Gross Income

1
Chapter 5

• Gross Income

2
What is Income?

• Historical Development of Income Concept
• Income versus Capital
• Common Law
• 16th Amendment to Constitution (1913)
• Economic Concept
• Income change in net worth over period of time
  (market value)
• consumption

3
What is Income?

• Accounting concept
• Realization must have occurred. This involves
• external transaction
• earnings process is complete
• Historical cost basis

4
Tax Concept of Income

• Code Sec. 61
• All income, from any source, unless excluded by
  the code
• Form of income not important

5
Tax Concept of Income

• Operational Definition
• Realization must have occurred (Eisner v.
  Macomber). This involves
• External transaction (with external party)
• Change in property right or obligation
• Realization for tax does not equal
  realization for GAAP.
• IR Code or common law may exclude some items
• Historical costs basis

6
Tax Concept of Income

• IRS may recast income
• Recasting of reported income is allowed by the IR
  Code
• Several methods
• ex. Bank receipts and disbursements
• ex. Net worth approach to construct income
• Income change in net worth over period of time
  at historical cost consumption

7
Principles That Affect the Income Concept for Tax

• General Rule Recognize any realized income
  immediately, unless IR Code, Regs or courts say
  otherwise.
• Some principles that affect the general rule
• Form of benefit principle
• Payment in kind
• Barter transactions
• Bargain sale
• Relief of debt
• Others

8
Principles That Affect the Income Concept for Tax

• Return of Capital Principle
• Capital may not be taxed
• COGS is a return of capital
• Damages, depreciation
• Open transaction doctrine
• Many others
• Indirect Economic Benefit Exceptions
• Some employer-provided benefits which have
  business purpose other than compensation are
  excluded.

9
Principles That Affect the General Rule

• Wherewithal-to-Pay Exceptions in the Code
• Like-kind asset exchanges
• Replacement of casualty property
• Installment sales
• Many others

10
Tax Accounting Periods

• Calendar Year v. Fiscal Year
• For first return, accounting period is optional
• Change in accounting period requires IRS approval

Generally IRS approval is given only if there is
a bona-fide business reason for the change, and
if income recognition is deferred three months or
less. Adjustments are required.
11
Tax Accounting Periods

• Problem (opportunity) of Income Deferral
• Example TP-partner has 12/31 year end. P/S has
  fiscal year ending 3/31

12
Tax Accounting Periods

• IRS/Congressional Response Restrict most P/S,
  S-corps, and PSCs to a calendar year basis.
• Problems With This Approach
• Return Preparation
• Processing Returns

13
Year of Inclusion in Income

• General methods in use
• Cash
• Accrual
• Hybrid methods
• of cash and accrual
• installment
• long-term construction contracts (percentage of
  completion)
• others possible
• Accounting and tax method must be the same (Sec.
  446)
• The accounting method used must reflect income
• Tax methods DO NOT EQUAL GAAP

14
Two Basic Legal Doctrines that Affect the Timing
of Income Recognition

• All Events Test (Accrual TPs)
• Applies to Both Income and Expenses
• Two Part Test
• All events must have occurred that establish the
  right to the income or obligation for the expense
  (ex. title has passed)
• Amount of income or expense can be determined
  with reasonable accuracy
• The All Events Test controls accrual basis TPs,
  but not cash basis TPs

15
Two Basic Legal Doctrines that Affect the Timing
of Income Recognition

• Claim of Right Doctrine
• Actual or constructive receipt of income under a
  claim of right (an unrestricted claim) is
  included in gross income for tax purposes
• Applies to both cash basis and accrual basis TPs
• Thus, Claim of Right Doctrine supercedes All
  Events Test
• Examples
• Rental damage deposits
• Receipt of prepaid fees

16
Cash Basis Reporting

• General Rule Report revenues when cash is
  received report expenses when cash is paid.
• Qualifications to the General Rule
• Cash equivalent concept
• Constructive receipt (judicial)
• Claim of right doctrine
• Original issue discount
• Certain crop losses which are insured
• Inventory
• Series E EE bonds

17
Cash Basis Reporting

• Limitations on use of cash method Businesses
  that may not use the cash method
• Regular (large) C corporations
• P/S with regular C corporations as partners
• Tax shelters

18
Accrual Basis Reporting

• General Rule
• All events test controls
• Report revenues when earned, even if not yet
  received report expenses when incurred, even if
  not yet paid
• Accrual method mandatory for sales, purchases,
  and inventory if the inventory is an income
  producing factor

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Accrual Basis Reporting

• Exceptions to the General Rule
• Claim of right doctrine controls unless income is
  clearly misstated as a result
• For many prepaid items, report income when the
  prepaid payments are received
• Interest, rents, royalties
• Advance payment for goods
• Advance payment for services
• Long-term contracts
• Prepaid dues and subscriptions

20
Interest Income

• General
• Recognize interest income when received (cash
  basis) or when earned (accrual basis)
• But, always report prepaid interest income when
  received

21
Interest Income

• Discounted Investments
• Generally, for any investment
• purchased at a discount (purchase price lt
  redemption price)
• that carries an interest rate that is lt the
  market rate at the time of purchase
• Report as income the amortized discount or the
  difference between the instruments stated
  interest rate and market rate, TIMES the principal

Example OID
22
Interest Income Examples

• Bond with 0.0 rate of interest, FV 1000, sold
  at 700 (original issue or repurchase).
• 1000 Face Value
• 700 Purchase Price
• 300 To become interest income, amortized at
  market interest rate using the effective interest
  method
• 1000 bond which pays 3 interest is purchased
  for 950 when market interest rate 4

Interest Income 3 interest paid annually plus
amortized portion of the discount (1000 - 950)
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Reporting Interest Income From Investments
24
Educational Savings Bonds

• Series EE Bonds Issued After 1989
• Accrued interest is exempt from taxation if
  redeemed Series EE bonds are used to pay for
  qualified educational expenses
• Tuition, fees, books, and supplies
• LESS scholarships, fellowships and employer
  provided assistance
• Exclusion available only to TPs age 24 or older,
  and is taken on the tax return of the original
  purchaser and his/her spouse
• But, excluded interest may be spent on TP,
  spouse, or dependents

25
Educational Savings Bonds

• Exclusion is phased out for high income
  taxpayers
• Exclusion of interest allowed only to extent TP
  uses redemption proceeds for qualified
  educational expenses

26
Educational Savings Bonds Example

• Z, As parent, cashed 9,500 of qualifying
  savings bonds to pay for As college expenses.
• As expenses included 3,500 tuition and fees,
  700 books, 100 supplies, 2,500 meals and
  2,700 dormitory room.
• The bonds included 1,500 of accrued interest.
• How much, if any, of the interest is taxable?

4,300 X 1,500 678.95 exclusion
9,500 1500 - 678.95 821.05 addition to
income