Major Differences between GAAP and Income Tax Accounting - Essay Example

1. What are some of the major differences between GAAP and income tax accounting? The Generally Accepted Accounting Principles and income tax accounting differ in their use in financial reporting. The primary difference exists at two levels: basis of accounting, and matching principle and other items. GAAP is based on accrual basis of accounting whereas income tax is based on cash basis of accounting although accrual basis is also used. The main difference is that GAAP measures revenues and expenses while income tax accounting measures gross income and deductions. Under the GAAP, the matching principle records revenue and losses when they are received or expended by any company whereas under the tax accounting these are recognized and recorded automatically. For example, the collection of fees in advance will be recorded in GAAP when it earned while according to tax accounting it will be considered as rent taxable income automatically. Another example is the recording of depreciation of fixed assets. Under the GAAP it asset will depreciated using different methods such as straight-line while under the tax accounting only one method is allowed known as MACRS. Under both the depreciation methods, the effect is on the net income. The difference resulting from both the accounting methods may cause differed tax assets or liabilities which can be transferred from one accounting period to the other depending on the financial situation of the company. Another difference between GAAP and tax accounting is the recognition of other revenues or items. For example, the revenue earned from municipal bonds is recognized as interest earned in GAAP whereas such revenues are exempt from federal taxes accounting. 2. What are all the possible filing statuses? What characteristics distinguish each of the filing statuses? The filing status depends on an individual’s marital status and his/her family situation. There are five possible filing statuses. These are married filing jointly, surviving spouse, head of household, single, and married filing separately. Although there are five filing statuses, only four rate schedules or tax tables are used because surviving spouse and married filing jointly usually use the same rate. The characteristics that distinguish each of the filing statuses are based on four factors which also determine how much tax rate is applied to each of them. These factors are maintenance of household, having any dependents, marital status, and citizenship. To qualify to apply for ‘married filing jointly’ must be married and are citizens but do not require any maintenance of household or have any dependents. The tax rate is the lowest in this status. The characteristic of a surviving spouse is that he/she has to maintain a household, have dependents such as a daughter or a son, the marital status remains the same for atleast two years and is a citizen. The tax rate is that same as that of the married couples filing jointly. The characteristic of a head of household is that he/she should maintain a household, has dependents, is single, and is a citizen. Intermediate tax rates are applied to this status. The characteristic of a single filing status is the requirement of being single and has no other compulsory factors because of which it has the highest tax rates. The only characteristic that distinguishes ‘married filing separately’ is the married factor while other factors are not compulsory. The tax rates for this status are the highest. 3. When is a taxpayer required to file a federal income tax return? What are the consequences of failing to file a tax return that you were otherwise required to file? When would a taxpayer with no income tax liability and no withholding want to file a tax return? A taxpayer is required to file if the gross income equals or exceeds the sum of the personal exemption and standard deduction. There are different gross income levels which require different filing statuses to file a federal income tax return. For example, if a person is single and comes under the category of single filing status, and has an income over $9,350, he/she is required to file a tax return. A tax paper if falls under the following three categories has to file a tax return even if the gross income is less than the required gross income filing returns. Taxpayer receives advance payment of earned income credit Taxpayer with net self-employment income of $400 or more Taxpayer who can be claimed as dependent by other and has unearned income over $950 If a taxpayer fails to file a tax return, he/she may be penalized by the IRS. The penalty or fines can often exceed than original debt amount as the penalty accumulates and is applied each month for 5% of the total tax amount not paid. The refund is lost, if any refund is applicable. If a taxpayer is subject to receive earned income credit, it can also be lost if tax return is not filed. If a taxpayer voluntarily fails to file, he/she can be forced by IRS to pay as liens can be placed against property, business and assets. A taxpayer with no tax liability or no withholding would file a return the same as that of regular taxpayer to take advantage of any refunds that may be available. In addition, a taxpayer can also file a return if any penalty is imposed to reduce or remove the penalty or fine. 4. What types of income disqualify taxpayers from claiming the EIC? A taxpayer can become disqualified from claiming the EIC if it includes disqualifying income. If the disqualified income exceeds $2,200, a taxpayer Disqualifying income includes both taxable and tax-free interest, net income from rent and royalties, dividends, net capital gains, and net passive income not received from self-employment. Money that is earned while imprisoned, government assistance payments, military housing and subsistence allowances can also disqualify a taxpayer from claiming the EIC. In addition to this, the earned income should not include any alimony or child support, unemployment insurance, social security benefits, veteran’s benefits, pensions, welfare benefits, and interest or dividends. In addition to this, two types of income disqualify a person from claiming EIC but is still subject to federal income tax. These are taxable scholarships or fellowship grants, and income received while performing work as an inmate. 5. What is the difference between a tax credit and a tax deduction? Which is preferable? What is the difference between a refundable and non-refundable tax credit? There are many differences between a tax credit and tax deduction. These differences are can be related to affect on tax owed, reporting the tax credit and deduction, calculation of credit and deduction, and for what it is qualified for. There are different benefits for both. Tax credit applies directly to a taxpayer’s tax liability whereas tax deductions reduce the taxable income whose value depends on the marginal tax rate of the taxpayer. Since tax credit means a dollar for dollar cut in the income taxes, it has a more financial benefit. For example if a taxpayer has a $500 tax credit, he/she will pay $500 less tax regardless of the tax bracket. Tax deduction on the other hand reduces the adjusted gross income. For example, if a tax bracket is of 10% and a taxpayer has $500 of tax reduction, he/she will pay $50 less tax for the year. In other words, tax deduction lowers income and tax credit lowers tax burden. Given the examples of tax credit and tax deduction, it would seem that people would prefer tax credit. But this is not always the case. Tax credits usually expire quickly unlike deductions because of which majority of the tax payers opt for tax deduction. Tax credits and tax deductions are reported on IRS Form 1040 but tax credits usually require specific tax forms which can be a hassle and time consuming. Tax deduction is not refundable whereas tax credit is usually refundable but can also be non-refundable. Refundable tax credit such as earned income tax credit can reduce the total tax owed to negative which means that the government pays the taxpayer. For example, suppose the total tax before tax credit is $2000, a $2200 refundable tax credit means that a taxpayer would get everything back along with an additional $200 from the government. On the other hand, a non-refundable tax credit can reduce the tax to zero but cannot go below zero. For example, if the total tax before tax credit is $2000, a $2200 non-refundable tax credit will mean that a taxpayer can get back his tax credit amount only. Therefore the difference between refundable and non-refundable tax credit is the repayment of amount of tax owed by the government. 6. What is the difference between tax avoidance and tax evasion? Tax avoidance in simplest terms means that a taxpayer is not obliged to make arrangements to maximize the tax received by the government. In fact, individuals as well as business entities are entitled to take all the lawful steps that can help minimizing their taxes. This means that if a taxpayer follows the rules to minimize the taxable income, it is not an illegal action. Such minimization can be achieved through tax deductions and changing business structure through incorporation or establishing an offshore company. Tax avoidance is generally considered a legal exploitation of the tax laws for a person’s own advantage. Tax evasion on the other hand, is the opposite of tax avoidance. It occurs when taxpayers intentionally evade the payment of taxes usually through illegal means to pay fewer taxes than are actually due to the government. Tax evasion is usually practiced by not reporting actual income or reporting inaccurate deductions. Tax evasion occurs mostly in income taxes but can also be observed in state sales taxes and employment taxes. For example, a taxpayer, whether individual or business entity can misrepresent the income to reduce tax liability by intentionally declaring lower income, gains or profits, or overstating the deductions. Such practice is a crime and is monitored by IRS to ensure it doesn’t occur by imposing penalties and fines. Many people consider tax avoidance and tax evasion the same thing but both are very different. For example, reinvestment of capital gains proceeds from old real estate in a new real estate in order change the capital gain tax is tax avoidance rather than tax evasion. This is because it is a legal practice of ‘putting off’ the payment of taxes until later through deferment rather than evading it. 7. What are some year-end tax planning strategies you (personally) can employ to minimize your next year’s tax liability? There are a number of ways which can employ to minimize next year’s tax liability. These are as follows: Shifting Income: As the tax system is progressive families can reduce the tax by shifting the income to other members of the family who are in the lower tax brackets. Reducing the Income: Since income the basis for any tax, reducing it can be beneficial. One way is to participate in the 401(k) plan through which income can be deferred to retirement. Another way is to defer the end-of-year bonuses till the next year. If any hobby income is being earned, it can be converted into legitimate business in order to take its expenses against the income such as home office deduction although there has to be a profit for two years. Reducing income can also be achieved through giving out charities, and increase in expenses where possible. Maximizing Itemized Deductions: If the expenditures are properly timed, it can increase the deductions. If the itemized deductions are less than the standard deductions, it is possible to defer some payment to maximize expenses for a year. For example, if my itemized deductions excluding property taxes are $2500 and property taxes for 2009 and 2010 are $1000 and $1000 respectively. If I don’t double up, the itemized deductions would be $2500 + $1000 = $3500 which is less than standard deduction of $4000. But by doubling up, I can increase my itemized deductions to $4500 ($3000+$1000+$1000). In addition to this, if my medical expense is under 7.5% of AGI, I can create a deduction by doubling up. Other ways that can increase the deduction are opening a health savings account, paying student loans, moving to a new location, or starting college. Other actions to maximize deductions: Other actions that can help accelerate deductions include pre-pay deductible interest, making an IRA contribution, or pre-paying medical expenses in December. In addition, credits can reduce the amount tax owed instead of just reducing the tax liability. One such credit that can be acquired is by attending college, purchasing hybrid vehicle, or installing energy-saving equipment. 8. What is the definition of being self-employed? What distinguishes a self-employed individual from an employee? Why is this distinction important? Explain. A generally accepted rule is that any person who performs a service for someone is his/her employee if they control what will be done and how will it be done. This distinction between employee and self-employed is important because both are taxed differently. For the tax purposes, IRS differentiates self-employed and employees based on twenty laws for tax purposes. The most common bases for distinguishing self employed individual from an employee are given below: No instructions: Self-employed individuals are not required to follow instructions to finish a job whereas employees are required to follow instructions No training: No training is required by the self-employed individuals as they use their own method to accomplish a job. Essentiality of work: Hiring company’s success does not depend on the work of the self-employed individuals. Time Clock: Self-employed individuals work on their time schedule whereas employees have to work according to their company’s time. Relationship: Self-employed individuals do not have continuous relation with hiring companies whereas employees do. Location: Self-employed workers have their own locations where they work and control. Jobs: Self-employed workers can pursue other jobs at one time unlike employees Order of work: The order and sequence of work to be performed is determined by the self-employed individuals themselves unlike employees. Interim Reports: Self-employed individuals do not have to give any interim reports. Pay Scale: Employees are paid by the time they work and the job they do whereas self-employed individuals are paid by the job. Expenses: Self-employed have to account for their expenses whereas employees do not have to account for the expenses incurred by their offices. Investment: Self-employed individuals have to invest in their own tools, equipments and offices unlike employees. Termination: Self-employed individuals cannot be fired if they produce satisfactory job results, whereas employees can be terminated according to company conditions and on their own job results. 9. When could overpayment of Social Security taxes occur? How does one go about getting a refund of excess Social Security payments? A Social Security tax which is 6.2% is withheld by employers and help to determine the benefits an individual receives when he/she retires. As there is a limit on how can be contributed each year, taxpayers unintentionally overpay the social security tax. In such cases a taxpayer can get back the credit on his/her tax return. For example, the Social Security tax collected at a rate of 6.2% on the $100,000 earnings was $6200 in a year. If an individual earns at least that amount in a year and the Social Security withheld by the employer goes over the limit, the company stops withholding the tax. Now if an individual changes job and the combined income from both the employers went over the limit, it is possible that the overpayment of Social Security taxes occurred as the new employer also withheld the tax. In order to get a refund of excess Social Security payments, line 69 in the Form 1040, is the place to mention the overpayments to receive credit for it. This is only possible if there are two employers. For example, the taxpayer should report the Social Security tax withheld by each employer on W-2s form and then deduct the Social Security limit. The result is to be reported on line 69. In case of one employer, excess Social Security cannot be claimed on a tax return. Instead, the taxpayer should ask the employer to refund the surplus. 10. How is the write-off of a bad debt handled on the tax return? How does the debtor have to handle the forgiveness of the debt? Why? If someone owes the taxpayer any debt either personal or business and fails to pay it can be a considered as a bad debt. In order to determine how the bad debt will be handled on tax return, it is important to know if the bad debt is personal or business. Business bad debts are deemed as business expenses and are simply deducted in the business tax return in the year it is considered as a bad debt. These debts are deductible in full in the Form 1120. On the other hand, personal bad debt results when a friend or relative fails to repay the loan. This type of bad debt is known as a short-term capital loss in the Form 1040: Schedule D. The capital loss has to be matched against capital gain and will then be reported in the Form 1040 with a limit of $3000 a year in deductible capital losses. The personal bad debt must be reported with extreme caution as IRS can request additional documents to prove that the loan was a loan and not a gift. Forgiveness of debt is taxable and it is important for the person who owed the loan to report the amount forgiven as income. But before the creditor can claim any unpaid debt, he/she has to send the debtor Form 1099 to inform that the debt was forgiven. It is a debtor’s gain as they received the funds and now does not have to return it because it has been forgiven. This forgiven debt should be reported on Line 21 on Form 1040 under ‘Other Income.’ This is the reason that the debtor has to include the loan in the income. 11. How is basis determined? What events can adjust basis up or down? How does tax basis differ from GAAP accounting basis? Basis is usually the cost to acquire the asset. If the cost of the asset cannot be used as a basis, the fair market value may be used. In order to figure out the gain or loss from sale, exchange, or disposition of an asset, or to calculate depreciation, depletion or amortization, certain adjustments are made to the basis of the property the result of which gives the adjusted basis. There are certain events that can increase or decrease the original basis. The events that can increase the basis of a property include cost of improvements that has a useful life of more than one year. These improvements are cost of extending the utility service lines to the property, zoning costs, legal fees for defending and perfecting a title or obtaining a decrease in the assessment charged against the property for any local improvements, capital improvements, casualty losses, and capitalized value of redeemable ground rent. In addition to this, the rehabilitation expenses can also the increase the basis but any rehabilitation credit must be subtracted before the expenses are added to the basis. The events that can decrease the basis include Section 179 deductions, deduction for clean-fuel vehicles or refueling the property, credit for qualified electric vehicles, investment credit, insurance reimbursements or theft losses, nontaxable corporate distributions, gain from sale of home that has been postponed, certain canceled debt, rebates, exclusion from income of subsidies for energy conservation measures, and most important depreciation. For example the adjusted basis of a property would be: Original cost of the property $80,000 Adjustments to basis: Add: Improvements $10,000 Restoration of damaged property $5000 Subtract: Depreciation $14000 Theft loss $3000 Adjusted basis for the property $78000 GAAP accounting basis differ from tax basis because certain deductions are not allowed in GAAP for tax purposes which are allowed by tax basis. This difference can cause the difference in the cost basis under both the methods. Deductions that are not allowed can include depreciation deduction (MACRS) and Section 179 expense deduction. 12. Are you qualified to claim a home office deduction if you have another full-time office? Explain. No, a person is not qualified to claim a home office deduction if he/she has another full-time office. Home office deduction strictly applies to one principal place where all the business management activities are conducted and from on other place. A person can spend large portions of work time seeing customers outside home office but if the administrative activities are conducted at the principal place, then he/she qualifies for home office deduction. In another case, if a person is an employee and works from home for the convenience of the employer, home office deduction can be claimed. But if the employer provides office space and the employee asks to work part-time from home, the employee is disqualified for the deduction. Read More