Tax Periods and Methods - Childrens Company - Assignment Example

COVER PAGE Assignment 3. Tax Periods and Methods Submitted by: Submitted Finance and Accounting May, TABLE OF CONTENTS 1. Company analysis 3 2. Accounting periods 4 3. Types of accounting methods that would be available for business, recommended method that would minimize the tax liabilities for the company and rationale 4 4. Two (2) specific transactions, proposed one (1) special accounting method which company would use to account for these transaction, and significant tax consequences that may result from the method proposed 6 5 Change of accounting method chosen after three (3) years in business, after having discovered that another method would be more advantageous from a tax perspective; the rules regarding changes in accounting methods, and a table that illustrates the effect on taxable impact for three (3) of your business unique transactions 7 5. An argument that supports the proposed accounting method change and letter to the IRS to justify position 8 6. References  10 TAX PERIODS AND METHODS 1. Company analysis Owner has chosen to start an online retail business that sells shoes, bags, toys and school supplies for school children that will be called “ Children’s Company”. The structure of the business is sole proprietorship because it is a small start-up company. Children’s Company will be located at San Francisco, California, where there are 837,442 populations as of 2013 (U.S. Census Bureau). My business objectives are to achieve 15 percent growth in revenues and earnings within the first 12 months of operation. Owner chose to establish a sole proprietorship structure because it is easy to start up. It does not require filing of too many complex forms like the one needed by corporations. The advantage of this type of structure is that owner does not need to file a separate tax , instead business information are detailed in the income tax return. Business capital will come from personal savings and borrowings from parents and friends. Supplies will come from established factories in San Francisco, and others will be imported from China or India where these materials are sold cheaper. As a marketing strategy, company website will be opened to act as a virtual store where the merchandise will be displayed. Transactions are done online. Delivery of orders are completed by a courier, like the Fedex, etc. once payment of order is confirmed or received. Orders may also be paid by cash on delivery. 2. Accounting periods. Accounting periods are the calendar period and the fiscal period. The calendar period is a 12 month period that starts January 1st and ends at December 31st of the same year. The calendar year is typically used by individuals and businesses. The Fiscal year is also a 12 month system of reporting, that typically ends on a month other than December. For instance fiscal year used by the U.S. Government starts at Oct. 1st and ends Sept. 30. Others that are not considered are short tax year and improper tax year, both of which are used under extra-ordinary situations. Accounting period selected for the business is calendar year that ends December 31st. Since company is a sole proprietorship, filing of income tax is from January first of the following year up to deadline of April 15. For example for Calendar year 2014, despite the fact that business began operation May 1, owner must incorporate in his tax filings all pertinent business operations from that period up to Dec. 31st. Owner has 4 months to report his income in business from JAN. 1ST to April 15, 2015. Sole proprietors have to complete Schedule C of IRS Form 1040 to tell whether the business made a profit or loss for the year. Owner should be able to track down income and expenses since they are needed in filing of IRS. 3.Ttypes of accounting methods that would be available for business, recommended method that would minimize the tax liabilities for the company and rationale There are two types of accounting methods available for business, the cash receipts and disbursements method and the accrual method. In the cash receipts method, all cash , property, or services are recorded in the taxpayer’s gross income in the year of actual receipt. As such this is the easiest method used by sole proprietors and small businesses. Cash basis accounting method recognizes cash when it is received and expenses when bills are paid. Cash basis method of accounting, according to Hill, Rebekkah,2015 is pretty good in tracking of cash flow because it records cash in and cash out fully well, but this system does not take into consideration the matching of revenues and expenses during the accounting period that they occur. Under the accrual method, revenues are reported on the income statement when they are earned, while on the cash basis of accounting, revenues are reported on the income statement when cash is received. Under the accrual method, expenses are matched with related revenues and not when cash is paid. A small business with sales below $5 million per year is free to use either the cash or accrual method of accounting. However, if the business keeps inventory of merchandise to sell to customers, it is required by the Internal Revenue Service to use accrual method for inventory. (FindLaw, 2014). Since it would be cumbersome to monitor two accounting methods at the same time, accrual method is proposed for the business. The accrual reporting is favored by businesses because it presents the true financial picture of the company’s operation, and that it is in line with accepted accounting principles. Tax liability is the amount a taxpayer is obliged to pay the government as a result of taxable event, such as sale of goods and services. Given that this is a sole proprietorship, the accrual reporting accounting method is the more appropriate method to be adopted by the Children’s Company because it gives a true picture of the company’s operation at any given time by calculating the accounts receivable and accounts payable. Owners of businesses must pay taxes during the year or next, but there it can strategize to decrease tax liability as much as possible. 4. Two (2) specific transactions, proposed one (1) special accounting method which company would use to account for these transaction, and significant tax consequences that may result from the method proposed. Transaction 1. The company sold $500 merchandise to a customer on December 15, 2014 received payment only on March 15, 2015, how would it be recorded? Transaction 2. The company received a bill from a supplier on December 31, but was only paid on JAN. 15, how will the expense be recorded. Special accounting method proposed for the transactions is the accrual method wherein owner can invoice the sale immediately and count it as income for 2014, or send the invoice on Jan 1, 2015 to record sale for next year. Tax consequences is that tax liability has been transferred to 2015 instead of 2014 when transaction was done. Accrual treats this as an expense as soon as bill is received and will be reflected in the financial statements as accounts payable. Tax consequence is that it increases deductible expenses for the taxable year and reduces tax payable. Strategizing tax liability allows owner to defer tax payments and use funds to grow the business. 5.Change of accounting method chosen after three (3) years in business, after having discovered that another method would be more advantageous from a tax perspective; the rules regarding changes in accounting methods, anda table that illustrates the effect on taxable impact for three (3) of your businesss unique transactions In order to change the accounting method after using it for three years in business, owner can request the IRS for a change. IRS approval is needed to change accounting method from cash method to accrual or vice versa; a change in the method of valuing inventory; or a change in the depreciation method. (IRS Publication 538, December, 2012). Company is asking to change accounting method from accrual to cash in valuing inventory. Owner claims that he is entitled to exemptions, under Revenue Procedure,2001-10, because revenues do not exceed $1,000,000 a year. When the application is approved, owner now uses two methods that are acceptable with the IRS. Case 1 Situation Tax impact Cash accounting method Bank credited interest to company’s account in December 2014. Owner did not withdraw or record it into the books of account until 2015. Solution: owner must include it in the gross income for 2014, the year it is received Increases gross income of owner. Case 2 Accrual Accounting method Company applies calendar year. Owner buys school supplies in December 2013, receives the supplies and the bill in January 2014, and pays bill in January 2013. SOLUTION: Owner can deduct the expense in 2013 because liability occurred in 2012, and economic performance is determined. Increase in deductible expenses for CY 2012, and a reduction of tax liability. Case 3 Lower cost method in valuing inventory In this case, owner must take the cost price and the market price whichever is lower. For instance, cost of item is A is $300 and the market price is $500, the lower cost of $300 is used. Costing will be done individually, which is quite difficult if inventory is big. Increases gross income of the company. 6. An argument that supports your proposed accounting method change. Create a letter to the IRS to justify your position.  The company needs accounting method change particularly in valuation of inventory, from accrual to cash method. Inventory of the company consists of assets held for sale in the ordinary course of business. Supplies come in finished form and ready for sale and added costs are shipping, and conversion costs, so that the need to record it on the time of possession of goods is a valid reason for change. Furthermore, business is entitled for a change under the IRS provisions given that it is a small company whose average sale for 3 years does not exceed $1,000,000. Under the cash accounting method, entry to the books of account is entered upon receipt of merchandise. May 23, 2015 Letter to the IRS Internal Revenue Service San Francisco, California Dear Sir: I would like to request to change accounting method used by my business, the “Children’s Company” from accrual method to cash basis accounting method starting CY 2015 for my inventory. I am only a small-start-up company that has been in business for three years. I believe my business should be exempted and be considered as a qualifying taxpayer under Revenue Procedure 2001-10 because my company’s gross receipts do not exceed $1 million a year. The average gross receipts for my three year operation is less than $1 million, and that inventory item materials are not incidental supplies and materials. I am submitting this request thru the automatic change procedures of Revenue Procedures 2001-10. Attached is Form 3115 for your approval. Thank you. Very truly yours, NAME OF OWNER REFERENCES CITED FindLaw. 2014. Cash vs. Accrual Accounting for Small Business. Retrieved from http://smallbusiness.findlaw.com/business-finances/cash-vs-accrual-accounting-for-small-businesses.html IRS Publication 538. December 2012. Accounting Periods and Methods, p. 20. Retrieved from http://www.irs.gov/pub/irs-prior/p538--2012.pdf HILL. Rebekiah . 2015. The Differences between Accrual and Cash Basis Accounting. Retrieved from http://study.com/academy/lesson/the-differences-between-accrual-cash-basis-accounting.html Read More