Federal Taxations Week 2 Lecture 1
Federal Taxations Week 2 Lecture 1
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Date Created: 11/15/15
Federal Taxations Week 2 Lecture 1 1. In the previous lesson we discussed Tax Determination; Personal and Dependency Exemptions. In this lesson we will discuss Gross Income: Concepts and Inclusions and begin discussing in more detail some of the concepts that make up the current internal revenue code. Next Slide: 2. This lesson is concerned with the first step in the computation of taxable income – the determination of gross income. Questions that are addressed include the following: What: What is income? When: In which tax period is the income recognized? And Who: Who must include the item of income in gross income? Next Slide: 3. After completing this lesson, you should be able to: Explain the concepts of gross income and realization and distinguish between the economic, accounting, and tax concepts of gross income. Describe the cash and accrual methods of accounting and the related effects of the choice of taxable year. Identify who should pay the tax on a particular item of income in various situations, and Apply the Internal Revenue Code provisions on alimony, loans made at below-market interest rates, annuities, prizes and awards, group term life insurances, unemployment compensation, and Social Security benefits. Next Slide: 4. The Internal Revenue Code has specific definitions for some terms; however gross income is not one of those terms. Section sixty-one-A of the Internal Revenue Code defines the term gross income as, except as otherwise provided in the subtitle, gross income means all income from whatever source derived. Supreme court decisions have made it clear that all sources of income are subject to tax unless Congress excludes the type of income received. So, this allows for very broad coverage of the income that should be included on an individual’s income tax return. As mentioned in previous lessons, it may help you as we discuss these terms to use Form ten-forty and the instructions booklet that can be downloaded from www.irs.gov. Accountants and economists measure income differently. Economists measure income by first determining the fair market value of the individual’s net assets at the beginning and end of the year, change in net worth. Then, to arrive at economic income, this change in net worth is added to the goods and services that person actually consumed during the period. The accounting concept of income is based on the realization principle, as in financial accounting. According to this principle, income is not recognized until it is realized. For realization to occur, an exchange of goods or services must take place between the accounting entity and some independent group, and in the exchange the accounting entity must receive assets that are capable of being objectively valued. Next Slide: 5. For many concepts, income tax rules and financial accounting rules are the same; however, some differences do exist. One difference that can cause a significant difference in the net income on an income statement and taxable income on a tax return is the fact that unearned or prepaid income received by an accrual basis taxpayer often is taxed in the year of receipt. For financial accounting purposes, such prepayments are not treated as income until earned due to the realization principle. Because of this and other differences, many corporations report financial accounting income that is substantially different from the amounts reported for tax purposes. So in a sense you have a set of “tax books” just as you do “financial books.” Gross income is not limited to cash received but also includes income realized in any form, such as money, property, or services. Income does not include recovery of a taxpayer’s capital investment, such as the repayment of the principle portion of a loan from another taxpayer. Next Slide: 6. The annual accounting period or taxable year is generally a twelve month period. An entity usually uses the calendar year to report its income. However, a fiscal year can be elected if the taxpayer maintains adequate books and records. The three primary methods of accounting are the cash receipts and disbursement method, the accrual method, and the hybrid method. Depending on which method is selected will determine the amount and timing of income reported on the tax return. Under the cash receipts method, property or services are included in the taxpayer’s gross income in the year of actual or constructive receipt by the taxpayer or agent, regardless of whether the income was earned in that year. Most individual taxpayers use receipt by the taxpayer or agent, regardless of whether the income was earned in that year. Most individual taxpayers use this method. Under the accrual method, an item is generally included in the gross income for the year in which it is earned, regardless of when the income is collected. This closely resembles the accrual basis of accounting for financial reporting. The hybrid method is a combination of the accrual and cash method. Generally, when the hybrid method is used, inventory is an income-producing factor. Next Slide: 7. There are some exceptions to the cash basis rules. One is constructive receipt of income. Sometimes the taxpayer has access to income but does not take custody of it. This is known as constructive receipt. If the taxpayer has received income or has income that is available to him or her, then the IRS believes the taxpayer has the wherewithal to pay and states that the income must be included in the current year’s tax return. The rationale for the constructive receipt doctrine is that if the income is available, the taxpayer should not be allowed to postpone the income recognition. Another exception is original issue discounts. Lenders frequently make loans that require a payment at maturity of more than the amount of the original loan. The difference between the amount due at maturity and the amount of the original loan is actually interest but is referred to as original issue discount. The Internal Revenue Code states that the original issue discount should be reported as income when earned and not received. Certain U.S. government savings bonds are issued at a discount and are redeemable for fixed amounts that increase at stated intervals. The difference between the purchase price and the amount received on redemption is the bondholder’s interest income from the investment. When a taxpayer elects to report the income from the bonds on an annual basis, this is a departure from the cash basis rules. Next Slide: 8. Although accrual basis can be used for financial reporting and income tax purposes, there are some differences. As you are aware for financial reporting purposes, advance payments received from customers are reflected as prepaid income and as a liability of the seller. However, for tax purposes, the prepaid income often is taxed in the year of receipt. Generally, a taxpayer can elect to defer recognition of income from advance payments of goods if the method of accounting for the sale is the same for tax and financial reporting purposes. The IRS also permits an accrual basis taxpayer to defer recognition of income for dvance payments for services to be performed after the end of the tax year of receipt. Next Slide: 9. For tax purposes, the income from personal services must be included in the gross income of the person who performs the services at their fair market value. Services performed by an employee for the employer’s customers are considered performed by the employer. In other words, the employer is taxed on the income from the services provided to the customer, and the employee is taxed on any compensation received from the employer. Income from property must be included in the gross income of the owner of the property. According to the IRS, interest accrues daily so the interest for the period that includes the date of the transfer is allocated between the transferor and transferee based on the number of days during the period that each owned the property. A corporation is taxed on its earnings, and the shareholders are taxed on the dividend paid to them from the corporation’s after-tax earnings. The dividend can take the form of an actual dividend or a constructive dividend. The dividend is taxed to the party who is entitled to receive them. This results in a concept known as double taxation. 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. Next Slide: 10. Income from Partnerships, S Corporations, Trusts and Estates are taxable at the owner level rather than at the entity level. So, the income from these pass-through entities is taxed using the taxpayer’s individual tax rates. Under a community property system, all property is deemed either to be separately owned by the spouse or to belong to the marital community. The general rules for taxing the income from services performed by residents of community property states can create complications and even inequities for spouses who are living apart. Next Slide: 11. For some sources, Congress has provided more specific rules for determining the gross income. One of these sources is alimony. Alimony and separate maintenance payments are deductible by the party making the payments and are includible in the gross income of the party receiving the payments. Payments made under post-1984 agreements and decrees are classified as alimony only if the following conditions are satisfied: Payments are in cash. The agreement or decree does not specify that the payments are not alimony. The payor and payee are not members of the same household at the time the payments are made. And There is no liability to make the payments for any period after the death of the payee. A taxpayer does not realize income from the receipt of child support payments made by his or her former spouse. This result occurs because the money is received subject to the duty to use money for the child’s benefit. In other words, child support is not taxable to the recipient or deductible by the payor. Imputed interest is another source that Congress has issued specific guidance for calculating gross income. The imputed interest is calculated using the rate the Federal government pays on new borrowings and is compounded semiannually. This federal rate is adjusted monthly and is published by the IRS. You can locate the rates at www.irs.gov. The imputed interest rules apply to the following types of below-market loans: gift loans, Compensation-related loans, Corporation-shareholder loans, and tax avoidance loans. Next Slide: 12. Annuity contracts generally require the purchaser to pay a fixed amount for the right to receive a future steam of payments. Generally, an annuity contract specifies a date on which monthly or annual payments will begin – the annuity starting date. Often the contract will also allow the annuitant to collect a limited amount before the starting date. Early collections and loans against annuity that are less than or equal to increases in cash value are included in gross income. Amounts greater than the increases in cash value are treated as a recovery of capital until the cost is recovered. Additional amounts are then included in income. Early distributions may be subject to a ten percent early withdrawal penalty. Next Slide: 13. There are some other items that the Internal Revenue Code specifically includes in gross income. The fair market value for prizes and awards must be included in gross income. The premiums on the first fifty thousand dollars of group term life insurance protection are excludible from the employees’ gross income. The benefits of this exclusion are available only to employees. Premiums paid for life insurance in excess of the fifty thousand dollars is included in gross income based on the IRS tables. The unemployment compensation program is sponsored and operated by the states and federal government to provide a source of income for people who have been employed and are temporarily out of work. Unemployment compensation is fully taxable. If a taxpayer’s income exceeds a specified base amount, as much as eighty five percent of Social Security retirement benefits must be included in gross income. Next Slide: 14 Gross income is a key component of the base used in calculating a taxpayer’s income tax liability. The Internal Revenue Code provides an all- inclusive definition of gross income. However, a number of exclusions from gross income have evolved over time because of legislative, judicial, or administrative action. The method of accounting adopted by a taxpayer is important because it generally determines the period in which income is recognized. However, special rules apply in certain situations to various types of income that affect the time of recognition. Finally, another important issue involves deciding who or what entity should recognize any income that is subject to tax. Fundamentally, however, all realized income must be recognized for income tax purposes unless a provision in the law specifically exempts the item from taxation.