submitted in order to receive CPE credit. They are included as an additional tool to enhance your learning experience. We recommend that you answer each review question and then compare your response to the suggested solution before answering the final exam questions related to this chapter. 1. Which of the following is a reason for a business to keep good records: a) they will help a business to prepare accurate financial statements b) they will help a business prepare its tax return c) they will help the business monitor its progress d) all of the above 2. A record-keeping system for a small business should include a business checkbook and a daily summary of cash receipts. a) true b) false 3. A double-entry bookkeeping system is the easiest to maintain. a) true b) false 4. How long must a business retain its records: a) three years b) five years c) as long as it remains in business d) as long as they may be needed for the IRS or any other law Maintaining Business Records 12-12

332 Chapter 12 Solutions and Suggested Responses 1. A: Incorrect. Good records will help a business in many ways, including preparing accurate financial statements. However, this is not the best answer. B: Incorrect. Good records will help a business in many ways, including preparation of its tax return. However, this is not the best answer. C: Incorrect. Good records will help a business in many ways, including charting its progress. However, this is not the best answer. D: Correct. All of the above are reasons to keep good business records. (See page 12-1 of the course material.) 2. A: True is correct. A good record-keeping system includes a summary of all business transactions. Business transactions are ordinarily summarized in books called journals and ledgers. A record-keeping system for a small business might also include a check disbursement journal, depreciation worksheet, and employee compensation record. B: False is incorrect. These are some of the important records that should be maintained by any small business. (See page 12-2 of the course material.) 3. A: True is incorrect. The easiest is actually a single-entry system. B: False is correct. A double-entry bookkeeping system uses journals and ledgers. Transactions are first entered in a journal and then posted to ledger accounts. These accounts show income, expenses, assets (property a business owns), liabilities (debts of a business), and net worth (excess of assets over liabilities). Income and expense accounts are closed at the end of each tax year. Asset, liability, and net worth accounts, on the other hand, are kept open on a permanent basis. (See page 12-5 of the course material.) Maintaining Business Records 12-13

333 4. A: Incorrect. There is no specific requirement for all types of records. B: Incorrect. There is no specific time period for all records. C: Incorrect. This is not the rule. Some businesses have been in business for hundreds of years, and have obviously destroyed some records. D: Correct. In general, a business must keep its records as long as the IRS or other government agencies mandate. There is no one time period for all records. (See page 12-6 of the course material.) Maintaining Business Records 12-14

334 Glossary A Accrual method: An accounting method under which you report your income when you earn it, whether or not you have received it. You generally deduct your expenses when you incur a liability for them, rather than when you pay them. Amortization: Writing off an intangible asset investment over the projected life of the assets. At-risk rules: Rules that limit the amount of loss you may deduct to the amount you risk losing in the activity. B Bartering: Bartering is an exchange of property or services. Basis: Basis is the amount of the investment in property for tax purposes. The basis of property you buy is usually its cost. Basis is used to figure gain or loss on the sale or disposition of investment property. Below Market Loan: A below-market loan is a loan on which no interest is charged or on which interest is charged at a rate below the applicable federal rate. C Calendar Tax Year: A calendar tax year is 12 consecutive months beginning January 1 and ending December 31. Cash Basis Method: Method of determining when income must be reported and when expenses can be deducted. It is used by most individual taxpayers. Under the cash method, income is generally reported in the tax year money is received, and expenses are usually deducted in the tax year they are paid. Common Paymaster: When two or more related corporations employ the same individual at the same time and pay that individual through a common paymaster which is one of the related corporations, there are limits on the amount of FICA tax due. The related corporations pay FICA as if the corporations were one employer. Contribution: The money or other item(s) of value invested by a member in a limited liability company. Corporate Officers: Corporate officers are specifically included within the definition of an employee under FICA, FUTA, and for federal income tax withholding purposes (IRC 3121(d)(1), 3306(i), and 3401(c)). The common law standard is not applicable. Glossary G-1

335 Corporation: A legal entity that has rights usually only reserved for individuals. The primary advantage of a corporation is that it provides its shareholders with a right to participate in the profits without any personal liability. D Distribution: Payments made to members of a limited liability company or partnership. May include dividends from earnings, capital gains from sale of portfolio holdings and return of capital. Dividend: A distribution of money or other property made by a corporation to its shareholders out of its earnings and profits. E Employment Taxes: Employers large and small are responsible for the collection and remittance of the following federal employment taxes: (1) federal income tax withholding; (2) social security and Medicare taxes; and (3) federal unemployment tax. Excise Taxes: A federal or state tax imposed on the manufacture and distribution of certain non-essential consumer goods. Examples of excise taxes include environmental taxes, communications taxes, and fuel taxes. F Fair Market Value: The price at which an item can be sold at the present time between two unrelated people, neither under compulsion to buy or sell. Federal Insurance Contributions Act (FICA): Social security and Medicare taxes pay for benefits that workers and their families receive under the Federal Insurance Contributions Act (FICA). Social security tax pays for benefits under the old-age, survivors, and disability insurance part of FICA. Medicare tax pays for benefits under the hospital insurance part. Employers withhold part of these taxes from their employee's wages and pay a matching amount. Federal Unemployment Tax Act (FUTA): The federal unemployment tax is part of the federal and state program under the Federal Unemployment Tax Act (FUTA) that pays unemployment compensation to workers who lose their jobs. Employers must report and pay FUTA tax separately from social security and Medicare taxes and withheld income tax. Employers pay FUTA tax only from their own funds. Employees do not pay this tax or have it withheld from their pay. Fiscal Tax Year: A fiscal tax year is 12 consecutive months ending on the last day of any month except December. Glossary G-2

336 G General Partnership: A partnership that has only general partners and no limited partners. Each partner is liable for all partnership debts and there is no limited liability. Gross Profit: Pre-tax net sales minus cost of sales. Also called gross income. I Independent Contactor: People such as doctors, dentists, veterinarians, lawyers, accountants, contractors, subcontractors, public stenographers, or auctioneers who are in an independent trade, business, or profession in which they offer their services to the general public are generally independent contractors. L Limited Liability Company (LLC): An entity formed under state law that has the legal protection of owners similar to a corporation and the tax status of a partnership. Limited Partner: A partner in a limited partnership not involved in the active management of the enterprise. Limited Partnership: A partnership that is a business arrangement whereby the operation is administered by one or more general partners and funded by limited or silent partners who are legally responsible for losses based only on the amount of their investment. M Medicare: A nationwide, Federally administered health insurance program authorized in 1965 to cover the cost of hospitalization, medical care, and some related services for most people over age 65, people receiving Social Security Disability Insurance payments for 2 years, and people with End-Stage Renal Disease. Medicare consists of two separate but coordinated programs Part A (Hospital Insurance, HI) and Part B (Supplementary Medical Insurance, SMI). All persons entitled to HI are eligible to enroll in the SMI program on a voluntary basis by paying a monthly premium. Health insurance protection is available to Medicare beneficiaries without regard to income. Member: The term used to describe the owner of an interest in a limited liability company. Merger: The process by which one business entity combines with another business entity. N Net Earnings: Gross sales minus taxes, interest, depreciation and other expenses. Net Profit: Gross sales minus taxes, interest, depreciation and other expenses. Also called net earnings or net income. Glossary G-3

337 P Partnership: A type of unincorporated business organization in which multiple individuals, called general partners, manage the business and are equally liable for its debts. Passive Activity: An activity involving the conduct of a trade or business in which you do not materially participate and any rental activity. However, the rental of real estate is not a passive activity if both of the following are true: (1) More than one-half of the personal services you perform during the year in all trades or businesses are performed in real property trades or businesses in which you materially participate; and (2) You perform more than 750 hours of services during the year in real property trades or businesses in which you materially participate. R Retained Earnings: When a corporation elects to retain a certain amount of earnings rather than distribute them to shareholders, it may be liable for tax on such retained earnings. S S Corporation: A special type of corporation in which shareholders receive the benefits of pass-through taxation generally available to partnerships while still maintaining limited liability. A number of requirements limit the type of entities eligible for this type of federal tax treatment. Self-Employed Individual: An individual in business for himself is self-employed. Sole proprietors and partners are self-employed. Self-employment can include part-time work. Self-Employment Tax: Self-employment tax (SE tax) is a social security and Medicare tax primarily for individuals who work for themselves. It is similar to the social security and Medicare taxes withheld from the pay of most wage earners. Sole Proprietorship: A sole proprietorship is an unincorporated business that is owned by one individual. It is the simplest form of business organization to start and maintain. A sole proprietorship has no separate legal existence apart from the owner. Statutory Employee: If a worker is not an employee under the usual common law rules of a corporate officer, the worker and the business may nevertheless still be subject to employment taxes. IRC 3121(d)(3) lists individuals in four occupational groups who, under certain circumstances, are considered employees for FICA tax, and, in some instances employees for FUTA tax, but not for income tax withholding. These workers are referred to as statutory employees. They are: (1) agent-drivers or commission drivers; (2) full-time life insurance salespersons; (3) home workers; and (4) traveling or city salespersons. Glossary G-4

338 T Tax Credit: The direct dollar-for-dollar reduction of an individual s tax liability. Compare with tax deduction which reduces an individual s tax liability in proportion to his tax bracket. Tip: Optional payment given in addition to a required payment, usually to express appreciation for excellent service; also called gratuity. Subject to income tax and employment taxes. Glossary G-5

339 Index A accrual method, 2-19, 2-25, 4-2, 4-3, 4-4, 4-5, 4-6, 4-7, 4-10, 7-6, 7-7, 8-1, 8-2, 10-7, 10-8, alternative minimum tax, 6-9, 6-16 American Jobs Creation Act of 2004, 2-29 at-risk limits, 10-6 B bartering, 7-2, 7-4 below-market loans, 2-18 C cash method, 2-19, 2-25, 4-2, 4-3, 4-4, 4-6, 4-7, 4-8, 4-9, 5-16, 6-13, 7-3, 7-7, 10-7, 10-8, 10-15, charitable contributions, 2-14, 2-19, 2-20, 10-30, community property, 1-9 constructive receipt, 4-3, 4-4 distributive share, 2-11 dividends, 1-5, 1-6, 2-1, 2-14, 2-17, 2-20, 2-21, 2-22, 2-23, 2-28, 2-29, 7-6, double taxation, 1-6, 2-17, 2-27 D E economic performance, 4-5, 4-6, 10-7, 10-8 exclusive use test, 10-28, I installment sales, 2-15, 4-10, 5-12, 5-13, 5-14, 5-15, 5-16, 5-28, 5-29 insurance premiums, 2-7, 2-10, 7-6, 10-8, IRS 20-factor test, 3-9, 3-10, 3-17, 3-18, 3-34 kickbacks, 7-10, 10-30, 10-31, K M modified accelerated cost recovery system (MACRS), 10-2, N necessary expenses, 8-4, 10-20, 10-23, 10-26, O ordinary expense, 10-1, organizational cost, 2-23, 2-25 P passive activities, 10-6 product class, 5-3, 5-4 Q qualified intermediary, 5-5 G general asset classes, 5-3, 5-4 H hedging transaction, 5-26, 5-27 Index 1

340 S Section 3509, 3-3, 3-6 Section 530 Relief, 3-3 standard mileage rate, 10-10, 10-11, 10-18, statutory employees, 1-1, 3-3, 3-6, 3-9, 3-18, 3-19, 3-20, 3-22, 3-25, 3-28, 3-29, 7-6 statutory non-employees, 3-27, 3-29 uniform capitalization rules, 4-9, 5-20, 5-21 U Index 2