Chapter 2 Income Tax Concepts Federal income taxation is based on a system of rules and regulations that determine the treatment of various items of income and expense Concept a broad principle that provides guidance on the income tax treatment of transactions Construct a mechanism that has been developed to implement a concept Doctrine a construct that has been developed by the courts General Concepts o Ability to Pay Concept States that the tax levied on a taxpayer should be based on the amount that the taxpayer can afford to pay The income tax base is a net income number income deductions and losses Uses a progressive tax rate structure o Administrative Convenience Concept States that items may be omitted from the tax base whenever the cost of implementing a concept exceeds the benefit of using it Also allows taxpayers to take a standard deduction in lieu of accumulating the information necessary to deduct the actual allowable deductions o Arm s Length Transaction Concept One in which all parties have bargained in good faith and for their individual benefits not for the benefit of the transaction group Related Party Provisions designed to prevent unwarranted tax avoidance by related parties The provision regarding losses disallows losses on sales between related parties o Losses can NOT be deducted Require an accrual basis taxpayer to use a cash method of accounting for expenses that are paid to a cash basis related party Common Related Party Relationships o Family Members spouse siblings descendants and ancestors o Individuals and a Corporation or partnership if the individual owns more than 50 of the corporation o A corporation and a partnership if the same person owns more than 50 of both the corporation and the partnership Constructive Ownership Rules state the relationships within which an individual is deemed to indirectly own an interest actually owned by another person or entity o Pay as You Go Concept Requires taxpayers to pay tax as they generate income Introduced in 1943 during WW2 Implemented through withholding and estimated tax payment requirement The withholding provisions require employers to withhold amounts from each employee s paycheck to pay the tax on the income in that check Individual taxpayers are required to make quarterly estimated tax payments when their estimated tax due for the year is at least 1000 Corporations must also file quarterly estimated tax payments Failure to make the required estimated tax payments will result in a penalty for underpayment of estimated taxes o Guide the proper accounting for and recording of transactions that affect the tax liability Accounting Concepts of taxpayers o Entity Concept Most basic Each tax unit must keep separate records and report the results of its operations separate and apart from other tax units 2 basic entity types Taxable Entities those that are liable for the payment of tax o Must pay a tax based on their taxable income o Consist of 4 entities Individuals Regular C Corporations Estates Some Trusts Conduit Entities o Nontaxable reporting entities o The tax attributes of the entity flow through the entity to the owner s of the entity for tax purposes o The entities record transactions undertaken by the entity and report the results to the government o Pass Through Entity The tax characteristics of the operating results are passed through the conduit entity and are taxed to its owners o Not useful in income shifting strategies o 3 types Partnerships Subchapter S Corporations Sole Proprietorship Trusts are a mixture of both o They are taxed on income that is retained and are not taxed on income that is distributed Assignment of Income Doctrine All income earned from services provided by an entity is to be taxed to that entity and income from property is to be taxed to the entity that owns the property o Annual Accounting Period Concept States that all entities must report the results of their operations on an annual basis and that each taxable year is to stand on its own apart from other tax years 2 Basic Accounting Periods Calendar Year ends December 31 Fiscal Year end on the last day of any other month the taxpayer chooses Accounting Method 2 methods o Cash Basis of Accounting Taxpayers are taxed on income as it is received and take deductions as they are paid o Accrual Basis of Accounting Taxpayers report their income as it is earned and take deductions as they are incurred without regard to the actual receipt or payment of cash Tax Benefit Rule Any deduction taken in a prior year that is recovered in a subsequent year is reported as income in the year it is recovered to the extent that a tax benefit is received from the deduction Substance over Form Doctrine Judicially created States that the taxability of a transaction is determined by the reality of the transaction rather than some possibly contrived appearance o The transaction is to be taken at its face value only when it has some business or economic purpose other than the avoidance of tax Income Concepts o All Inclusive Income Concept All income received is considered taxable unless some specific provision can be found in the tax law that excludes the item in question from taxation o Legislative Grace Concept States that any tax relief provided to taxpayers is the result of specific acts of Congress that must be applied and interpreted strictly Only Congress can grant an exclusion from income and the exclusion must be taken in its narrowest sense Capital Asset any asset that is not a receivable inventory real or depreciable property used in a trade or business or certain intangible assets such as copyrights Primarily consist of stocks bonds other investment related assets and personal use assets home furniture clothing automobile etc Capital Gain the gain from the sale of capital assets Net long term capital gains are given preferential treatment through a reduction in the tax rate that must be paid on this type of income o 0 if the taxpayer is in the 10 or 15 marginal tax rate bracket o 20 if the taxpayer is in the 39 6 marginal tax rate bracket o This is versus the top marginal tax rate of 39 6 for individual Capital Loss the loss from the sale of capital assets Only 3000 of the net capital loss can be deducted from an individual s taxpayers tax return per year Capital gains and losses must be separated from other gains and losses and aggregated through a prescribed netting procedure o Capital Recovery Concept Income States that no income