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	$	286,000
Catering revenues		89,910		$	375,910
Expenditures:
Donut supplies	$	145,660
Catering expense		36,580
Salaries to shop employees		61,000
Rent expense		47,360
Accident insurance premiums		8,808
Other business expenditures		8,890			-308,298
Net Income				$	67,612

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.

1. 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 $2,550, and Hank reduced the reported catering fees for the first year to reflect the expected refund.
2. In the first year, HW received a $7,260 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.
3. In July, HW paid $2,520 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 $420 for the violation. HW paid the fine, and Hank included the fine and the cost of the campaign in “other business” expenditures.
4. In July, HW also paid $8,808 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 $8,808 as accident insurance premiums.
5. 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 $2,340 as a damage deposit and $8,900 for rent ($890 per month). Hank explained that the damage deposit was refundable at the end of the lease. At this time, Hank also paid $36,120 to lease kitchen equipment for 24 months ($1,505 per month). Both leases began on June 1 of the first year. In his estimate, Hank deducted these amounts ($47,360 in total) as rent expense.
6. 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, $9,930, 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 $9,930 in last year’s catering expense.
7. 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 $5,950 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.
8. In the first year, HW catered a large breakfast event to celebrate the city’s anniversary. The city agreed to pay $8,120 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 $6,180. 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:

1. 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.
2. Determine the taxable income that HW will generate if Hank chooses to account for the business under the accrual method.

	a. The tax return is due by 15th day of April Taxable income b. Taxable income

Answer 1

Part A

HW’s results should be reported on a Schedule C filed with Hawk’s personal tax return. The tax is due on 15^th day of April.

	Balance	Adjust	Correct
Revenue:
Donut sales	$ 286000		$ 286000
Catering revenues	$ 89910	$ 2550	$ 99720
		$ 7260
Total Revenue	$ 375910		$ 385720
Expenditures:
Donut supplies	$ 145660		$ 145660
Catering expense	$ 36,580	(9930)	$ 26650
Salaries to shop employees	$ 61000		$ 61000
Rent expense	$ 47360	(2340)	19435
		(25585)
Accident insurance premiums	$ 8808	(6973)	1835
Other business expenditures	$ 8890	(420)	2520
		(5950)
Total Expenses	$ 308298		$ 257100
Net Income	$ 67612		$ 128620

Adjustments under the cash method

a. refunds cannot be deducted from revenue until paid = 2550

b. prepaid income is recognized in the period received = 7260

c. a fine is non-deductible = 420

d. only 5 months are deductible 8808-(8808 x 5/24) = 6973

e. deposits are not deductible = 2,340

deduct 7 months of equipment lease 36120-(1505*7) = 25585

f. last month cater expense unpaid at year end = 9,930

g. key person insurance premium is not deductible = 5,950

h. no change under the cash method

Part B

	Balance	Adjust	Correct
Revenue:
Donut sales	$ 286000		$ 286000
Catering revenues	$ 89910	$ 2550	$ 100822
		$ 242
		$8120
Total Revenue	$ 375910		$ 386822
Expenditures:
Donut supplies	$ 145660		$ 145660
Catering expense	$ 36,580		$ 36580
Salaries to shop employees	$ 61000		$ 61000
Rent expense	$ 47360	(2340)	$ 16765
		(2670)
		(25585)
Accident insurance premiums	$ 8808	(6973)	1835
Other business expenditures	$ 8890	(420)	2520
		(5950)
Total Expenses	$ 308298		$ 264360
Net Income	$ 67612		$ 122462

Adjustments under the Accrual method

Adjustments under the accrual method

a. refunds are a payment liability so no deduction = 2550

b. prepaid income ($7260/30*1) is deferred one year = 242

c. a fine is non-deductible = 420

d. only 5 months are deductible 8808-(8808 x 5/24) = 6973

e. deposits are not deductible = 2,340

Deduct 7 months of shop lease 8,900-(890x7) = 2670

deduct 7 months of equipment lease 36120-(1505*7) = 25585

f. catering expense is accrued properly

g. key person insurance premium is not deductible = 5,950

h. no change under the cash method = 8120

Therefore,

a	The tax return is due by	15th day of April
	Taxable income	$ 128620
b	Taxable income	$ 122462