Micro, an accrual basis corporation, reported $505,100 net income before tax on
ID: 2332707 • Letter: M
Question
Micro, an accrual basis corporation, reported $505,100 net income before tax on its financial statements prepared in accordance with GAAP. Micro’s records reveal the following information:
* Micro paid $25,000 in legal fees and $100,000 to a former employee to settle a claim of sexual harassment. To avoid negative publicity, Micro insisted that the settlement include a confidentiality agreement.
* Late in the year, Micro entered into a five-year licensing agreement with an unrelated firm. The agreement entitles the firm to use a Micro trade name in marketing its own product. In return, the firm will pay Micro an annual royalty of 1 percent of gross revenues from sales of the product. The firm paid a $40,000 advanced royalty to Micro on the day the agreement was finalized. For financial statement purposes, this prepayment was credited to an unearned revenue account.
* At its final meeting for the year, Micro’s board of directors authorized a $15,500 salary bonus for the corporation’s president to reward him for an outstanding performance. Micro paid the bonus on January 12. The president doesn’t own enough Micro stock to make him a related party for federal tax purposes.
* Micro was incorporated last year. On its first tax return, it reported a $21,400 net operating loss.
Compute Micro's taxable income by showing the adjustments to book income to arrive at taxable income. (Amounts to be deducted should be indicated with a minus sign.)
Micro’s net book income before tax Sexual harassment settlement and legal fees Prepaid royalty income Accrued bonus expense NOL carryforward deduction Micro’s taxable income $0Explanation / Answer
Micro's Taxable Income
Note 1
Section162(q) of IRS provides:
So, the amount of 125,000 already deducted from the income should be added back.
Note 2
As per GAAP, Royalty advances received may be refundable or non-refundable. Refundable royalty advances are credited to the liability account: Unearned Advances. This balance is reduced as royalty earnings are reported. Non-refundable advances are treated as income.
Suppose here the advance are refundable, they are not to treated as income.
Now, over here the income of 40,000 is already included, we have to deduct it.
Note 3
As per GAAP, rule allows businesses to deduct bonuses employees have earned during a tax year if the bonuses are paid within 2½ months after the end of that year (by March 15 for a calendar-year company). only accrual-basis taxpayers can take advantage of the 2½ month rule — cash-basistaxpayers must deduct bonuses in the year they’re paid, regardless of when they’re earned.
Since here bonus has been paid withinh 2.5 months after the close of the year, we need to deduct the bonus expense this year.
Note 4
As per GAAP, an NOL can be used in some other tax reporting period as an offset to taxable income, which reduces the tax liability of the reporting entity. The basic rules for using an NOL are:
Particulars Amount Micro’s net book income before tax 505,100 Sexual harassment settlement and legal fees (Note1) 125,000 Prepaid royalty income (Note2) -40,000 Accrued bonus expense (Note3) -15,500 NOL carryforward deduction (Note4) -21,400 Micro’s taxable income 553,200