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Unformatted text preview: * C HAPTER F IVE * GROSS INCOME SOLUTIONS TO PROBLEM MATERIALS DISCUSSION QUESTIONS 5-1 The discrimination that exists between renters and owners is attributable to the income definition adopted for tax purposes. The tax definition of income generally excludes benefits received in kind from property (e.g., the net rental value of using ones personal residence), while the economic definition would include such benefits as income, since these represent a type of consumption. For example, assume an individual in the 28 percent bracket has $100,000 to invest in either a home or a security. Also assume the consumption value of the house (what it would cost to rent the home) was $10,000, which is equivalent to the interest received on the bond. After taxes, the return on the investment in the house is $10,000, while the return on the bond investment is $7,200 [$10,000 (28% $10,000)]. As is apparent from this example, failure to treat the rental value of the house as taxable income creates an unfavorable bias against one who chooses to rent rather than buy. The taxpayer who chooses to invest in the security with the intention of using the income to rent a house, must pay tax on the income, which reduces the amount available for rent. (See Example 44, pp. 5-3, 5-4 and 5-43, and 61.) 5-2 The economists approach to measuring income has been applied for tax purposes and is referred to as the net-worth method. The net-worth method is an indirect way of computing income and is typically used when the taxpayers records are an inadequate basis for determining the tax liability (e.g., no records have been maintained or the records have been destroyed or falsified). Income is determined using the net-worth approach by ascertaining the increase or decrease in net worth during the period and adding the taxpayers nondeductible consumption expenditures. (See Example 1 and pp. 5-4 and 5- 5.) Implementation of this approach requires the IRS to establish a definite opening net worth to serve as a starting point. This step is perhaps the most difficult. Taxpayers normally claim that the opening net worth shown by the IRS is inappropriate because of the existence of substantial cash that was hidden. In one case, U.S. v. Holland, 54-2 USTC 19714, 46 AFTR 943, 75 S. Ct. 127 (USSC, 1954), the IRS asserted that the taxpayers opening net worth included $2,153 in cash, while the taxpayer claimed the Service had failed to include $113,000 in currency, which at various times had been in a canvas bag, a suitcase, and a metal box. In connection with the opening net worth, the taxpayer usually gives information to the IRS indicating the specific sources from which the cash has come, such as prior earnings, stock transactions, inheritance, and gifts. The Service typically investigates these leads in order to confirm or deny their validity. Problems in establishing the taxpayers ending wealth may also exist. Often the Service is required to search for concealed assets. Existence of concealed assets (and thus unreported income) is generally concealed assets....
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