Q: For Exercise Step 5, could we use the whole $201,887 Section 179 Deduction to reduce taxable income to below zero? Would we not be allowed to take that full amount once taxable income falls below $0?
A: No. Internal Revenue Service guidelines regarding the use of a Section 179 Deduction earned by a “pass-through” entity (a Partnership, Subchapter S Corp, or Limited Liability Company) say first that the deduction shall be used only by the partners, owners, or members on a pro-rata basis rather than by the business entity itself. An additional piece of IRS guidance requires that the Section 179 Deduction “passed through” in any given year shall not exceed the Ordinary Business Income earned by the company in the same year to avoid using the deduction to create a tax loss.
A consequence of this guidance is that the Section 179 Deduction is not used as a deductible expense in calculating Ordinary Business Income for a “pass through” entity. Note also that Generally Accepted Accounting Principles prevent a “pass through” business from using a Section 179 Deduction as an expense in calculating profits. With that additional guidance, note also that the Section 179 Deduction has no impact on the calculation of Accumulated Depreciation.
Q: Is it your professional recommendation to use tax returns and reconcile back to book earnings using the reconciling information presented in the Schedule M-1? Or would you instead recommend using company prepared financial statements in analyzing performance?
A: I encourage you to use GAAP-driven accrual financial statements in conducting credit analysis. Accrual statements present a quantified version of business activity for the period reported. Since we seek to analyze the efficiency and effectiveness of the business activity conducted, accrual statements are our best vehicle and most reliable source of information for doing so.
In the absence of accrual statements, please make use of the techniques described today to convert the tax return “front page” schedule to an accrual income statement.
Course overview: Schedule M-1 and the Accrual Income Statement