Stan and Susan, two calendar year taxpayers, are starting a new business to manu

Question

Stan and Susan, two calendar year taxpayers, are starting a new business to manufacture and sell digital circuits. They intend to incorporate the business with $600,000 of their own capital and $2 million of equity capital obtained from other investors. The company expects to incur organizational and start-up expenditures of $100,000 in the first year. Inventories are a material income-producing factor. The company also expects 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 digital circuit business will require continual research and development activities. What accounting methods and tax elections must Stan and Susan consider in their first year of operation? For each method and election, explain the possible alternatives and the advantages and disadvantages of each alternative.

Explanation / Answer

Ans.

1) In order to establish the tax year for the corporation to follow, Susan and Stan need to make the first tax election during the formation of the corporation. Stan and Susan may choose either calendar year or fiscal year. In the calendar year scheme, starting month is Jan. 1st and ending is Dec. 31st. According to fiscal year, the 12-month period ends on any month`s last day other than December. If Susan and Stan form a C-corporation then they will have the freedom to make such decision. If they form an outline other than this one for the corporation then they have to follow the calendar year as the taxes that follow the calendar year are going to flow through to their own income tax returns. This is vital to make this decision as the company will have to go on with this decision for at least 48 months before submitting the Form 1128 to change the tax year period. Susan and Stan have to consider the date of formation of the corporation when they elect a tax year. The calendar tax year is the best pick if the corporation is created at the starting of the year. When the corporation is chosen to form in the middle of the year then they could select a fiscal year or they also may choose the calendar year and can file a short time return for their primary tax return.

2) For the purpose of tax, Susan and Stan also have to select an accounting method. There are three options for them to choose from as a method: the accrual method, the cash method, and the hybrid method. Accrual method has to be used by most of the corporations as it reports about the expenses in the tax year they use. The accrual method is regarded as the standard reporting layout for financial reporting as it is just tax calculations at the end of the year. Yet, the corporation belonging to Susan and Stan may use the cash method since they meet the gross receipts test $5 million dollar. In the cash method, the company gets reports whenever it gets a payment or pays expenses rather than according to the period they are incurred in. Stan and Susan think of their inventories that these are a material and income producing factor and will rule out the cash method. But Stan and Susan are bound to use either accrual method or hybrid method. The hybrid method uses both cash and accrual method; one to report about sales, costs, inventories and accounts receivable and payable, and other one for reporting any other expenses or income. The hybrid scheme might be the best preference as the cash method is less burdensome to use for other objects related to income and cost.

Therefore Stan and Susan ought to decide whether they want to create a C corporation (with the possibility of being taxed twice) or want to make an S corporation in order to pass the start up losses or want to capitalize the corporation with dept as well as equity.

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