3 - 1 ©2005 Prentice Hall, Inc. Determining Gross Income Chapter 3.

3 - 1©2005 Prentice Hall, Inc.

DeterminingGross Income

Chapter 3


What is Gross Income?

Code Section 61(a) defines gross income as

“except as otherwise provided in this subtitle, gross income means all income from whatever source derived...”


What is Income?

Gross income is realized income that is not excluded

Taxable income is gross income less all deductions


Tax vs. Financial Accounting

The goals of financial accounting are not the same as those for tax reporting Financial accounting seeks to provide

information that decision makers find useful Tax reporting seeks to collect revenue

equitably Differences fall into two categories

Temporary or timing differences Permanent differences


Temporary Differences

Arise when income is taxed either before or after it is accrued for accounting purposes Example: prepaid rent generally is taxable

when received but it is included in financial accounting income only as it is earned

Are accounted for as either a deferred tax asset or deferred tax liability on financial statements


Permanent Differences

Income that is not taxed but is reported for financial accounting purposes Example: municipal bond interest

generally is not taxed but is recorded as income in financial accounting records


Return of Capital Principle

Basis = amount invested in an asset Basis can be recovered tax-free

If the taxpayer’s return is more than basis, the taxpayer has a gain

If taxpayer’s return is less than basis, the taxpayer has a loss


Investment Alternatives

Investments yielding appreciation Tax deferred until gain is recognized Gain is frequently taxed at lower capital gains

rates Investments yielding annual income

Interest income is taxed annually at the marginal tax rate for ordinary income; dividends taxed annually but at lower capital gains rates generally


The Tax Year

Calendar year Individuals S corporations and partnerships have

restrictions on allowable tax years, so usually use a calendar year

Fiscal year – 12-month period ending on month other than December 52-to-53 week year (ends on same day) Corporations freely select tax year


Short Tax Year

A short-year tax return reports less than 12 months of operating results

Income must be annualized (adjusted to reflect 12 months of operations to calculate tax) Required by businesses that change their tax

year Not required in year entity begins or ends

business


Accounting Methods

Taxpayers can use different methods for financial accounting and tax Cash method: receipt of cash or cash

equivalents determine income/expense recognition

Accrual method: the all-events test determines income/expense recognition


Cash Method

Income is recognized when cash or cash equivalents received Cash equivalents broadly defined to include

property and services Cash equivalents included at fair market value

A cash-basis taxpayer must recognize income when an amount is Credited to the taxpayer’s account Set apart for the taxpayer, or Made available in some other way to the taxpayer


Constructive Receipt Doctrine

Constructive receipt is a modification that prevents cash basis taxpayers from “turning their backs” on income

Income is not constructively received if The taxpayer is not entitled to the income The payor has insufficient funds from which to

make payment There are substantial limitations or restrictions

placed on actual receipt


Limits on Cash Method

Businesses that carry inventory and sell merchandise to customers generally must use the accrual method to account for sales and purchases

Hybrid method – accrual for sales of inventory & cost of goods sold; cash method for other income and expenses

Large corporations (gross receipts of more than $5 million) cannot use cash method


Accrual Method

Income is recognized when “all events test” is met All events have occurred that establish the

right to the income and The income amount can be determined with

reasonable accuracy If liability is in dispute, the all events test is

not satisfied until dispute is resolved


Claim of Right Doctrine

Claim of right doctrine modifies the normal recognition rules for accrual basis taxpayers

Applies whenever the taxpayer receives income but there is a dispute regarding the taxpayer’s right to keep some or all of the income

Taxpayer must recognize income even though some of the income may have to be repaid later


Prepaid Income

Prepaid Income is another exception to the accrual method of accounting

Based on “wherewithal to pay concept” income must be reported when received Examples: rent, interest, and royalty

payments Refundable deposits are not prepaid income


Installment Method

Gain is recognized as proceeds from sale are received

Use severely restricted – generally available for casual sales only (excludes sales of inventory and securities)

May not want to use if Marginal tax rate is expected to increase Unused losses are expiring


Long-Term Contracts

Completed Contract Method—no income is recognized and no deductions taken until contract completion

Percentage-of-Completion Method—income is recognized as contract progresses based on an estimate of actual costs incurred to total projected costs for contract


Assignment of Income Doctrine

A taxpayer cannot assign earned income to a third party to escape taxation

Earned income must be taxed to the taxpayer rendering the services Community property states (Arizona,

California, Idaho. Louisiana, Nevada, New Mexico, Texas, Washington, Wisconsin) allocate half of income to each spouse

Income from property is taxed to taxpayer who owns the property


Interest Income

Interest income from savings accounts, certificates of deposit, corporate bonds, and Treasury bills is included in gross income

Interest on state and local (municipal) bonds is excluded from gross income High income taxpayers may have a higher

after-tax return on municipal bonds than taxable bonds offering a higher interest tax

Gain on the sale of tax-exempt securities must be included gross income


Original Issue Discount

Some debt instruments are issued at prices below their maturity values

This original issue discount (OID) is effectively interest paid at maturity rather than periodically over the debt instrument’s life

Both cash and accrual basis taxpayers recognize OID income as it accrues Exception: Series EE bonds


Market Discount

Bonds purchased after issue in the open or secondary market at a price below maturity value Excess of redemption proceeds over cost is

recognized as ordinary income in year of redemption

Electively, market discount can be accrued as interest income over life of bond


Below-Market-Rate Loans

Certain loans between related parties (family members) may be made at low interest rates (or even interest free)

On other loans, interest income that is not actually received or accrued may be imputed (treated as received or accrued and taxed) at the applicable federal rate of interest


Gift Loan Exceptions

Any gift loan of $10,000 or less is exempt from the imputed interest rules

For gift loans of $100,000 or less Imputed interest cannot exceed the borrower’s

net investment income for the year If borrower’s net investment income is no

more than $1,000, imputed interest is zero


Other Loans

Loan to employee – imputed exchange of cash is treated as taxable compensation (income to employee and deduction for employer)

Loan to shareholder – imputed exchange of cash is treated as a dividend (taxable income to shareholder, no deduction for corporation)


Dividend Income

Cash and FMV of other assets distributed by a corporation from earnings and profits (E&P) are treated as dividends includable in the shareholder’s income 2003 Tax Act reduced tax rate to the 15% rate

applicable to long-term capital gains (5% rate for individuals in 10% or 15% tax bracket)

Distributions in excess of E&P are nontaxable return of capital (reducing stock basis)

Distributions in excess of stock basis are taxed as capital gain (as if stock if sold)


Mutual Fund Dividends

May pay dividends from gains they realize on the sale of investment assets

These dividends are actually net long-term capital gains and are called capital gains distributions


Dividend Reinvestment Plans

Treated as if the shareholder receives the cash and then purchases additional shares of stock with the dividend income. Value of dividend included in income.

It is important for each shareholder to keep track of basis for all shares


Stock Dividends

Stock dividends are distributions of a corporation’s own stock to its shareholder (stock splits)

Usually stock dividends are not taxable to the shareholder (unless shareholder has option of receiving cash)

Shareholders simply own a greater number of shares and the basis in their original holdings is divided among all shares of stock now held


Annuity Income

Usually consists of a taxable and nontaxable amounts Nontaxable amount represents a return of capital Nontaxable amount of a payment is equal to the

Investment in annuity / expected return from annuity x annuity payment received

If the amounts invested in the annuity were all made by the employer (or by the employee using pre-tax dollars), then the employee’s investment is treated as zero


Prizes and Awards

Prizes, awards, gambling winnings, and treasure finds are taxable

The fair market value of goods or services received is included in gross income


Government Transfer Payments

Need-based payments, such as welfare payments, school lunches & food stamps, are excluded from income

Unemployment compensation is taxable because it is a substitute for wages that would be taxable


Social Security Benefits

Government devised a complex formula that can result in the taxation of up to 85% of social security benefits for taxpayers who have significant other income while leaving benefits completely tax free for those who have little other income

MAGI = AGI before any social security benefits + exempt interest income + ½ of social security benefits


Social Security Benefits

If MAGI is less than $25,000 for single individuals or $32,000 for married couples, then none of the social security benefits received are taxable

Single taxpayers with MAGI above $34,000 and married taxpayers with income above $44,000 can be taxed on up to 85% of their benefits

Taxpayers between the above thresholds can be taxed on up to 50% of their social security benefits


Damage Awards

Damages for physical injuries are not taxed (under the return of capital doctrine)

Damages for all other awards are taxed (because they are viewed as substitute for what would otherwise be taxable income)

Punitive damages are taxable


Divorce-Related Payments A property settlement is simply a division of

assets (no income, no deduction) Alimony is a legal shifting of income so it is

taxable income to the person receiving it and deductible by the person who pays it First year’s alimony should not exceed average of

2nd and 3rd year payments by more than $15,000 Child support fulfills a legal obligation to

support a child (no income, no deduction) Both parties may benefit by negotiating an

increase in payment if it qualifies as alimony


Discharge of Debt

If a legal obligation is satisfied for less than the outstanding debt, the amount of debt forgiven represents an increase in the taxpayer’s wealth and is subject to taxation Exceptions are provided for debtors who are

bankrupt or insolvent


Tax Benefit Rule

If a taxpayer deducted an expense or loss in one year but recovers the amount deducted in a subsequent year, all or a portion of the amount recovered may have to be included in the gross income in the year it is recovered

Amount included in income is limited to the extent of tax benefit received by the tax deduction Example: bad debt recovery or refund of taxes

previously deducted


Exclusions

Gifts Inheritances Life Insurance

Proceeds received are tax-free but any interest income on proceeds is taxable

Inside buildup (increase in cash surrender value) is not taxable income unless policy is liquidated for more than premiums paid


Accident & Health Insurance

Accident & health insurance proceeds from are tax-free to extent they pay qualified medical or dental expenses; excess benefits taxable if employer provided policy

Disability insurance—substitute for lost pay If premiums for disability insurance paid by

employer, then benefits received are taxable If premiums paid by employee, exception

allows benefits to be tax free


Scholarships

Qualified scholarships are excluded from gross income “Scholarship” includes only tuition, fees,

books, supplies, equipment, and related expenses required for courses

Amounts designated or spent for room, board, and laundry are included in income and are taxable


Scholarships

Any grant received in return for past, present, or future services must be included in gross income Funds received by students in return for

teaching or research services are taxable When taxable portion cannot be determined

until end of academic year, taxable income can be deferred until the taxable year in which the academic year ends


Other Exclusions

Improvements made on leased property are excluded from landlord’s income unless improvements made in lieu of paying rent

Fringe benefits discussed in next chapter Exclusion of gain on sale of home

$250,000 if single, $500,000 if married and both spouses qualify

Must have owned and lived in home as principal residence for at least 2 of previous 5 years


International Issues

Source principal - countries tax income earned within their borders but exclude income from activities sourced in other countries Applies to foreign persons and foreign

corporations Residency principle – countries tax worldwide

income Applies to resident citizens and corporations


Tax Treaty

An agreement between two countries that explains how a taxpayer of one country is taxed when conducting business in a second country

Objective is to minimize double taxation


International Taxation

A business is usually only taxed in country of residence unless it maintains a permanent establishment (e.g. office) in another country

Source country can tax income earned within it’s borders when a permanent establishment exists

Resident country allows taxpayer a foreign tax credit up to tax paid in source country


Taxpayers Subject to U.S. Tax

U.S. citizens, resident aliens, and U.S. corporations are subject to U.S. tax on their worldwide income

Resident alien – individual who is not a U.S. citizen who has a legal residence in U.S. established through Green card or Substantial presence test (183 days)

Nonresident alien – individual who is not U.S. citizen and does not satisfy test to be resident alien


Nonresident Aliens and Foreign Corporations

Effectively connected income – U.S. business income subject to U.S. income tax

Non-U.S. business income – not subject to U.S. income tax

U.S. investment income – taxed at flat 30% (or treaty rate if lower)


State and Local Taxation

Most states (and some local governments) impose both corporate and individual income taxes on both residents and nonresidents

Nonresidents can only be taxed on Income derived from business activity within

that state and Income from property in that state


State Tax Issues

Nexis is the type and degree of connection between a business and a state necessary for the state to have the right to impose a tax

Multi-state businesses may be able to reduce their overall tax cost by shifting income from a high-tax state to a low-tax state


Total Effective Tax Rate

For federal tax purposes, state income tax is deductible in computing taxable income

Tax savings from this federal deduction reduces the cost of the state income tax

When a taxpayer pays income tax at both the federal and state levels, it increases the total effective tax rate and decreases the after-tax cash flow


The End

3 - 1 ©2005 Prentice Hall, Inc. Determining Gross Income Chapter 3.

Documents

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financial accounting

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