Tax Accounting - Chapter 5

Scholarships

-Students seeking a college degree can exclude scholarships that pay for required tuition, fees, books, and supplies. -Exclusion applies only if the recipient is not required to perform services in exchange for receiving the scholarship (limited exception for tuition waivers for student employees and teaching and research assistants).

Property Dispositions

-Taxpayers usually realize a gain or loss when disposing of an asset. -Taxpayers are allowed to recover their investment in property (tax basis) before they realize any gain.

Definition of gross income for tax purposes

-§61(a): "gross income means all income from whatever source derived" -Reg. §1.61-(a): "includes income realized in any form, whether in money, property, or services"

Realization Principle (when to recognize gross income)

1) The taxpayer engages in a transaction with another party 2) Transaction results in a measurable change in property rights In other words, assets or services are exchanged for cash, claims to cash, or other assets with determinable value.

Taxpayers recognize gross income when

1)They realize the income, and 2)They receive an economic benefit 3)The tax law does not provide for exclusion or deferral

Common Exclusions Provisions that allow taxpayer to permanently certain items from the tax base

1. Municipal Bond Interest -Bonds issued by state and local governments located in the United States (This exclusion is generally recognized as a subsidy to state and local governments) 2. Gains on the Sale of Personal Residence - Taxpayers may exclude up to $250,000 ($500,000 if married filing jointly) of gain on the sale of their principal residence -Must satisfy ownership and use tests -Any excess gain generally qualifies as a long-term capital gain 3. Fringe Benefits -The value of these benefits is included in the employee's gross income as compensation for services. -Certain fringe benefits, called "qualified" fringe benefits, are excluded from gross income. (Common qualifying fringe benefits are medical and dental health insurance coverage, life insurance coverage, de minimis (small) benefits)

Types of payment that do not qualify as alimony

1. property divisions 2. child support payments fixed by the divorce 3. separation agreement

Single taxpayers meeting certain homeownership and use requirements can permanently exclude up to ______ of the realized gain on the sale of their principal residence

250000

The highest percentage of Social Security benefits that may be taxed is _____%, and only for moderate to high-income taxpayers.

85%

Which of the following choices describe exclusions and deferrals for tax purposes? a. These provisions are narrowly defined b. These provisions are the result of specific congressional action c. These provision reduce the tax liability dollar for dollar d. These provisions are often granted in order to subsidize or encourage particular behaviors e. These provisions are generally deducted from AGI and reduce taxable income

A/B/D

When is a discharge of indebtedness NOT included in gross income? Multiple choice question. A. When the taxpayer works out a debt settlement arrangement that lowers his debt, rather than totally discharging it B. When the taxpayer's debt forgiveness does not exceed $10,000 C. When the taxpayer is insolvent before, but not after the debt forgiveness D. When the taxpayer is insolvent before and after the debt forgiveness

Answer: D When the taxpayer is insolvent before and after the debt forgiveness

To satisfy the ownership test for excluding the gain on a personal residence the taxpayer must have owned the residence for ______. Multiple choice question. A. five or more years during the past seven-year period ending on the date of sale B. at least the two years prior to the sale C. at least the 12 consecutive months prior to the sale D. two or more years during the past five-year period ending on the date of sale

Answer: D two or more years during the past five-year period ending on the date of sale

True or false: In general, prizes awarded to taxpayers are excluded from gross income.

False Reason: Prizes and awards are taxable unless they meet very specific exceptions.

Abby sold a parcel of land for $18,000. She paid a real estate agent a commission of $1,200 for assisting with the sale. Abby had purchased the land several years earlier for $14,500. What is the gain on the sale of the land? A. Gain of $2,300 B. Gain of $3,500 C. Gain of $16,800 D. Gain of $18,000

Gain of $2,300 Reason: $18,000 - $1,200 - $14,500 = $2,300

Tax Benefit Rule

Holds that a tax refund of an amount deducted in a previous period is only included in income to the extent that the deduction reduced taxable income.

fringe benefits

In addition to receiving a salary from a company, many employers provide benefits that are excluded from gross income

For a divorce agreement entered into BEFORE January 1, 2019, alimony is ______

Included in the gross income of the person receiving it and deductible by the person paying it Reason: This is true for divorce agreements on or after January 1, 2019. included in the gross income of the person receiving it but not deductible by the person paying it

If a taxpayer cashes out a life insurance policy before death due to a chronic illness, she may exclude from income the amount used to pay for her ________-_________ ________

Long-term care

income from services (earned income)

Payment for services including salary, wages, and fees that a taxpayer earns through services in a nonemployee capacity. Including unemployment compensation. -Income from labor most common source of gross income -Generated by the efforts of taxpayer

Workers' Compensation

Payments from workers' compensation plans are excluded from gross income.

Tax Benefit Rule

Refunds of expenditures deducted in a prior year are included in gross income to the extent that the refund reduced taxes in year of the deduction

Health Care Reimbursement

Reimbursements by health and accident insurance policies for medical expenses paid by the taxpayer are excluded from gross income

Which of the following options is NOT available to taxpayers who have worked outside the United States and meet the requirements necessary to receive tax relief on their foreign earnings?

Tax deduction for foreign-earned income

Which one of the following is NOT an advantage of the cash method for reporting income? A. Taxpayers are able to deduct expenses in the period incurred, which may be before they actually pay them. B. Taxpayers recognize income in the period they receive it, giving them the wherewithal to pay the tax. C. Taxpayers have some control over when income is received and expenses are paid which assists in tax planning. D. The cash method generally simplifies the computation of income.

Taxpayers are able to deduct expenses in the period incurred, which may be before they actually pay them.

Inheritance

may be subject to the federal estate tax which is paid by the estate of the person who died

Other Sources of Gross Income

Income other than wages or business and property

Claim of Right

Income recognized when there are no restrictions on use of income (e.g., no obligation to repay

Accounting Methods

cash basis and accrual basis. Corporations: accrual method of accounting. Individuals: cash method of accounting

Mitch, a single taxpayer, earns $100,000 in taxable income and $10,000 in interest from an investment in the city of Birmingham Bonds. Using the U.S. tax rate schedule for year 2018, how much federal tax will he owe? $22,000$18,289.50$13,879$24,000None of the choices are correct.

$18,289.50$100,000 - 82,500 = 17,500 * 24% = 4,200 + 14,089.50 = $18,289.50

Sam traded a parcel of land for a tractor and a car. He had purchased the land five years earlier for $16,000. The market value of the car and tractor is $20,000. What is the amount of gross income resulting from this transaction? A. $16,000 B. $20,000 C. $4,000 D. $0

$4,000

Community Property Systems

-Nine states implement community property systems -Half of the income earned from the services of one spouse is included in the gross income of the other spouse -Half of the income from property held as community property by the married couple is included in the gross income of each spouse -Property that a spouse brings into a marriage is treated as that spouse's separate property §How income from separate property is treated varies across states (either treated as earned solely by spouse that owns property or equally by each spouse)

Sickness and Injury-Related Exclusions

-Several exclusion provisions apply to taxpayers who are sick or injured to reflect their inability to pay the tax and facilitate recovery.

Andrews, Badin, and Carr formed a partnership, ABC. During Year 2, the partnership sold some land that was held for investment and generated a long-term capital gain. How will this income be reported on the partners' individual tax returns? Multiple choice question. A. The income will retain its character and be reported as a long-term capital gain. B. The income will be combined with the profit generated by the partnership and flow through to the partners as ordinary income. C. The partnership will pay the tax due on the long-term capital gain rather than allocate it to the partners. D. The income will be reported on the partners' individual tax returns only if they receive the proceeds from the sale.

A. The income will retain its character and be reported as a long-term capital gain.

Bart sold a parcel of land for $21,000. He paid a real estate agent a commission of $1,500 for assisting with the sale. Bart had purchased the land several years earlier for $20,000. What is the amount realized on the sale of the land? Multiple choice questions. A. $21,000 B. ($500) C. $1,000 D. $19,500

Amount realized = Sales proceeds minus selling expenses. D. $19,500

Action Sport is an S corporation owned equally by three shareholders. During the current year, Action Sport generated taxable income of $60,000. What is the tax treatment, if any, of the $60,000 income? Multiple choice question. A. Action Sports will report and pay tax on $60,000. B. Each shareholder will report the portion of income that he or she receives in cash, and Action Sport will pay tax on the remaining income. C. S corporations are tax-exempt entities, so there is no tax liability resulting from Action Sport's operations. D. Each shareholder will report $20,000 in taxable income.

D. Each shareholder will report $20,000 in taxable income.

Abby sold a parcel of land for $18,000. She paid a real estate agent a commission of $1,200 for assisting with the sale. Abby had purchased the land several years earlier for $14,500. What is the gain on the sale of the land? A. Gain of $3,500 B. Gain of $16,800 C. Gain of $18,000 D. Gain of $2,300

D. Gain of $2,300

Educational Expenses

Earnings on investments in plans such as 529 plans, Coverdell savings accounts, and U.S. Series EE bonds are excluded from taxation if the proceeds are used for qualifying expenses

Nonrecognition provisions refer to specific types of income that taxpayers realize but are allowed to permanently _______ from gross income or temporarily ________ until a later period.

Exclude/defer

True or false: Darlene owns stock in several different companies. When she received a dividend check from her Avatar stock, she endorsed the checks and deposited the money in her daughter's checking account. Consequently, her daughter will be assessed the tax on the dividends.

False Reason: The assignment of income doctrine states that the owner of income-producing property must pay tax on the income from the property.

Which of the following options is NOT available to taxpayers who have worked outside the United States and meet the requirements necessary to receive tax relief on their foreign earnings? A. Tax credit for foreign taxes paid B. Income exclusion for foreign-earned income C. Tax deduction for foreign-earned income D. Tax deduction for foreign taxes paid

Tax deduction for foreign-earned income Reason: Tax deductions are available for taxpayers who worked outside the US and meet the requirements necessary to receive tax relief on their foreign earnings.

Municipal Bonds

The interest on these bonds is excluded from federal income taxation.

Which of the following terms is used to refer to income from property? A. Exempt income B. Earned income C. Unearned income D. Deferred income

Unearned income

Which of the following items is income from services? A. Dividend income B. Royalty income C. Interest income D. Wage income

Wage income

Which of the following types of imputed income are NOT included in gross income (i.e. are NOT taxable)? a. A bargain purchase between a father and his son b. An employer's $12,000 loan to an employee with no interest on the note c. Employee discounts of 25% on services

a. A bargain purchase between a father and his son

Any reimbursement a taxpayer receives from a medical or accident insurance policy for medical expenses paid by the taxpayer during the current year (taxable/nontaxable) for the taxpayer.

nontaxable

Life insurance proceeds may be included in gross income when ______.

proceeds are paid over time and a portion represents taxable interest payments a life insurance policy is transferred to another party for valuable consideration

Foreign-Earned Income

-A maximum of $107,600 (2020) of foreign-earned income can be excluded from gross income for qualifying individuals. -A maximum of $15,064 (2020) of employer-provided foreign housing also may be excluded (but only to the extent that costs exceed $17,216 (2020)). -To be eligible for the foreign-earned income and housing exclusions, the taxpayer must have her tax home in a foreign country and (1) be considered a resident of the foreign country by living in the country for the entire year (calendar year) or (2) live in the foreign country for 330 days in a consecutive 12-month period.

True or false: Scholarships received by college students qualify as gifts and are, therefore, nontaxable. The actual use of the money (tuition, fees, housing, meals, and any other expenses) does not affect the taxable status of the scholarship.

False Reason: Scholarships that pay for tuition, fees, books, supplies, and other equipment required by the student's courses are excluded from the gross income. Housing is taxable

assignment of income doctrine

This doctrine holds that the taxpayer who earns income from services must recognize the income, and the income from property is taxed to the person who owns the property.

True or false: Gross income only includes income received in cash because cash is a measurable change in wealth. True false question.

True Reason: Gross income includes income realized in any form - money, property, or services.

Prizes, Awards, and Gambling Winnings

•Excluded only if made 1)For scientific, literary, or charitable achievement under certain conditions 2)For employee length of service or safety achievement ($400 tangible property limit per employee per year) To Team USA athletes from U.S. Olympic Committee on account of their competition in Olympic and Paralympic games (AGI limit applies

Life Insurance Proceeds exclusions do not apply when:

•Exclusion generally does not apply when (a) a life insurance policy is transferred to another party for valuable consideration or (b) taxpayer cancels life insurance contract and receives proceeds in excess of previous premiums paid. •Exclusion available for accelerated death benefits in certain circumstances

When to recognize income?

•Individual taxpayers file tax returns for a calendar-year period •Corporations often use a fiscal year-end •The method of accounting generally determines the year in which realized income is recognized and included in gross income

Deferral Provisions

-Allow taxpayers to defer (but not permanently exclude) the recognition of certain types of realized income -Transactions generating deferred income include •Installment sales •Like-kind exchanges •Involuntary conversions, and •Contributions to non-Roth qualified retirement accounts

Annuities

-An investment that pays a stream of equal payments over time -A portion of each annuity payment as a nontaxable return of capital and the remainder as gross income -Taxpayers use the annuity exclusion ratio to determine the return of capital (nontaxable) portion of each payment -Annuity exclusion ratio = original investment/ expected value of the annuity

Education-Related Exclusions

-As an incentive for taxpayers to participate in higher education, Congress excludes certain types of income if the funds are used for higher education.

Exclusions That Mitigate Double Taxation

-Congress provides certain exclusions to eliminate the potential double tax that may arise for: -gifts and inheritances -life insurance proceeds -foreign earned income

Alimony

-For tax purposes it is defined as 1. A transfer of cash made under a written separation agreement or divorce decree 2. The separation or divorce decree does not designate the payment as nonalimony. 3. In the case of legally separated (or divorced) taxpayers under a separation or divorce decree, the spouses do not live together when the payment is made. 4. The payments cannot continue after the death of the recipient.

Income from property (unearned income)

-Includes gains or losses from sale of property, dividends, interests, rents, royalties, and annuities -Depends on type of income and type of transaction generating income

Recovery of amounts previously deducted

-Individuals typically claim deductions in the year paid -Deductions may sometimes be reimbursed or refunded in a subsequent year

Constructive Receipt

-Taxpayer must realize and recognize income when it is actually or constructively received -Deemed to occur when the income is credited to the taxpayer's account or when income is unconditionally available to the taxpayer, the taxpayer is aware of the income's availability, and there are no restrictions on the taxpayer's control over the income.

Recognition (when to recognize gross income)

-Taxpayers who realize an economic benefit must include the benefit in gross income unless a specific provision of the tax code says otherwise. -Realized income is assumed to be recognized absent a deferral or exclusion provision

Assignment of Income

-The assignment of income doctrine holds that the taxpayer who earns income from services must recognize the income. -Income from property such as dividends and interest is taxable to the person who actually owns the income-producing property. -To shift income from property to another person, a taxpayer must also transfer the ownership in the property to the other person.

Return of Capital Principal

-The cost of an asset is called tax basis -Return of capital means the tax basis is excluded when calculating realized income §Return of capital does not represent an economic benefit -Gain from the sale or disposition of an asset is included in realized income

Why does Congress allow certain types of income to be excluded or deferred?

-To subsidize or encourage particular activities -To mitigate inequity

Single taxpayers

1)If modified AGI + 50% of Social Security benefits ≤ $25,000, Social Security benefits are not taxable. 2)If $25,000 < modified AGI + 50% of Social Security benefits ≤$34,000, taxable Social Security benefits are the lesser of (a) 50% of the Social Security benefits or (b) 50% of (modified AGI + 50% of Social Security benefits − $25,000 3)If modified AGI + 50% of Social Security benefits > $34,000, taxable Social Security benefits are the lesser of (a) 85% of Social Security benefits or (b) 85% of (modified AGI + 50% of Social Security benefits − $34,000), plus the lesser of (1) $4,500 or (2) 50% of Social Security benefits.

Andrea owed $12,000 on a medical bill to University Hospital. The hospital agreed to discharge the debt due to Andrea's financial situation. Immediately prior to the discharge of the debt, Andrea's debts exceeded her assets by $5,000. How much of the debt forgiveness will Andrea need to include in her gross income? Multiple choice question. A. $5,000 B. $7,000 C. $0 D. $12,00

Answer: $7,000 Reason: By forgiving $12,000 in debt, Andrea will be solvent by $7,000, so she should include $7,000 in gross income.

Which of the following statements are correct? (Check all that apply.) Multiple select questions. A. When taxpayers sell non-depreciable assets, they may exclude the original cost of those assets from gross income. B. A taxpayer must recognize cash received in exchange for services rendered, but NOT property or services if they were received instead of cash. C. Taxpayers who exchange or trade goods or services with each other must recognize the increase in the value of the goods or services as income. D. If a taxpayer receives a state tax refund for a tax year where she deducted the state tax paid, she must report the refund as gross income. E. A current year insurance reimbursement of prior year medical expenses is recognized even if the expenses were NOT deducted in the prior year.

Answer: A, C & D •When taxpayers sell non-depreciable assets, they may exclude the original cost of those assets from gross income. •Taxpayers who exchange or trade goods or services with each other must recognize the increase in the value of the goods or services as income. •If a taxpayer receives a state tax refund for a tax year where she deducted the state tax paid, she must report the refund as gross income.

Which of the following statements are correct? (Select all that apply) A. A current year insurance reimbursement of prior year medical expenses is recognized even if the expenses were NOT deducted in the prior year. B. When taxpayers sell non-depreciable assets, they may exclude the original cost of those assets from gross income. C. If a taxpayer receives a state tax refund for a tax year where she deducted the state tax paid, she must report the refund as gross income. D. Taxpayers who exchange or trade goods or services with each other must recognize the increase in value of the goods or services as income. E. A taxpayer must recognize cash received in exchange for services rendered, but NOT property or services if they were received instead of cash.

Answer: B, C, D •When taxpayers sell non-depreciable assets, they may exclude the original cost of those assets from gross income. •If a taxpayer receives a state tax refund for a tax year where she deducted the state tax paid, she must report the refund as gross income. •Taxpayers who exchange or trade goods or services with each other must recognize the increase in value of the goods or services as income.

What is the tax treatment for a taxpayer receiving a gold watch valued at $350 in recognition of his 25th year of working for the same company? Multiple choice question. A. The value of the watch is included from gross income. B. The value of the watch is only excluded from gross income if the taxpayer donates it to a charitable organization. C .The value of the watch is excluded from gross income. D. One-half of the value of the watch must be included in gross income.

C. The value of the watch is excluded from gross income. (The nontaxable awards are limited to $400/year of tangible property other than cash or cash equivalents)

Assignment of Income Doctrine

The doctrine holds that the taxpayer who earns income from services must recognize the income, and the income from the property is taxed to the person who owns the property. (Requires income to be taxed to the taxpayer who actually earns it).

During the current year, Sam received interest income from the following investments: $400 from State of Wyoming bonds, $200 from Ford Motor Co., $50 from City of Laramie bonds, $100 from U.S. Treasury bonds. How much of the interest received will be included in gross income? a. $700 b. $600 c. $300 d. $200

c. $300 Reason: $300 - The State of Wyoming and City of Laramie bonds are not taxable.

Alimony/Spousal Support

§For divorce or separation agreements executed before January 1, 2019, alimony is included in gross income of the recipient and deductible for AGI by the payor. §For divorce or separation agreements executed after December 31, 2018, alimony is not taxable to the recipient or deductible by the payor.

Which of the following statements are INCORRECT regarding the receipt of Social Security benefits? A.Up to 85% of Social Security benefits may be taxed to taxpayers with moderate to high taxable income. B. 50% of Social Security benefits are taxable to all taxpayers because the employer contributed funds that were never taxed to the employee. C. Social Security benefits are not taxable if the recipient has relatively low taxable income. D. Social Security benefits are not taxable because the contributions were taxed when the taxpayer was working.

•50% of Social Security benefits are taxable to all taxpayers because the employer contributed funds that were never taxed to the employee. •Social Security benefits are not taxable because the contributions were taxed when the taxpayer was working.

Disability Insurance

•Also called wage replacement insurance •Pays the insured individual for wages lost when the individual misses work due to injury or disability •If an individual purchases disability insurance directly, any disability benefits are excluded from gross income. •If the individual's employer purchases the disability insurance and the individual excludes the benefit from her compensation, then disability benefits are taxable.

Life Insurance Proceeds

•Amounts received due to the death of the insured are excluded from the income of the recipient. •Similar to inheritances, life insurance proceeds are typically subject to the federal estate tax. •If the proceeds are paid over a period of time rather than in a lump sum, a portion of the payments represents interest and must be included in gross income.

Payments Associated with Personal Injury

•Awards that relate to physical injury or sickness or are payments for the medical costs of treating emotional distress are excluded from gross income. •Other payments including punitive damages are fully taxable.

Imputed Income

•Certain employee discounts or low-interest loans generate income via indirect benefits. •For low-interest loans, the amount of imputed income is the difference between the amount of interest using the applicable federal interest rate, and the amount of interest the taxpayer actually pays.

Economic Benefit (When to recognize gross income)

•Common examples include: -compensation for services in the form of cash, other property or even services received. -Proceeds from property sales (typically cash, property, or debt relief). -Income from investments or business activities (such as business income, rents, interest and dividends). • Borrowed funds represent a liability, not gross income

Which of the following choices are characteristics of qualified tuition programs, also known as 529 plans?

•Distributions made to the beneficiary for purposes other than education are taxable and incur a penalty on the plan earnings. •Earnings on the account are NOT taxable if used for qualified education expenses. •The distributions can be made for tuition expenses for kindergarten through 12th grade.

Which of the following payments to a taxpayer should be included in gross income? A. Emotional distress damages awarded due to slander of the taxpayer's reputation B. Emotional distress damages awarded due to injuries from a car accident C. Compensatory damages for lost wages awarded in a sex discrimination lawsuit D. Punitive damages awarded after an accident at work where the taxpayer sustained a non-physical injury E. Compensatory damages awarded for lost wages due to injuries sustained in a fall at the grocery store

•Emotional distress damages awarded due to slander of the taxpayer's reputation •Compensatory damages for lost wages awarded in a sex discrimination lawsuit •Punitive damages awarded after an accident at work where the taxpayer sustained a non-physical injury

Income from flow-through entities

•Individuals may invest in various business entities •The legal form of the business affects how the income generated by the business is taxed •If the entity is a flow-through entity such as a partnership or S corporation, the income and deductions of the entity "flow through" to the owners of the entity (partners or shareholders

Gifts and Inheritances

•Individuals may receive property as gifts or from a decedent's estate (an inheritance). •While the receipt of property is most certainly real income to the recipient, the value of gifts and inheritances is excluded from gross income because these transfers are subject to a federal gift and estate tax.

Social Security Benefits

•Taxable up to 85 percent of Social Security benefits in gross income depending on the taxpayer's filing status, Social Security benefits, and modified AGI •Modified AGI is regular AGI (including 50 percent of Social Security benefits) plus tax-exempt interest income, excluded foreign income, and certain other deductions for AGI.

Other Educational Subsidies

•Taxpayers are allowed to exclude from gross income earnings on investments in qualified education plans such as 529 plans and Coverdell education savings accounts as long as they use the earnings to pay for qualifying educational expenditures. •Taxpayers can elect to exclude interest earned on Series EE savings bonds when the redemption proceeds are used to pay qualified higher-education expenses. •The exclusion of interest on Series EE savings bonds is restricted to taxpayers with modified AGI below specific limits

Imputed interest rules

•The borrower is deemed to pay imputed interest (interest expense to borrower, interest income to lender), and then the lender is deemed to have returned the imputed amount (the tax consequences depend on relationship between borrower and lender) •Imputed interest rules do not apply to aggregate loans of $10,000 or less between the lender and borrower

Which of the following rules must be met for a taxpayer to be able to exclude the gain on the sale of a personal residence? A. The taxpayer must have used the property as their principal residence for a total of two or more years during the five year period prior to the sale. B. he taxpayer must NOT have used the gain exclusion provision in the five years prior to the sale. C. The taxpayer must have owned the residence for at least two years of the five year period prior to the sale. D. If married, both spouses must meet the ownership and principal-use tests.

•The taxpayer must have used the property as their principal residence for a total of two or more years during the five year period prior to the sale. •The taxpayer must have owned the residence for at least two years of the five year period prior to the sale.

Who (which taxpayer) recognizes the income?

•This question arises when an income-shifting strategy is involved -Assignment of income -Community property systems

Discharge of Indebtedness

•When a taxpayer's debt is forgiven by a lender, the taxpayer must usually include the amount of debt relief in gross income. oExceptions exist for certain types of loans. •To provide tax relief for insolvent taxpayers—taxpayers with liabilities, including tax liabilities, exceeding their assets—a discharge of indebtedness is not taxable. •If the discharge of indebtedness makes the taxpayer solvent, the taxpayer recognizes taxable income to the extent of his solvency