Gross Income

1
Chapter 5

• Gross Income

2
Introduction

• Determination of the final income tax liability
  begins with the identification of a taxpayers
  gross income.
• Three important generalizations developed in this
  chapter are
• Income is broadly construed for tax purposes to
  include virtually any type of gain, benefit, or
  profit that has been realized.
• Although the scope of the income concept is
  broad, certain types of income are exempted from
  taxation by statute, administrative ruling, or
  judicial decree.
• Taxpayers who realize income may not be required
  to recognize and report it immediately but may be
  able to postpone recognition until some time in
  the future.

3
Income

• There are three basic questions to address
  concerning income
• Did the taxpayer have income?
• If the taxpayer had income, was it realized?
• If the taxpayer has realized income, must it be
  recognized now or is it permanently excluded or
  perhaps temporarily deferred and reported at some
  future date?

4
Gross Income Defined

• Section 61(a) of the Code defines gross income as
  follows except as otherwise provided in this
  subtitle, gross income means all income from
  whatever source derived, including (but not
  limited to) the following items
• Compensation for services, including fees,
  commissions, fringe benefits, and similar items
• Gross income derived from business
• Gains derived from dealings in property
• Interest
• Rents

5
Gross Income Defined (contd)

• Royalties
• Dividends
• Alimony and separate maintenance payments
• Annuities
• Income from life insurance and endowment
  contracts
• Pensions
• Income from discharge of indebtedness
• Distributive share of partnership gross income
• Income in respect of a decedent and
• Income from an interest in an estate or trust.

6
Gross Income Defined (contd)

• Taxable income includes many other economic
  benefits not identified above.
• In situations where clear statutory guidance is
  absent, the difficult task of ascertaining how
  far the definitional boundary of income extends
  falls to the courts.

7
Economic Concept Of Income

• Economists define income as the amount that an
  individual could have spent for consumption
  during a period while remaining as well off at
  the end of the period as the beginning of the
  period.
• There are two key aspects of an economists
  definition.
• The first is the emphasis on a change in net
  worth.
• The second and perhaps more critical aspect of
  the economists definition from a tax perspective
  is the notion that consumption and the change in
  net worth must be computed using market values on
  an accrual basis rather than on a realization
  basis.
• Economists approach to measuring income is
  called the net worth method.

8
Accounting Concept of Income

• Accountants recognize income when it is realized.
  Income is generally considered realized when
• (1) the earnings process is complete, and
• (2) an exchange or transaction has taken place.
• Normally, some type of conversion occurs that
  substantially changes the taxpayers relationship
  to the asset.
• Accounting income usually does not recognize
  changes in market values of assets during a
  period (as would economic income) unless such
  changes have been realized.

9
Income For Tax Purposes The Judicial Concept

• The courts have adopted key elements of both the
  economic and accounting definition of income
  income is any increase in the taxpayers net
  worth (i.e., wealth) that has been realized.
• It should be emphasized that even though a
  taxpayer may have income that has in fact been
  realized, this by itself does not guarantee that
  it will be taxed.
• In tax parlance, the question still remains as to
  whether the taxpayer must recognize the income
  (i.e., report the income for tax purposes).

10
Income For Tax Purposes The Judicial Concept
(contd)

• There are three relatively common exceptions to
  the general rule that all income must be
  recognized immediately
• Excluded income Income that has been realized
  need not be recognized if it is specifically
  exempted from taxation by virtue of some
  provision in the Code.
• Accounting methods A taxpayer may be able to
  defer recognition of income to a subsequent year
  by following some particular method of accounting
  (e.g., the installment sales method or the
  completed contract method).
• Nontaxable exchanges Income realized on a sale
  or exchange may be deferred under a special
  non-recognition rule.
• For example, a taxpayer who swaps one parcel of
  land costing 10,000 for another parcel worth
  50,000 is not required to recognize the 40,000
  gain under the like-kind exchange rules. The
  theory underlying non-recognition in this and
  similar situations is that the taxpayer has not
  liquidated his investment to cash but has
  continued it, albeit in another form.

11
Refinements Of The Gross Income Definition

• There are three major principles that are
  relevant to the income concept
• Form of Benefit Must income be realized in a
  particular form, such as cash, before it becomes
  taxable?
• Return of Capital Does gross income mean gross
  receipts or net gain after allowance for a
  tax-free recovery of the taxpayers capital
  investment?
• Indirect Economic Benefits Are benefits
  provided by an employer (such as a company car)
  taxable where they are not intended as
  compensation?

12
Form-Of-Benefit Principle

• Income is not limited to receipts of cash but
  also extends to receipts of property, services,
  and (as we will see) any other economic benefits.
  
• The measure of income is its fair market value at
  the time of receipt.
• Please see examples 2 and 3.
• Barter transactions are fully taxable under the
  form-of-benefit principle.

13
Return of Capital Doctrine

• When a taxpayer lends money and it is later
  repaid, no income is recognized since the
  repayment represents merely a return of capital
  to the taxpayer.
• The return of capital doctrine allows the
  taxpayer to determine the income upon a sale or
  disposition of property by reducing the amount
  realized (cash the fair market value of other
  receipts such as property) by the adjusted basis
  of the property.
• The return of capital doctrine also stands for
  the important proposition that gross income is
  not the same as gross receipts.
• Gross income total sales - COGS.

14
Damages

• The return of capital doctrine may also apply to
  amounts awarded for injury inflicted upon the
  taxpayer.
• In many cases, amounts are also awarded to
  penalize the party responsible for the
  wrongdoing. These so-called punitive damages are
  normally taxable.
• Similarly, where the damages awarded represent
  reimbursement for lost profits, the amounts are
  considered taxable since they are merely
  substitutions for income.

15
Damages (contd)

• Awards or settlements for antitrust violations or
  patent infringements are examples of
  substitutions for income and thus are taxable.
• Compensation for damages to property are taxable
  to the extend that amounts received exceed the
  adjusted basis of the assets.

16
Other Considerations

• The scope of the return of capital doctrine
  extends beyond situations involving damages and
  simple sales transactions.
• Numerous Code sections are grounded on this
  principle, and often contain detailed rules for
  ascertaining how a receipt should be apportioned
  between capital and income.
• For example, amounts received under a life
  insurance policy are not taxable on the theory
  that the proceeds at least in part represent
  a return of the taxpayers premium payments.
• Similarly, where the taxpayer purchases an
  annuity (i.e., an investment which makes a series
  of payments to the investor in the future), the
  return of capital doctrine provides that each
  payment is in part a tax-free return of capital.

17
Other Considerations (contd)

• In addition, somewhat intricate provisions exist
  to determine whether a corporate distribution
  represents a distribution of earnings (i.e., a
  dividend) or a tax-free return of the taxpayers
  investment.
• The special rules governing life insurance,
  annuities, and dividends are covered in detail in
  Chapter 6.

18
Indirect Economic Benefits

• Current law grants an exclusion only if the
  employee can demonstrate that the benefit served
  a business purpose of the employer other than to
  compensate the employee.
• In the following situations an employee is
  permitted to exclude the benefit received
• An employer provides the employee with a place to
  work and supplies tools and machinery with which
  to do the work. Similarly, an employee is not
  taxed when his or her secretary types a letter.
• An employer provides tuition-free, American-style
  schools for its overseas employees.
• An employer provides an executive with protection
  in response to threats made by terrorists.
• An employer requires its employees to attend a
  convention held in a resort in Florida and pays
  the travel costs of the employee.
• Exceptions are discussed in Chapter 6 concerning
  exclusions.

19
Reporting Income

• Once the taxpayer has realized an item of taxable
  income, he or she must determine when the income
  should be reported.

20
Accounting Periods

• Taxable income is usually computed on the basis
  of an annual accounting period (the taxable
  year).
• There are two types of taxable years a calendar
  year and a fiscal year.
• Partners in Partnerships and S Corporation
  shareholders report their distributive shares of
  the entitys income in their taxable year within
  which (or with which) the partnership or S
  corporation tax year ends.
• Partners or S shareholders must report their
  share of the income regardless of the amounts
  distributed to them.
• Although certain exceptions enable these entities
  to use a fiscal year on a limited basis, as a
  general rule, these taxpayers normally must use
  the calendar year.

21
Accounting Methods

• Once a tax year is identified, the taxpayer must
  determine in which period a transaction is to be
  reported.
• The rules that determine when a particular item
  is reported are generally referred to as
  accounting methods.
• The Code identifies four permissible methods of
  accounting
• The cash receipts and disbursements method
• The accrual method
• Any other method permitted by the Code (e.g., a
  method for a specific situation such as the
  completed contract method or the use of LIFO to
  value inventories) or,
• Any combination of the three methods above
  permitted by the Regulations.

22
Accounting Methods (contd)

• The term accounting method includes the
  treatment of any particular item if such
  treatment affects when the item will be reported.
• Taxpayers are generally allowed to select the
  methods of accounting they wish to use. In all
  cases, however, the IRS has the right to
  determine if the method used clearly reflects
  income, and, if not, to make the necessary
  adjustments.

23
Tax Methods vs. Financial Accounting Methods

• The objectives of the income tax system differ
  from that of financial accounting.
• The primary goal of financial accounting is to
  provide useful information to management,
  shareholders, creditors, and other interested
  parties.
• The goal of the income tax system is to ensure
  that revenues are fairly collected.
• Due to these different goals, the tax law may
  disregard fundamental accounting principles.
• Perhaps the most obvious example can be found in
  the tax laws allowance of the cash method of
  accounting.

24
Tax Methods vs. Financial Accounting Methods
(contd)

• Reporting of prepaid income and the treatment of
  estimated expenses are just two examples of where
  financial accounting principles deviate from tax
  accounting.
• The key point to recognize is that a particular
  item may be treated one way for financial
  accounting purposes and another way for tax
  purposes.
• As a practical matter, this may mean that two
  sets of books are maintained.

25
Cash Method of Accounting

• General Rule Virtually all individuals, as well
  as many corporations, partnerships, trusts and
  estates, use the cash method of accounting.
• Under the cash method, taxpayers simply report
  items of income and deduction in the year in
  which they are received or paid.
• In using the cash method, items of income need
  not be in the form of cash but need only be
  capable of valuation in terms of money.
• Under this rule, sometimes termed the cash
  equivalent doctrine, the taxpayer reports income
  when the equivalent of cash is received.

26
Cash Method of Accounting (contd)

• Under the doctrine of constructive receipt, a
  taxpayer is deemed to have received income even
  though such income has not actually been received
  when three conditions are satisfied
• The taxpayer has control over the amount without
  substantial limitations and restrictions
• The amount has been set aside or credited to the
  taxpayers account and
• The funds are available for payment by the payer.
• Note from a financial accounting perspective,
  the cash method is entirely inappropriate since
  income and expense are recognized without regard
  to the taxable year in which the economic events
  responsible for the income or expense actually
  occur.

27
Cash Method of Accounting (contd)

• The following entities are normally prohibited
  from using the cash method
• Regular C Corporations
• Partnerships that have regular C Corporations as
  partners and
• Tax shelters, generally defined as any enterprise
  in which interests have been offered for sale in
  any offering required to be registered under
  Federal or State security agencies.

28
Cash Method of Accounting (contd)

• The following entities are allowed to use the
  cash method
• Any corporation or partnership whose annual gross
  receipts for all preceding years do not exceed 5
  million.
• Certain farming businesses.
• Qualified personal service corporations where all
  of the activities consist of performing services
  in the fields of health, law, engineering,
  architecture, accounting, actuarial science,
  performing arts, or consulting, and at least 95
  percent of its stock is held by the employees who
  are providing the services.

29
Accounting for inventory

• If a business sells inventory
• Taxpayers must capitalize the cost of inventory
  purchases and can expense such costs only when
  the item is sold.
• Businesses with inventories also must accrue and
  recognize income at the time of sale regardless
  of when the cash is received.
• Both halves of the accrual requirement are
  significant since both effect the amount of
  income that the taxpayer ultimately reports in a
  particular year.
• Note materials and supplies that are considered
  incidental to the primary function of the
  business may be expensed currently.

30
Accounting for inventory

• In 2000, the IRS began to relax its position on
  the mandatory use of inventories and at the same
  time the mandatory use of the accrual method by
  carving out two major exceptions
• Gross Receipts of 1,000,000 or Less Items must
  be accounted for as non-incidental materials and
  supplies and expensed as they are used or
  consumed.
• Taxpayers who fall under this exception need not
  recognize accounts receivable income until they
  collect the receivables. In other words, they
  may defer the recognition of income until they
  receive payment for the merchandise.
• Gross Receipts Less Than 10,000,000 A special
  exception only for small business
• If they are not in certain industries, including
  manufacturing, wholesale, retail and information
  industries, or meet certain other exceptions.
• These businesses need not use the accrual method
  for purchases and sales but inventory must be
  accounted for as non-incidental materials and
  supplies and expensed as they are used or
  consumed.

31
Changes In Accounting Methods

• Once a particular method has been adopted it may
  not be changed unless consent is granted by the
  IRS.
• Taxpayers are normally required to report any
  adjustment attributable to a change in method in
  the year of the change and pay any additional tax
  due (or receive a refund).

32
Changes In Accounting Methods (contd)

• If the change is voluntary, the adjustment is
  spread over a four year period (the year of the
  change and the three subsequent years).
• If the change is involuntary (e.g., the taxpayer
  is under examination and is not allowed under the
  rules of Revenue Procedure 97-27 to make a
  change) and the adjustment is positive, the
  entire adjustment is included in the earliest tax
  year under examination.
• However, a taxpayer may elect to use a one-year
  adjustment period if the entire adjustment is
  less than 25,000.

33
Changes In Accounting Methods (contd)

• Errors such as mathematical mistakes or the
  improper calculation of a deduction or credit can
  be corrected by the taxpayer without permission
  of the IRS by simply filing an amended return.

34
Accounting For Income Special Considerations

• The claim of right doctrine Under this rule, if
  a taxpayer actually or constructively receives
  income under a claim of right (i.e., the taxpayer
  claims the income is rightfully his or hers) and
  such income is not restricted in use, it must be
  included in gross income.
• Earnings received must be included in income if
  the taxpayer has an unrestricted claim,
  notwithstanding the possibility that the income
  may be subsequently relinquished if the
  taxpayers claim is later denied.
• The claim of right doctrine applies to both cash
  and accrual basis taxpayers.

35
Accounting For Income Special Considerations
(contd)

• The claim of right doctrine does not apply where
  the taxpayer received the income but recognizes
  an obligation to repay.
• For example, a landlord would not be required to
  report the receipt of a tenants security deposit
  as income because the deposit must be repaid upon
  the tenants departure if the apartment unit is
  undamaged.

36
Prepaid Income

• Over the years, a web of exceptions and special
  rules have developed regarding the reporting of
  prepaid income by an accrual basis taxpayer.
• These rules apply to accrual basis taxpayers
  only.
• A cash basis taxpayer reports all of these
  prepaid items of income in the year the cash is
  received.

37
Prepaid Interest, Rents and Royalties

• Several types of advance payments are included in
  income when received. For example
• Prepaid interest is income when received.
• Prepaid rent and lump-sum payments, such as
  bonuses or advance royalties received upon
  execution of a lease or other agreement, are also
  income when received.
• Prepaid rents must be distinguished not only from
  services but also from lease or security
  deposits.
• Amounts received from a lessee that are
  refundable provided the lessee complies with the
  terms of the lease are not income since the
  lessor recognizes an obligation to repay.

38
Prepaid Service Income

• Income is reported as it is earned under an
  agreement were all of the services are required
  to be performed by the end of the next tax year
  (i.e., the tax year following the year of
  receipt).
• If services may be performed after the next tax
  year, all income is reported when received.
• The treatment accorded service income also
  applies to rents where significant services are
  also rendered for the occupant.

39
Advance Payments for Goods

• Normally, an accrual basis taxpayer reports
  advance payments for sales of merchandise when
  they are earned (e.g., when the goods are
  shipped).
• This approach is allowed only if the taxpayer
  follows the same method of reporting for
  financial accounting purposes.

40
Long-Term Contracts

• A long-term contract is defined as any contract
  for the manufacture, building, installation, or
  construction of property that is not completed
  within the same taxable year in which it was
  entered into.
• A manufacturing contract is still not considered
  long-term unless it also involves either
• The manufacture of a unique item not normally
  carried in finished goods inventory (e.g.,
  special piece of machinery), or
• Items that normally require more than 12 months
  to complete.

41
Long-Term Contracts (contd)

• The tax law has long allowed taxpayers who enter
  into a long-term contract to use the percentage
  of completion method or the completed contract
  method (subject to certain limitations) to
  account for advance payments.
• The percentage of completion method requires the
  taxpayer to recognize a portion of the gross
  profit on the contract based on the estimated
  percentage of the contract completed.
• The completed contract method allows the taxpayer
  to defer income recognition until the contract is
  complete and acceptance has occurred.

42
Long-Term Contracts (contd)

• Long-term contracts currently entered into
  normally must be accounted for using the
  percentage of completion method.
• There are two situations where the completed
  contract method can still be used. These
  include
• Home construction contracts.
• Contracts of small businesses.

43
Long-Term Contracts (contd)

• If less than 10 percent of the contracts costs
  have been incurred, the taxpayer may elect to
  defer reporting until the year in which the 10
  percent threshold is reached.
• Any contract for which the percentage of
  completion method is used is subject to the
  special look-back provisions.
• Under these rules, once the contract is complete,
  annual income is recomputed based on final costs
  rather than estimated costs.
• Interest is then paid to the taxpayer by the IRS
  if there was an overstatement of income.
• Conversely, the taxpayer must pay interest to the
  IRS if income was understated.

44
Prepaid Dues and Subscriptions

• Section 455 permits the taxpayer to elect to
  recognize prepaid subscription income ratably
  over the subscription period. Section 456
  provides that taxpayers may elect to report
  prepaid dues ratably over the membership period.

45
Interest Income

• As a general rule, cash basis taxpayers recognize
  interest income when received, while accrual
  basis taxpayers recognize the income when it is
  earned.
• Both accrual and cash basis taxpayers that
  received interest before it as earned (prepaid
  interest) must report the income when it is
  received.
• In many instances, a taxpayer will purchase an
  interest-bearing instrument between payment
  dates.
• When this occurs, it is assumed that the purchase
  price includes the interest accrued to the date
  of the purchase.
• The portion accrued to the date of purchase is
  considered a nontaxable return of capital that
  reduces the taxpayers basis in the instrument.

46
Non-Interest-Bearing Obligations Issued at a
Discount

• For reporting purposes, taxpayers may elect to
  include in income the annual increase in the
  redemption price of the bond.
• If income is not reported on an annual basis, the
  taxpayer reports the entire difference between
  the redemption and issue prices as income when
  the bond is redeemed.
• Series E and EE Bonds may be exchanged within one
  year of their maturity date for Series HH Bonds
  that pay interest semiannually.
• By exchanging the Series E or EE Bonds for Series
  HH Bonds, the taxpayer is able to postpone the
  recognition of any unreported income attributed
  to the Series E or EE Bonds to the year in which
  the Series HH Bonds are redeemable.

47
Government Obligations

• Special rules also govern the treatment of the
  discount arising upon the purchase of short-term
  government obligations such as Treasury bills.
• Typically, a taxpayer purchases a short-term
  Treasury bill at a discount and redeems it for
  par value shortly thereafter.
• Any gain realized by cash basis taxpayers from
  the sale or redemption of non-interest bearing
  obligations issued by governmental units that
  have a fixed maturity date that is one year or
  less from the date of issue is always ordinary
  income.
• This ordinary income is reported in the year of
  sale or redemption.
• In contrast, accrual basis taxpayers are required
  to amortize the discount (i.e., include it in
  income) on a daily basis under Code Section 1281
  (a).

48
Original Issue Discount

• When interest-bearing obligations such as
  corporate bonds are issued at a discount, a
  complex set of provisions operates to prevent
  taxpayers from not only deferring the discount
  income but also converting it to capital gain as
  depicted in Example 30.
• These rules apply only to discount that arises
  when the bonds are originally issued.

49
Income From Personal Services

• Income is taxable to the taxpayer who earns it.
  In explaining what has become known as the
  assignment of income doctrine, the Court gave
  birth to the well-known fruit of the tree
  metaphor. According to Justice Holmes, the fruit
  (income) must be attributed to the tree from
  which it grew.
• Section 73 directly addresses the treatment of a
  childs earnings
• Amounts received for the services of a child are
  included in the childs gross income.
• However, the unearned income of a child under age
  14 may be reported on his or her parents tax
  return and taxed at the parents rates.
• The assignment of income doctrine makes it
  virtually impossible for taxpayers to shift
  income arising from services

50
Income From Property

• The assignment of income doctrine also applies
  when income from property is received.
• Income from property is included in the gross
  income of the taxpayer who owns the property.

51
Unearned Income of Children Under 14

• In 1986, Congress took steps to reduce tax
  avoidance opportunities by enacting a special
  provision affectionately referred to as the
  kiddie tax.
• The thrust of this rule is to tax the unearned
  income of a child under the age of 14 as if it
  were the parents rates.
• Accordingly, shifting techniques based on gifts
  of property such as stocks, bonds, and rental
  property that produced unearned income (e.g.,
  dividends, interest and rents) are now severely
  limited.

52
Interest-Free and Below-Market Loans

• To be successful in shifting income to another,
  the assignment of income doctrine generally
  requires that the taxpayer transfer the
  income-producing property itself, not merely the
  income from the property.
• Consequently, shifting income normally requires a
  completed gift of the property.

53
Interest-Free and Below-Market Loans (contd)

• In general, Section 7872 applies to loans when
  the interest charged is below the current market
  rate of interest.
• This results in the following tax consequences
• The borrower may be allowed a deduction for the
  interest hypothetically paid to the lender, while
  the lender reports the fictitious payment as
  interest income.
• The lender treats the hypothetical payment to the
  borrower as either compensation, dividend, or
  gift depending on the nature of the loan.
• Similarly, the borrower treats the payment as
  either compensation, dividend, or gift as the
  case may be.

54
Interest-Free and Below-Market Loans (contd)

• The Code classifies loans into three types
  according to the relationship between the lender
  and the borrower
• Gift loans those where the foregone interest is
  in the nature of a gift
• Compensation-related loans- those made by an
  employer to an employee or an independent
  contractor and
• Corporation-shareholder loans those made by a
  corporation to a shareholder.
• The thrust of these rules is to treat the
  borrower as having paid the proper amount of
  interest which is funded by the lender through
  compensation, dividends, or gift.
• See example 37.

55
Exempted Loans

• Section 7872 does not apply to gift loans as long
  as the loans outstanding during the year do not
  exceed 10,000 and the borrower does not use the
  loan proceeds to purchase or carry
  income-producing assets.
• Congress also granted compensation-related and
  corporation-shareholder loans an exemption from
  the onerous rules of Section 7872 if they do not
  exceed 10,000.

56
Interest Income Cap

• If the amount of outstanding loans does not
  exceed 100,000 and their principal purpose is
  not tax avoidance, the deemed interest payment by
  the borrower to the lender is limited to the
  borrowers investment income.
• In addition, the lender is treated as having no
  imputed interest income if the borrowers
  investment income does not exceed 1,000.
• However, the lender is still deemed to have made
  a gift of the forgone interest.

57
Income From Community Property

• In the United States, the rights that married
  individuals hold in property are determined using
  either the common law or community property
  system.
• The community property system categorizes
  property into two types
• Separate property, which is considered belonging
  separately to one of the spouses, and
• Community property, which is considered owned
  equally by each spouse.

58
Income From Community Property (contd)

• In Texas, Louisiana, and Idaho, income from
  separate property is community property.
• Accordingly, for Federal tax purposes each
  spouse is responsible for one-half of the income.
  
• In the other seven community property states,
  income from separate property is separate
  property and must be reported by the person
  owning the property.
• However, income from personal services is
  generally treated as belonging to the community.

59
Income From Community Property (contd)

• Section 66 provides that a spouse will be taxed
  only on the earnings attributed to his or her
  personal services if during the year the
  following requirements are satisfied
• The two married individuals live apart at all
  times.
• The couple does not file a joint return with each
  other.
• No portion of the earned income is transferred
  between the spouses.
• This rule only applies to income from personal
  services and not income from property.