1. © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Essentials of Taxation 1 Chapter 4 Gross Income

2. 2 The Big Picture (slide 1 of 3) Dr. Cliff Payne opens his new dental practice as a qualified personal service corporation. –He selects a December 31 year-end and the accrual method of accounting. During the year, Dr. Payne billed patients and insurance companies for $385,000 of dental services. –At the end of the year, $52,000 of this amount has not been collected. Dr. Payne also earns the following: –$500 of interest on a money market account. –$500 of interest on bonds issued by the Whitehall School District.

3. 3 The Big Picture (slide 2 of 3) Dr. Payne’s salary from his corporation is $10,000 per month. –However, he did not cash his December payroll check until January. To help fund his new business, Dr. Payne’s parents loaned him $150,000 –They did not charge him any interest. He also owns stock that has increased in value from $7,000 at the beginning of the year to more than $25,000 at the end of the year.

4. 4 The Big Picture (slide 3 of 3) Although Dr. Payne took several accounting classes in college, he would like your help in calculating his gross income and the gross income of the corporation. Read the chapter and formulate your response.

5. 5 Components Of The Tax Formula (slide 1 of 3)

6. 6 Components Of The Tax Formula (slide 2 of 3) Income (Broadly Conceived) –Includes all income, both taxable and nontaxable Essentially equivalent to gross receipts Does not include –A return of capital, or –Borrowed funds Exclusions –Certain types of income are excluded from the income tax base Principal income exclusions that apply to all entities are –Life insurance proceeds –State and local bond interest

7. 7 Components Of The Tax Formula (slide 3 of 3) Deductions –Generally, all ordinary and necessary trade or business expenses are deductible –Such expenses include Cost of goods sold Salaries Wages Operating expenses (such as rent and utilities) Research and development expenditures Interest, Taxes, Cost recovery (Depreciation, amortization, and depletion)

8. 8 Gross Income (slide 1 of 3) Definition: Gross income includes all income from whatever source derived, unless specifically excluded under the Code Concept is interpreted broadly by the courts

9. 9 Gross Income (slide 2 of 3) Taxability of income follows the realization principle from accounting –Income is recognized (taxed) when realized Mere appreciation in wealth (economic income) is not considered realized income

10. 10 Gross Income (slide 2 of 3) Taxability of income follows the realization principle from accounting –Income is recognized (taxed) when realized Mere appreciation in wealth (economic income) is not considered realized income

11. 11 Gross Income (slide 2 of 3) Taxability of income follows the realization principle from accounting –Income is recognized (taxed) when realized Mere appreciation in wealth (economic income) is not considered realized income

12. 12 Gross Income (slide 2 of 3) Taxability of income follows the realization principle from accounting –Income is recognized (taxed) when realized Mere appreciation in wealth (economic income) is not considered realized income

13. 13 The Big Picture - Example 2 Economic Income vs. Gross Income Return to the facts of The Big Picture on p. 4-1. Dr. Payne’s portfolio has increased in value by more than 250% during the tax year. –That additional value constitutes economic income to him. The Federal income tax law does not include the value increase in Dr. Payne’s gross income –Even though he could convert those gains to cash through, say, a margin loan from his broker.

14. 14 The Big Picture - Example 2 Economic Income vs. Gross Income Return to the facts of The Big Picture on p. 4-1. Dr. Payne’s portfolio has increased in value by more than 250% during the tax year. –That additional value constitutes economic income to him. The Federal income tax law does not include the value increase in Dr. Payne’s gross income –Even though he could convert those gains to cash through, say, a margin loan from his broker.

15. 15 Gross Income (slide 3 of 3) Income is recognized whether it is in the form of cash, or “in-kind” cash equivalents (i.e., property or services) –The amount of income from “in-kind” receipts is equal to the FMV of the property or services Income does not include recovery of the taxpayer’s capital investment

16. 16 Accounting Periods Taxable year is generally a 12-month period –Taxable year for most individual taxpayers is the calendar year –Fiscal year can be elected if taxpayer maintains adequate records Fiscal year is a 12-month period ending on the last day of a month other than December –Example: July 1 to June 30

17. 17 Accounting Methods (slide 1 of 2) There are 3 primary methods of accounting for tax purposes: –Cash receipts and disbursements method –Accrual method –Hybrid method

18. 18 Accounting Methods (slide 2 of 2) In addition to overall accounting methods, taxpayers may choose (elect) tax treatment for various transactions, for example –Taxpayers can elect to use the installment method –Certain contractors may elect to use either the percentage of completion method or the completed contract method

19. 19 Cash Receipts Method Income is recognized in the year it is actually or constructively received in cash or cash equivalent An amount is constructively received when it is set aside and made available to taxpayer without substantial restrictions

20. 20 Exceptions To Cash Receipts Method Original Issue Discount (OID) interest is taxable when earned rather than when interest is received Savings bonds are not subject to the OID rules –However, a cash basis taxpayer may elect to recognize the interest when earned

21. 21 Accrual Method (slide 1 of 2) Income is recognized in the year that it is earned regardless of when it is collected Income is earned when: –All events have occurred that fix taxpayer’s right to the income, and –The amount can be determined with reasonable accuracy The accrual method is required for determining purchases and sales when inventory is an income- producing factor

22. 22 Exceptions to Accrual Method (slide 1 of 2) Taxpayer can elect to defer recognition of income from advance payment for goods if same method of accounting is used for tax and financial reporting purposes

23. 23 Exceptions to Accrual Method (slide 2 of 2) Advance payment for services to be performed after year-end is included in income in the year following receipt –The portion of the advance payment that is earned in the current year is included in income in the year of receipt Prepaid rents or interest income are always recognized in the year received rather than when earned

24. 24 Example 17 - Advance Payment For Services (slide 1 of 2)

25. 25 Example 17 - Advance Payment For Services (slide 2 of 2)

26. 26 Hybrid Method A combination of cash and accrual methods Generally, used when inventory is a material income-producing factor –Use accrual method to account for inventory –Use cash method for other income and expenses

27. 27 Income Sources Income from personal services is taxable to the person who performs the services Income from property is taxable to the owner of the property –Assignment of income is not permitted

28. 28 Dividends (slide 2 of 4) Recent legislation has provided partial relief from double taxation of corporate dividends –Generally, qualified dividends are taxed at the same marginal rates applicable to a net capital gain Thus, individuals otherwise subject to the 10% or 15% marginal tax rates in 2013 pay 0% tax on qualified dividends received Individuals subject to the 25, 28, 33, or 35 percent marginal tax rates pay a 15% tax on qualified dividends Individuals subject to the 39.6% marginal tax rate pay a 20% tax on qualified dividends

29. 29 Income Received By An Agent Income received by the taxpayer’s agent is considered to be received by the taxpayer –A cash basis principal must recognize the income at the time it is received by the agent

30. 30 Income Received By An Agent Income received by the taxpayer’s agent is considered to be received by the taxpayer –A cash basis principal must recognize the income at the time it is received by the agent

31. 31 Imputed Interest on Below-Market Loans (slide 1 of 4) Interest is imputed, using Federal government rates, when a loan does not carry a market rate of interest –Imputed interest = the difference between the amount that would have been charged at the Federal rate and the amount actually charged Applies to: Gift loans Compensation-related loans Corporate-shareholder loans Tax avoidance loans

32. 32 Imputed Interest on Below-Market Loans (slide 2 of 4) Exhibit 4.1

33. 33 Imputed Interest on Below-Market Loans (slide 3 of 4) Gift loans –Exemption for loans of ≤ $10,000 between individuals If loan proceeds are used to purchase income-producing property, the following limitation applies –On loans of $100,000 or less between individuals Imputed interest is limited to borrower’s net investment income for year No imputed interest if net investment income is $1,000 or less

34. 34 Imputed Interest on Below-Market Loans (slide 4 of 4) $10,000 exemption also applies to compensation-related and corporation- shareholder loans –No exemption if principal purpose of loan is tax avoidance Makes practically all loans of this type suspect Interest expense imputed to borrower may be deductible

35. 35 The Big Picture - Example 28 Imputed Interest On Gift Loans Return to the facts of The Big Picture on p. 4-1. Dr. Payne’s loan from his parents likely is a gift loan, as his parents are not shareholders in the personal service corporation. Imputed interest must be computed annually with regard to this loan by both Dr. Payne and his parents –The principal amount of the loan exceeds $100,000 and –The loan proceeds were invested in an income-producing asset.

36. 36 Tax Benefit Rule If taxpayer receives a deduction for an item in one year and in a later year recovers all or a portion of the prior deduction, the recovery is included in gross income –Amount included in income is limited to the amount for which a tax benefit was received

37. 37 Tax Benefit Rule If taxpayer receives a deduction for an item in one year and in a later year recovers all or a portion of the prior deduction, the recovery is included in gross income –Amount included in income is limited to the amount for which a tax benefit was received

38. 38 Interest on State and Local Government Obligations Interest from municipal bonds is tax exempt –Reduces borrowing costs of state and local governments –High-income taxpayers can increase after-tax yields with municipal bonds –Municipal interest is considered for Social Security benefits inclusion and may be considered for alternative minimum tax calculation

39. 39 Interest on State and Local Government Obligations Interest from municipal bonds is tax exempt –Reduces borrowing costs of state and local governments –High-income taxpayers can increase after-tax yields with municipal bonds –Municipal interest is considered for Social Security benefits inclusion and may be considered for alternative minimum tax calculation

40. 40 Interest on State and Local Government Obligations Interest from municipal bonds is tax exempt –Reduces borrowing costs of state and local governments –High-income taxpayers can increase after-tax yields with municipal bonds –Municipal interest is considered for Social Security benefits inclusion and may be considered for alternative minimum tax calculation

41. 41 Improvements on Leased Property Improvements made to leased property –Excluded from landlord’s gross income unless the improvement is made to the property in lieu of rent

42. 42 Life Insurance Proceeds (slide 1 of 4) Exempt income to beneficiary if paid solely due to death of insured –Relationship to decedent not determinative

43. 43 Life Insurance Proceeds (slide 2 of 4) If owner of life insurance policy cancels the policy and receives the cash surrender value –Gain must be recognized to extent amount received exceeds premiums paid on policy –Loss is not recognized

44. 44 Life Insurance Proceeds (slide 3 of 4) Transfers for valuable consideration –If policy is transferred for valuable consideration, proceeds are taxable to extent they exceed amount paid for policy plus subsequent premiums paid –Exceptions exist for policy transfers: To facilitate funding of buy-sell agreements, Pursuant to a tax-free exchange, and For receipt of a policy by gift

45. 45 Life Insurance Proceeds (slide 3 of 4) Transfers for valuable consideration –If policy is transferred for valuable consideration, proceeds are taxable to extent they exceed amount paid for policy plus subsequent premiums paid –Exceptions exist for policy transfers: To facilitate funding of buy-sell agreements, Pursuant to a tax-free exchange, and For receipt of a policy by gift

46. 46 Discharge from Indebtedness Income from the forgiveness of debt is taxable –Certain discharge of indebtedness situations get special treatment: Creditors’ gifts Discharges in bankruptcy and when debtor is insolvent Discharge of farm debt Discharge of qualified real property business indebtedness Seller’s cancellation of buyer’s debt Shareholder’s cancellation of corporation’s debt Forgiveness of certain student loans Discharge of indebtedness on taxpayer’s principal residence that occurs between 2007 and 2014, and is the result of the financial condition of the debtor

47. 47 Discharge from Indebtedness Income from the forgiveness of debt is taxable –Certain discharge of indebtedness situations get special treatment: Creditors’ gifts Discharges in bankruptcy and when debtor is insolvent Discharge of farm debt Discharge of qualified real property business indebtedness Seller’s cancellation of buyer’s debt Shareholder’s cancellation of corporation’s debt Forgiveness of certain student loans Discharge of indebtedness on taxpayer’s principal residence that occurs between 2007 and 2014, and is the result of the financial condition of the debtor

48. 48 Discharge from Indebtedness Income from the forgiveness of debt is taxable –Certain discharge of indebtedness situations get special treatment: Creditors’ gifts Discharges in bankruptcy and when debtor is insolvent Discharge of farm debt Discharge of qualified real property business indebtedness Seller’s cancellation of buyer’s debt Shareholder’s cancellation of corporation’s debt Forgiveness of certain student loans Discharge of indebtedness on taxpayer’s principal residence that occurs between 2007 and 2014, and is the result of the financial condition of the debtor

49. 49 Gains and Losses from Property Transactions (slide 1 of 3) In order for gains (losses) to be recognized (included in gross income), they must be realized: –Realized gain (loss) = amount realized – adjusted basis Amount realized = selling price – costs of disposition Adjusted basis = cost + capital additions – cost recovery

50. 50 Gains and Losses from Property Transactions (slide 2 of 3) All realized gains are recognized unless a specific tax provision provides otherwise (e.g., nontaxable exchanges) Realized losses may or may not be recognized depending on the circumstances –Generally, losses on the sale or disposition of personal use property are not recognized

51. 51 Gains and Losses from Property Transactions (slide 3 of 3) Once recognized gains or losses have been determined, they must be classified as ordinary or capital –Ordinary gains are fully taxable –Ordinary losses are fully deductible Capital gains and losses are subject to special tax treatment

52. 52 Gains and Losses from Capital Asset Transactions (slide 1 of 2) Capital assets are defined as any property other than: –Inventory, –Accounts Receivable, and –Depreciable property or real property used in a business –Certain other property Most personal use assets owned by individuals are capital assets –Losses on these assets are not deductible

53. 53 Gains and Losses from Capital Asset Transactions (slide 2 of 2) Gains and losses from capital asset transactions must be netted –Net gains and losses by holding period –If excess losses result, tax treatment depends on whether taxpayer is an individual or corporation

54. 54 Max Tax Rates for Net Capital Gains of Individuals Classification Maximum Rate Short-term gains (held ≤ one year) 35% Long-term gains (held > one year) 0%/15%/20%

55. 55 Treatment of Capital Losses (slide 1 of 2) Net capital losses of individuals are deductible for AGI up to $3,000 yearly –Excess capital losses are carried over to the next tax year –When carried over, capital losses retain their classification as short- or long-term

56. 56 Treatment of Capital Losses (slide 2 of 2) Corporations must also net capital gains and losses –Net capital gains do not receive special tax treatment –Capital losses can only offset capital gains Excess capital losses may not be deducted against ordinary income Unused capital losses can be carried back 3 years and then carried forward 5 years to offset capital gains in those years