J.K. Lasser's Small Business Taxes 2018. Barbara Weltman
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own a building in which you conduct your business. Real property taxes for the property tax year ending June 30 are $12,000. You are an accrual method taxpayer on a calendar year of reporting. You can elect to ratably accrue the taxes. If the election is made, you deduct $6,000 in the current year, the amount of taxes that relates to the period for your tax year. The balance of the taxes is deductible next year.
Any real property taxes that would normally be deductible for the tax year that apply to periods prior to your election are deductible in the year of the election.
The election must be made for the first tax year in which real property taxes are incurred. It is made simply by attaching a statement to the return for that tax year. The return must be filed on time (including any extensions) in order for the election to be valid. Include on the statement the businesses to which the election applies and their methods of accounting, the period of time to which the taxes relate, and the computation of the real property tax deduction for the first year of the election.
Once you make this election, it continues indefinitely unless you revoke it. To revoke your election, you must obtain the consent of the IRS. However, there is an automatic procedure rule that allows you to elect or revoke an election by attaching a statement to your return. Under this method, you may assume you have IRS consent; you do not have to request it and wait for a reply.
If you have been accruing real property taxes under the general rule for accrual, you must file for a change in accounting method, which is explained later in this chapter.
You can make an election to ratably accrue real property taxes over the period to which they relate for each separate business you own.
TWO-AND-A-HALF-MONTH RULE
If you pay salary, interest, or other expenses to an unrelated party, you can accrue the expense only if it is paid within 2½ months after the close of the tax year.
Example
You declare a year-end bonus for your manager (who is not related to you under the rules discussed). You are on the calendar year. You can accrue the bonus in the year in which you declare it if you actually pay it no later than March 15.
Related Parties
If expenses are paid to related parties, a special rule applies. This rule, in effect, puts an accrual taxpayer on the cash basis so that payments are not deductible until actually paid. Related parties include:
● Members of an immediate family (spouses, children, brothers and sisters of whole or half blood, grandchildren, and grandparents).
● An individual and a C corporation (other than a PSC) in which he or she owns more than 50 % of the corporation's outstanding stock (based on the stock's value). Stock ownership may be direct or indirect. Direct means that the individual holds the stock in his or her name. Indirect ownership means the stock is owned by a member of the individual's immediate family (listed above) or by a corporation, partnership, estate, or trust owned in full or in part by the individual. If the individual has only a partial ownership interest, that same proportion of stock owned by the entity is treated as owned by the individual. For example, if an individual owns 75 % of stock in Corporation X and X owns 100 % of the stock in Corporation Y, the individual is treated as owning 75 % of the stock in Y for purposes of this accrual method limitation.
● An individual and an S corporation in which he or she owns any of the corporation's outstanding stock. The Tax Court has said that this includes employees who are participants in an S corporation's ESOP.
● A PSC and any owner-employee (regardless of the amount of stock ownership). Thus, if an individual owns 10 % of the stock in Corporation X (a PSC), and X owns 100 % of the stock in Y, the individual is treated as owning 100 % of the stock in Y.
● Other categories of related parties (e.g., 2 corporations that are members of a controlled group – they have certain owners in common).
If you fall under this related party rule, you cannot deduct the expense until payment is actually made and the related party includes the payment in his or her income.
Example
You have an accrual business in which your child is an employee. Your business is on the calendar year. On December 31, 2017, you declare a year-end bonus of $5,000 for your child. You may not accrue the bonus until you pay the $5,000 to your child and your child includes the payment as income. Therefore, if you write a check on January 15, 2018, for the bonus and your child cashes it that day, you can accrue the expense in 2018.
For businesses involved in building, constructing, installing, or manufacturing property where the work cannot be completed within one year, special accounting rules exist. These rules do not affect the amount of income or expenses to be reported – they merely dictate the timing of the income or expenses.
Generally, you must use the percentage-of-completion method to report income and expenses from these long-term contracts. Under this method, you must estimate your income and expenses while the contract is in progress and report a percentage of these items relative to the portion of the contract that has been completed. However, income and expenses are not fully accounted for until the earlier of either the completion of the job and acceptance of the work or the buyer starts to use the item and 5 % or less of the total contract costs remain to be completed.
You may also have to use a look-back method (discussed later) to compensate for any inaccuracies in your estimates for income or expenses.
EXCEPTIONS FROM THE PERCENTAGE-OF-COMPLETION METHOD
Under this method you account for your income and expenses when, as the name implies, the contract has been completed. You can account for income and expenses using the completed-contract method if:
1. The contracts are small construction contracts that will be completed within 2 years and average annual gross receipts for the 3 preceding years from the start of the contract do not exceed $10 million.
2. The contracts are for the construction of homes containing 4 or fewer dwelling units. Eighty percent or more of the estimated total costs of the contract must be for these homes plus any related land improvements.
3. The contracts are for the construction of residential apartments (80 % or more of the total contract costs are attributable to these buildings).
You can account for your income and expenses using the completed-contract method if you meet either of the first 2 exceptions. If you meet the third exception, you account for your income and expenses under a special method called the percentage-of-completion/capitalized-cost method. Under this hybrid method, 70 % of income and expenses are reported under the percentage-of-completion method while 30 % of income and expenses are reported under the completed-contract method.
Manufacturing contracts are treated as long-term contracts only if they involve the manufacture of unique items that cannot be completed within a 12-month period. Thus, income and expenses relating to most manufacturing contracts are reported under the company's usual method of accounting.
LOOK-BACK METHOD
At the end of the contract period, you must look back to each year that the contract was in progress and recalculate the income using the correct contract price and costs. These revised numbers determine whether the business owes additional interest on the taxes it should have paid or it is entitled to receive interest on the taxes already paid. Interest for this purpose is hypothetical interest on the overpayment and underpayment for each of the years in issue. This interest is calculated on Form 8697, Interest Computation Under the Look-Back Method for Completed Long-Term Contracts.
Small business owners, however, may escape the application of the look-back method. This method is not required if the contract is completed within a 2-year period and the contract's gross sale price does not exceed the lesser of $1 million or 1 % of the business’ average annual gross receipts for the 3 years preceding the tax year in which the contract is completed.
Even if the exception for small businesses cannot be met,