ACCT 308 - CHAP. 4 - GROSS INCOME: CONCEPTS AND INCLUSIONS

What types of below-market loans do the imputed interest rules apply to?

1. Gift loans (made out of love, affection, or generosity) 2. Compensation-related loans (employer loans to employees) 3. Corporation-shareholder loans (a corporation's loans to its shareholders)

Determining exclusion amount for recovery of capital for annuities

(exclusion ratio) x (annuity payment) = exclusion amount exclusion ratio = (investment/expected return) expected return is the annual amount to be paid to the annuitant multiplied by the number of years the payments will be received

An individual must comply with the holding period rule, in order for there dividends to be considered qualified dividends. The holding period requirement is that the stock must have been held for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date. If he/she complies with the holding period rule, he/she is subject to preferential 0%/15%/20% treatment in that taxable year. If he/she does not comply with the holding period rule, his/her dividends will be taxed at ordinary income rates. True or false?

True

Because a partner pays tax on income as the partnership earns it, a distribution by the partnership to the partner is treated under the recovery of capital rules. True or false?

True

Because no tax is due until a gain has been recognized, the law favors investments that yield appreciation rather than annual income. True or false?

True

Services performed by an employee for the employer's customers are considered performed by the employer. Thus, 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. True or false?

True

The U.S. taxes foreign corporations only on the income the corporation earns in this country. Therefore, if the corporation does no business in the U.S. but pays dividends to shareholders subject to U.S. taxes, the corporation's income is only taxed once. True or false?

True

The ability to defer income using the cash method is a distinct advantage over the accrual method; therefore, service businesses usually use the cash method. However, the accrual method must be used when inventories are an income-producing factor to the business. True or false?

True

The basic difference between common law and community property systems centers around the property rights of married persons. True or false?

True

The constructive receipt doctrine does not reach income the taxpayer is not yet entitled to receive even though the taxpayer could have contracted to receive the income at an earlier date. True or false?

True

The imputed interest rule prevents an individual from shifting income to another individual through the use of interest-free loans. True or false?

True

The income from U.S. savings bonds is generally deferred until the bonds are redeemed or mature. Thus, U.S. savings bonds have attractive income deferral features not available with corporate bonds and certificates of deposit issued by financial institutions. True or false?

True

The tax law presumes that because an individual is receiving alimony, he/she is better able to pay the tax on the amount than the payor is. Therefore, the recipient must include the alimony income in his/her gross income, and the payor is allowed to deduct the alimony payment from his/her gross income. True or false?

True

U.S. government bonds (Series EE) can be purchased by parents for their children. When this is done, the children generally should file a return and elect to report the income on the accrual basis. True or false?

True

Under the accrual method, taxpayer's rights to the income generally accrue when title to property passes to the buyer or the services are performed for the customer/client. True or false?

True

Under the cash receipts method, the income received need not be reduced to cash in the same year. All that is necessary for income recognition is that property or services received have a fair market value - a cash equivalent. True or false?

True

Unearned income (i.e. prepaid interest and rent) generally is taxed in the year of receipt, regardless of the method of accounting used by the taxpayer. True or false?

True

Unemployment compensation is taxable. True or false?

True

Unlike interest, dividends do not accrue on a daily basis because the declaration of a dividend is at the discretion of the corporation's board of directors. True or false?

True

When a married couple divorce or become legally separated, state law generally requires a division of the property accumulated during the marriage. In addition, one spouse may have a legal obligation to support the other spouse. True or false?

True

When a taxpayer's right to income is contested (i.e. when a contractor fails to meet specifications), the year in which the income is subject to tax depends upon whether payment has been received. If payment has not been received, no income is recognized until the claim is settled. Only then is the right to the income established. However, if the payment is received before the dispute is settled, a claim of right doctrine requires the taxpayer to recognize the income in the year of receipt. True or false?

True

Generally, dividends are taxed to the person who is entitled to receive them - the shareholder of record as of the corporation's record date. True or false?

True.

The IRS has broad powers to determine whether the accounting method chosen by a taxpayer clearly reflects income. True or false?

True. A change in method of accounting requires the advance consent of the IRS.

If the change in the amount of alimony payments exceeds statutory limits, alimony recapture results to the extent of the excess alimony payments. True or false?

True. Alimony recapture is the amount of alimony that previously has been included in the gross income of the recipient and deducted by the payor that now is deducted by the recipient and included in the gross income of the payor as the result of front-loading.

A payment is deemed child support if the amount of the payments would be reduced upon the happening of a contingency related to a child (i.e. the child attains age 21 or dies). True or false?

True. Also, if payments are less than required, they are considered first to cover the required child support with any excess treated as the required alimony payments.

Realization of income occurs when the taxpayer performs services or sells goods, thus becoming entitled to a payment form the other party. True or false?

True. Also, no income is recognized unless it is realized.

The beneficiaries of estates and trusts generally are taxed on the income earned by the estates or trusts that is actually distributed or required to be distributed to them. True or false?

True. Any income not taxed to the beneficiaries is taxable to the estate or trust.

The life insurance industry commonly uses substantial restrictions in designing life insurance contracts with favorable tax features. Ordinary life insurance policies provide (1) current protection—an amount payable in the event of death—and (2) a savings feature—a cash surrender value payable to the policyholder if the policy is terminated during the policyholder's life. The annual INCREASE in cash surrender VALUE is NOT taxable because the policyholder must cancel the policy to actually receive the increase in value. True or false?

True. Because the cancellation requirement is a substantial restriction, the policyholder does not constructively receive the annual increase in cash surrender value.

In response to the argument that deferral of income until it is actually earned properly matches revenues and expenses, the IRS responds that collection of tax is simplest in the year the taxpayer receives the cash from customer or client. True or false?

True. But, the IRS has modified its rules regarding prepaid income in SOME situations.

income

for tax purposes, an increase in wealth that has been realized

recovery of capital doctrine

there is no income subject to tax until the taxpayer has recovered the capital invested Sellers can reduce their gross receipts (selling price) by the adjusted basis of the property sold to determine the amount of gross income. When a taxable sale or exchange occurs, the seller may be permitted to recover his or her investment (or other adjusted basis) in the property before gain or loss is recognized.

For income tax purposes, a partnership includes a syndicate, group, pool, or joint venture, as well as ordinary partnerships. In an ordinary partnership, two or more parties combine capital and/or services to carry on a business for profit as co-owners. True or false?

True

Generally, a check received is considered a cash equivalent and, upon receipt, must be recognized as income by a cash basis taxpayer. An exception to this rule is if the person paying with the check requests that the check not be cashed until a subsequent date, the income is deferred until that later date. True or false?

True

Generally, a taxpayer can elect to defer recognition of income from advance payments for goods if the method of accounting for the sale is the same for tax and financial reporting purposes. True or false?

True

If a father gives his daughter the right to collect the rent from his rental property, the father will be taxed on the rent because he retains the ownership of the property. On the other hand, if a father gives his daughter the property, she is taxed on all the income earned after she receives the property. True or false?

True

If a taxpayer sells stock AFTER a dividend has been declared but BEFORE the record date, the dividend generally will be taxed to the purchaser. But, if a donor makes a gift of stock to someone (i.e. a family member) AFTER the declaration date but BEFORE the record date, the donor does NOT shift the dividend income to the donee. True or false?

True

If interest is charged on the loan but is less than the Federal rate, the imputed interest is the difference between the amount that would have been charged at the Federal rate and the amount actually charged. True or false?

True

If the rights to income have accrued but are subject to a potential refund claim (i.e. under a product warranty), the income is reported in the year of sale and a deduction is allowed in subsequent years when actual claims accrue. True or false?

True

In a common law system, each spouse owns whatever he or she earns. True or false?

True

In all community property states, income from personal services (i.e. salaries, wages, income from professional partnership) is generally treated as if one-half is earned by each spouse. True or false?

True

In contrast to the cash basis of accounting, expenses need not be paid to be deductible, nor need income be received to be taxable. True or false?

True

In the case of a gift of income-producing property, the donor must recognize his/her share of the accrued income at the time it would have been recognized had the donor continued to own the property. However, if the transfer is a sale, the transferor must recognize the accrued income at the time of the sale. This results because the accrued interest will be included in the sales proceeds. True or false?

True

Income from personal services must be included in the gross income of the person who performs the services. True or false?

True

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. True or false?

True

Income set apart or made available is not constructively received if its actual receipt is subject to substantial restrictions. True or false?

True

MAGI, in regard to social security benefits, is the taxpayer's adjusted gross income from all sources (other than Social Security) plus the foreign earned income exclusion and any tax-exempt interest income. True or false?

True

Partial relief from double taxation is provided by taxing qualified dividends received by individuals at the same rate as capital gains. True or false?

True

gross income

"all income from whatever source derived"; income subject to the Federal income tax

What conditions must be satisfied for payments to be considered alimony?

1. The payments are in cash. (This clearly distinguishes alimony from a property division.) 2. The agreement or decree does not specify that the payments are not alimony. (This allows the parties to determine by agreement whether the payments will be alimony.) 3. The payor and payee are not members of the same household at the time the payments are made. (This ensures that the payments are for maintaining two households.) 4. There is no liability to make the payments for any period after the death of the payee.

In what situations does the exclusion of a prize or award (by transferring it to a qualified governmental unit or nonprofit organization) produce beneficial tax consequences?

1. The taxpayer does not itemize deductions and thus would receive no tax benefit from the charitable contribution. 2. The taxpayer's charitable contributions exceed the annual statutory ceiling on the deduction. 3. Including the prize or award in gross income would reduce the amount of deductions the taxpayer otherwise would qualify for because of gross income limitations (i.e. the gross income test for a dependency exemption or the adjusted gross income limitation in calculating the medical expense deduction).

What are some reasons that applicable tax rates can change between the years?

1. With a progressive rate system, a taxpayer's marginal tax rate can change from year to year. 2. Congress may change the tax rates. 3. The relevant rates may change because of a change in the taxpayer's status (i.e. person may marry or business may be incorporated) 4. Several provisions in the Code are dependent on the taxpayer's gross income for the year (i.e. whether the person can be claimed as a dependent)

Examples that DO NOT align with the accounting concept of income

1. the appreciation in the market value of an asset owned is not realized (and would only be included in gross income once the asset is sold) 2. income is not realized when an individual creates assets for his or her own use (i.e. vegetables grown in a personal garden) because there is no exchange transaction with another party

What are the conditions that need to be satisfied in order for community property spouses living apart to avoid including one-half of each other's salary in their gross income?

A [former] spouse is taxed only on his/her actual earnings from personal services if: 1. The individuals live apart for the entire year. 2. They do not file a joint return with each other. 3. No portion of the earned income is transferred between the individuals.

assignment of income

A taxpayer attempts to avoid the recognition of income by assigning to another the property that generates the income. Such a procedure will not avoid income recognition by the taxpayer making the assignment if the income was earned at the point of the transfer. In this case, the income is taxed to the person who earns it.

alimony and separate maintenance payments

Alimony deductions result from the payment of a legal obligation arising from the termination of a marital relationship. Payments designated as alimony generally are included in the gross income of the recipient and are deductible for AGI by the payor.

What requirements need to be satisfied, in order for a prize or award to be excluded from gross income?

All must be satisfied: 1. The prize or award is received in recognition of religious, charitable, scientific, educational, artistic, literary, or civic achievement (e.g., Nobel Prize, Pulitzer Prize, or faculty teaching award). 2. The recipient transfers the prize or award to a qualified governmental unit or nonprofit organization. 3. The recipient was selected without any action on his or her part to enter the contest or proceeding. 4. The recipient is not required to render substantial future services as a condition for receiving the prize or award.

fruit and tree metaphor

An individual who earns income from property or services cannot assign that income to another. The fruit (income) must be attributed to the tree from which it came (the individual who earned the income). example: a father cannot assign his earnings from commissions to his child and escape income tax on those amounts

accrual method

An item is generally included in gross income for the year in which it is earned, regardless of when it is collected. The income is earned when (1) all events have occurred that fix the right to receive such income and (2) the amount to be received can be determined with reasonable accuracy. reflects expenses incurred and income earned for any one tax year

imputed interest

For certain long-term sales of property, the IRS can convert some of the gain from the sale into interest income if the contract does not provide for a minimum rate of interest to be paid by the purchaser. The seller recognizes less long-term capital gain and more ordinary income (interest income). Imputed interest is calculated using the rate the Federal government pays on new borrowings and is compounded semiannually.

What is the rationale for the constructive receipt doctrine?

If the income is available, the taxpayer should not be allowed to postpone the income recognition.

What is the realization principle of the accounting concept of income?

Income is not recognized until it is realized. For realization to occur, (1) an exchange of goods or services must take place between the accounting entity and some independent, external party and (2) in the exchange, the accounting entity must receive assets that are capable of being objectively valued.

constructive receipt

Income that has not actually been received by the taxpayer is taxed as though it had been received (income is constructively received) under the following conditions: (1) The amount is made readily available to the taxpayer (even if it's not physically in the taxpayer's possession) (2) The taxpayer's actual receipt is not subject to substantial limitations or restrictions example: accrued interest on a savings account; under this concept, the interest is taxed to a depositor in the year available, rather than the year actually withdrawn (doesn't matter if the depositor uses cash basis of accounting for tax purposes or not)

What makes jointly owned property different from community property?

Jointly owned property (i.e. tenants in common, joint tenants): (1) is not limited to married couples (2) more than two owners can be involved

group term life insurance

Life insurance coverage provided by an employer for a group of employees. Such insurance is renewable on a year-to-year basis, and typically no cash surrender value is built up. The premiums paid by the employer on the insurance are not taxed (excludible from employee's gross income) to the employees on coverage of up to $50,000 per person. The exclusion is only available to: (1) employees (proprietors and partners are not considered employees), (2) employees who satisfy the group requirement (not shareholder employees), and (3) only to term insurance

cash receipts method

Property or services received are included in the taxpayer's gross income in the year of actual or constructive receipt by the taxpayer or the taxpayer's agent, regardless of whether the income was earned in that year. reflects deductions as paid and income as received in any one tax year However, deductions for prepaid expenses that benefit more than one tax year (i.e. prepaid rent and prepaid interest) usually are spread over the period benefited rather than deducted in the year paid.

A taxpayer can avoid including prizes and awards in gross income by refusing to accept the prize or award. True or false?

True

A taxpayer may exclude employee achievement awards from gross income IF they are in the form of tangible property, and the award is made in recognition of length of service or safety achievement. True or false?

True

A transfer of property, OTHER THAN CASH, to a former spouse under a divorce decree or agreement is not a taxable event. True or false?

True

According to the IRS, interest accrues daily. True or false?

True

An annuitant can exclude from income (as a recovery of capital) the proportion of each payment that the investment in the contract bears to the expected return under the contract. True or false?

True

accounting methods

The method under which income and expenses are determined for tax purposes 1. cash receipts and disbursements method (commonly used by individuals) 2. accrual method (commonly used by large corporations) 3. hybrid method (commonly used by small businesses) 4. installment method (taxpayer can spread the gain from an installment sale of eligible property over the collection periods) 5. percentage of completion method (contractors can spread profits from contracts over the periods in which the work is done) 6. completed contract method (contractors can defer all profit until the year in which the project is completed - used under limited circumstances)

A tax liability of a family can be minimized by shifting income from higher- to lower-bracket family members by giving gifts of income-producing property. True or false?

True

A cash basis taxpayer who receives a note in payment for services has income in the year of receipt equal to the fair market value of the note. However, a creditor's mere promise to pay (i.e. an account receivable), with no supporting note, usually is not considered to have a fair market value and therefore is not a cash equivalent. Thus, the cash basis taxpayer defers income recognition until the account receivable is collected. True or false?

True

A corporation is taxed on its earnings, and the shareholders are taxed on the dividends paid to them from the corporation's after-tax earnings. True or false?

True

The receipt of funds with an obligation to repay that amount in the future is the essence of borrowing. Because the taxpayer's assets and liabilities increase by the same amount, no income is realized when the borrowed funds are received. True or false?

True. If an obligation to repay the funds exists, the receipt of deposited or borrowed funds is not a taxable event. example: If a landlord receives a damage deposit from a tenant, the landlord does not recognize income until the deposit is forfeited because the landlord has an obligation to repay the deposit if no damage occurs. However, if the deposit is a prepayment of rent, it is taxed in the year of receipt.

On gift loans of $100,000 or less between individuals, the imputed interest cannot exceed the borrower's net investment income for the year (gross income from all investments less the related expenses). True or false?

True. If the borrower's net investment income for the year DOES NOT EXCEED $1,000, no interest is imputed on loans of $100,000 or less. However, these limitations for loans of $100,000 or less do not apply if a principal purpose of a loan is tax avoidance.

A recovery of capital and gain realized on separate property retain their identity as separate property. True or false?

True. Items like nontaxable stock dividends, royalties from mineral interests, and gains and losses from the sale of property take on the same classification as the assets to which they relate.

The exclusion ratio applies until the annuitant has recovered his/her investment in the contract. True or false?

True. Once the investment is recovered, the entire amount of subsequent payments is taxable. If the annuitant dies before recovering the investment, the unrecovered cost (adjusted basis) is deductible in the year the payments cease (usually the year of death).

In a community property system, one-half of the earnings of each spouse is considered owned by the other spouse (or the "marital community"). True or false?

True. Property may be held separately by a spouse if it was acquired before marriage or received by gift or inheritance following marriage. Otherwise, any property is deemed to be community property. For Federal tax purposes, each spouse is taxed on one-half of the income from property belonging to the community.

Qualified dividends are not included as capital gains in the gains and losses netting process. Thus, they are not reduced by capital losses. True or false?

True. Qualified dividend income is merely taxed at the rates that would apply to the taxpayer if he/she had an excess of net long-term capital gain over net short-term capital loss.

Deferred taxes are the same as interest-free loans. True or false?

True. Tax planners must consider tax rates for the years this income is shifted from and to.

A partnership files an information return (Form 1065). True or false?

True. The Form 1065 services to provide the data necessary for determining the character and amount of each partner's distributive share of the partnership's income and deductions. The income must be reported by each partner in the year it is earned, even if such amounts are not actually distributed to the partners.

No income is recognized by the annuitant at the time the cash value of the annuity increases because the taxpayer has not actually received any income. True or false?

True. The income is not constructively received because, generally, the taxpayer must cancel the policy to receive the increase in value (the increase in value is subject to substantial restrictions).

An accrual basis taxpayer may defer recognition of income for advance payments for services to be performed after the end of the tax year of receipt. True or false?

True. The portion of the advance payment that relates to services performed in the tax year of receipt is included in gross income in the TAX YEAR OF RECEIPT, matching what was reported in the taxpayer's financial statements. The portion of the advance payment that relates to services to be performed AFTER the tax year of receipt is included in gross income in the SUBSEQUENT tax year. Refer to Example 19 in Chapter 4-2d

An S (small business) corporation may elect to be taxed similarly to a partnership. As a result, the shareholders rather than the corporation pay the tax on the corporation's income. True or false?

True. The shareholders report their proportionate shares of the corporation's income and deductions for the year, regardless of whether the corporation actually makes any distributions to the shareholders.

If a taxpayer's income exceeds a specified base amount, as much as 85% of Social Security retirement benefits must be included in gross income. True or false?

True. The taxable amount of benefits is determined through the application of one of two formulas that utilize a unique measure of income—modified adjusted gross income (MAGI).

The original issue discount rules do not apply to U.S. savings bonds (Series E before 1980 and Series EE after 1979) or to obligations with a maturity date of one year or less from the date of issue. True or false?

True. These U.S. government savings bonds are issued at a discount and are redeemable for fixed amounts that increase at stated intervals. No interest payments are actually made. The difference between the purchase price and the amount received on redemption is the bondholder's interest income from the investment.

No interest is imputed on total outstanding gift loans of $10,000 or less between individuals, UNLESS the loan proceeds are used to purchase income-producing property. True or false?

True. This exemption eliminates immaterial amounts that do not result in apparent shifts of income.

The fair market value of prizes and awards (other than certain exempted scholarships) must be included in gross income. True or false?

True. This means TV giveaway prizes, magazine publisher prizes, awards from an employer to an employee in recognition of performance, etc. are fully taxable to the recipient.

Amounts earned from personal services provided by a child must be included in the child's gross income. True or false?

True. This result applies even though the income is paid to other persons (i.e. the parents).

A taxpayer does not realize income from the receipt of child support payments made by his or her former spouse. True or false?

True. This result occurs because the money is received subject to the duty to use the money for the child's benefit.

Dividend income should be included in the gross income of the donee (the owner at the record date). In this case, the taxpayer gave stock to a qualified charity (a charitable contribution) after the declaration date and before the record date. True or false?

True. Thus, gifts to charities and gifts to family members are treated differently.

The measure of accrual basis income is generally the amount the taxpayer has a right to receive. True or false?

True. Unlike the cash basis, the fair market value of the customer's obligation is irrelevant in measuring accrual basis income.

Differences between income tax rules and financial accounting measurement concepts sometimes exist. Because of this, many corporations report financial accounting income that is substantially different from the amounts reported for tax purposes. Provide an example.

Unearned (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.

hybrid method

a combination of the accrual and cash methods of accounting; the taxpayer may account for some items of income on the accrual method (i.e. sales of inventory and cost of goods sold) and other income and expense items (i.e. services and interest income) on the cash method typically used when inventory is an income-producing factor

annuity

a fixed sum of money payable to a person at specified times for a specified period of time or for life. If the party making the payment (i.e. the obligor) is regularly engaged in this type of business (i.e. an insurance company), the arrangement is classified as a commercial annuity. A so-called private annuity involves an obligor that is not regularly engaged in selling annuities (i.e. a charity or family member).

claim of right doctrine

a judicially imposed doctrine applicable to both cash and accrual basis taxpayers that holds that when a taxpayer's right to income is contested, the amount is includible in income upon actual or constructive receipt if the taxpayer has an unrestricted claim to the payment

What is the tax accounting problem associated with receiving annuity payments?

apportioning the amounts received between recovery of capital (the original investment in the contract) and income

Why did the Supreme Court choose to define income from an accounting perspective, as opposed to an economic perspective?

because the economic income model is impractical; valuing assets annually would make compliance with the tax law burdensome; using market values to determine income for tax purposes could result in liquidity problems (i.e. commercial real estate) Economic income is the change in the taxpayer's net worth, as measured in terms of market values, plus the value of the assets the taxpayer consumed during the year.

The Uniform Gifts to Minors Act

model law adopted by all states that facilitates income shifting A gift of intangibles (i.e. bank accounts, stocks, bonds, life insurance contracts) can be made to a minor but with an adult serving as custodian.

term insurance vs. ordinary life insurance

term insurance - protection for a PERIOD of time but with NO cash surrender value ordinary life insurance - LIFETIME protection PLUS a cash surrender value that can be drawn upon before death

taxable year

the annual period over which income is measured for income tax purposes. Most individuals use a calendar year, but many businesses use a fiscal year based on the natural business year

original issue discount (OID)

the difference between the original amount of a loan and the amount due at maturity (actually interest) when the issue price is LESS THAN maturity value The Code requires the original issue discount to be reported when it is earned, regardless of taxpayer's accounting method. The interest "earned" is calculated by the effective interest rate method and is applied to both cash and accrual basis lenders This difference is not considered to be original issue discount for tax purposes when it is less than one-fourth of 1% of the redemption price at maturity multiplied by the number of years to maturity.