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413sol3-04 - Chapter 3 Income Sources 3-1 CHAPTER 3 INCOME...

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Chapter 3: Income Sources 3-1 ________________________________________________________________________ CHAPTER 3 INCOME SOURCES ____________________________________________________________________ DISCUSSION QUESTIONS 1. How is the definition of income for income tax purposes different from the definition used by economists to measure income? Economists measure income as the change in wealth that occurs during a year. As such, all increases and decreases in the value of assets, whether they are actually realized, are part of the change in wealth. The income tax definition includes only those changes in wealth that are realized by the taxpayer during the year. Thus, the income tax law does not tax as income increases (decreases) in the value of assets that have not been realized in an arm's-length transaction. 2. One of Adam Smith's four criteria for evaluating a tax is certainty. Does the income tax definition of gross income promote certainty in the U.S. tax system? Explain. Certainty means that a taxpayer should know when and how a tax should be paid. In addition, it means that the taxpayer should be able to determine the amount of tax to be paid. The income tax definition of gross income promotes certainty by requiring that a realization occur before income is recognized. This eliminates the need for taxpayers to revalue all their assets from year to year in determining the amount of the tax. The taxpayer only need ascertain those transactions in which a realization has occurred during the year and determine the income tax effects of those transactions. The use of exclusions in calculating gross income does not promote certainty. That is, the tax law contains so many instances in which income is excluded from tax that the taxpayer often has difficulty ascertaining which exclusions apply to them. 3. What is the difference between realized income and recognized income? Realized income occurs when a taxpayer receives an increase in wealth in an arm's-length transaction. Recognized income is income that is actually taxed in the current tax year. Therefore, all recognized income must first be realized. However, all realized income may not be recognized currently. Some forms of income are excluded permanently from tax (e.g., municipal bond interest), while other forms of income are deferred for recognition in a future period (e.g., gains from like-kind exchanges). 4. Buford purchased a new automobile in March for $23,000. In April, he receives a $500 rebate check from the manufacturer. The rebate was paid to all customers who purchased one of the manufacturer's automobiles in March. Should Buford include the $500 rebate in his gross income? Explain. The rebate check is not income. It is an adjustment of the sales price of the automobile. Buford's wealth has not increased as a result of the receipt of the check because rebate checks are used as sales tools. It is a reduction of the selling price paid directly by the manufacturer rather than the dealer. Therefore, Buford has really paid $22,500 (his basis is $22,500) for the new automobile as a result of the rebate.
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Chapter 3: Income Sources 3-2 5. What is a cash equivalent? How does a cash equivalent affect the reporting of income?
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