Question 1
If a taxpayer can deduct expenses to the extent of gross income for a hobby, is there really no taxable income? And what would be the benefit, to the taxpayer, of having it considered a for profit activity by the IRS?
Upon inquiry by the IRS, a taxpayer was unable to show that his activity had a profit in three of the past five years. Therefore, the IRS deemed the activity to be a hobby. The taxpayer believes the activity to be profit motivated. How would the taxpayer prove that the activity is profit motivated? Discuss ideas that might convince the IRS that the activity is profit motivated. What other options does the taxpayer have?
Respond to this... The IRS has some guidelines when inquiring if a person is running a profitable business or a hobby. The main material issue is if the business is profitable. For example the IRS will deem a business a hobby if they have not turned a profit 3 out of 5 years. Additionally if the tax payer has a hobby they can deduct all expenses up to the amount of income. Issues however have come to light and have been under review by the IRS due to the fact that many people (specifically those with incomes of 100k or higher) were using "hobbies" as tax shelters and taking large losses lowering their AGI.
"A number of taxpayers who have significant income from other sources reduce their taxable income by reporting losses from activities that may or may not be engaged in for profit. It is up to IRS examiners to make a factual determination whether anactivity is engaged in for profit"(IRS, 2016)
The issues come into play regarding legitimacy,is the business trying to make a profit? Does fraud or money laundering look apparent by "flagged" material losses or illegitimate business fronts?
Some taxpayers may want to try and keep their "business" profitable ever so slightly so they can incur major losses the following year.Essentially if a taxpayer has a business and tries to keep it profitable every other year on the off years they can take large losses lowering their taxable income. Ultimately the IRS looks to make sure that businesses are attempting to be legitimate and profitable while hobbies reflect the actions of hobby related transactions to ensure that they are differentiated.
https://www.irs.gov/businesses/small-businesses-self-employed/irc-183-activities-not-engaged-in-for-profit-atg
Question 2
Inventory valuation is seen by many companies as an important factor in their success. What do you feel are types of decisions a company must make when choosing an inventory valuation method? What is the relationship of this decision to the cost of goods sold for the company? Explain your reasoning.
Respond to this... The inventory method chosen by a company is mainly based upon what is sold by the company. A company that sells food will generally follow the FIFO method, the first item in the store is the first sold. The cost of goods sold follows the inventory and generally will reveal the true valuation of the company's cash situation. LIFO is good for retail as the last item in is deducted from the costs leaving a lower inventory amount on the books. Reducing the profit and tax burden of the company; that said, it does produce a higher cash flow for the company. Builders who build multiple houses at the same time will most likely used an average method and disburse the cost of inventory across many houses. A builder that uses a weighted method will, for the most part build few houses at a time and generally have those houses be more customizable. The COGS for both of these methods will fall in-between the FIFO and LIFO methods. Giving the company a in-between valuation of the remaining cash on the books.
Once a company chooses an inventory method for itself it can styles with the exception of the LIFO method. Going to or breaking away from this method generally requires approval for the IRS as it gives tax breaks to the company. The other methods benefit the IRS and its cash flow so it does not mind the use of this method.
Question 3
Discuss some of the pros and cons of using debt as a long-term source of capital funding for a company. Why does using an appropriate amount of debt increase the value of the firm?
Respond to this...There are many pros and cons of using debt as a long term source of capital funding. Some examples of Pros of using debt are the interested payments are tax deductible. The companies with debt will generally have greater profits.
Another pro is if you finance debt, bankers and lenders are not looking for ownership in the company. The company remains in control and can still choose the business direction.
Debt tends to keep managers on their toes. They will need to focus on running efficiently and making profit for their departments.
One example of a con for debt financing is the repayment schedule. If you finance through debt, banks want their money according to the lending agreement the business signed. It doesn't matter if the company has a bad month or had a flood in part of the building. The bank gets paid or you pay big penalties for non-payment or late payments.
When financing debt, it affects the companies' credit rating. If you have too many credit cards in your name, you may be declined for a loan. Just like in our personal lives, too much financing can create a negative credit rating and it may be more difficult to get additional financing in the future.
Another con of debt financing is it makes the company less financially flexible. If a new project comes along, the amount of debt could make it hard to get additional funds for a new project.
Using an appropriate amount of debt increases the value of a firm because it develops a good credit which will get lower interest rates. Low interest rates say good risk or assets to cover what they are borrowing. Just like in your personal life, if your credit rating is good, more people are willing to help and you have more options available to the company.
https://www.securedocs.com/blog/2012/04/debt-financing-pros-and-cons