Chapter 3 Gross Income Inclusions Economic Accounting and Tax Concepts of Income o Economic o Income consumption change in wealth o Unrealized gains as well as gifts and inheritances are income o Adjusts for inflation in measuring income o Accounting o Income measured by a transaction approach Usually when it s realized in a transaction o Recognize report income expenses gains and losses that have been realized as a result of a completed transaction o Believe economic concept is too subjective for financial reporting Therefore traditionally used historical cost o Realization upon Change in form or substance of a taxpayer s property and Transaction with a second party o Tax o Three conditions for an amount to be taxable Must be economic benefit Not limited to cash payments Income must be realized Generally occurs when earnings process complete and transaction with another party takes place that permits the objective measure of the income Must be recognized Some items not taxable because of provisions in the law Law also contains exclusions that exempt specific types of income o A need for objectivity o Wherewithal to pay concept Tax should be collected when taxpayer is in best position to pay it Prepaid income subject to taxation at time it is collected rather than earned At time of collection taxpayer clearly has the cash available to pay tax o Gross income defined income from whatever source derived All sources are presumed to be taxable unless there is a specific exclusion in the law IRS does not have to prove an item is taxable Taxpayer must prove the item of income is excluded Not limited to amount received in cash May be realized in any form whether in money property or services Depends on whether taxpayer receives an economic benefit Rule covers barter transactions o Each party is taxed on value of the property or services received in the exchange o In general cost basis of property given up in barter transaction can be subtracted from value of property received to arrive at taxable amount Frequently an employer may make an expenditure in which its employees may incidentally or directly benefit Excludible if it is made to serve business needs of employer and benefit to employee is secondary and incidental Instances when not taxable fringe benefits To Whom is Income Taxable Assignment of Income o An individual is taxed on the earnings from his her personal services o Agreement to assign income does not permit person to avoid being taxed on income o Income from property is taxed to the owner of the property o To transfer income from property taxpayer must transfer ownership of property itself Allocating Income between Married People o Income allocated between husband and wife depending on state of residence o Generally taxed to individual who earns income either through labor or capital o Generally the only joint income in a common law state is income from jointly owned property Income of Minor Children system than child s o Earnings of a minor child are taxed to the child regardless of the state s property law o Unearned income of a child under 24 may be taxed at parents rate if it is higher o Alternatively parents may elect to include child on their return o Individual who earns income is the one that is taxed on it When is Income Taxable o IRS has power to change accounting method used by taxpayer if in the opinion of the IRS the method being used does not clearly reflect income o Regulations require taxpayers to use accrual method for determining purchases and sales when taxpayer maintains inventory o Cash Method o Used by most individuals and small businesses o Income reported in year taxpayer actually or constructively receives income rather than year the income is earned o Can be received by taxpayer or taxpayer s agent o Can be inform of cash other property or services o An accounts receivable or other unsupported promise is considered to have no value Therefore no recognition until cash is collected o Reporting prepaid income can have harsh results Not offset by related deductions Income taxed before expense incurred may not have enough cash to pay expense when incurred o Constructive receipt Means income made available to taxpayer so he she may draw upon it at any time Not constructively received if tax payer s control is subject to substantial limitations or restrictions Prevents taxpayers from deferring income otherwise available by turning back on it Cannot defer income recognition by refusing to accept payment till later taxable year Not constructively received if Subject to substantial limits restrictions Payor doesn t have funds to make payment Amount unavailable to taxpayer Exceptions to basic rule that taxpayer report when constructively received Interest on Series E and EE US savings bonds need not be reported till final maturity date Special rules for farmers and ranchers Small taxpayer exceptions for inventory o Hybrid Method o Combination of cash and accrual methods o Most often used by small businesses that maintain inventory and are required to use accrual method for purchase and sale of goods Use cash method for other items because it is simpler and may provide greater flexibility for tax planning Items of Gross Income o Compensation o Payment for personal services o Included salaries wages fees commissions tops bonuses and specialized o The fact that services are part time one time seasonal or temporary is forms immaterial o Are exclusions for variety of employer provided fringe benefits Group term life insurance premium Health and accident insurance premium Employee discount Contributions to retirement plans Educational benefits o Limited exclusion applicable to foreign earned income o Business income o In case of businesses that provide services gross business income is total o Manufacturing merchandising and mining gross income is total sales less o Gross income for tax purposes comparable to gross profit for financial amount received cost of goods sold accounting purposes o Cost of goods sold treated as return of capital and therefore not income o Gains from dealings in property o Gains realized from property transactions included in gross income unless non recognition rule applies o Taxpayer my deduct cost of property to arrive at gain from property transaction o Losses not offset from gains in computing gross income Most losses are deductions for AGI Net capital losses subject to provisions that limit amount that can be deducted to 3000 year