1. Module 7 Gross Income

2. Module Topics General concepts Statutory exclusions Special inclusions for business income Cost of goods sold and inventories Inventory cost flow assumptions, particularly LIFO The Uniform Capitalization Rules

3. General Concepts Key Learning Objectives §61 Defines gross income Overriding the cash- or accrual-basis distinctions Note that accounting periods and methods are discussed in depth in the next module

4. §61 General Definition Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including ( but not limited to ) the following items: 1. Compensation for services, including fees, commissions, fringe benefits, and similar items; 2. Gross income from business; 3. Gains derived from dealings in property; 4. Interest; 5. Rents; 6. Royalties; 7. Dividends; 8. Alimony and separate maintenance payments; 9. Annuities;

5. §61 General Definition (con’t) 10. Income from life insurance and endowment contracts; 11. Pensions; 12. Income from discharge of indebtedness; 13. Distributive share of partnership gross income; 14. Income in respect of a decedent; and 15. Income from interest in an estate or trust.

6. Overriding the Cash- or Accrual-Basis Distinctions Forms of income The cash equivalent doctrine Constructive receipt doctrine Claim-of-right doctrine

7. Forms of Income n Substance over form n Debt relief n In-kind receipt of property or services n Benefit transferred to another n Windfall gains

8. The Cash Equivalent Doctrine Cash Property Services

9. Constructive Receipt Doctrine Credited to account Set apart or otherwise made available Could have drawn upon it during the taxable year if notice of intention to withdraw had been given Not constructive receipt if control is subject to substantial limitations or restrictions.

10. Claim-of-Right Doctrine Amount is includable in income at the latest when it is received Provided that the taxpayer has an unrestricted right to the funds Even if the amounts are received in error or The right to such income is contested and subsequent events require repayment

11. Research Query: When Is A Prepaid Legal Fee Income? n Prepaid legal fees were deposited by a law partnership in trustee accounts established to comply with a state ethics law. n Are these fees includible in income when deposited or earned? n HINT: Miele, Agatha, (1979) 72 TC 284

12. Prepaid Legal Fee Solution--Research Query: Prepaid Legal Fee n Whether a cash basis law firm is in receipt of income when a prepaid legal fee is received depends on whether the firm received the fee under a claim of right and without restriction as to disposition.

13. Prepaid Legal Fee Solution--Research Query: Prepaid Legal Fee (con’t) n Consequently, a firm has no income of a prepaid legal fee until an undisputed amount is due the firm from the prepaid fee. n However, once earned, the fees are includible in income even though the firm leaves the fees in the trustee account.

14. Statutory Exclusions Key Learning Objectives Statutory exclusions that apply to business income Special provisions for forgiveness of indebtedness income The tax benefit rule

15. Statutory Exclusions (con’t) §§101-137 “Items specifically excluded from gross income” §103: Interest on state and local bonds §109: Improvements by lessee on lessor’s property   Unless constructed in lieu of rent

16. §108: Income From Discharge of Indebtedness An exclusion for forgiveness of indebtedness if the discharge relates to: (a) a bankruptcy under Title 11 (b) an insolvent taxpayer limited to the amount by which the taxpayer is insolvent after the forgiveness. limited to the amount by which the taxpayer is insolvent after the forgiveness. (c) qualified farm indebtedness (d) qualified real property business indebtedness of noncorporate taxpayer

17. Special Business Income Inclusion Rules Key Learning Objectives Prepaid income Long-term contracts Bad debt expense of service providers u The nonaccrual experience method The installment method for certain dealers

18. Advance Payments Almost Always Income Applies to cash and accrual taxpayers Does not apply to security deposits Discussed further in Module 8

19. Long-Term Contracts Construction not completed during the tax year initiated Must use percentage-of-completion method At completion, required to recompute tax liabilities for all years of the contract using actual contract costs and contract revenue The taxpayer is required to pay interest on any underpayments

20. Estimating Bad Debts of Accrual Basis Service Providers The nonaccrual experience method Not available if the taxpayer charges interest or penalties on late payments Estimated bad debt based on bad debt experience in prior years Works much like the reserve method for bad debts

21. The Installment Method for Certain Dealers Gross income is reported as installments of the total sales price are received Available only for (a) property used in the trade or business of farming (b) residential lots (c) timeshare ownership interests of six weeks or less in residential real property

22. Inventory--Basic Concepts Key Learning Objectives Basic reason for inventories When required How valued

23. The Reason for Inventories Reg. §1.61-3 defines “gross income” for a manufacturing or merchandising business as sales less cost of goods sold plus income from other sources Ensures that only gain from sale of inventory is taxed Limits benefits of cash basis method of accounting

24. When Are Inventories Required? Whenever in the opinion of the Secretary Necessary to clearly reflect income when u Production u Purchase u Sale of merchandise Is an income-producing factor

25. What Must Be Inventoried? n Only raw materials and supplies which have been u Acquired for sale, or u Will physically become a part of merchandise intended for sale

26. Compliance Query: Materials & Supplies n In January, John’s Secretarial Services, a cash basis taxpayer purchased: Spare computer parts$5,000 Office supplies 500 n Items are used internally. John’s keeps no record of consumption or inventory records. n Can the company deduct these items in full in the current tax year?

27. Reg §1.162-3 Solution--Compliance Query: Materials & Supplies Reg §1.162-3 n Materials and supplies are deductible only in the amount actually consumed and used in operation during the year. n However, incidental materials and supplies. are deductible if u No record of their consumption is kept u No physical inventory is taken u This method may be used only if it clearly reflects income.

28. Reg § 1.162-3 (con’t) Solution--Compliance Query: Reg § 1.162-3 (con’t) n The $5,000 of spare computer parts are probably not incidental.John’s should do a physical inventory at year end to determine the amount to deduct. n The $500 of office supplies are probably incidental and can be deducted in full.

29. Valuation of Inventories n Cost n Lower of cost or market n Cost flow assumptions + Specific identification + Average cost + FIFO + LIFO

30. Inventory--Special Issues Key Learning Objectives LIFO inventories Dollar-value LIFO methods

31. Electing LIFO--Pros & Cons Cushion the impact of price increases in an inflationary economy Must use for books also

32. Electing LIFO Elect by filing Form 970 for change tax year Prior approval not required Revocation requires prior approval u Cumulative adjustment required u No new elections for a 10-year period w/out permission

33. Dollar Value LIFO Determine inventory cost on the basis of total dollars (for a base year) Rather than the quantity and price of each inventory item Simplified Dollar-Value LIFO eliminates many problems of pooling

34. Uniform Capitalization Rules Key Learning Objectives General description Who must follow rules Costs that must be capitalized

35. §263A Uniform Capitalization Rules: An Overview n UNICAP rules n Apply to producers and resellers of property n Extend the concept of absorption costing

36. Taxpayers Exempt from the UNICAP Rules Reseller of personal property with average gross receipts of $10,000,000 or less during the preceding three taxable years Certain farming businesses Personal use property Research and experimentation expenditures deductible under §174 Certain costs associated with oil and gas properties Certain timber and ornamental trees

37. Category 1 --Costs That Must Be Inventoried Repairs & maintenance Rent & utilities Indirect labor Production supervisory wages Indirect materials & supplies Small tools & equipment Quality control & inspection

38. Category 3--Costs That Follow Financial Statement Treatment Taxes other than state or local income taxes (e.g..., property) Financial statement depreciation/depletion Employee benefits for production labor Rework labor, scrap, and spoilage Factory administrative expenses Production officers’ salaries Insurance costs