Question

1.What type of accounting method do corporations use? What about partnerships?

2. What is the difference between Ordinary Business Income and Portfolio Income? Name some types of income that would qualify for each category

3. What is the difference between Business interest Expense (IRC 163j) and Investment Interest Expense (163d)? What are the limitations on both?

Answer 1

1. The 2 main types of accouting systems are Cash accounting and Accrual accounting

Cash accounting refers to the accounting system in which revenues are recorded when they are received (rather than when they are actually earned) and expenses are accounted in the period when they are paid (rather than actually incurred). This method has limitations for large companies which have dozens of transactions on a daily basis, and it becomes diffiult to find out actual profitability during a specific period

Accrual accounting is when the revenues and expenses are recorded when they become due(irrespective of whether actual cash has been paid or received) The main advantage of the accrual method is that it provides a more accurate picture of how a business is performing over the long-term than the cash method.

In general, most businesses use accrual accounting, while individuals and small businesses use the cash method. The IRS states that qualifying small business taxpayers can choose either method, but they must stick with the chosen method. “Small business” taxpayers include corporations and partnerships with gross receipts of less than $10 million.

Hence, if the corporation or the partnership has gross receipts of less than $10 million, they can choose either the cash or the accrual basis of accounting, while those with gross receipts of over $10 million will have to follow the accrual basis.

2. Ordinary business income or earned income is compensation from employment or the actual involvement of a business. This type of income includes your salary, wages, tips, etc.

Portfolio income is income from investments, dividends, interest and capital gains. Royalties received from property held for investment is also considered portfolio income.

The tax treatment of both these types of incomes is different. Earned income is the most taxed form of income. Earned income is subject to personal income tax , as well as other taxes, such as social security and Medicare taxes. Portfolio income is subject to capital gains tax, which is lower than the taxes for earned income.

3. Business interest Expense (IRC 163j) means the amount of interest paid or accrued by the taxpayer during the tax year, less the amount of interest income includable in the taxpayer's gross income for the year. Investment interest expenses include margin interest used to leverage securities in a brokerage account and interest on a loan used to buy property held for investment.

On April 2, the U.S. Department of the Treasury and the IRS released Notice 2018-28 to provide interim guidance on the section 163(j) interest deduction limitation. New section 163(j) limits the taxpayer’s annual deduction of interest expense to the sum of: (1) business interest income, (2) 30 percent of the adjusted taxable income of the taxpayer, and (3) the floor plan financing interest of the taxpayer for the taxable year. The last element, floor plan financing, applies to dealers of self-propelled motor vehicles designed for transporting persons or property on a public street, highway, or road; boats; or self-propelled farm machinery or equipment. Aside from floor plan financing, a taxpayer’s limitation on net interest expense (i.e., interest expense less interest income) will generally be 30 percent of adjusted taxable income.

While the 163(j) limitations only apply to business interest expense, these limitations impact many areas in the investment space. It is important to be aware of these limitations so that you can plan around them.