Tax Ch 3 notes: Gross Income: Conclusions

Economic and Accounting Concepts of Income

Economic Concept: Income is the amount an individual could consume during a period and
remain well off at the end of the period as he was at the beginning; thus

 Income = Consumption + Change in Wealth

Accounting Concept: Income measured when it is realized in a transaction; realization generally

results upon occurrence of two events: 1) change in the form or substance of a taxpayer’s
property and 2) transaction with a second party (ie- when TP sells propertyrealization; when
property value increasesno realization)

Tax Concept of Income

Tax law follows accounting concept of income because of administrative convenience and
wherewithal to pay concepts. In general, three conditions must be met for amounts to be taxable:

1) Economic benefit present: benefit not limited to cash payments (ie employees who
receive company stock) and even if employees order their salaries be paid directly to
another party, benefit still present
2) Income must be realized: realization occurs when earning process is complete and
transaction with another party takes place to permit objective measure of income (this
increases “administrative convenience”)
3) Income must be recognized: some income items not taxable because of provisions in tax
law (ie certain real estate exchanges and corporate reorganizations because of statutory
non-recognition rules). In these cases, taxpayer receives a lower basis in replacement
property and that means income is recognized when property is sold

Administrative Convenience: need for objectivity in determining taxable income is evident;

otherwise, disputes over valuation issues would be frequent and courts would be burdened with
added litigation (seen in cases where valuations are required in tax determination (ie value of
property that taxpayers who contribute property to charity can deduct))

Wherewithal to Pay: concept holds that tax should be collected when the taxpayer is in the best
position to pay the tax. Tax law allows TP who sells property on installment basis to report the
gain as installment payments are collected, rather than at time of sale; but losses cannot be
reported on installment basis since “wherewithal to pay” is not an issue.

- also used to justify differences between tax law and financial accounting principles
(ie prepaid income subject to taxation at time it is collected not earned (not income
from account standpoint))
Gross Income Defined: As defined in Sec 61(a): all income from whatever source derived,
including but not limited to: compensation for services including fees, commissions, etc; gross
income derived from business, gains derived from property dealings, interest, rents, royalties, etc
(see pg 3-4)

IRS doesn’t have to provide income item is taxable; TP must prove item is excluded (thus
gambling winnings and illegal income are taxable)

 Forms of Receipt: gross income not limited to amounts received in cash (can be in any
realized form such as money, property, or services). Important factor is whether TP
receives an economic benefit (covers barter transactions as well)
 Indirect economic benefit: if taxpayer benefits from an item, it is taxable. However,
indirect benefits may be excluded from gross income (see pg 3-5 section for examples);
an expenditure is excludable if it is made to serve the business needs of the employer and
any benefit to the employee is secondary/incidental. Fringe benefits (such as employee
discounts) also excluded from gross income

To Whom is Income Taxable

Assignment of Income: 1930 case decided individual is taxed on the earnings from his personal
services; an agreement to assign income doesn’t permit person to avoid being taxed on it (1940
case extended income to income from property)

Allocating Income Between Married People: for federal income tax purposes, income is
allocated between husband/wife depending on state of residence (41 states follow common law
property system, 9 states use community system).

- Common law: income is generally taxed to individual who earns income either
through labor or capital
o generally, only joint income in a common law state is income from jointly
owned property
- Community property: income may be either separate or community
o Community income is considered to belong equally to the spouses; income
from personal efforts of either spouse is considered to belong equally to the
spouses
o Separate property: consists of all property owned before marriage and gifts
and inheritances acquired after marriage

When couples file separate returns, normally each spouse is expected to report half of all
community income but is unfair if one spouse isn’t aware community income is earned. Thus
special rules excuse an “innocent spouse” who fails to report community income on separate
return (IRS includes entire amount in income of other spouse)

Income of Minor Children: earnings are taxed to child regardless of state’s property law system
(not to parents). Unearned income of child under age 24 may be taxed at parents’ tax rate if it is
higher than child’s rate (or parents may choose to include child’s unearned income on their
return)

When is Income Taxable (see pg 3-9 in book for chart)

IRS requires taxpayers to use accrual method for determining purchases and sales when
inventory is maintained. Exception: taxpayers whose annual gross receipts for three prior years
do not exceed $1 million ($10 million if TP’s principal business is not sale of inventory) may use
cash method

Section 448 requires C corps and partnerships with corporate partners, tax, shelters, and certain
trusts to use accrual method

Cash Method: used by most individual TP and small business; income is reported in year TP
receives income rather than when income in earned (can be received by TP or TP’s agent and in
the form of cash, other property, or services). Prepaid income is taxed when received which
creates mismatch of income/expenses

 Constructive Receipt: Cash basis TP reports income in year it is actually or constructively

received: CR = income is made available to the TP so he may draw upon it at any time.
However, income is not CR if TP’s control of the receipt is subject to substantial
limitations or restrictions (this rule prevents TP from deferring income by “turning their
backs” on it TP cannot defer income recognition by refusing to accept payment until
later taxable year)
o Ex where TP must report income even if no cash received: 1) check received after
banking hours, 2) interest credit to bank savings account, 3) bond interest coupons
that have matured but not redeemed, 4) salary available to employee who doesn’t
accept payment
o Ex where amount is NOT considered CR: 1) if payor doesn’t have funds to make
payment, 2) amount is unavailable to TP
o Exceptions to rule of reporting income when actually/constructively received:
interest on Series E and Series EE US savings bond don’t need to be reported
until final maturity date
o Note on small taxpayer exception for inventories: Rev. Proc. 2001-10 states small
taxpayer exception of maintaining inventory and using cash method of average
annual gross receipts are $1 million or less for prior three years is revised to only
allow small taxpayer to deduct inventory purchases in the year of purchase if 1)
 inventory purchases are paid for by year end and 2) inventory is actually sold in
the year

Accrual Method: used to report income in the year it is earned; income is earned when all the
events have occurred that fix the right to receive income and when the amount can be determined
with reasonable accuracy (ie in sale of propertywhen title passes to buyer; income from
services accrues as services are performed)

 Prepaid income: generally taxable in year of receipt but there are two exceptions: 1)
accrual basis taxpayers may defer recognizing income in the case of certain advance
payments for goods and for services to be rendered (ie TP may defer advance payment
for goods (inventory) if method of accounting for sale is same for tax and financial
accounting purposes)
o Under Rev. Proc. 2004-34 TP may defer payments for future services to year
following the year in which payment is received. Revenue relating to services
provided in the year payment is received is reported currently; revenue relating to
future years is reported in the year following the year of receipt even if payments
relate to multiple future years (ie Internet service, dance lessons, maintenance
contracts). This is only available when services and products are provided
together. Does NOT apply to rent (if services aren’t associated with it), insurance
premiums, interest, warrant contracts

Hybrid Method: combination of cash/accrual methods. Method most often seen in small
businesses with inventories and are required to use the accrual method for purchases and sales of
goods(use cash method for all other items of income/expense)

Items of Gross Income: Sec 61(a)

Section states that gross income includes, but is not limited to, 15 specific types of income

Compensation: payment for personal services including salaries, wages, fees, commissions, tips,
bonuses, and specialized compensation forms (ie director’s fees, jury fees, marriage fees).
Exclusions exist for variety of employer-provided fringe benefits such as group term life
insurance premiums, health and accident insurance premiums, employee discounts, contribution
to retirement plans. Also a limited exclusion applicable to foreign earned income

Business Income:

Gains from Dealings in Property:

Interest:

Rents and Royalties:

Dividends:

Alimony and Separate Maintenance Payments:

Pensions and Annuities:

Income from Life Insurance and Endowment Contracts:

Income from Discharge of Indebtedness:

Income Passed Through to Taxpayer:

Other Items of Gross Income

Prizes, Awards, Gambling Winnings, Treasure Finds:

Illegal Income:

Unemployment Compensation:

Social Security Benefits:

Insurance Proceeds and Court Awards:

Recovery of Previously Deducted Amounts:

Claim of Right:

Tax Planning Considerations

Alimony:

Prepaid Income:

Taxable, Tax Exempt, or Tax Deferred Bonds:

Reporting Savings Bond Interest:

Deferred Compensation Arrangements:

Compliance and Procedural Considerations