Chapter 4

1
Chapter 4 Gross Income

• Cash v Accrual (pages 4-1 to 4-17)
  exceptions to
• Community Property
• Alimony / Child Support
• Annuities
• Prizes / Awards
• Group Term Life
• Gifts to Individuals and Employees
• Social Security Benefits

2
Economic Income (vs Accounting)
Problem 29 Problem 30

• Bought House 1984 for 125,000 ..
• FMV today is 250,000.
• Do I have taxable income?
• Bought 1,000 shs of Starbucks in 1992 for
  10,000. FMV today is 150,000.
• Do I have taxable income?

When is income RECOGNIZED?
There must be a transaction (sale) to have
recognized income
3
Tax YearsCash Basis versus Accrual Basis
Problem 31 Problem 41 Problem 35

• Know the tax year (fiscal or calendar).
• Issues j When was the income earned?
• k When was the payment received?

• Are we (individuals) cash basis taxpayers or
  accrual basis taxpayers?

4
Tax YearsCash Basis versus Accrual Basis (cont)

• Example Springs Inds. declares a dividend on
  December 15th (declaration date) for shareholders
  of record on December 20th (date of record). The
  dividend is paid on December 30th (payment date).
  
• Harry Emerson receives the dividend of 1,000 in
  the mail on January 3rd.
• When is the dividend taxable to HBE?

5
Exceptions to Cash Basis
Problem 35, 41

• Constructive Receipt Doctrine income has not
  been received but taxpayer has the right to
  receive.
• Employee can contract for services that he has
  not yet earned. This is done prior to the
  beginning of the year.
• Note concept of Substantial Limitation.

6
Exceptions to Cash Basis (cont)
Problem 55

• Loans loans are an exception to the cash basis
  of accounting and the constructive receipt of
  doctrine. Loans are not taxable. There is an
  obligation to repay.
• What if obligation is relieved?
• i.e forgiveness of indebtedness

7
Exception to Accrual Basis

• Prepaid Income included in income in the year
  of receipt .. prepaid rent is the best example.
  Except for this exception, accrual basis
  taxpayers would not recognize income until it was
  earned.
• Advance Payment for Services Income recognition
  is deferred if payment is made for services to be
  performed on or before the end of the tax year
  following receipt, but not more than one tax year
  beyond year of receipt.
• example Calendar year taxpayer. Payment
  received on July 1, 2003 for services to be
  performed over the next 36 months.

8
Income Sources (p. 3-14 to 3-16)
Problem 30

• Income and the resulting tax liability cannot be
  assigned. Lucas versus Earl
• Services performed by an employee for the
  employer is considered performed by the employer.
• Interest accrues daily on bonds, so when there is
  a sale, income has to be allocated.
• Dividends do not accrue daily .. considered
  earned on the date of record. Corporations pay
  tax on earnings. Shareholders pay tax on
  dividends that are paid to them.

9
Income Sources (p. 3-14 to 3-16) cont
Problem 42

• Agents income received by an agent is
  considered received by the taxpayer.
• Partnerships, S-Corps, Trusts -- the entity is
  not taxed. Rather, the income and deductions are
  passed through to the partners, shareholders or
  beneficiaries.

10
Community Property States
Problem 44

• There are 10 community property states (mostly
  western states). The remaining states are
  common law states.
• Separately owned property either acquired
  before the marriage or received during the
  marriage by gift or inheritance.
• Marital Property All other property that which
  is acquired during the marriage.

11
Community Property States (cont)

• Wages belong to the community split 50/50
• Unearned income (interest dividends) on marital
  property is split 50/50.
• Unearned income on separate property is treated
  two different ways
• Texas income is considered community property
  despite the fact that the property is
  individually owned.
• California income is not split 50/50, but is
  taxed to the spouse that owns the property

12
Alimony
Problem 45 Problem 47

• Income to the recipient and deductible for AGI by
  the payor.
• Must have characteristics of alimony versus a
  property settlement.
• Payments must be in cash.
• Agreement does not say payments are not alimony.
• Payor and Payee do not live together.
• Not required to be paid after death of recipient.

13
Child Support

• No income recognized by the recipient no
  deduction to the payor.
• Payments usually ceases when child reaches
  majority.

14
Below Market Loans

• Below market amount is deemed to be income (or
  gift received) to the recipient and interest
  expense (or gift paid) by the lender.
• Government publishes going rate (Applicable
  Federal Rates or AFR). Note 3 different rates.
• Considered to be gifts between family members,
  compensation (W-2) between ER / EE, and dividend
  between shareholder / corp.
• Loans whose principle purpose is tax avoidance
  are not recognized by the Service.

15
Below Market Loans (page 4-26)

• Exception for loans between individuals of less
  than 10,000
• Exceptions for loans between individuals of less
  than 100,000 where investment income of the
  recipient is lt 1,000.
• Exception for loans between corporation and
  employee where loan is lt 10,000.

16
Annuties
Workbook 10, 11, 12 Problem 23, 52

• Purchaser pays a fixed amount for a future stream
  of payments. Income not recognized until the
  taxpayer begins to receive payments.

Example Taxpayer purchases for 100,000 a 20
year annuity from an insurance company. The
annuity pays taxpayer 1,000 per month for 24
months. What is the basis? What is the profit?
Recovery of Capital Doctrine page 4-6
17
Annuities (continued)
Problem 52

• Same example
• How much of each payment is includable in income?
• Assume annuity starts on October 15th, 2005.
• How much income is included for 2005?
• How much income is included for 2006?

• Investment X Annuity Payment Exclusion
• Expected Return

18
Annuities (continued)

• How do we handle lifetime annuities? (answer
  use tables p. 4-29 and 4-30)
• What happens when the recipient outlives the
  life expectancy?
• What happens when the recipient dies early
  (what happens tax-wise)?

Age 54. Paid 90,000 for a lifetime annuity of
500 per month.
19
Taxation of Social Security

• For low income taxapayers (income lt 25,000),
  social security is not taxable.
• For higher income taxpayers (say, income gt
  44,000), 85 of social security is taxable.
• There is a complicated formula in which part of
  the social security is taxable. The computer
  handles this fantastically.
• For purposes of calculating income, inlcude
  one-half of the social security benefit and tax
  free interest.

20
Prizes and Awards
Problem 53

• Generally, included in income.
• Exception
• Prize is in recognition of religious, charitable,
  et. al.
• Prize given to a nonprofit
• Recipient did not enter contest or apply for the
  prize
• Recipient not required to perform services.
• 2nd Exception
• Employee Achievement Awards lt 400
• Recognition for length of service or safety

21
Miscellaneous Other (p. 3-31)
Workbook 15, 16

• Group Term Life First 50,000 of premiums tax
  exempt balance is added to W-2. See chart on
  p. 4-32.
• Unemployment Compensation taxable