Question

Ralph and Teresa, two calendar year taxpayers, are starting a new manufacturing business. They intend to incorporate the business with $600,000 of their own capital and 42 million of equity capital obtained from other investors. The company expects to incur organizational and startup expenditures of4100,000 in the first year. Inventories are a material income-producing factor. The Company also expe3cts to incur losses of $500,000 in the first two years of operations and substantial research and development expenses during the first three years. The company expects to break even in the third year and be profitable at the end of the fourth year, even though the nature of the business will continually require research and development activities. What accounting methods and tax elections must Ralph and Teresa consider in their first year of operations? For each method and election, explain the possible alternatives and the advantages and disadvantages of each alternative.

Answer 1

Firstly, they have to decide their tax year, which is also known as accounting period.

There are two tax years- 1. Calendar year 2. Fiscal year (its a 12 months period that end on the last day of the month other then December)

A partnership or LLC must choose the same tax year as of the majority of its owners.

In this case, Ralph and Teresa both are calendar year taxpayer, so they can use calendar year as their accounting period.

If they are starting their business anytime during the year (other then January), they can use fiscal year, as this will give them a longer period to earn income to offset startup cost.

Next, they have to decide on accounting method. There are two accounting methods:

1. Cash method - In this income is recorded when cash is received and expenses are booked when cash is paid

2. Accural method - In this, income is recorded at the time of sale, even if the cash is not yet received and expenses are booked when they occur, even if they are not yet paid.

In this case, they can use accural method for sale as the inventories are the material income producing factor, and cash method for other item, means hybrid method, if they are eligible or permitted to use that.

They have to decide on accounting method for inventory i.e. FIFO, LIFO or LCM. what method they use depends on items of inventory and their market price.

They also have to consider, whether they want to write off organisational and startup expenditure or they want to amortize it over a period of 60 months or more. Amortization will reduce the loss in the first year, and will offset it against income in later years

Decision regarding Research and development cost to be consider, whether to write off in the year of expense or to amortize it over a period. Write off will increase the loss in the year of expenses where as amortization will reduce the loss for the first year and off set it against income in later years.