 Income tax 2023-2024. Inventory, uniform capitalization rules and changes in accounting method. Get ready and some coffee because you're supporting an entire generation with your income tax preparation 2023-2024. Most of this information can be found in publication 3-3-4 tax guide for small business for individuals who use Schedule C tax year 2023, which you can find on the IRS website at iris.gov, iris.gov. Looking at the income tax formula, the first half of the income tax formula basically being a funny income statement. Most income statements having income minus expenses resulting in net income, here having income minus various deductions resulting in taxable income. This sole proprietorship Schedule C rolling into line one income, which is a little funny because the Schedule C itself is also an income statement in essence having business income minus business expenses which you could call business deductions resulting in essence in net business income rolling in from the Schedule C to line one income on the income tax formula representing the formula on the form 1040. Just being the first page of a form 1040, the Schedule C ultimately rolling into line number eight additional income from Schedule 1. This is the Schedule 1 additional income and adjustments. First a word from our sponsor. If you would like a commercial free experience, consider subscribing to our website at accountinginstruction.com or accountinginstruction.thinkific.com to income plus income. Part one where the Schedule C rolls into line three business income or loss from the Schedule C here is a Schedule C profit or loss from business having the P and L profit and loss or income statement format of an income minus expenses. So continuing on with our discussion of accounting methods given the fact that the Schedule C is of course a type of financial statement in essence basically an income statement as opposed to the other major type of financial statement. The balance sheet and it is representing performance over a time frame. Therefore we need to have some kind of accounting that we're going to be doing in order to guide us in terms of how we're going to be putting the income statement together. Our regulations come from the tax code but of course the tax code might be deferring to standard kind of accounting regulations and authorities. The primary two types of methods we use cash method and accrual method or possibly some kind of hybrid between them. Noting that the major things that would push us from going from a cash method the easier method typically to an accrual method are when our business our industry have accrual type of things we need to deal with such as inventory because it's going to go on the books as an asset. Specifically when we purchase it which is a deviation from a cash based accounting thing to do and when we buy large things like property plants and equipment. In that case even if on a cash based system we would have to put it on the books basically as a balance sheet or on the tax return as a depreciable asset allocating the cost in accordance with the depreciation rules that also being a deviation from a cash based system. Alright so uniform capitalization rules under the uniform capitalization rules you must capitalize the direct cost and part of the indirect cost for production or resale activities. So when we think about capitalization in this context what we're talking about typically is putting something on the books rather than as an expense as an asset. In other words usually when we buy things when we're thinking about our accounting process when the money is going out of our checking account it's because we're purchasing things and normally we just expense them when we pay for them such as the utility bill the phone bill supplies for example. But we have some of those things usually the large purchases and then the inventory where when we purchase them the money goes out and we instead of expensing them put them on the books as an asset we can call that basically capitalizing them putting them on the books as an asset. And they're on the books as an asset because we're not getting the consumption of them that's helping us to generate revenue in the current period but rather we're in basically investing in something we're investing in the inventory we're investing in the property planting equipment that depreciable assets which will help us to generate revenue into the future therefore under an accrual method we would want to be expensing them as we consume them rather than when the cash was paid for them. So include these costs and the basis of property you produce or acquire for resale rather than claiming them as a current deduction so rather than expensing them we have to put them on the books in essence as an asset and then expense them in the future in the form of depreciation for fixed assets or in the form of cost of goods sold for the inventory. You recover the costs through depreciation amortization or cost of goods sold when you use sell or otherwise dispose of the property. So if it's inventory we buy it we typically put it on the books as an asset inventory then we get the expense when we sell it in the form of cost of goods sold. If it's a depreciable property we put it on the books as equipment or something like that an asset then we get the expense when we depreciate it. Amortization would be intangible things that have a similar capacity or process as with tangible depreciable property amortizing them over the useful life instead of depreciating them same concept though. Activity subject to the uniform capitalization rules you may be subject to the uniform capitalization rules if you do any of the following unless the property is produced for your use other than in a business or an activity carried on for profit. So produce real or tangible personal property for this purpose tangible personal property includes film sound recording videotape book or similar property acquire property for resale. So if we're producing something you would think that as we produce it we're producing it in order to sell it so it might be something that would be capitalized basically as inventory if we acquire something then clearly it's going to be inventory because we purchased it in order to sell it in the future. And the idea there being that instead of expensing it at the point in time we purchase it or expensing it as the point in time that we consume costs in order to make the thing that we're making we're basically making the inventory or the thing that we're going to sell. We're instead going to put it on the books as an asset and then expense it when we sell it in the form of cost of goods sold you would think exceptions these rules do not apply to the following. So we always have that small business taxpayers to find earlier under inventories where we might have an exception so inventories once again an area that could cause us problems forcing us to deviate from a cash basis to an accrual basis. However there could be some exceptions therefore especially for small businesses when you're dealing with inventory you want to think pretty well in depth about how exactly is my business going to work logistically and what is going to be the tax basis that would be best for me. And not only in the current year but also kind of thinking forward in terms of is this going to lead me to have to change my accounting method in the future which is kind of a pain. And we have to ask permission for typically or follow certain rules to do so and we'd like to make it as easy as possible being consistent if we can property you produce in your indirect cost of producing the property are $200,000 or less. So special methods there are special methods of accounting for certain items of income or expense these include the following amortization discussed in chapter seven. So we'll get into like depreciation and types of assets later and then of course amortization are going to follow their own kind of rules which are basically separate from what you might expect. You might expect the tax code to say hey we'll just default to accounting principles generally accepted accounting principles and they kind of do that. But then they deviate from that for other reasons which are probably lobbying type reasons and so on where they're trying to accelerate the depreciation methods. Therefore the depreciation rules that we go to for taxes may differ than normal best practices for accounting and that's another area where things get a bit messy. So bad debts discussed under topic number four five three bad debt deduction. We might talk about that later. Depletion discussed in chapter seven of publication two to five. So depletion is kind of a special area that might be in certain types of industry. So for example if you have an oil well or something like that. Well now you you don't just have a building that's going to depreciate over time. You have an asset that you have to estimate you would think how much is there how much oil is under the crown. What's the value of it and then obviously you should be able if you were able to have the knowledge of how much was there. You can then calculate as you as you extract it you know how much has been depleted and so on and so forth and that valuation. So that would be a special area. A depreciation discussed in publication nine four six how to depreciate property. Now many small businesses if you are a like a gig worker or something you might not have a whole lot of property that you have to deal with depreciation with. And these days you might be able to depreciate most of it in the year that you buy it like microphones and stuff of your YouTuber or something because of the special rules for accelerated depreciation that could come in place. But depreciation typically is something that affects more small businesses meaning if you buy larger pieces of equipment you're going to have to deal with depreciation. Depreciation causes all kinds of problems because it's more complicated than simply a cashed based system. We have to track all the records for the depreciation and then it really kind of becomes a problem when we dispose of property or sell property because then we have to deal with the adjusted costs. We have to deal with the fact that we depreciated part of it. Is there any difference in the type of tax rates in terms of capital gains versus ordinary income when we sell it and those kind of questions come up with regards to depreciation. So it's often even for small businesses kind of an area of complication. There's also could be differences between depreciation methods for taxes versus bookkeeping which we talked about earlier in terms of best practices for bookkeeping versus what the tax code says we need to do according to the tax code. So we'll talk about depreciation in some detail later although again depreciation is a place that you can dive into for some time. So installment sales discussed in publication 537 installment sales. So that's a type of sales structure that could be set up and there could be special rules with regards to installment sales which again would be somewhat of a unusual situation but not that unusual that those types of sales could come up and then how would you recognize revenue within them. Long term contract methods of accounting see section 460. So if we have a long term contract again the long term contracts could complicate things like revenue revenue generation principles and some industries that are engaged in them could be specialized areas. So like construction for example might be an area of specialization due to differences in accounting methods and therefore tax treatment often as well. So change in accounting method. Once you have set your accounting method you must generally get IRS approval before you can change to another method a change in your accounting method includes a change in number one. The overall method such is such as from cash to an accrual method. So one of the core concepts of accounting in general is consistency is because we want to be able to make comparisons year over year. So when we think of accounting we're typically thinking internal decision making from management as well as external decision making for people like investors who are using financial statements to try to invest in like stocks stocks. For example so that in that case I want comparable performance statements year over year consistency in the company so I can compare year over year as well as consistency across companies so we can compare one company to another. So if we choose one method and then we were able to change it all the time then the tax code for taxes. You would think that people would use that manipulation to change the cut off dates to try to reduce taxes. Obviously the IRS is not going to like that and therefore you're going to need to keep a particular method unless there's a rationale for it in which case you have to get approval by the IRS. Now with a cash to an accrual method you can imagine the IRS might be OK with that in some cases because you're usually going to a more complex method. And sometimes you might need to such as if you didn't have inventory before and now you do have inventory or you were small business before and you've grown to a larger business. And now you need to track your inventory in a more specific way for whatever reason. So there are rationales when it could happen but you're going to get approval for it or need approval. And what you really want to make sure that you do is not mess up the first schedule C and choose the wrong accounting method in which case you need to change the accounting method. Not because you've grown not because you've changed the type of business not because you've included inventory but because you messed up. And that could end up being a problem. You might be able to you know you could try to amend the prior return or something like that. But again you want to avoid that problem to your treatment of any material items. So when we think about material we're not talking about like a physical thing you can touch. We're talking about it has a tang it has a impact on decision making or the amount of tax that's going to be paid. It's not in material with regards to the taxes and the taxes that will be paid. So to get approval you must file form 3 1 1 5. So what if I want to change my method. I have to get approval we got form 3 1 1 5. You can get IRS approval to change and accounting method under either the automatic change procedures or the advanced consent request procedures. You may have to pay a user fee and that's always not fun to pay a fee. But that's part of the process for more information you can see instructions for form 3 1 1 5. So if you need to make that change IRS website take a look at the form 3 1 1 5 and the related instructions for it. Automatic change procedures what's it look like 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 provisions of the automatic change procedures. So obviously one of the issues with making these changes is the time it takes to get approval which can be a stressful type of process and you have to do some accounting basically in the meantime. So you would like to possibly able to qualify for the automatic change procedure so you can basically assume that the change will be accepted right. Because if it's not accepted and then you made the change in your bookkeeping has changed and so on and so forth and then they reject it. And then you have to appeal it or whatever is going to go on that's going to cause havoc to your bookkeeping and tax preparation. So no user fee is required for an application filed under an automatic change procedure generally covered in revenue procedure 2015-13 2015 5 IRB 419 which is available at the IRS website. Generally you must file form 3 1 1 5 to request an automatic change again for more information. See the instructions for form 3 1 1 5 which you can find on the IRS website iris.gov iris.gov.