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 $ 282,000 Catering revenues 87,750 $ 369,750 Expenditures: Donut supplies $ 143,140 Catering expense 35,560 Salaries to shop employees 60,000 Rent expense 46,500 Accident insurance premiums 8,760 Other business expenditures 8,650 - 302,610 Net Income $ 67,140 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 $2,450, and Hank reduced the reported catering fees for the first year to reflect the expected refund. In the first year, HW received a $7,200 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 $2,400 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 $400 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 $8,760 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 $8,760 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 $2,300 as a damage deposit and $8,800 for rent ($880 per month). Hank explained that the damage deposit was refundable at the end of the lease. At this time, Hank also paid $35,400 to lease kitchen equipment for 24 months ($1,475 per month). Both leases began on June 1 of the first year. In his estimate, Hank deducted these amounts ($46,500 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, $9,850, 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 $9,850 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 $5,850 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 $8,000 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 $6,100. 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: 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. 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	Correcct
Donut sales	282000		282000
Catering revenue	87750	2450	97400
		7200
Total revenue	369750		379400
Expenditure:
Donut supplies	143140		143140
catering expenses	35560	-9850	25710
salaries	60000		60000
rent	46500	-2300	44200
		-25075
Accident insurance premium	8760	-6935	1825
Other business exp	8650	-400	2400
		-5850
Total expenses	302610		277275
Net income	67140	60060	102125

Adjustment under cash method

Refund cannot be deducted from revenue 2450

Prepaid income is recognised in period received 7200

Last month cater expenses unpaid at year end 9850

deposit are non deductible 2300

deduct 7 monnths1475*7=10325 (35400-10325) 25075

fine is not deductible 400

7 months are deductible 8760-(8760*5/24) 6935

Revenue	Balance	Adjust	Correcct
Donut sales	282000		282000
Catering revenue	87750	2450	98440
		240
		8000
Total revenue	369750		380440
Expenditure:
Donut supplies	143140		143140
catering expenses	35560		35560
salaries	60000		60000
rent	46500	-2300	16485
		-25075
		-2640
Accident insurance premium	8760	-6935	1825
Other business exp	8650	-400	2400
		-5850
Total expenses	302610		259410
Net income	67140	53810	121030

Accrual Method

No deduction 2450

No change under cash method 8000

prepaid income deferred one year 240

deposit are non deductible 2300

fine is not deductible 400

deposit are non deductible  

only 7 month of lease 8800-(880*7) = 2640

deduct 7 monnths1475*7=10325 (35400-10325) 25075