Question

Hank started a new business, Hank’s Donut World (HW for short), in June of last year. He has requested your advice on the following specific tax matters associated with HW’s first year of operations. Hank has estimated HW’s income for the first year as follows: (Do not round intermediate calculations.)

Revenue:
Donut sales	$	284,000
Catering revenues		88,830		$	372,830
Expenditures:
Donut supplies	$	144,400
Catering expense		36,070
Salaries to shop employees		60,500
Rent expense		46,930
Accident insurance premiums		8,784
Other business expenditures		8,770		-	305,454
Net Income				$	67,376

HW operates as a sole proprietorship and Hank reports on a calendar year. Hank uses the cash method of accounting and plans to do the same with HW (HW has no inventory of donuts because unsold donuts are not salable). HW does not purchase donut supplies on credit nor does it generally make sales on credit. Hank has provided the following details for specific first-year transactions.

A small minority of HW clients complained about the catering service. To mitigate these complaints, Hank’s policy is to refund dissatisfied clients 50 percent of the catering fee. By the end of the first year, only two HW clients had complained but had not yet been paid refunds. The expected refunds amount to $2,500, and Hank reduced the reported catering fees for the first year to reflect the expected refund.

In the first year, HW received a $7,230 payment from a client for catering a monthly breakfast for 30 consecutive months beginning in December. Because the payment didn’t relate to last year, Hank excluded the entire amount when he calculated catering revenues.

In July, HW paid $2,460 to ADMAN Co. for an advertising campaign to distribute fliers advertising HW's catering service. Unfortunately, this campaign violated a city code restricting advertising by fliers, and the city fined HW $410 for the violation. HW paid the fine, and Hank included the fine and the cost of the campaign in “other business” expenditures.

In July, HW also paid $8,784 for a 24-month insurance policy that covers HW for accidents and casualties beginning on August 1 of the first year. Hank deducted the entire $8,784 as accident insurance premiums.

On May of the first year, Hank signed a contract to lease the HW donut shop for 10 months. In conjunction with the contract, Hank paid $2,320 as a damage deposit and $8,850 for rent ($885 per month). Hank explained that the damage deposit was refundable at the end of the lease. At this time, Hank also paid $35,760 to lease kitchen equipment for 24 months ($1,490 per month). Both leases began on June 1 of the first year. In his estimate, Hank deducted these amounts ($46,930 in total) as rent expense.

Hank signed a contract hiring WEGO Catering to help cater breakfasts. At year-end, WEGO asked Hank to hold the last catering payment for the year, $9,890, until after January 1 (apparently because WEGO didn’t want to report the income on its tax return). The last check was delivered to WEGO in January after the end of the first year. However, because the payment related to the first year of operations, Hank included the $9,890 in last year’s catering expense.

Hank believes that the key to the success of HW has been hiring Jimbo Jones to supervise the donut production and manage the shop. Because Jimbo is such an important employee, HW purchased a “key-employee” term-life insurance policy on his life. HW paid a $5,900 premium for this policy and it will pay HW a $40,000 death benefit if Jimbo passes away any time during the next 12 months. The term of the policy began on September 1 of last year and this payment was included in “other business” expenditures.

In the first year, HW catered a large breakfast event to celebrate the city’s anniversary. The city agreed to pay $8,060 for the event, but Hank forgot to notify the city of the outstanding bill until January of this year. When he mailed the bill in January, Hank decided to discount the charge to $6,140. On the bill, Hank thanked the mayor and the city council for their patronage and asked them to “send a little more business our way.” This bill is not reflected in Hank’s estimate of HW’s income for the first year of operations.

Required:

a.

Hank files his personal tax return on a calendar year, but he has not yet filed last year’s personal tax return nor has he filed a tax return reporting HW’s results for the first year of operations. Explain when Hank should file the tax return for HW and calculate the amount of taxable income generated by HW last year.

    

b.

Determine the taxable income that HW will generate if Hank chooses to account for the business under the accrual method.

Answer 1

Revenue	Balance	Adjust	Correct
Donut Sales	$ 284,000		284,000
catering revenue	88,830	2,500	98,560
		7,230
Total Revenue	372830		382,560
Expenditures:
Donut Supplies	144,400		144,400
Catering Expenses	36,070	-9,890	26180
Salaries to shop employees	60,500		60,500
Rent Expense	46,930	-2,320	19,280
		-25,330
Accident insurance premium	8,784	-6954	1830
Other business expenditures	8,770	-410	2,460
		-5,900
Total Expense	67376.00	60534	127910
Adjustments under cash method
refunds cannot be deducted from revenue until paid	2500
prepaid income is recognised in the period received	7230
fine is non deductible	410
only 7 months are deductible 8784-8784*5/24	6954

deposits are not deductible	2,320
deduct 7 month of equip lease	25330
caterer expense unpaid at year end	7,230
key person premium not deductible	5900
total adjustment under cash method	60534
Net income taxable	127910

hank should report the HWs result unde schedule Cfiled with his personal tax return which is due by the 15th day of april HW's taxable income is 127910