Chapter 4Concepts of Income:1. Economic income - the amount that an individual could consume during a period and be as well off at the end of the period as he/she was at the beginning of the period.The economic definition of income would include unrealized gains, gifts, inheritances, as well as wages, salaries, and other "profits" as income. In addition, the economic income definition automatically adjusts for inflation.2. Accounting income - is an increase in wealth realizedby an individual. Realization requires:1. A severance of the economic interest in the property (sometimes stated as asignificant change in the taxpayer's property rights).2. A transaction with a second entity.a. Transaction = an exchange of goods or services that can be objectively valued.The U.S. tax law has adopted the accountant's concept of income, with a few exceptions.The primary reasons for the realization requirement are:1. Administrative convenience2. Wherewithal-to-pay conceptExamples:1. Bob earned a salary of $50,000. His net worth at the beginning of the year was $100,000 (adjusted for inflation) and at the end of the year his net worth was $120,000. He consumed $45,000 in expenses for housing, food, clothing, etc...What is his economic income?What is his accounting income?Answer:His economic income for the year is $65,000 = [45,000 + (120,000 - 100,000)].His accounting income is $50,000.2. Ted is a school teacher. Instead of teaching summer school, he built his personal residence. The cost of the land, materials, and labor Ted purchased from others was$80,000. The fair market value of the completed house was $100,000. Ted moved 1
into the house as soon as it was completed. What is his taxable income from his efforts?Answer: Even though Ted has experienced an increase in wealth of $20,000, he doesnot have taxable income because he has not realized the increase in wealth. Ted has not received anything from another entity, so the realization requirements are not met.Note: If he should sell the house in the following year for $110,000, he would have $30,000 of taxable income (capital gain), if he couldn’t make use of the home exclusion of $250,000/$500,000.Gross income is not limited to cash received. Income can be in the form of money, property, or services. Remember that gross income does not include the adjusted basis of property sold because of the recovery of capital doctrine.The usual period for measuring income is the "taxable year."1. Generally, an entity must use the calendar year as its taxable year.2. However, some entities (including individuals) can elect to use a different fiscal year if adequate books and records are kept.Income is recognized in the year of inclusion, which is often determined by the taxpayer's accounting method.1. The taxpayer may electto use the cash, accrual, or hybrid methods of accounting.2. The election to use a method is made by filing an initial return using that method.