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 Catering revenues $ 256,000 73,710 329,710 Expenditures: Donut supplies Catering expense Salaries to shop employees Rent expense Accident insurance premiums Other business expenditures $126,760 28,930 53,500 40,910 8,448 7,090 - 265,638 $ 64,072 Net Income 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 1. 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 $1,800, and Hank reduced the reported catering fees for the first year to reflect the expected refund 2. In the first year, HW received a $6,810 payment from a client for catering a monthly breakfast for 30 consecutive months beginning 3. In July, HW paid $1,620 to ADMAN Co. for an advertising campaign to distribute fliers advertising HW's catering service 4. In July, HW also paid $8,448 for a 24-month insurance policy that covers HW for accidents and casualties beginning on August 1 of 5. 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 in December. Because the payment didn't relate to last year, Hank excluded the entire amount when he calculated catering revenues Unfortunately, this campaign violated a city code restricting advertising by fliers, and the city fined HW $270 for the violation. HW paid the fine, and Hank included the fine and the cost of the campaign in "other business" expenditures the first year. Hank deducted the entire $8,448 as accident insurance premiums paid $2,040 as a damage deposit and $8,150 for rent ($815 per month). Hank explained that the damage deposit was refundable at the end of the lease. At this time, Hank also paid $30,720 to lease kitchen equipment for 24 months ($1,280 per month). Both leases began on June 1 of the first year. In his estimate, Hank deducted these amounts ($40,910 in total) as rent expense 6. 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, $9,330, 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 Januarv after the end of the first vear. However, because the payment related to the first

Answer 1

Part A

HW’s results should be reported on a Schedule C filed with Hawk’s personal tax return. The tax is due on 15^th day of April.

	Balance	Adjust	Correct
Revenue:
Donut sales	256000		256000
Catering revenues	73710	1800	82320
		6810
Total Revenue	329710		338320
Expenditures:
Donut supplies	126760		126760
Catering expense	28930	(9330)	19600
Salaries to shop employees	53500		53500
Rent expense	40910	(2040)	17110
		(21760)
Accident insurance premiums	8448	(6688)	1760
Other business expenditures	7090	(270)	1620
		(5200)
Total Expenses	265638		220350
Net Income	64072		117970

Adjustments under the cash method

a. refunds cannot be deducted from revenue until paid = 1800

b. prepaid income is recognized in the period received = 6810

c. a fine is non-deductible = 270

d. only 5 months are deductible 8,448-(8,448 x 5/24) = 6688

e. deposits are not deductible = 2,040

deduct 7 months of equipment lease 30,720-(1,280x7) = 21760

f. last month cater expense unpaid at year end = 9,330

g. key person insurance premium is not deductible = 5,200

h. no change under the cash method

Part B

	Balance	Adjust	Correct
Revenue:
Donut sales	256000		256000
Catering revenues	73710	1800	82957
		227
		7220
Total Revenue	329710		338957
Expenditures:
Donut supplies	126760		126760
Catering expense	28930		28930
Salaries to shop employees	53500		53500
Rent expense	40910	(2040)	14665
		(2445)
		(21760)
Accident insurance premiums	8448	(6688)	1760
Other business expenditures	7090	(270)	1620
		(5200)
Total Expenses	265638		227235
Net Income	64072		111722

Adjustments under the accrual method

a. refunds are a payment liability so no deduction = 1800

b. prepaid income ($6,810/30*1) is deferred one year = 227

c. a fine is non-deductible = 270

d. only 5 months are deductible 8,448-(8,448 x 5/24) = 6688

e. deposits are not deductible = 2,040

Deduct 7 months of shop lease 8,150-(815x7) = 2445

deduct 7 months of equipment lease 30,720-(1,280x7) = 21760

f. catering expense is accrued properly

g. key person insurance premium is not deductible = 5,200

h. no change under the cash method = 7220

Therefore,

a.	The tax return is due by	15th day of April
	Taxable income	$117,970
b.	Taxable income	$111,722