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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 year (contractual obligation to pay in future…no note)
65 Cash Equivalent Doctrine
Notes receivable vs. accounts receivable – Cowden (CA-5, 1961)
• • • • • • Was obligation readily convertible to cash? Was it negotiable? Was agreement unconditional? Was it transferable? Could obligation be sold at a reasonable discount? Was the debtor solvent? 66 Cash Method of Accounting
WHEN? CONSTRUCTIVE RECEIPT—(If cash is not actually received, income will be recognized if it is constructively received. Tests: Taxpayer has control over income without substantial restrictions Amount is set aside or credited to taxpayer Funds are available for payment 67 Cash Basis Reporting Constructive Receipt Defined:
The tax wizard deems that the income is received even though you didn’t receive it Income available to a taxpayer but not actually reduced to his possession is treated as if it was received 68 Oprah's Car Giveaway Sparks Tax Dilemma
Luckily, the recipients weren't given the car on the spot so they can at least start to save now. Although Oprah seemed to have the winners choose their cars from an enormous lot filled with Pontiac G6 sedans, the cars will actually be delivered to a dealer near each winner's home. Some recipients are going to wait a few months before actually picking up their cars so they can figure out how to pay for the taxes. "We have to pick the car up between Oct. 1, 2004, and Feb. 28, 2005," said Nelson. "We've decided that we are going to wait until the first of the year so we can have all of 2005 and the first four months of 2006 to figure out how to pay for this."
71 Cash Basis Reporting Claim of Right
Defined: Income received and treated as your own must be included when received Income must be received Unrestricted use Do not recognize an obligation to repay Included even if possibility of repayment
72 You’ve Got to be Kidding Department
Consider Mr. Irving, who was entitled to a payment of $183.69 on his discharge from the Army. The government mistakenly issued him a Treasury check for $836,939.19. He used the funds to pay off the mortgage on his father’s home, to buy Jeeps for himself and his wife, for home renovations, charitable contributions, and gifts to relatives. Irving spend over $340,000 of the proceeds of the check before the government discovered its error. Mr. Irving must be given the award for the most creative excuse of the year. At trial, he testified that a short time before receiving the check he had gone to a lonely road and prayed that he would become self sufficient and be able to take care of others. He claimed that he thought the check was a miraculous answer to his prayer, not a government mistake. Irvin was convicted for conversion and for failing to report the funds as income were affirmed. 73 Cash Basis Reporting
Prohibition of Cash Method Regular C corps Pshps with regular C corps as partners Tax shelters Exceptions 74 Cash Basis Reporting No C corps except Small C corps Average annual gross receipts for all preceding years is less than $5 million [(current + prior 2 yrs)/3] Farmers Personal service corporations 75 Cash Method: Small C Corporation
• Year • First yr 19x1 19x2 19x3 19x4 19x5 Receipts $4 2 6 10 Can we use in 19x5? Average Annual • Avg Annual Gross Receipts = (Current + prior 2 yrs) 3 76 • Problem 5-47 Cash Basis Reporting Cash basis can be used by: Personal service corporation (PSCs) C Corporation 95% owned by employees Provide services in 1 of the following 8 areas
1. 1. 2. 2. 3. 3. 4. 4. 5. 5. 6. 6. 7. 7. 8. 8. Health Health Engineering Engineering Accounting Accounting Actuarial Actuarial Architectural Architectural Law Law Physicians Physicians Consulting Consulting
77 Cash Basis Reporting Cash basis can be used by: Individuals Trusts Estates S Corps Partnerships and LLC Small C Corps (< $5 million rule) PSCs
78 Cash Method and Inventories Special rules governing inventory Taxpayers on the cash method are generally required to use the accrual method for sales, purchases, and inventory if the inventory is an income producing factor Certain exceptions for small taxpayers 79 Accounting for Inventory
Reg. § 1.471-1 “[I]n order to reflect taxable income correctly, inventories….are necessary in every case in which the production, purchase, or sale of merchandise is an income producing factor.” Reg. § 1.446-1(c)(2) adds that “in any case in which it is necessary to use an inventory the accrual method of accounting must be used with regard to purchases and sales…” 80 Accounting for Inventory
Knight-Ridder Newspapers, Inc. v. U.S. (743 F.2d 781) (CA-11, 1984) According to accounting wisdom the income realized from the sale of merchandise is most clearly measured by matching the cost of the merchandise with the revenue from its sale. In order to achieve such matching of revenue and cost, it is necessary to keep an inventory account reflecting the costs of merchandise, raw materials, and manufacturing expenses. These costs are not deducted immediately when paid but are deferred until the year when the resulting merchandise is sold. 81 Accounting for Inventory
Reg. § 1.471-1 “[I]n order to reflect taxable income correctly, inventories….are necessary in every case in which the production, purchase, or sale of merchandise is an income producing factor.” • Is there merchandise? • Distinction between merchandise and materials or supplies • Is the merchandise an income producing factor or is there something else that is producing the income?
82 What Is Inventory?
Mortuary provided funeral services, including supplying the caskets. Charged flat fee for service (did not charge separately for the caskets). Regarding the costs of the caskets, the taxpayer
1. 1. 2. 2. 3. 3. Must capitalize the cost of the caskets (i.e., inventory the costs) May expense the costs of the caskets (i.e., need NOT maintain inventories) Some other answer
83 Accounting for Inventory
If inventory is income producing factor, must use accrual method to account for all elements of gross profit: accounts receivable, purchases, accounts payable Problem: Definition of inventory Wilkinson-Beane Inc. v. Comm. (CA-11, 1970) What Is Inventory?
Corp provides cancer treatments. Employs physicians, Corp provides cancer treatments. Employs physicians, nurses, lab techs, office workers in business to provide nurses, lab techs, office workers in business to provide chemotherapy. Uses drugs when providing chemotherapy chemotherapy. Uses drugs when providing chemotherapy treatments. Regarding drug costs and income from treatments. Regarding drug costs and income from treatments, the taxpayer treatments, the taxpayer
1. 1. 2. 2. 3. 3. 4. 4. 5. 5. 6. 6. May expenses the costs of the drugs and need NOT accrue the May expenses the costs of the drugs and need NOT accrue the income (e.g. receivables from insurance companies or Medicare) income (e.g. receivables from insurance companies or Medicare) May expense the costs of the drugs but must accrued the income May expense the costs of the drugs but must accrued the income Must capitalize the costs of the drugs (inventory) and accrue the Must capitalize the costs of the drugs (inventory) and accrue the income income Must capitalize the costs of the drugs but need not accrued the Must capitalize the costs of the drugs but need not accrued the income income Follow GAAP Follow GAAP None of the above None of the above 85 Tax Accounting Principles – Accrual Method of Accounting When? GAAP? Tax? 1 Accrual Method GAAP Report revenues when earned, even if not yet received Report expenses when incurred, even if not yet paid Tax 2 Accrual Method Tax General Rule— Accrual method taxpayers report income in the taxable year in which income is earned All events test: All the events have occurred which
• • fix the taxpayer’s right to the income and it can be determined with reasonable accuracy Fixed at earlier of: required performance occurs, payment is due or payment is made 3 Accrual Method Example:
In Hallmark Cards, the calendar year accrual basis taxpayer shipped Valentine cards before year end but deferred income from the sales to the following year. Early shipment was necessary to deal with certain production and shipping problems related to supplying cards in a timely manner to its customers (more than 20,000 retailers at over 35,000 locations). Contracts with the customers specified that title and risk of loss passed to customers on January 1. The IRS believed that the income should be reported in the previous year when it was shipped. What result?
5 Here are some examples of this “all events” test Problems 5-48, 49, 50 6 Accrual Method Example: H&N, an accrual basis company, agrees with Client to analyze its operations and determine to what it extent it might qualify for the research tax credit. H&N receives 25 percent of the any credit ultimately recovered. On December 15, 2005, H&N completed its study, determining that Client was entitled to $1,000,000 that could be recovered by filing amended returns. It presents Client with a bill of $250,000. What result?
7 Accrual Method
Example X Corp is an automobile dealer. It has an excess amount of 2003 model inventory and wishes to sell the excess inventory by the end of 2003. On October 1, 2003 X enters into a $1,000,000 contract with an advertising agency (ABC, who is a calendar year, accrual method taxpayer) to do a 3-month marketing blitz using TV and newspaper advertising in order to promote the sale of its excess inventory. The advertising services will be performed over this 3-month period beginning October 1, 2003 and ending December 31, 2004. Under the contract, X will pay ABC on January 1, 2004 for its services. In order to be paid, ABC must submit an invoice to X at the end of the campaign. Such invoice must include proof that the advertising was done in accordance with X’s specifications. When is ABC required to recognize income on the $1,000,000 advertising services contract?
8 Accrual Method
Exceptions: Dividends reported when received rather than date of record Certain items of prepaid income 9 Accrual Method of Accounting “Claim of Right Doctrine” Defined: 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 Claim of right doctrine supercedes all events test Prepaid income: rents, interest, royalties, etc. Examples: Problem 5-37 10 Special Accounting Methods
11 Prepaid Income and Accrual Method: When report? Accrual Method: Prepaid Income GAAP Tax
Generally report when received even though accrual method Why? Claim of right doctrine Wherewithal to pay principle 13 Accrual Method: Prepaid Income Report when received Prepaid interest, rents, royalties included in income when received Deposits distinguished 14 Accrual Method: Prepaid Income Prepaid service income: Rev. Proc. 2004-34 Full inclusion method: All in first year Limited deferral method • First Year: Same as financial accounting • Second year: Balance year: Balance 15 Accrual Method: Prepaid Income Prepaid rents vs. prepaid services Is “rent” a service? 16 Accrual Method: Prepaid Income Deposits Treatment Not income since there is an obligation to repay Problem 5-38 17 Accrual Method: Prepaid Income vs. Deposits
Example Indianapolis Power & Light 110 S.Ct. 589 (USSC, 1990) Indianapolis Power and Light, an accrual basis taxpayer, requires potential credit risks to transfer certain amounts—normally twice the customer’s estimated monthly bill—to insure payment of their future utility bills. IPL pays 6% interest on a deposit held for a year or more. Customers can obtain a refund if made timely payments for 9 months or satisfying a credit test. Are the amounts received income?
18 Example HHG sell appliances. It also offers a warranty at the time of the sale. The warranty generally covers all repairs during the warranty period that normally runs for 3-5 years depending on the appliance (e.g., television, washer-dryer, dishwasher, CD player). When will it report the warranty income? 19 Prepaid Dues and Subscriptions
Accrual Method of Accounting Prepaid dues (§ 455) reported ratably Prepaid subscriptions reported ratably 20 Accrual Method: Prepaid Income Advance payments for goods 21 Advance Payment for Goods Accrual basis taxpayers may elect either Full Inclusion Method Tax year of receipt Earlier of tax year • Amounts would be recognized for tax purposes without regard to receipt; or • Amounts are recognized for financial reporting purposes Income Deferral Method 22 Advance Payment for Goods – Exceptions Reg. § 1.451-5(c) – Inventoriable Goods Include by year after year of “substantial advance payment” if a “Substantial advance payment” (payment or payments that equal or exceed taxpayer’s cost) is received AND Inventory on hand or available through normal source of supply 23 Advance Payment for Goods
Example Needless Markup, a department store, sells gift certificates in December, 2005 for $1,000,000 and the gift certificates are still outstanding at the end of year 2006. When does the company report the $1,000,000 advance payment? Needless has met both tests (1) received “substantial advance payments” (amounts equal to or exceeding its costs) in 2006 and (2) the goods are in inventory or can be secured through normal channels. When payments exceed costs and the inventory is available, the amount must be included no later than next tax year, 2007. There will probably be no matching deduction in cost of goods sold because the goods are not likely to be identified before the certificate is redeemed. Note that if the goods have been identified by the end of the first year, inventory costs for the goods (actual or estimated) are included in the cost of goods sold for the year, even if the goods have not been delivered by year-end.
24 LONG-TERM CONTRACTS
25 Long-Term Contracts
Defined LONG-TERM CONTRACTS—Building, installation, construction, or manufacturing contract which is not completed within taxable year in which it is entered into For manufacturing contracts, items must be unique or require more than 12 months to complete. If does not qualify, advance payment rules may apply Contracts for services normally do not qualify Treatment Completed Contract Percentage of Completion
26 Long Term Contracts Completed Contract Method
Treatment Report revenue and expense when contract is complete 27 Long Term Contracts Completed Contract Method
May elect only if meet 1 of following 4:
1. Expected completion time is no more than two years and the contractor is “small” (average annual gross receipts < $10 million) 2. Contract for “home construction” (80% of costs related to buildings with 4 or fewer dwelling units) 3. Contract for “residential construction” (70% rule) 4. Contract for qualified ship contracts 28 Long Term Contracts
Percentage of Completion Method Treatment Report portion of total contract price each taxable year Total Contract Price x Direct & indirect costs this period/total estimated costs. Revenue Recognized Initial Phase Exemption: defer reporting if at end of tax year, less than 10% of total contract costs incurred Look-back rule: upon completion, recompute annual income using actual rather than estimated total costs
• Interest paid on over/under reporting • Interest paid on over/under reporting
29 Long-Term Contracts
Long-Term Construction Contracts Alternative Minimum Tax— If the completed contract method is allowed and used for regular tax purposes, the deferred income is a tax preference item for the alternative minimum tax
• Exception for home construction contracts). 31 Interest Income When report Recognize interest income when received (cash basis) or when earned (accrual basis) Always report prepaid interest income when received 32 Interest: Buying or Selling Bonds Interest income on sale of bonds between interest dates:
Seller must accrue interest to date of sale even if cash basis and include in income Buyer: purchase price deemed to include accrued interest; later receipt is nontaxable return of capital 33 34 Interest Income Treasury products Bills Notes Bonds Series E or EE bonds Series I bonds 35 Interest Income Treasury Bill (T-Bills) Purchased at discount Periods of 13 or 26 weeks Cash basis taxpayer reports discount when redeemed or sells Accrual reports as accrues 36 Interest Income Treasury Notes (T-Notes) Sold in 2, 3, 5 or 10 year maturities Pay interest every six months Treasury Bonds 30-year maturity Pay interest every six months 37 Interest Income Series E and EE Savings Bonds Return
Earn interest for up to 30 years Do not pay interest, but purchased at discount (50% of face value, $50 EE bond costs $25) Increase in value annually May cash in at any time Sold in various denominations $50, $75, $100, $200, $500, $1,000, $5,000, $10,000 38 Interest Income Series E and EE Savings Bonds
Optional reporting methods for cash or accrual taxpayers Report increase in redemption value annually annually when bond is redeemed. when bond is redeemed. 39 Educational Savings Bonds
(see also Chapter 6) 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 if issued to those 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 40 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
If redemption proceeds > qualified educational expenses, include interest received in excess of the exclusion amount: qualified educational expenses paid during year x
total bond redemption proceeds during the year accrued bond interest = exclusion amount 41 Z, A’s parent, cashed $9,500 of qualifying savings bonds to pay for A’s college expenses. A’s 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
42 Interest Income Discounted Investments: (see Chapter 16) Generally, for any investment Purchased at a discount Report as income the amortized discount or the difference between the instrument’s stated interest rate and market rate, TIMES the principal Example: OID
43 Interest Income Examples Buy bond at original issue with face value of $1,000 and 0% interest rate for $700 (i.e., $300 discount)
1000 700 300 Face Value Purchase Price Original Issue Discount (OID): 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)
44 Reporting Interest Income From Investments
Reporting By Cash Basis TPs OID Series E, EE Accrual reporting required TP may use cash or accrual method Accrual Basis TPs Accrual reporting required TP may use cash or accrual method Must report on accrual basis
45 T-Bills and Notes Report on cash basis Changes In Accounting Methods & Periods
GENERAL RULE – Accounting methods and periods generally are, once elected, irrevocable CHANGE IN ACCOUNTING PERIOD – File Form 1128. CHANGE IN ACCOUNTING METHOD – File Form 3115. 1 Change of Accounting Method
Why change method? Involuntary change forced by IRS Voluntary changes Must receive permission from IRS, even if change is from impermissible method. Why?
• Possible omission of income • Possible duplication of expenses
2 Taxable Income Change of Accounting Method
Example: • 2006 business on cash basis • 2006 earns income • 2007 bills client and switches to accrual • 2007 receives • Result
– – – No income in 2006 since on cash method and didn’t receive No income in 2007 since on accrual method and earned in 2006 Magic! Change of Accounting Method: Permission to change required Why? To eliminate omission of income and duplication of deductions, must ask permission to change. Permission normally granted if the taxpayer agrees to report the omitted income or eliminate the double deduction that otherwise results. 5 Change of Accounting Method: § 481(a) adjustment Insures no omission of income Insures no duplication of deduction Covers cumulative effect of change Adjustment period 4 years for voluntary change Negative adjustments included all in the year of the change. Procedural rules favor voluntary changes
6 Example of Sec. 481(a) Adjustment
Involuntary change 7 Example of Sec. 481(a) Adjustment Taxpayer has been using cash method Used cash method through 2001 Year of change is 2002, first year of accrual method 9 Example of Sec. 481(a) Adjustment End of year 2001 (year prior to change)
(income not reported using cash method) $150,000 PRO IRS 70,000 PRO IRS (72,000) PRO Taxpayer $148,000 Inventories
(expensed using cash method) Accounts payable
(expenses not reported using cash method) Overall cumulative effect 10 Example of Sec. 481(a) Adjustment Involuntary Change
later audit in 2004 Assume change is forced by IRS at time of Taxpayer must absorb 2002 (year of change) (year of change) all effects of change in $148,000 additional taxable income (150+70-72) in 2002 Interest, penalties, etc. have already run for 2 years
11 Example of Sec. 481(a) Adjustment
Voluntary change 12 Example of Sec. 481(a) Adjustment Voluntary change
and IRS approves Alternatively if file Form 3115 within 2002 Sec. 481(a) adjustment is spread over 4 yrs ($148,000/4 = $37,000) Taxpayer includes $37,000 per year in 2002, 2003, 2004 and 2005 (instead of $148,000) 13 Example of Sec. 481(a) Adjustment Voluntary change (cont.) Generally 4 year forward spread is mandatory Taxpayer may elect to include all in year of change, if total adjustment is $25,000 or less Negative adjustments may be included all in the year of the change. Note that cumulative effect may be positive (income) or negative (deduction) 14 Example of Sec. 481(a) Adjustment Involuntary Change Assume that the change is forced by IRS at time of later audit in 2004 Taxpayer must absorb all effects of change in year of change, 2002 $148,000 additional taxable income Interest, penalties, etc. have already run for 2 years 15 Example of Sec. 481(a) Adjustment Voluntary Change Alternatively assume taxpayer files Form 3115 within 2002, and IRS approves Sec. 481(a) adjustment is spread over 4 years. ($148,000/4 = $37,000) Thus taxpayer includes $37,000 per year in 2002, 2003, 2004 and 2005. 16 Example of Sec. 481(a) Adjustment Voluntary Change Generally 4 year forward spread is mandatory However, taxpayer may elect to include all in year of change, if total adjustment is $25,000 or less
Negative adjustments included all in the year of the change. Note that cumulative effect may be positive (income) or negative (deduction) 17 Change of Accounting Method:
Obtaining permission to change Must File Form 3115 Must file in year for which change is desired 18 19 Identification of the Taxpayer
WHO IS THE TAXPAYER? WHO REPORTS THE INCOME? 20 Lucas v. Earl 2 USTC 496, 281 U.S. 111 (USSC, 1930)
The taxpayer, Guy C. Earl, and his wife entered into a contract in 1901 agreeing that 1901
“any property either of us now has or may hereafter acquire in any way, either by earnings (including salaries, fees, etc.) or any rights by contract or otherwise, during the existence of our marriage, or which we or either of us may receive by gift, bequest, devise, or inheritance, and all the proceeds, issues, and profits of any and all such property shall be treated and considered, and hereby is declared to be received, held, taken, and owned by us as joint tenants, and not otherwise, with the right of survivorship.”
Board of Tax Appeals (Tax Court) agrees with IRS CA-9 reversed. Supreme Court in 1930 says….
21 Lucas v. Earl 2 USTC 496, 281 U.S. 111 (USSC, 1930)
Justice Holmes for the Supreme Court There is no doubt that the statute could [have been written to] tax salaries to those who earned them and provide that the tax could not be escaped by anticipatory arrangements and contracts however skillfully devised to prevent the salary when paid from vesting even for a second in the man who earned it. [However,] That seems to us the import of the statute before us and we think that no distinction can be taken according to the motives leading to the arrangement by which the fruits are attributed to a different tree from that on which they grew. 22 Assignments of Income The Fruit of the Tree Doctrine 23 Identification of the Taxpayer Income from personal services Assignment of income doctrine Income taxed to the person who earns the income since he controls the source. Cannot arbitrarily assign income earned by the taxpayer to another through contract or otherwise 24 Identification of the Taxpayer Income from property Income taxed to owner of the property Shift income by shifting ownership of property 25 Interest Free and Below-Market Loans Problem: How to shift income from high-bracket to low-bracket taxpayer without losing control of property Interest free loans Solution 26 Interest Free and Below-Market Loans Typical Income Shifting Plan High-bracket loans $100,000 to low-bracket Transfer is a loan rather than a gift to ensure control Loan is a demand loan enabling continuous control Low bracket taxpayer invests the $100,000 to produce investment income Investment income is taxed at low rate Loan is interest free so no income at high-bracket §7872 enacted to attack
27 Interest Free and Below-Market Loans § 7872 Attack Loans affected Demand loans bearing interest less than the applicable federal rate Term loans where the amount loaned exceeds the present value of all payments due under the loan discounted at the AFR Hypothetical treatment.
As if the borrower/debtor paid interest to the lender who subsequently transfers an equal amount back to the borrower Result: 28 Interest Free and Below-Market Loans § 7872 Attack Impute interest Borrower/debtor deemed to pay interest to the lender who subsequently transfers an equal amount back to the borrower Result: Lender treats hypothetical “payment” from borrower as Lender treats hypothetical “payment” from borrower as income (thus moving the income back to the lender) income (thus moving the income back to the lender) Borrower may have deduction for the “payment” Borrower may have deduction for the “payment” Lender’s payment to Borrower is treated as gift, Lender’s payment to Borrower is treated as gift, compensation or dividend, depending on relationship compensation or dividend, depending on relationship 29 Interest Free and Below-Market Loans
§ 7872 Hypothetical Treatment
Interest income to lender L Deemed interest payment L B Interest free demand loan Gift, Compensation, Dividend 30 Interest Free and Below-Market Loans § 7872 Attack Exception for loans not exceeding $10,000 No tax consequences if loans outstanding never exceed $10,000 during year unless
A gift loan and borrower uses loan proceeds to purchase or carry income producing assets A nongift loan and one of its purposes is tax avoidance 31 Interest Free and Below-Market Loans § 7872 Attack Exception for loans not exceeding $100,000 If loans do not exceed $100,000,
Lender is still treated as having made a gift as determined above Borrower's hypothetical interest payment is deemed equal to his net investment income (which is considered zero if less than $1,000) 32 Interest Free and Below-Market Loans § 7872 Attack Exception for loans to qualified continuing care facility (§ 7872(g)) Must meet certain requirements 33 Income from Community Property Community property in general Rights of married couples in property Community property: considered owned equally by each spouse Separate property: considered owned by either husband or wife but not both Ten community property states 34 10 Community Property States
35 Income from Separate Property in Community Property States Income from separate property Is community property in TX, LA, ID and each spouse is responsible for reporting his or her share In remaining 7 states, treated as separate property and the spouse that owns the property is responsible for reporting the income. Income from personal services Treated as community property!
36 Separate property income is community property
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This note was uploaded on 03/21/2010 for the course ACCOUNTING 533 taught by Professor Eric during the Spring '09 term at Universidade do Minho.
- Spring '09