3-1 ©2010 Pearson Education, Inc. Publishing as Prentice Hall.

3-1©2010 Pearson Education, Inc. Publishing as Prentice Hall

3-2

GROSS INCOME: GROSS INCOME: INCLUSIONSINCLUSIONS

(1 of 2)(1 of 2)

Economic and accounting concepts of income

Tax concept of incomeTo whom is income taxable?When is income taxable?Items of gross income

©2010 Pearson Education, Inc. Publishing as Prentice Hall

3-3

GROSS INCOME GROSS INCOME INCLUSIONSINCLUSIONS

(2 of 2)(2 of 2)

Other items of gross incomeTax planning considerationsCompliance and procedural

considerations


3-4

Concepts of IncomeConcepts of IncomeEconomic Concepts of IncomeEconomic Concepts of Income

Wealth that flows to individualsChanges in value in individuals’

wealthUnrealized gains Gifts & inheritances considered

income


3-5

Concepts of IncomeConcepts of IncomeAccounting Concepts of IncomeAccounting Concepts of Income

Accounting concepts of incomeValues are measured by a

transaction approachIncome realized as result of

completed transactionsUse historical cost


3-6

Tax Concept of IncomeTax Concept of Income

Conditions to make income taxable

Administrative convenienceWherewithal to payGross income defined


3-7

Conditions to MakeIncome Taxable

Economic benefit to taxpayerIncome must be realized

Earnings process completeIncome must be recognized


3-8

Administrative Convenience

Economic concept is considered too subjective

Objectivity achieved at price of equity


3-9

Wherewithal to Pay

A tax should be collected when the taxpayer can most easily pay


3-10

Gross Income Defined(1 of 2)

Section 61(a) defines gross income“all income from whatever source

derived,” including (but not limited to) the following items:Compensation, income derived from

business, gains from dealings in property, interest, rents, royalties, dividends, alimony, annuities, life insurance, pensions


3-11

Gross Income Defined(2 of 2)

Form of receiptGross income not limited to cash§1.61-1a, income may be “realized in

any form, whether in money, property, and services”

Indirect economic benefit Items indirectly benefiting taxpayers

excluded from gross income


3-12

To whom Is Income To whom Is Income Taxable?Taxable?

Assignment of incomeAllocating income between

married peopleIncome of minor children


3-13

Assignment of Income

Supreme Court in Lucas v. Earl (1930)Ruled that individual taxed the

earnings from his personal servicesHelvering v. Horst (1940)

Ruled that assignment of income doctrine applies to property


3-14

Allocating Income between Married People (1 of 2)

Common law property systemUsed in 42 statesIncome taxed to person who

earns it or who owns the income-producing propertyJoint income comes from jointly

owned property


3-15

Allocating Income between Married People (2 of 2)

Community property statesAll income deemed to be earned

equally by spouses except income from separate property

Separate propertyProperty owned by each spouse prior to

marriageMay be community income or separate

income, depending on state of residence


3-16

Income of Minor Children

Taxed to child regardless of state’s property law system

Unearned income of minor under 24 may be taxed at parent’s higher rateSee Chapter I2


3-17

When Is Income Taxable?When Is Income Taxable?

Cash methodAccrual methodHybrid methodSee Topic Review 1


3-18

Cash Method(1 of 3)

Used by most individual taxpayers and most non-corporate businesses that do not have inventory

Constructive receiptReport income in year actually received

Check received after banking hoursBond interest coupons that have matured but not redeemed


3-19

Cash Method(2 of 3)

No constructive receipt ifIt is subject to substantial

limitations Payor does not have funds

necessary to make paymentAmount is unavailable to taxpayer


3-20

Cash Method(3 of 3)

Exceptions to basic cash methodInterest on Series E or EE Savings

BondsSpecial rules apply to farmers and

ranchersSmall taxpayer exception for

inventories


3-21

Accrual Method

Report income in year income earnedRight to incomeAmount can be determined with

reasonable accuracyPrepaid income

Generally taxable when receivedExceptions in Rev. Proc. 2004-34


3-22

Hybrid Method

Accrual method for purchases and sales

Cash method in computing all other income and expenses


3-23

Items of Gross IncomeItems of Gross Income(1 of 2)(1 of 2)

CompensationBusiness incomeGains from dealings in propertyInterest

Series EE bond interest exceptionRents and royaltiesDividends


3-24

Items of Gross IncomeItems of Gross Income(2 of 2)(2 of 2)

Alimony and separate maintenance payments

Pensions and annuitiesIncome from life insurance and

endowment contractsIncome from discharge of indebtednessIncome passed through to taxpayer


3-25

Dividends(1 of 3)

Included in shareholder gross incomeResults in double taxation

Earnings taxed at corporate levelEarnings taxed at shareholder level when

distributed as a dividendC corps allowed a 70, 80, or 100% div

received deduction based on ownership %Relief from multiple levels of taxation


3-26

Dividends(2 of 3)

Individuals taxed at 15% on dividends5% if in 10% or 15% tax bracketReduces effects of double taxationMust hold stock for at least 60 daysTaxed at ordinary rates after 2010

Distributions to extent they are out of corporate earnings and profits


3-27

Dividends(3 of 3)

Stock dividendsNot taxableBasis in stock allocated to new shares

Capital gain dividendsTaxed at long-term capital gain rates

Constructive dividendsTaxed as regular dividends


3-28

Alimony and Separate Maintenance Payments

Only receipt of alimony is taxable Alimony is deductible by one who

paysChild support not taxableProperty settlement not taxable


3-29

Pensions and Annuities

Income portion of annuity taxableInvestment portion is excluded

Exclusion ratioBasis in annuity ÷ Expected ReturnExpected return

Payment x # of expected payments


3-30

Income Passed Through to Taxpayer

Income from flow-through entities taxed directly to ownersIncome from partnershipIncome from S corporationIncome in respect of a decedentIncome from an estate or trustIncome from RIC or REIT


3-31

Other Items of Gross Other Items of Gross IncomeIncome

(1 of 2)(1 of 2)

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

Illegal income – taxable Unemployment compensation -

taxableSocial security benefits – up to 85%

taxable


3-32

Other Items of Gross Other Items of Gross IncomeIncome

(2 of 2)(2 of 2)

Insurance proceeds and court awardsSpecial rules apply

Recovery of previously deducted amounts – taxable

Revenue received that is disputed must still be reported as incomePreviously reported income that is

subsequently refunded is deductible


3-33

Tax Planning Tax Planning ConsiderationsConsiderations

(1 of 2)(1 of 2)

Shifting incomeFrom high income family members

to low income family membersAlimony

Deductible by payor and includible by payee

Prepaid income


3-34

Tax Planning Tax Planning ConsiderationsConsiderations

(2 of 2)(2 of 2)

Taxable, tax-exempt, or tax-deferred bondsNeed to compare present value of

after-tax returnsReporting savings bond interestDeferred compensation

arrangements


3-35

Compliance and Compliance and Procedural Procedural

ConsiderationsConsiderations

Form 1040 – Wages, Salaries and tips

Schedule B – Interest and DividendsSchedule C – Business Income Schedule D – Capital gainsSchedule E – Rents and RoyaltiesSchedule F – Farm Income


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