Hank started a new business in June of last year, Hanks Donut World (HW for short). He has requested your advice on the following specific tax matters associated with HWs first year of operations. Hank has estimated HWs income for the first year as follows:

Revenue:

Donut sales $ 252,000

Catering revenues 71,550 $ 323,550

Expenditures:

Donut supplies $ 124,240

Catering expense 27,910

Salaries to shop employees 52,500

Rent expense 40,050

Accident insurance premiums 8,400

Other business expenditures 6,850 - 259,950

Net Income $ 63,600

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 do they 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, Hanks 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 $1,700, and Hank reduced the reported catering fees for the first year to reflect the expected refund.

In the first year, HW received a $6,750 payment from a client for catering a monthly breakfast for 30 consecutive months beginning in December. Because the payment didnt relate to last year Hank excluded the entire amount when he calculated catering revenues.

In July, HW paid $1,500 to ADMAN Co for an advertising campaign to distribute fliers advertising HW catering service. Unfortunately, this campaign violated a city code restricting advertising by fliers, and the city fined HW $250 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 $8,400 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 $8,400 as accident insurance premiums.

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 paid $2,000 as a damage deposit and $8,050 for rent ($805 per month). Hank explained that the damage deposit was refundable at the end of the lease. At this time Hank also paid $30,000 to lease kitchen equipment for 24 months ($1,250 per month). Both leases began on June 1 of the first year. In his estimate, Hank deducted these amounts ($40,050 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, $9,250, until after January 1 (apparently because WEGO didnt 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 $9,250 in last years 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 $5,100 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 citys anniversary. The city agreed to pay $7,100 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 $5,500. 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 Hanks estimate of HWs income for the first year of operations.

Required:

a) Hank files his personal tax return on a calendar year, but he has not yet filed last years personal tax return nor has he filed a tax return reporting HWs results for the first year of operations. Explain 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.

c) Describe how your solution might change if Hank incorporated HW before he commenced business last year.