Unformatted text preview: Chapter 5 Gross Income
1 Definition of Gross Income
Section 61: Gross Income Defined
(a) General definition Except as otherwise provided in this subtitle,
gross income means all income from whatever source derived, including (but not limited to) the following items: (1) Compensation for services, including fees, commissions, fringe benefits, and similar items; (2) Gross income derived from business; (3) Gains derived from dealings in property; (4) Interest; (5) Rent; (6) Royalties; (7) Dividends; (8) Alimony and separate maintenance payments; (9) Annuities; (10) Income from life insurance and endowment contracts; (11) Pensions; (12) Income from discharge of indebtedness; (13) Distributive share of partnership gross income; (14) Income in respect of a decedent; and (15) Income from an interest in an estate or trust 3 “Except as otherwise provided…”
§101 Certain death benefits. §102 Gifts and inheritances. §103 Interest on State and local bonds. §104 Compensation for injuries or sickness. §105 Amounts received under accident and health plans. §106 Contributions by employer to accident and health plans. §107 Rental value of parsonages. §108 Income from discharge of indebtedness. §109 Improvements by lessee on lessor's property. §110 Qualified lessee construction allowances for short-term leases. §111 Recovery of tax benefit items §112 Certain combat zone compensation of members of Armed Forces §115 Income of states, municipalities, etc. §117 Qualified scholarships. §118 Contributions to the capital of a corporation. §119 Meals or lodging furnished for convenience of the employer §120 Amounts received under qualified group legal services plans. §121 Exclusion of gain from sale of principal residence. §122 Certain reduced uniformed services retirement pay. §123 Amounts received under insurance contracts for certain living expenses §125 Cafeteria plans §126 Certain cost-sharing payments. §127 Educational assistance programs 4 What is Income? Historical Development 16th Amendment to Constitution (1913) Tax on “income” but not defined Conceptual considerations Economic concept of income Accounting concept of income Judicial concept
5 What is Income? Economic Concept
Ending net worth – Beginning net worth Change in net worth + Consumption expenditures = Income Measured at FMV Imputed income
6 What is Income? Accounting concept Realization must have occurred. External Earnings transaction process is complete Historical cost basis 7 What is Income? Judicial Concept of Income Glenshaw Glass:
Supreme Court holds that punitive damages awarded under antitrust laws were income and creates all inclusive concept of income concept Income is any increase in wealth that has been realized. All-inclusive approach Everything is income except what’s not!
8 Form of income irrelevant Judicial Concept of Income
Everything is taxable! 9 Income for Tax Purposes
1. 2. 3. Is there any income? If there is income, was it realized? If there is income and it was realized, must it be recognized immediately?
1. 1. 2. 2. 3. 3. Permanently excluded by the Code Postponed due to accounting method Nonrecognition provision provides deferral 10 What Is Income? You make the call
1. T mows your lawn for $20 cash 2. T mows your lawn weekly for room and board all summer 3. T's tenant adds a porch to T's rental property 4. T finds an i-Pod while taking a stroll 5. T's house (cost $50,000) declared historical landmark, value now $90,000 6. T cashes in on house increase, borrows $20,000 secured by home 11 What Is Income? You make the call
7. T discovers oil on his property, FMV increases by $500,000 8. T discovers gold coins buried in backyard worth $100,000 9. T embezzles $100,000 from his employer 10. T's dad says happy birthday and tells his son to forget his $5,000 debt 11. T buys stock for $1,000 and sells six months later for $3,000 12. T loses finger on job; sues employer; awarded $100,000 13. T's employer allows him to buy stereo worth $1,000 at a 10% discount
12 Principles Affecting Income Concept for Tax Purposes General Rule: Recognize any realized income immediately, unless Code, Regs or courts say otherwise Principles affecting general rule:
Form of benefit principle Return of capital doctrine Indirect economic benefits Wherewithal to pay principle 15 Form of Benefit
What about the benefits of EXTREME MAKEOVER? Will I have to pay taxes on the change? After Before Principles Affecting Income Concept for Tax Purposes Form of benefit principle Form is irrelevant "Gross income includes income realized in any form, "Gross income includes income realized in any form, whether in money, property or services." (Reg. § 1.61-1(a)). whether in money, property or services." (Reg. § 1.61-1(a)). Noncash benefits are taxed under the cash equivalent Noncash benefits are taxed under the cash equivalent doctrine (FMV of benefit received) doctrine (FMV of benefit received) Payment “in kind” Payment “in kind” Barter transactions Barter transactions Bargain sale Bargain sale Relief of debt Relief of debt Others Others
17 Examples Principles That Affect the Income Concept for Tax Return of Capital Doctrine Capital may not be taxed Sale CoGS is a return of capital Damages, depreciation “Open transaction” doctrine Many others 18 Principles That Affect the Income Concept for Tax Indirect Economic Benefit Exceptions Some employer-provided benefits excluded Theory Patterson v. Thomas: exclusion if demonstrate that it served a business purpose of the employer other than to compensate the employee.
• Business purpose other than compensation • Business purpose other than compensation • Serves the convenience of the employer • Serves the convenience of the employer Problem 5-6
19 Principles Affecting the General Rule Wherewithal-to-Pay Exceptions in the Code Like-kind asset exchanges Replacement of casualty property Installment sales Many others
21 TIMING ISSUES Accounting Periods and Methods When is income reported? When are deductions claimed?
Who cares? 1 Present Value of $1 Paid at End of Year Years 1 5 10 20 PV at 10% $0.909091 $0.620921 $0.385543 $0.148644
2 Tax Accounting Principles
Why should you care about accounting methods? • Time Value of Money • Income: • Deferral • Deductions: • Accelerate • Other reasons
4 5 Change the Rules? Reagan signs the Tax Reform Act of 1986 6 Tax Rate Changes? New Opportunities? Potential Problems? Year
1934–35 1936-37 1938-39 1940 1941 1942-43 1944-45 1946-47 1948-49 1950 1951 1952-53 Individual Rate (%)
63 79 79 79 81 88 90 85.5 77 80 87.2 88 Corporate Rate (%)
13.75 15 19 22.1 31 40 40 38 38 42 50.75 52 Difference
49.25 64 60 56.9 50 48 50 47.5 39 38 36.45 36
7 Individual & Corporate Tax Rates Historical Comparison Year
1954-63 1964 1965-78 1979-81 1982-86 1987 1988-90 1991-92 1993-2001 2003-2009 Individual Rate (%)
87 77 70 70 50 38.5 28 31 39.6 35 Corporate Rate (%)
52 50 48 46 46 40 34 34 34/35 35 Difference
35 27 22 24 4 (1.5) (6.0) (3.0) 5.6 0.0
8 When is the income reported?
9 When report the income? Accounting Periods and Methods
REPORTING PERIOD TAXABLE YEAR 12/31/08 12/31/09 ASSIGNMENT OF INCOME AND DEDUCTIONS TO PERIODS ACCOUNTING METHODS Tax Accounting Principles PERIODS
12 Tax Years
What year should I use? What year CAN I use? 2008
13 ACCOUNTING PERIODS: GAAP VS. TAX Internal Revenue Code Financial vs. Tax Is conformity required?
14 Accounting Periods Conformity requirement Period: must be same as used for books (§446(c)) Meet by sufficient workpapers that reconcile differences between book and tax May be modified by statutory requirements 15 Tax Years – Possibilities
• Calendar year • Fiscal year • 52-53 week year
What year should I use? 2009
What year CAN I use? 16 Tax Years – Calendar Year
• What? • Who uses?
2009 17 Tax Years • Fiscal Year
– What? – Who can use a fiscal year? – How about individuals, S corps, pshps, PSCs, trusts, estates, exempts? – Limitations. Why? 2008
What year should I use? What year CAN I use? 18 Tax Years:
Reporting Income from Partnerships and S Corps Partners or S shareholders Report their shares of the entity’s income in their taxable year within which (or with which) the partnership or S corporation tax year ends Income Pshp Pshp
19 Tax Years
Reporting Income from Partnerships and S Corps
Income Pshp 2/1 1/31/05 1/1/05 12/31/05
20 Problem 5-41 9/30 $120,000 1st qtr $30,000 $1,000 1/1 12/31 Tax Years Stakes: Deferral Example:
Partner has 12/31 year end. Pshp has fiscal year ending 1/31 2/1 1/31 FMAMJJASO N D 1 2 3 4 5 6 7 8 9 10 11 22 Tax Years General rules Tax year of flow-thru entities generally must conform to that of owners Partnerships and LLCs S Corporations Trust must use calendar year Other special provisions
23 Tax Years
52-53 Week Year What? Ends on same day of week each year
Last Saturday in month Day of week nearest the end of the month Examples We want our year to always end on Friday 24 52-53 Week Year: Last Friday of Month
S March 2006 March 2007 March 2008 March 2009 March 2010 March 2011 March 2012 26 25 23 22 21 20 26 M 27 26 24 23 22 21 27 T 28 27 25 24 23 22 28 W 29 28 26 25 24 23 29 R 30 29 27 26 25 24 30 F 31 30 28 27 26 25 31 31 29 28 27 26 1 S From 3/25/11 to 3/30/12 there is an extra week = 53 week yr5 2 Whole Foods Market owns and operates the country's largest chain of natural foods supermarkets, with 74 stores currently open in 17 states. The Company operates on a 52/53 week fiscal year ending the last Sunday in September. The first quarter consists of 16 weeks, the second and third quarters each consist of 12 weeks, and the fourth quarter consists of 12 or 13 weeks. Fiscal year 1996 was a 53 week year, with 13 weeks in the fourth quarter. CompUSA Converted to 53 Week Year So Execs Could Cash Big Bonuses? Some are wondering whether CompUSA converted to a 53 week year last year, to enable upper management to reap large bonus checks, according to a company insider. Most places have their quarters that run in: 4, 5, 4 (13 weeks = 1 Quarter). Last year CompUSA had (4, 5, 5). = 53 weeks/ year. Yes CompUSA had a 53 week year.. Not sure how, but the upper management got some huge bonuses because they hit the base numbers they needed to. Tax Years Adoption of Tax Year Is consent required? How adopt? Considerations What about changing tax year? 28 Tax Years: Adoption and Change Calendar Year v. Fiscal Year For first return, may select accounting period Certain limitations 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.
29 Tax Accounting Principles METHODS
30 Tax Accounting Principles – Methods of Accounting
Types Overall Cash, accrual, hybrid Completed contract, LIFO, installment sale, etc. Specific What is a method? Why important? 31 Tax Accounting Principles: Accounting Methods
What is a method of accounting? Why care?
A method is any rule, technique, treatment that effects WHEN a particular item is reported Generally cannot change method without permission 32 Accounting Method Defined Accounting method Overall method Treatment of any item Defined Matter of timing Not a change in underlying facts Adoption of consistent treatment for > two tax years Not a correction of math errors, posting errors 33 Example: FIFO to LIFO Accounting Method
Which of the following is an accounting method? Utility read meter every two months and bills were submitted thereafter. It changed to billing every month based on estimates Bank pays interest on customer deposits; changes from compounding interest on monthly basis to daily basis Retailer ships goods, booking income when title and risk of loss passed to customers. Changes to book income when shipped 1 and 2 1 and 3 2 and 3 All of the above
34 Changes directly made to this slide will not be displayed in Live Meeting. Edit this slide by selecting Properties in the Live Meeting Presentation menu. Accounting Method v. Correction of Error
Distinction between change in method and mere correction of errors such as math mistakes Stakes Correction of error Correct by filing amended returns for only open years Simpler to correct (no permission required) Possible windfall (no adjustment for duplication of deductions or omission of income). § 481 adjustment required to report omitted income or duplicated deductions Requires correction on cumulative basis for all years affected regardless of statute of limitations Change in method 35 Accounting Method v. Correction of Error Huffman 126 TC 17 (2006)
Car dealerships used link-chain, dollar value LIFO Accountant omitted important step in calculation Taxpayer asserted that omission was mere error while IRS said change in accounting method Distinction between corrections of errors and change in accounting method Change in method: § 481(a) adjustment reflects cumulative amount including closed years Correction of error: Limited to amendment of open years Tax Court: Omitted step in link-chain LIFO calculation was a material timing item, not a computational error Accounting method change required 36 Tax Accounting Principles – Methods of Accounting
What is a permissible method? Is the taxpayer free to choose? 37 Accounting Methods Overriding consideration: method must clearly reflect income 38 Clearly Reflect Income Doctrine
Knight-Ridder Newspapers, Inc. v. U.S. (743 F.2d 781) (CA-11, 1984) On the subject of accounting methods (cash vs. accrual): The Code is possessed of great wisdom and tolerance. It knows that man must generally choose his own way. Therefore, it leaves to the taxpayer the original choice of which accounting method to use. Section 446(c) specifically authorizes both the cash and accrual methods. Yet the Code also understands that either extreme possesses inherent weaknesses and can become blinded to reality. Thus the Code and subsequent Treasury Regulations empower the Secretary of the Treasury and the Commissioner of Internal Revenue to cure the blindness. Section 446(b) of the Code provides that if the method used does not clearly reflect income, the computation of taxable income shall be made under such method as, in the opinion of the Secretary, does clearly reflect income. 39 Tax Accounting Principles – Methods of Accounting Relationship between tax and financial accounting methods Does use of GAAP clearly reflect income? 40 Tax Accounting Principles – Methods of Accounting Relationship between tax and financial accounting methods Thor Power Tool (439 U.S. 522 USSC, 1979) 439 U.S. 522 USSC, 1979)
• Vastly different objectives • Vastly different objectives • GAAP: • GAAP: – Protect investors, creditors, other stakeholders – Protect investors, creditors, other stakeholders • Tax: • Tax: – Collect revenues – Collect revenues – Wherewithal to pay concept – Wherewithal to pay concept – Administrative consideration – Administrative consideration Examples
46 Accounting Methods Ford Motor Co. vs. Comm., 102 T.C 87 (1994) Gas tank in Ford Pinto was known by Ford engineers to be defective and could burst into flames in a 30 mph rear-end collision Ford did a "cost-benefit analysis" of altering the fuel tanks. It estimated that the unsafe tanks would cause 180 burn deaths, 180 serious burn injuries, and 2,100 burned vehicles each year. It calculated that it would have to pay $200,000 per death, $67,000 per injury, and $700 per vehicle, for a total of $49.5 million. However, the cost of saving lives and injuries ran even higher: alterations would cost $11 per car or truck, which added up to $137 million per year. Essentially, Ford decided not to fix the cars and let their customers burn! Victims sued Ford
48 Accounting Methods Ford Motor Co. vs. Comm., 102 T.C 87 (1994) Entered into structured settlements calling for payments totaling $24,477,699 over various periods up to 58 years Ford purchased annuities for about $4.4 million structured so that yearly annuity payments would equal the yearly amount of the deferred payments owed to the tort claimants under the agreements. Ford deducts $24 million on 1980 return For GAAP, claimed expense of $4.4 million 49 Clearly Reflect Income Ford, an accrual basis taxpayer, can
Deduct nothing since it hasn't paid anything Accrue a deduction of $24 million (actual payments to be made) Accrue a deduction of $4.4 million (the cost of the annuity whose proceeds will be used to make the payments) Changes directly made to this slide will not be displayed in Live Meeting. Edit this slide by selecting Properties in the Live Meeting Presentation menu. 50 Accounting Methods Ford Motor Co. vs. Comm., 102 T.C 87 (1994) Taxpayer argued that because all events had been met, the IRS did not have authority to disallow deduction Court held the IRS did not abuse discretion in determining the deduction did not clearly reflect income Significance: IRS did not abuse discretion even though the taxpayer’s method of accounting was otherwise permitted under the Code and Regulations 51 Iaccoa Lee Iaccoca, automobile guru and CEO, was responsible for which of the following
Ford Mustang Pinto The Minivan Getting Chrysler out of bankruptcy 3 and 4 All of the above None of the above Changes directly made to this slide will not be displayed in Live Meeting. Edit this slide by selecting Properties in the Live Meeting Presentation menu. 52 Tax Accounting Principles – Methods of Accounting Book vs. Tax: Differences Cash vs. accrual Prepaid income Bad debts Estimated expenses 53 Tax Accounting Cash Method
54 Tax Accounting Methods Cash Method of Accounting When? 55 Cash Basis Reporting General Rule: Report revenues when cash is received Report expenses when cash is paid “Cash equivalent” concept “Constructive receipt” (judicial) “Claim of right” doctrine Original issue discount Inventory Series E & EE bonds
56 Special considerations Oprah's Car Giveaway: Tax Consequences? 57 Cash Basis Reporting Cash Equivalent Doctrine Cash basis taxpayer reports income when the equivalent of cash is received Income is income whether received in the form of cash, property or services Amount is FMV of what is received 58 Oprah's Car Giveaway Sparks Tax Dilemma
Oprah called the show part of her "wildest dreams" season. But for many of the 276 recipients of the new Pontiacs that the talk-show queen gave away last week, there was a bit of reality to come with that dream -- they are going to have to fork over thousands of dollars in taxes. It turns out that free car wasn't so free. That's because while Pontiac agreed to pay for most of the local charges -- things like state sales tax and licensing fees -- the recipients have to report the value of the cars as income once tax time comes. By adding $28,500 to someone's income, it can push them into a higher tax bracket -- which means they will have to pay about 25 percent or more of the car's value in taxes. And for a nearly $30,000 car, that probably means, for most of the recipients, shelling out $7,125 for the "free car." And if you live in Illinois, tack on another 3 percent or so in state taxes.
59 Cash Equivalent Doctrine Bartering transactions are fully taxable! Amount of income is FMV of property received 60 Cash Equivalent Doctrine Cash Cash Equivalent Doctrine
What about the benefits of EXTREME MAKEOVER? Will I have to pay taxes on the change? After Before Cash Equivalent Doctrine
What about meals and lodging provided by employer, use of company car or plane, bargain purchase, free cable, free movie tickets, interest free loans, etc. What about accounts receivable? notes receivable? 64 Cash Equivalent Doctrine
Notes receivable vs. accounts receivable •Cowden (CA-5, 1961)
– Taxpayer, cash-basis, negotiates bonus payment of $511,000 from company under lease contract allowing it to drill for oil, gas, other minerals – Received $11,000 first year – Other $500,000 not due until January of next year and following yea...
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- Spring '09
- Taxation in the United States, Generally Accepted Accounting Principles, Tax Accounting Principles