Understanding Gross Income Concepts in Taxation

1. Chapter 4 Gross Income 1

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. 2

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. 3

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. 4

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

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 6

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) 7

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. 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. 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. 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. 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. The Big Picture - Example 2Economic 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. 13

14. The Big Picture - Example 2Economic 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

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. 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. 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. 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. 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. 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. 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. Accrual Method (slide 2 of 2) • Claim of right doctrine • Requires amounts received to be included in income even though the amount is in dispute and might be returned to the payor at a later date • If payment has not been received, no income is recognized until the claim is settled

23. 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

24. 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

25. Example 17 - Advance Payment For Services (slide 1 of 2) 25

26. Example 17 - Advance Payment For Services (slide 2 of 2) 26

27. 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

28. Income Sources • Income from personal services is taxable to the person who performs the services • Fruit and tree metaphor • Income from property is taxable to the owner of the property • Assignment of income is not permitted

29. The Big Picture - Example 18Personal Service Income(slide 1 of 2) Return to the facts of The Big Picture on p. 4-1. Assume that Dr. Payne entered into an employment contract with his corporation and receives a salary. All patients contract to receive their services from the corporation. Those services are provided through the corporation’s employee, Dr. Payne. 29

30. The Big Picture - Example 18Personal Service Income(slide 2 of 2) The corporation earns the income from patients’ services and must include the patients’ fees in its gross income. Dr. Payne includes his salary in his own gross income. The corporation claims a deduction for the reasonable salary paid to Dr. Payne. 30

31. Interest Income • Interest income accrues daily • If interest bearing instrument (e.g., bonds) is transferred, must allocate interest income between transferor and transferee based on the number of days during the period that each owned the property

32. Dividends (slide 1 of 4) • Dividends are generally taxed to the party who is entitled to receive them • Dividends on stock transferred by gift after declaration date but before record date are generally taxed to the donor

33. 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

34. Dividends (slide 3 of 4) • The following dividends are not eligible for the reduced tax rates • Dividends from certain foreign corporations, • Dividends from tax-exempt entities, and • Dividends that do not satisfy the holding period requirement • Stock on which the dividend is paid must have been held for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date to qualify for the reduced tax rates

35. Dividends (slide 4 of 4) • Dividends from foreign corporations are eligible for qualified dividend status only if: • The foreign corporation’s stock is traded on an established U.S. securities market, or • The foreign corporation is eligible for the benefits of a comprehensive income tax treaty between its country of incorporation and the United States

36. 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

37. 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

38. 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

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

40. 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

41. 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

42. The Big Picture - Example 28Imputed 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. 42

43. 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 43

44. 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 44

45. 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 45

46. 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 46

47. 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 47

48. The Big Picture - Example 33Tax Exempt Municipal Bonds Interest Return to the facts of The Big Picture on p. 4-1. Dr. Payne includes in gross income the $500 of interest income from the bank’s money market account, but not the $500 that is earned on the Whitehall School District bonds. 48

49. 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 49

50. Life Insurance Proceeds (slide 1 of 4) Exempt income to beneficiary if paid solely due to death of insured Relationship to decedent not determinative 50