 Income tax 2022-2023, accounting for your income. Let's do some wealth preservation with some tax preparation. Support accounting instruction by clicking the link below, giving you a free month membership to all of the content on our website, broken out by category, further broken out by course, each course then organized in a logical, reasonable fashion, making it much more easy to find what you need than can be done on a YouTube page. We also include added resources such as Excel practice problems, PDF files and more like QuickBooks backup files when applicable. So once again, click the link below for a free month membership to our website and all the content on it. Most of this information comes from the tax guide for small business for individuals who use Schedule C Publication 334 Tax Year 2022. You can find on the IRS website, irs.gov, irs.gov. Looking at the income tax formula, we're focused online. One income, remember in the first half of the income tax formula is in essence an income statement, but just an outline, a scaffolding, other forms and schedules flowing into it. The Schedule C for business income, basically an income statement in and of itself having income minus business expenses, the net income then flowing from the Schedule C to line one income of our income tax formula. This is the first page of the Form 1040, noting that the Schedule C would flow in to the Schedule 1 which would flow in to line eight of the Form 1040 here. This is the Schedule C profit or loss from business where we can see the income statement format of an income and expenses. Alright, so now we're going to be talking about accounting for your income. Accounting for your income for income tax purposes differs at times from accounting for financial purposes. So note when we think about the bookkeeping, the general accounting process, what we're trying to do is compile past financial transactions. Financial transaction benefits you today. In such a way that it makes sense for whatever purpose we're using it for, generally that being decision making purposes for us as managers and possibly providing it to external users, investors possibly, to make investment decisions. But here we're compiling basically that same financial information. Balance sheet income statement primarily focused on the income statement here because it's an income tax in order to do the taxes. So that means that when we think about the accounting methods that we're using, we usually think of an accrual method versus a cashed method and we often think from a bookkeeping standpoint about regulations on businesses that are usually regulating forcing businesses that are large corporations to use most of the time in accrual based method and using generally accepted accounting standards. But small businesses often aren't regulated even in their financial reporting because they're not publicly traded companies so they're going to use whatever method is best for their internal use and then they basically have to do their taxes and the taxes are going to be regulated by the tax code. So now we've got to make sure that we're in compliance. We might have to make some tweaks between what we do on a bookkeeping standpoint to what is done basically on a tax code standpoint. Many small businesses might then just say, hey I'm just going to do my books on a cash basis because that way you don't have the adjusting entries to kind of move from a book basis to a cash basis or a tax basis I should say because you're primarily doing the books in order to comply with the tax code. Now note that the tax code is not the primary or best way to account for things because the tax code has all kind of rules that aren't designed for optimizing decision makings from a business standpoint. For example, the capitalization rules and the 179 depreciation, early depreciation, special depreciation, those are really distorting the concepts of normal accounting. But if you're a small business you might say well I'd rather just be on a tax based method and do as little kind of adjusting entries that I need to do at the end of the year in order to get the taxes done. So those are decisions that you might want to talk to your accountant about to think about how your bookkeeping would best be done so that your taxes can be as easy as possible and you can also take care of your internal needs for the financial statements and possibly any external needs for those financial statements perhaps for needing to get like a loan or something. Okay, so this section discusses some of the more common differences that may affect business transactions. So figure your business income on the basis of tax year and according to your regular method of accounting which we talked about before cash method or an accrual method or some kind of modification or combination of those methods. So if the sale of a product is an income producing factor in your business, you usually have to use inventories to clearly show your income. We talked about businesses that have inventory. If you deal with inventory, you're probably having to lean towards an accrual method to some degree because of that inventory. So make sure you're taking that into consideration. How are you going to account for the inventory? So dealers in real estate are not allowed to use inventories. For more information on inventories you can see chapter 2. Income paid to third party. So all income you earn is taxable to you. You cannot avoid tax by having the income paid to a third party. So we talked about I believe a little bit of that before when we thought about revenue recognition concepts. So you might say revenue is recognized when I receive the income. But what if I have that record revenue collected by somebody else? Well, they're collecting it on your behalf. There's nothing really stopping you from collecting it. So you would think that would still be basically income to you. For example, you rent out your property and the rental agreement directs the leasee to pay the rent to your son. So now I didn't get the income. It went to my son. Well, okay, you know, that's clearly some trying to avoid something here. So the amount paid to your son is gross income to you. So cash discounts. So these are amounts that the seller permits you to deduct from the invoice price for prompt payment. So in other words, sometimes usually when you have like larger kind of transactions or the volume of transactions, then there might be these cash discounts and that's a cash management strategy. They're usually very small discounts because if you buy something on account and you have to pay them within 30 days, if they can get you to pay them a little bit earlier, it might be worthwhile to give you a discount to pay them within 10 days or something like that. So you have that discount coming up. So the income tax for income tax purposes, you can use either the following two methods to account for cash discounts. Number one, deduct the cash discount from purchase. C line 36 purchases. C less cost of items withdrawn personal use in chapter six cost goods sold calculation to credit the cash discount to a discount income account. So in other words, if you're going to take the discount, you've got to determine are you locked in to take in the discount or are you going to record it without the discount and then account for the fact that you then got the discount when the discount is coming into play. So for example, let's imagine you're buying inventory and when you buy the inventory, you have the option of possibly having a discount. If you pay within 10 days, they give you this discount, which is usually a pretty low discount in order to incentivize you to pay early. So you could say, hey, look, I think when I buy the inventory, I'm going to take into consideration that discount. So I'm going to account for it at that point in time when I buy the inventory, putting the inventory on the books at the lower price with the discount. So you could put put it on the books at the higher price that that does not include the discount. And then if you do pay them within 10 days, you're like, oh, I'm able to pay them earlier within the discount period. Well, now you've got this discount, which you could credit the cash discount to a discount income account. So those are kind of the methods that that could you could use. You must use the chosen method every year for all of your purchase discount. So once again, they want consistency with the method like normal. If you use the second method, the credit balance in the account at the end of your tax year and business income under this method, you do not reduce the cost of goods sold by the cash discount you received because you're putting it in income instead of basically reducing the cost of goods sold account. Notice it's the same net effect in essence because it's income statement of income minus expenses. Are you going to be adjusting the cost of goods sold or are you going to be recording it as an increase in income decrease cost of goods sold or increase in income. When valuing your closing inventory, you cannot reduce the invoice price of merchandise on hand at the close of the tax year by the average or estimated discount received on the merchandise trade discounts. So these are reductions from list or catalog prices and are usually not written into the invoice or charged to the customer. So do you enter these discounts on your books of account instead? I'm sorry, do not enter these discounts on your books of account instead use only the net amount as the cost of the merchandise purchased. For more information there, you can see trade discounts in Chapter 6, payment placed in escrow. So if the buyer of your property places part or all of the purchase price in escrow, you do not include any part of it in gross sales until you actually constructively receive it. So you might be familiar with an escrow kind of situation with real estate type of transactions. You can have a similar concept basically with other transactions. The escrow is kind of that intermediary period where the deal is not completely finalized. You've got the third party that is holding on to the assets in that case. So you haven't really claimed them at that point in time because they haven't cleared through escrow. You haven't finalized the transaction yet. So then the question is if it's income to you on this transaction, you would think that you wouldn't have to record the income until it's out of escrow because that's when you would actually have claimed to it. However, upon completion of the terms of the contract and the escrow agreement, you will have taxable income even if you do not accept the money until the next year. So after the escrow is completed, even if you say, don't give me the money, right? Because I don't want to record this year. I want to record it next year. Well, you can't do that because now you have constructive receipt to it as we talked about in the income recognition. That would be like saying someone wants to pay you and you tell them, no, don't pay me until next year. Well, you have complete ability to get the money now. So you can't just say, well, I just don't want you to give me the money. You already have constructive receipt of the money after it's done with the escrow. So that would be income, you would think. Sales returns and allowances. Credits you allow customers for return merchandise and any other allowances you make on sales are deductions from gross sales in figuring net income. So this one's a little bit confusing because there's a timing difference issue and we've got this situation of net sales versus an expense. So for example, if you made a sale in say 2021 and then in 2022, they've returned the item if it was merchandise, for example, negating the sale that you made in 2021. So then you might say, well, the sale that I had and I pay taxes on in 2021 isn't really legitimate because I had to return the money and they reversed the sale in 2022. So am I going to go back to 2021, amend the return, reduce the sales amount in 2021? No, that would be tedious. Instead, we want to take care of it in the current year. So what could we do in the current year? We could reduce the sales in the current year, but we don't really like doing that because the sale actually happened last year in 2021. So sales or revenue, usually we like it only to go up. We don't like reducing sales, even though there was a reversal in this case. Instead, we create a Contra asset account. We call it is a net, which is returns and allowances. So that means when we talk about our sales line, we've got sales minus the returns and allowances, which isn't an expense, but kind of acts like an expense to get to the net sales instead of the growth sales, which is different than net income. And then we have the expenses. It's similar to having like a bad debt situation. If you just think someone's not going to pay you, we would record it as an expense of bad debt instead of reversing sales. If it's inventory, oftentimes we put it in net sales, which is a Contra sales account. Okay, advanced payments, special rules dealing with an accrual method of accounting for payments received in advance are discussed in chapter two under accrual method. So note that if you are an accrual method, you're not going to record revenue until you get paid generally. I mean, I'm sorry, on an accrual method, you're going to record revenue when you do the work. And typically you do the work at the same point in time or you do the work before you get paid. If you're a bookkeeper, you might do the work before bill the client and then get paid. If you're a restaurant, you probably do the work at the same point in time that you get paid. But you could have situations where they give you money in advance. If they give you money in advance in an accrual method, you wouldn't record the revenue until you earn the money. So if they give you an advance payment as a lawyer to do work in the future, then when you do the work under an accrual method, that's when you would record the revenue, not when you got the money before doing the work. But that's like an exception for the IRS because they're going to say, you've got the money, you've committed to doing the work, we want our piece of it. So you want to think about those advance payments for taxes. Do you have to include them in income even if using an accrual method at the point in time you've received them? Insurance proceeds. If you receive insurance or another type of reimbursement for a casualty or theft loss, you must subtract it from the loss when you figure your deduction. You cannot deduct the reimbursed part of a casualty or theft loss. In other words, if you get insurance proceeds, the proceeds should be compensating you for a casualty typically for the insurance. So you can't deduct the reimbursed part of the casualty or theft loss because you don't really have a theft loss. In that case, you would be netting it out. You can imagine this happening in a couple of different ways. You had a loss of property and then the insurance is covering it. So you can imagine you put the loss on the books as a loss, like an expense or something like that. And then when you got the insurance proceeds, you put them on their income. Income minus expenses nets out. Or more likely you're going to say the insurance proceeds aren't really income. What they're doing is they're putting you back to where you should be given this weird, this unusual event. So that would mean that you wouldn't record either the expense or the insurance proceeds because they net out against each other, right? Because you're not going to write off a loss if you've got reimbursed for the loss for the insurance proceeds, which in theory are bringing you back to whole. So for more information on casualty or theft loss, as you can see, publication 547.