© 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Chapter 2 Income Tax Concepts Murphy & Higgins, Concepts in Federal Taxation, 2010 edition

2-2 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Federal Income Taxation Based on a system of rules Developed around general concepts and specific exceptions

2-3 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Terminology Concept - a broad principle Construct - a means to implement a concept Doctrine - a construct developed by the courts Concept ConstructDoctrine

2-4 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. General Concepts Ability to Pay Tax should be based on an amount that a taxpayer can afford to pay. Constructs used Deductions Exclusions Credits Progressive tax rates

2-5 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. General Concepts Administrative Convenience The benefit derived from a concept, construct or doctrine should always exceed the cost of implementation. Constructs used Standard deduction amounts Fringe benefit exclusions

2-6 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Administrative Convenience Example Bow Company allows its employees to make copies for personal reasons without charge on the company copy machine. The employees are not required to include the value of the copies in taxable income.

2-7 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. General Concepts Arms-Length Transaction Concept A transaction between related parties must reflect economic reality. Constructs used Related-party provisions Constructive ownership rules

2-8 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Arms-Length Transaction Example Gaby sells 100 shares of IBM stock to her brother for $10,000. The shares had originally cost Gaby $12,000. Gaby is not allowed to use the $2,000 loss from the sale to reduce her taxable income.

2-9 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. General Concepts Pay As You Go Concept Taxpayers are required to pay tax as they generate income. Constructs used Withholding Estimated tax payments

2-10 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Accounting Concepts Entity Concept Each tax entity must keep separate records and report operations separately. Doctrine used Assignment of Income Constructs used Taxable entities Conduit entities Sole Proprietorships

2-11 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Assignment of Income Doctrine All income earned from services provided by an entity or property owned by an entity are to be taxed to that entity.

2-12 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Assignment of Income Example Sage is a self-employed electrician. She deposits all cash payments she receives in a bank account in her son’s name. Sage does not have use of the funds; however, she is required to include the amount of the cash payments in her gross income.

2-13 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Accounting Concepts Annual Accounting Period Concept Each taxpayer must select A tax year Calendar Fiscal An accounting method Cash Accrual Hybrid

2-14 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Annual Accounting Period Concept Constructs & Doctrines Used Tax Benefit Rule: If a tax benefit is derived from a deduction in one year, any refund received in a subsequent year must be reported as income.

2-15 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Tax Benefit Rule Example Abner had $4,000 of state income taxes withheld from his salary during He deducted the $4,000 as part of his itemized deductions on his 2008 federal return. On May 15, 2009, he received a refund of $1,000 from the state. When he files his 2009 federal return, Abner will be required to report the $1,000 as income.

2-16 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Annual Accounting Period Concept Constructs & Doctrines Used Substance-Over-Form Doctrine: A transaction must be realistic in an ordinary sense and not contrived merely to avoid tax.

2-17 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Substance Over Form Example Jacee “hired” her 4-year old son as office manager for her real estate firm. When she filed her federal tax return she deducted $20,000 as Salary Expense for him. The IRS disallowed the deduction when they examined her return.

2-18 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Income Concepts All-inclusive Income Concept All income received is taxable unless a provision of the law specifically excludes it.

2-19 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Income Concepts Legislative Grace Concept Any tax relief provided is the result of specific acts of Congress which are applied and interpreted strictly. Constructs used Exclusions, deductions and credits Special classifications such as capital assets

2-20 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Income Concepts Capital Recovery Concept A taxpayer may recover all invested capital before income is taxed. Constructs used Basis Gains and Losses

2-21 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Capital Recovery Example Nash sold 200 shares of common stock for $2,000. Because he had paid $800 for the shares, he is required to report only $1,200 as income.

2-22 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Income Concepts Realization Concept No income is recognized as taxable income until it has been realized by the taxpayer. Doctrines used Claim of Right Doctrine applies to accrual basis taxpayers Constructive Receipt Doctrine applies to cash basis taxpayers

2-23 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Realization Concept Doctrines Used Claim of Right Doctrine: Realization does not occur until an amount has been received without restriction. Applies when the taxpayer received payment but there is a dispute regarding the taxpayer’s right to keep some or all of it.

2-24 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Claim of Right Example Pamala rented her garage apartment to Mahlon and collected $450, the first-month’s rent, in advance. She also collected $500 as a security deposit that she will return to Mahlon if he doesn’t damage the apartment. She must report only $450 as income because she has no claim of right to the $500.

2-25 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Realization Concept Doctrines Used Constructive Receipt Doctrine is a modification that prevents cash basis taxpayers from “turning their backs” on income. Realization is deemed to have occurred if a taxpayer is aware an amount is available, the amount is unconditionally available (even without physical possession), and receipt of the amount is within the taxpayer’s control.

2-26 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Constructive Receipt Example Gail is a self-employed handyman. Tacy, one of his customers, brought a check for $250 on December 30, 2008, to pay for work Gail had finished. Gail asked her to mail the check instead, so he could check “delivery time.” Gail must report the $250 as income in 2008 even if the check isn’t delivered until 2009.

2-27 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Income Concepts Wherewithal-to-Pay Concept Tax should be recognized and paid when the taxpayer has the resources to pay. Constructs used Deferrals Recognition of unearned income

2-28 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Deduction Concepts Legislative Grace Concept Any deduction allowed is the result of specific acts of Congress which are applied and interpreted strictly.

2-29 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Deduction Concepts Business Purpose Concept Only expenditures made in order to generate income and for a purpose other than tax avoidance will be deductible. Examples: Trade or business expenses Investment expenses

2-30 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Business Purpose Example Michael may not deduct depreciation on his personal-use automobile because he does not use it in his business

2-31 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Deduction Concepts Capital Recovery Concept A taxpayer may deduct the amount of capital invested before income is reported. Constructs used Basis Capital expenditures