Can a small business first take its allowable business expense deduction for a necessary item (e.g., a business-related video) and later also take a tax deduction for a charitable donation of the slightly used item (the video) to a charity?

No, it is only expensible once. When you give it away all you do is re-classify the expense.

Buy it: charge to supplies
Give it: deduct it from supplies, add it to charitable donations

so it's only expensed once. That's because a small item like a video (under $200) can't be treated as an asset - at least in Canada, where that is the benchmark.

I don't know a thing about U.S. tax law. But I'd bet it's similar.

If you class an item you buy as an asset (by that I mean if it meets IRS standards for an asset) and then reclassify it as a donation when you give it away you are doing yourself a favor because assets can't be expensed (depreciated) within the year in which you buy them. So by giving an asset away to a charity you get to expense the whole amount in the current year.

Compare that with buying an asset, no longer needing it, but keeping it. You must expense it (through depreciation) over a period of years.

However, as you see, it can only be expensed once, however it is done.

"Unfair!" you say? No, because you only paid for it once.

Yes, you can. Here's how it looks on the books:

When you first purchase the tape, you affect the cash and expense accounts:

Debit "supply expense" $20
Credit "cash" $20

At the end of the year you'll close out your expenses (a routine entry that starts all your expenses out at zero for the new year):

Debit a capital account (retained earnings, owner's capital, etc) $20
Credit "supply expense" $20

At this point, you've recorded the expense on your taxes with the others on the year end's statements, and you're sitting on an asset (a small one) that has a fair market value and personal value to the company.

The following year, you donate it to a charity for it's fair market value:

debit "charitable donations" 99c
credit a capital account 99c

(If you had donated something listed on your balance sheet as an asset, like an old car, you would zero out the asset and enter the balance into the capital account.)

This is the way I've done it in the past, I'll look up in the circular to see if there's anything further.

NON-CASH CHARITABLE DONATIONS MUST ALWAYS HAVE ACCOMPANYING RECEIPTS WHETHER FOR PERSONAL TAXES OR BUSINESS.

babthrower & mahal: Thanks for getting me thinking, especially about a balance sheet, which I have not seen in a while. Following is my take on the challenge at hand.

credit: cash or petty cash
debit: videos

The videos account is a prepaid expense and so is on the assets side of a balance sheet, as is the cash/petty cash account. The two accounts cancel out one another.

When the tangible video is not completely used by the small business, whatever value it has as a charitable donation must be independently listed as other income to the small business prior to being listed as a personal tax deduction to a charity by the small business owner. There is no need to cancel out the other income in the small business, because the small business owner pays taxes on it, but the small business owner gets the charitable deduction.

Obviously, most small business owners conveniently forget to allow their business to be tapped for tax on other income by not adding in the other income at all (or by adding it in cash/petty cash and subtracting the videos account). In other words, tangible items are withdrawn left and right from a small business, and their value as other income is never listed in the business' books.

Now, here is a better way, because it yields a gain for the small business owner. I think that technically the videos account could be credited a small amount and the cash/petty cash account could be debited the same small amount. In short, the original accounting transactions would be reversed but for only the market value of the used video, which is the charitable deduction as well. In this way, the small business owner would come out ahead by the tax deduction of the charitable contribution without having to pay taxes on other income to the small business.

Now, which way is legal? Probably not both. However, the second way may be justified, because it is the benefit of having a business to be able to adjust accounts--thereby saving tax on other income!

Honestly, I have been doing it the other income way. Super honest or super foolish? I think that legally one must show a gain on a sale of an asset which is a prepaid expense. The law must recognize that the prepaid expense has tangible form and so is valuable unless consumed away. If the video were donated and neither listed as other income nor listed as a tax deduction, the government would be cheated of its taxes. Such generosity is not condoned by the government.

Here's more food for thought. If an asset is completely depreciated, there is no need to do anything to a business' books. So such an item may have a tiny value as a charitable contribution. Some lie and give such an item a greater value. Who checks?

I am probably way off, but I am giving you something about which to think long and hard. It's usually buyer beware, but the charity also has to be aware. It is time for all of us to read up on this challenge, as we seem to be way off from the way that the transactions should be done both in accounting and law!

Comments?

[This message was edited by tsaeb on 03-05-03 at 05:50 AM.]

I know that I made a few mistakes in my "analysis," but the biggest laugh is that I made the mistake of asking the question, because most years I cannot itemize deductions anyway! And the winner is . . . the charity! (Nah, I think that mahal got it correct or close to correct. )

[This message was edited by tsaeb on 03-05-03 at 06:23 AM.]

Mahal says:

"At the end of the year you'll close out your expenses (a routine entry that starts all your expenses out at zero for the new year):

Debit a capital account (retained earnings, owner's capital, etc) $20
Credit "supply expense" $20

At this point, you've recorded the expense on your taxes with the others on the year end's statements, and you're sitting on an asset (a small one) that has a fair market value and personal value to the company.

The following year, you donate it to a charity for it's fair market value:

debit "charitable donations" 99c
credit a capital account 99c

(If you had donated something listed on your balance sheet as an asset, like an old car, you would zero out the asset and enter the balance into the capital account.)"

Ummm. Couple of problems.

1. The IRS (if it is anything like Revenue Canada, and I trust that in this case it is)
will be sending you a stiff note asking you why your opening balance for the current year is different from your closing balance in the prior year; balance sheets are supposed to be the same on opening a new year as they were on closing the prior year. In other words, there is no time interval between the two reports during which 'magic transactions' can occur. It is one 'snapshot'.

So IRS would regard it as a transaction at the beginning of the new year. Since all expense accounts are zero at the beginning of the year, the transaction in reality is:

Credit retained earnings $20
Debit shareholders 19.01
Debit current year's donations expense .99

What that says is: "I have reversed an expense I claimed last year. I'm re-expensing part of it this year, and charging a shareholder for the difference."

(I assume that there is only one shareholder here. Otherwise it gets even more complicated, because 'retained earnings' represents dividends due to all shareholders.)

(2) What happens to the $19.01 ($20 - .99)? If it's sitting as a debit in a shareholder account, it means that the shareholder gets $19.01 less than otherwise.

So in effect this is what happened:

Year #1:

1. The supply was bought and expensed.

Year #2:

1. The prior year's expense was converted to a loan from shareholders. This is to say, the video was bought by shareholders for personal use.
2. The company then expensed a donation to a charity, crediting the shareholder.
3. The balance remained as a charge against the shareholder.

At the end of the year, the company pays tax on its earnings: the difference between its retained earnings account at the end of last year and the sum of (1) current earnings and (2) retained earnings at the end of this current year.

So the company has lost 19.01 of the tax advantage over the two-year period.

And the poor sap of a shareholders can't even claim it as a charitable donation on his/her personal tax because of the weird way it was done - no official charity receipts!

Trust me, you do not want to fiddle this. The reason: if you are audited and asked to explain the transaction, it is so obviously an attempt to double up a tax deduction that, even though it is quite pointless, the I.R.S. will flag you as a 'creative' bookkeeper and watch you like a hawk forever. And try and suppress their giggles as they walk away.

Be content with expensing it to supplies in the first year, then converting the part of it you consider fair value to donations if you like. IRS won't care because they're both expenses and this transaction (re-allocating it) affects your net profit not one whit. So if you want to, just give it away when it's no longer useful to you, and don't bother to book the gift at all.

Babs, from what I've heard of people who do both Canadian and American taxes, the Canadian Customs and Revenue is stiffer and less comprehensible (if you can imagine that).

END OF THE YEAR ENTRIES:

When you zero out your expenses at the end of the year, you convert all revenue and expenses to captital. Both revenue and expense accounts have zero balances both at the end of the year and at the beginning of the next year. There are no magical "in between" entries.

SELLING THE VIDEO TAPE:

You can't claim the full $20 of the original cost as you've shown because that's not the fair market value (so there's no $19.01 to worry about). You can only recover what the tape is worth (fair market value). The amount that you charge as an expense to your donations is equal to the value of the tape when it's donated, and the credit goes to the only other account that can be affected, the net worth of the company (a capital account) because you've given away a small portion of the company's net worth.

RETAINED EARNINGS:

If you're going to treat the transaction as if the company is a corporation, you need to affect the appropriate shareholder's account. At the end of the year, the expenses and revenues are zeroed to a profit and loss account, then the profit and loss account is zeroed to retained earnings after taxes.

There is no need to complicate the matter with shareholder issues because the retained earnings is the holding account for calculating the shareholders' share of the profits (if dividends are declared). The giving away of company assets SHOULD affect the net worth of the company before the declaration, therefore retained earnings is the correct holding account to be affected.

For partnerships, each owner will divide the loss according to the partnership agreement.

For sole corporations and sole proprietorships, there will only be one capital account anyway.

ACCRUAL ACCOUNTING:

Tsaeb, if your videos are a prepaid expense, you will still be adjusting the expense at the end of the year to reflect the actual amount spent, and so there's no need to treat any differently. (When you buy the tape, the expense will be recorded before the end of the year adjustment. When you give it away, you'll do the same.)

SUMMING RETAINED EARNINGS OF PREVIOUS YEARS??

We don't do this here in the states.

2002 taxes are paid on 2002 revenues less 2002 expenses. This is calculated on the profit and loss statement before retained earnings is affected.

(We used to have schedual "G", income averaging, but it went the way of the dodo in 1987 with Reaganomics, and I'm sure it was for personal income tax only.)

PUBLIC DECLARATIONS OF FINANCIAL STATEMENTS:

Babs suggested that last year's statements should reflect the same numbers as this years, and this is true. (Companies that don't publicly declare, in other words, whose stock is not for sale to the public: closed corporations, sole proprietorships, and partnerships, don't have to worry about this.)

ALTERNATIVE:

If this is something you do often, you could inventory your tapes and assign a value to them as an asset. The value will have to be fair market, not the original cost, or else the asset will appear to be overstated.

This way, when you record the donation, you would debit the expense and credit the asset, and the remainder of the asset balance should reflect the value of the remaining tapes. (Note that this asset can't be depreciated.)

SHARED ASSETS??

Tsaeb, you're now barking a different tree common to certain businesses like daycares run in a private home. They may buy certain tapes for use by the children, like "Terminator" or "Death Wish III" or "Devil's Advocate" ( ), and the family may wish to take some of the tapes for personal viewing.

Now you have to calculate a percentage of business use and personal use before you take the expense. The entire expense can only be taken on assets or supplies used "exclusively" by the business.

Originally posted by mahal:

"END OF THE YEAR ENTRIES:

When you zero out your expenses at the end of the year, you convert all revenue and expenses to captital. Both revenue and expense accounts have zero balances both at the end of the year and at the beginning of the next year. There are no magical "in between" entries."

Yes, that is what I said.

What did you mean when you said,

"At the end of the year you'll close out your expenses (a routine entry that starts all your expenses out at zero for the new year):

Debit a capital account (retained earnings, owner's capital, etc) $20
Credit "supply expense" $20

At this point, you've recorded the expense on your taxes with the others on the year end's statements, and you're sitting on an asset (a small one) that has a fair market value and personal value to the company."

If you meant that as a normal year-end entry, by crediting the expense you lose it as a deduction for tax purposes for that year.

That is why I interpreted what you said to mean that AFTER you file the tax and claim the expense of $20) you somehow whisk it into a balance sheet account.

But if you whisk it into a balance sheet account BEFORE you file your tax, you lose the expense exemption.

What did you mean?

Here are the steps in order (and in a little more detail):

1--Buy a video tape some time during the year

..debit: video expense $20
..credit: cash $20

2--End of the year corrections to the books (errors only, no end of the year adjustments yet)

3--End of the year profit/loss statements (no debits/credits here, just print commands)

4--Do your taxes (still no debits or credits, just copying of numbers from p/l to form 1120 or 1040)

5--End of the year adjustment:

..corporations

..debit: profit/loss $20
..credit: video expense $20

..other businesses

..debit: a capital account $20
..credit: video expense $20

6--End of the year adjustment:

..corporations

..debit: retained earnings $20
..credit: profit/loss $20

..other businesses

..no entry necessary

7--Start new year

8--Give away video

..debit: charitable donations $.99
..credit: capital/holding account $.99

For us, filing taxes has no impact on the balance sheet, nor do end of the year adjustments impact taxes. (There will be tax expenses to record, that's it.) Tax info comes from the p/l's before end of the year adjustments.

I guess there's an exception to every rule. Those business using accrual accounting (like using prepaid expenses as an asset) will do an end of the year adjustment on the accrued expenses, and this will have an impact on taxes because there must be an adjustment to the actual expense incurred, not the predicted expense.

Following the end of the year close-out, there will be another entry in the beginning of the year to reinstate the prepaid asset.

I think that the main point has been missed due to quibbling over bookkeeping entries and balance sheets. The main point is that for a small business, on our taxes we have to fill out a Schedule C, which is an income and expense statement, not a balance sheet. There is a place for other income on Schedule C, and it is where the charitable deduction must be listed as an income value to the small business, only when one qualifies to itemize charitable deductions. (If one does not qualify to itemize deductions, then consider the video to be thrown away.) Realize that if one does or does not get to qualify to itemize deductions, then one will be paying taxes on the other income = would-be tax deduction if one lists this amount as only other income. So to enter the movement out of videos correctly to not penalize oneself, one must, only if itemizing the donation:

debit: videos $.99
credit: cash/petty cash $.99

debit: cash/petty cash $.99
credit: retained earnings (other income on Schedule C) $.99

Realize that financially what happens is the video is said to have actually cost $.99 more all along, while the retained earnings (expected income from the donation) increases $.99. In other words, to remove the video physically in expectation of definitely itemizing, we first adjust its original cost basis before contemplating any gain to retained earnings upon donation of the physical video. On the income and expenses statement (Schedule C), the retained earnings of $.99 should appear as $.99 other income, which will be offset as the increased cost of the video of another $.99. By showing something for other income, one would possibly avoid an audit or be left alone if audited. (Anyone who worries about $.99 is verrrry honest.)

I think that the trick is to realize that the video appreciates (goes up) in value by the amount of the donation.

Since my accounting is verrrry rusty, how did I do?

P.S. I was assuming an unincorporated small business--no shareholders' earnings.

[This message was edited by tsaeb on 03-06-03 at 06:24 AM.]

Actually, tsaeb, I think you've managed to misinterpret just about every part of the transaction. Quite a feat! But since we're talking about accounting, that's a plus for your personality rating.

Scheduals A and C have absolutely nothing to do with each other. Business transactions will never affect itemize deductions.

Retained earnings is never recorded as other income.

The video did not appreciate, it lost value from $20 to 99c.

If you record the video as both a donation expense and an income, you're recording a +99c and a -99c, and the net result is $0. You might as well not record it at all unless you're monitoring your inventory.

The giving away of an asset does not generate income; it's a loss to the business. This is why you need to affect the capital account rather than a revenue account.

Your charitable contributions on schedual A are for contributions of your own personal money. The deduction on schedual C is for donation of business assets. You can't take from one to apply to the other.

Okay. If you don't have to file a balance sheet, that must be analagous to our business income declared on our personal return. It's only for unincorporated businesses.

In that case, avoid all the thrashing around with journal entries.

In the first year, post the $20

debit supplies $20
credit cash 20

At any time, post the $1 to charitable donations and credit $1 to supplies.

debit charitable donations $1
credit supplies $1

That is the correct way. Tax effect is the same.

Post to the owner's account as Mahal suggests if you like. That means you're borrowing the money from the owner to make the donation, but what the hey, it increases expenses.

Debit charitable donations $1
Credit owner's account $1

You don't have to wait until the following year to do this.

Since you don't have to file a balance sheet, no awkward questions will be asked. Also, as long as the amounts expensed are small, they will not arouse suspicion.

Babs, if you:

debit donations expense $1
credit supply expense $1

You're only transfering a dollar from one expense to another, a net affect of $0.

If you:

debit donations expense $1
credit supply (asset) $1

you're creating a prepaid expense, the same as tsaeb has done, and the supply must eventually be transferred to supply expense (same as if you had expensed it to begin with).

I just plain have to go with the way that I explained it when it is time to unload the video bought for business use--by considering that the video appreciates in value by its current market value, the retained earnings appreciate in value by the video's current market value, the video is withdrawn physically from assets, and the video is a personal charitable deduction on Schedule A for its current market value as though it had been bought for personal use all along. The net gain to the small business owner/philanthropist is the video's current market value as a charitable donation: $.99. WOW!

Originally posted by mahal:

Babs, if you:

debit donations expense $1
credit supply expense $1 "

Yes. That's why I said, 'tax effect is the same'.

Sigh. I guess I have to be more blunt. There is no ethical or legal way to inflate your actual expenses in order to obtain a tax advantages to yourself.

As I said on 3/4,

"Buy it: charge to supplies
Give it:
Deduct it from supplies, add it to charitable donations."

This way your books reflect the true picture of what occurred, which was an expense recovery re-expensed.

However, what I said on 3/6 was, if she wishes to do it Mahal's way and inflate the expense for her tax advantage, she need not do it in such a roundabout way. She simply would charge donations expense and credit OWNER. (Where you got prepaid expense I don't know.)

Because after all the thrashing around, changing the income statement, rolling it into a new year, etc., etc. as you outlined on 3/5 6:31, that is what you end up doing.

What do you think 'capital/holding' account (which is where you said to post the credit) is? This is a one-person operation here. She is not likely to hold the controlling shares of another company in it. So it's just a fancy name for 'suspense' account. But why post it to a suspense account?

All suspense/clearing accounts are closed at year end, to the account where they belong. There is only one account a pseudo-transaction such as this can go: the owner's.

You were right to call it a 'capital' account. That's what 'capital' means. Owner's equity.

Corporations must file a balance sheet. They must provide particulars of shareholder transactions. The reason is so that the shareholder transactions can be scrutinized. In a small business, details of owner transactions are not required. And such a small amount would not matter anyway. But it is not a good practice, and can lead you into trouble.

By inflating the expense as you recommend, not only do you defraud the tax department, you show the business owes more to the owner than it actually does. Again, where there is only one owner, this won't lead to a lawsuit, as it could do if more parties were involved and larger amounts were involved.

Because nothing you do in the books in whatever year can cloud the picture: Something bought for $x was expensed at greater than $x. That's fraud.

quote:

---

However, what I said on 3/6 was, if she wishes to do it Mahal's way and inflate the expense for her tax advantage, she need not do it in such a roundabout way. She simply would charge donations expense and credit OWNER. (Where you got prepaid expense I don't know.)

---

Now you've got it! (Whew!) When you credit the OWNER, the only account available to do that is the owner's capital account.

Where I got the prepaid expense from is your entry "supply". There are only two possible "supplies" (which one, you didn't specify). So I gave you two examples, one using supply expense, the other using a supply inventory (which is a prepaid asset).

(I know it couldn't be a supply liability, and after capital and asset accounts, liabilities are the only balance sheet accounts left.)

In case you're still confused, here's a real life example:

Back in the 80's, I worked for a convenience store chain (I was doing accounts payable). We used to buy our movies new, rent them until they were no longer active, then sell them as "previously viewed" tapes, just like you see at Blockbuster or Hollywood Video. This demonstrates that the tapes still retain a certain value, even if they've been viewed 100 times by customers.

When you sell the movies, you'll have to report the revenue as a source of income. When you give them away, the income you could have gotten is the fair market value. There's nothing inflated or unethical about this at all, and I know of no law preventing the recording of gifts of these assets.

IRS regulations are very specific. There's no reason to be afraid of losing in an audit if no ruling has been made. (In fact, since I work for the IRS during the tax season, I can tell you first hand that you are quite welcome to use IRS tax rules to soak the IRS for every penny you can and get away with it! That's what we're trained to do.)

This is so silly. It's like the conversation in Western Religions with Weeful, myself, Gar, Sid, Helpmate etc. about whether atheists could have true morality.

Now I've got it?

Before you ever posted, I posted:

"No, it is only expensible once. When you give it away all you do is re-classify the expense."

Then you came in and said:

"Yes, you can. Here's how it looks on the books:

Debit "supply expense" $20
Credit "cash" $20
...
At the end of the year you'll close out your expenses...
Debit a capital account (retained earnings, owner's capital, etc) $20
Credit "supply expense" $20
....
The following year...

debit "charitable donations" 99c
credit a capital account 99c"
...
"...4--Do your taxes

5--End of the year adjustment:

debit: a capital account $20
credit: video expense $20

6--End of the year adjustment:

..no entry necessary

7--Start new year

8--Give away video

debit: charitable donations $.99
credit: capital/holding account $.99"

Eight steps? All that thrashing about?

Then I showed the simple way:

1.

"debit supplies $20
credit cash 20

2 (a)

debit charitable donations $1
credit supplies $1"

"Supplies" was not inventory (an asset). Inventory is never shown on the balance sheet as 'supplies'. I was short-forming your term, 'supplies expense'.

I went on to say if Tsaeb wanted to inflate her expense your way, she could post instead:

2 (b)

"Debit charitable donations $1
Credit owner's account $1"

and she could do it without waiting till the next year.

It's fast and dirty, but it does what you want to achieve in only one step.

Then, to cap it all, you post this:

"When you sell the movies, you'll have to report the revenue as a source of income."

Exactly. You can either report it as income or offset it to the original expense account. Either way is correct, and affects the income statement as filed with the I.R.S.

When she gives it away and claims a deduction, the business is receiving a tangible benefit: the deduction for taxes. That is selling it, and it is an income statement transaction.

"There's nothing inflated or unethical about [reporting it as income] at all..."

Of course not. They did it correctly.

"IRS regulations are very specific. There's no reason to be afraid of losing in an audit if no ruling has been made."

In every industrialized nation, by law, good accounting practice must be adhered to. That ruling is primary.

Now I'll tell you what's wrong with your postings:

The owner's account records transactions between the owner and the business, e.g.

When an owner opens a business bank account, he puts the money into the business account, and then posts:

Debit bank 1,000.00
Credit owner's account 1,000.00

The cash is now 'in the hands of the business'. What the owner has in exchange is a debt owned to him by the company.

The business bought and owns the video. When the owner does this:

Dr. charitable donations $1
Cr. owner $1

this is bogus, because it is not 'in his hands' to give.

First he needs to post a transaction to put it into his hands:

Dr. owner' account $1
Cr. supplies exp. $1

So you see, if done properly and according to good accounting practice, the supplies expense must be reduced.

If Tsaeb is tempted, she will get away with it, because the amount is not material. But if she (or others reading this) think to use your method to reduce their income to zero and pay no tax at all (and why shouldn't they think that, based upon your posts, and your 'authority' as an IRS employee? (Not an auditor, I'll warrant)) then your advice is irresponsible.

Mahal's system carried to its logical conclusion:

Year 1:

Income 100,000
Expense 100,000

Thus paying no tax.

Then, after filing
cr expense 100,000
dr owner 100,000

Then the following year
dr expense 100,000
cr owner 100,000

And so on, thus paying no tax, ever, on income.

Is there something wrong with this picture?