Chapter 3 - 7 CHAPTER 3 What is the difference between...

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CHAPTER 3 7. What is the difference between earned income and unearned income? Earned income is a payment for human capital. That is, it results from the provision of labor and services for which payment or a profit (in the case of a sole proprietor) is received. Unearned income is a payment for a return on an investment. The taxpayer invests money or other assets. A payment is made for the use of the assets. There is no direct investment of human capital. 12. This chapter noted that returns on investment are taxable, whereas returns of investment are not taxable. What is the conceptual basis for this treatment? Cite examples of each type of return, and explain why they are or are not taxable. Returns of investment are not taxable due to the capital recovery concept. Returns on an investment represent increases in wealth and are taxed when realized. Examples include: Interest earned on a savings account - the interest is taxed when credited to the account (return on investment). When the taxpayer withdraws money from the account (return of investment), it is not taxed. Investment in stock - if the stock is from a corporation, cash dividends received represent returns on investment because they are distributions of corporate earnings to shareholders. When the stock is sold, no income is recognized until the amount invested in the stock is recovered (return of capital). Any gain on sale is the increase in wealth through holding the stock (return on investment). If the stock is S corporation stock, a different result occurs. The income of the S corporation is owned proportionately by the shareholders and flows through the corporation to them for tax purposes. Thus, when the corporation has income, the shareholder has income (return on investment). The payment of dividends to shareholders are returns of their investment and are not subject to tax. Rental Property - Rents received on property are a return on investment because the owner's wealth increases. A return of investment does not occur until the owner sells or otherwise transforms the value of the property. For example, a realization could occur due to a casualty and would constitute a return of capital if a deduction for a loss is sustained. 26. How does the wherewithal-to-pay concept affect the tax treatment of prepaid income? The wherewithal-to-pay concept affects the tax treatment of prepaid income received by accrual basis taxpayers. Under strict accrual accounting, prepaid income is deferred for recognition to the period in which the income is earned. However, the wherewithal-to- pay concept requires the tax to be paid in the period in which the taxpayer has the cash available to pay the tax. Under this concept, most receipts of prepaid income by an accrual basis taxpayer are included in gross income in the period of receipt, rather than 3-11
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3-12 Chapter 3: Income Sources the period in which the income is earned. NOTE: This concept does not affect a cash basis taxpayer who always recognizes income in the period of receipt.
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