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: Revenue: Donut sales $ 254,000 Catering revenues 72,630 $ 326,630 Expenditures: Donut supplies $ 125,500 Catering expense 28,420 Salaries to shop employees 53,000 Rent expense 40,480 Accident insurance premiums 8,424 Other business expenditures 6,970 −262,794 Net Income $ 63,836 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 $1,750, and Hank reduced the reported catering fees for the first year to reflect the expected refund. In the first year, HW received a $6,780 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 $1,560 to ADMAN Company 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 $260 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 $8,424 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 $8,424 as accident insurance premiums. In 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 $2,020 as a damage deposit and $8,100 for rent ($810 per month). Hank explained that the damage deposit was refundable at the end of the lease. At this time, Hank also paid $30,360 to lease kitchen equipment for 24 months ($1,265 per month). Both leases began on June 1 of the first year. In his estimate, Hank deducted these amounts ($40,480 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, $9,290, 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 $9,290 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 $5,150 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 $7,160 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 $5,540. 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: a-1 and a-2. 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. Identify when Hank should file the tax return for HW and calculate the amount of taxable income generated by HW last year. b. Determine the taxable income that HW will generate if Hank chooses to account for the business under the accrual method. Note: Do not round intermediate calculations.

Answer 1

Hank should file the tax return for HW by the due date of his personal tax return, which is April 15th of the following year. The taxable income generated by HW last year is $63,836.

Step-by-step explanation:

Hank should file the tax return for HW by the due date of his personal tax return, which is April 15th of the following year. In this case, he should file the tax return for HW and his personal tax return for last year on April 15th of the current year.

To calculate the taxable income generated by HW last year, we need to subtract the deductible expenses from the total income.

Revenue: Donut sales $254,000 + Catering revenues $72,630 = $326,630

Expenditures: Donut supplies $125,500 + Catering expense $28,420 + Salaries to shop employees $53,000 + Rent expense $40,480 + Accident insurance premiums $8,424 + Other business expenditures $6,970 = $262,794

Taxable Income: Total income - Deductible expenses = $326,630 - $262,794 = $63,836

Answer 2

To calculate HW's taxable income under the cash method, certain adjustments to revenues and expenditures must be made. The tax return should be filed by April 15th following the tax year, and the income will differ under accrual accounting, which recognizes income when earned and expenses when incurred.

Step-by-step explanation:

Calculating Taxable Income for Hank's Donut World

To calculate the taxable income for Hank's Donut World (HW) under the cash method of accounting for the first year, we consider the revenue and expenses as they are recognized when cash is received or paid. Given that Hank operates on a calendar year, he should file his tax return by April 15th of the following year. The adjustments needed for the income tax calculation would be as follows:

• Exclude the $6,780 catering payment for future services.
• Include the expected $1,750 refunds in the calculation of the revenue.
• Prorate the insurance premium of $8,424 for the portion of the year that applies ($3,510 for the first 5 months).
• Do not deduct the damage deposit of $2,020 as it is refundable.
• Exclude the $9,290 withheld payment for WEGO as it was not paid in the tax year.
• The life insurance premium on the key employee is not deductible as it benefits the company on the key employee's death.
• Include the $7,160 for the city's event as receivable under the accrual method.

The net income after these adjustments would be different from the initially reported $63,836 under the cash method, and the accrual method would yield a different taxable income as it requires recognizing income when earned and expenses when incurred, regardless of the cash flow.

If Hank selected the accrual method, additional changes would be made:

• Include all income earned during the year, not just when cash is received.
• Match all expenses incurred during the year against the income, not just when cash is paid.

These adjustments would affect the initial net income figure and result in a different taxable income amount. The actual calculation would require a detailed listing of all receivables and payables according to the accrual accounting standards.