Axis Corp. is an accrual-basis calendar-year corporation. On
December 13, 2012, the Board of Directors declared a 2% of
profits bonus to all employees for services rendered during 2012
and notified them in writing. None of the employees own stock
in Axis. The amount represents reasonable compensation for
services rendered and was paid on March 13, 2013. Axis’ bonus
(b) The requirement is to determine the correct statement
regarding Axis Corp.’s deduction for its employees bonus
expense. An accrual-method taxpayer can deduct compensation
(including a bonus) when there is an obligation to make payment,
the services have been performed, and the amount can be
determined with reasonable accuracy. It is not required that the
exact amount of compensation be determined during the taxable
year. As long as the computation is known and the liability is
fixed, accrual is proper even though the profits upon which the
compensation are based are not determined until after the end of
Although compensation is generally deductible only for the year
in which the compensation is paid, an exception is made for accrual
method taxpayers so long as payment is made within 2 1/2
months after the end of the year. Here, since the services were
performed, the method of computation was known, the amount
was reasonable, and payment was made by March 15, 2013, the
bonus expense may be deducted on Axis Corp.’s 2012 tax return.
Note that the bonus could not be a disguised dividend because
none of the employees were shareholders.
On December 1, 2012, Michaels, a self-employed cash-basis
calendar-year taxpayer, borrowed $100,000 to use in her business.
The loan was to be repaid on November 30, 2013.
Michaels paid the entire interest of $12,000 on December 1,
2012. What amount of interest is deductible on Michaels’ 2013
income tax return?
(b) The requirement is to determine the amount of the
2012 interest payment of $12,000 that was deductible on
Michaels’ 2013 income tax return. Generally, there is no deduction
for prepaid interest. When a taxpayer pays interest for a
period that extends beyond the end of the tax year, the interest
paid in advance must be spread over the period to which it applies.
Michaels paid $12,000 of interest during 2012 that relates
to the period beginning December 1, 2012, and ending November 30, 2013. Therefore, 1/12 × $12,000 = $1,000 of interest was
deductible for 2012, and 11/12 × $12,000 = $11,000 is deductible
Blair, CPA, uses the cash receipts and disbursements
method of reporting. In 2012, a client gave Blair 100 shares of a
listed corporation’s stock in full satisfaction of a $5,000 accounting
fee the client owed Blair. This stock had a fair market value of
$4,000 on the date it was given to Blair. The client’s basis for this
stock was $3,000. Blair sold the stock for cash in January 2013.
In Blair’s 2012 return, what amount of income should be reported
in connection with the receipt of the stock?
(c) The requirement is to determine the amount of
income to be reported in Blair’s 2012 return for the stock received
in satisfaction of a client fee owed to Blair. Since Blair is a
cash method taxpayer, the amount of income to be recognized
equals the $4,000 fair market value of the stock on date of receipt.
Note that the $4,000 of income is reported by Blair in 2012 when
the stock is received; not in 2013 when the stock is sold.
Unless the Internal Revenue Service consents to a change of
method, the accrual method of tax reporting is generally mandatory
for a sole proprietor when there are
Accounts receivable for services rendered
Year-end merchandise inventories
(d) The requirement is to determine whether the accrual
method of tax reporting is mandatory for a sole proprietor
when there are accounts receivable for services rendered, or yearend
merchandise inventories. A taxpayer’s taxable income
should be computed using the method of accounting by which
the taxpayer regularly computes income in keeping the taxpayer’s
books. Either the cash or the accrual method generally can be
used so long as the method is consistently applied and clearly
reflects income. However, when the production, purchase, or
sale of merchandise is an income producing factor, inventories
must be maintained to clearly reflect income. If merchandise inventories
are necessary to clearly determine income, only the
accrual method of tax reporting can be used for purchases and
Alex Burg, a cash-basis taxpayer, earned an annual salary of
$80,000 at Ace Corp. in 2012, but elected to take only $50,000.
Ace, which was financially able to pay Burg’s full salary, credited
the unpaid balance of $30,000 to Burg’s account on the corporate
books in 2012, and actually paid this $30,000 to Burg on January
30, 2013. How much of the salary is taxable to Burg in 2012?
(d) The requirement is to determine the amount of
salary taxable to Burg in 2012. Since Burg is a cash-basis taxpayer,
salary is taxable to Burg when actually or constructively
received, whichever is earlier. Since the $30,000 of unpaid salary
was unqualifiedly available to Burg during 2012, Burg is considered
to have constructively received it. Thus, Burg must report a
total of $80,000 of salary for 2012; the $50,000 actually received
plus $30,000 constructively received.
Which of the following taxpayers may use the cash method
of accounting for tax purposes?
(c) The requirement is to determine which taxpayer
may use the cash method of accounting for tax purposes. The
cash method generally cannot be used (and the accrual method
must be used to measure sales and cost of goods sold) if inventories
are necessary to clearly determine income. Additionally,
the cash method generally cannot generally be used by (1) a
corporation (other than an S corporation), (2) a partnership with
a corporation as a partner, and (3) a tax shelter. However, this
prohibition against the use of the cash method in the preceding
sentence does not apply to a farming business, a qualified personal
service corporation (e.g., a corporation performing services
in health, law, engineering, architecture, accounting, actuarial
science, performing arts, or consulting), and a corporation or
partnership (that is not a tax shelter) that does not have inventories
and whose average annual gross receipts for the most recent
three-year period do not exceed $5 million.
The uniform capitalization method must be used by
I. Manufacturers of tangible personal property.
II. Retailers of personal property with $2 million dollars in
average annual gross receipts for the three preceding years.
(a) Uniform capitalization rules generally require that
all costs incurred (both direct and indirect) in manufacturing or
constructing real or personal property, or in purchasing or holding
property for sale, must be capitalized as part of the cost of the
property. However, these rules do not apply to a “small retailer
or wholesaler” who acquires personal property for resale if the
retailer’s or wholesaler’s average annual gross receipts for the
three preceding taxable years do not exceed $10 million.
Mock operates a retail business selling illegal narcotic substances.
Which of the following item(s) may Mock deduct in
calculating business income?
I. Cost of merchandise.
II. Business expenses other than the cost of merchandise.
(a) The requirement is to determine whether the cost of
merchandise, and business expenses other than the cost of merchandise,
can be deducted in calculating Mock’s business income
from a retail business selling illegal narcotic substances. Generally,
business expenses that are incurred in an illegal activity are
deductible if they are ordinary and necessary, and reasonable in
amount. Under a special exception, no deduction or credit is
allowed for any amount that is paid or incurred in carrying on a
trade or business which consists of trafficking in controlled substances.
However, this limitation that applies to expenditures in
connection with the illegal sale of drugs does not alter the normal
definition of gross income (i.e., sales minus cost of goods sold).
As a result, in arriving at gross income from the business, Mock
may reduce total sales by the cost of goods sold, and thus is allowed
to deduct the cost of merchandise in calculating business
Banks Corp., a calendar-year corporation, reimburses
employees for properly substantiated qualifying business meal
expenses. The employees are present at the meals, which are
neither lavish nor extravagant, and the reimbursement is not
treated as wages subject to withholdings. For 2013, what percentage
of the meal expense may Banks deduct?
(b) The requirement is to determine the percentage of
business meals expense that Banks Corp. can deduct for 2013.
Generally, only 50% of business meals and entertainment is deductible.
When an employer reimburses its employees’ substantiated
qualifying business meal expenses, the 50% limitation on
deductibility applies to the employer.
Which of the following costs is not included in inventory
under the Uniform Capitalization rules for goods manufactured
by the taxpayer?
(a) The requirement is to determine which of the costs
is not included in inventory under the Uniform Capitalization
(UNICAP) rules for goods manufactured by a taxpayer.
UNICAP rules require that specified overhead items must be
included in inventory including factory repairs and maintenance,
factory administration and officers’ salaries related to production,
taxes (other than income taxes), the costs of quality control and
inspection, current and past service costs of pension and profitsharing
plans, and service support such as purchasing, payroll,
and warehousing costs. Nonmanufacturing costs such as selling,
advertising, and research and experimental costs are not required
to be included in inventory.