Acc 331 Chapter 4 Notes

ACC 331 Spring 2016

Class Notes

Chapter 4

Gross Income

1. Components of the Tax Formula

2. Gross Income – What is Income?

The Internal Revenue Code (IRC) §61 states:

“Except as otherwise provided in this subtitle, gross income means income from whatever source derived”

Tax law does not provide a proper definition of income, probably deliberate to leave open the inclusion of new forms of income (e.g., gains from financial derivatives)

Whatever source derived – includes all types of income (business profits, capital gains, etc.) and all locations (domestic or foreign)

Specific forms of income mentioned in the IRC include:

compensation for services,

business income,

gains from sales or other disposition of property,

interest,

dividends,

rents and royalties,

income from partnerships

Three 3 Basic Questions to consider if taxpayer needs to report income:

1) Was there an increase in wealth?

2) Was the increase in wealth realized?

3) Does the increase in wealth have to be recognized?

Economic Income – Economist measure income as an increase in net wealth (either through an increase in net worth or consumption)

Realization principle - Change in net wealth is “income” but difficult to measure, so income is included when there is a “realization event” (results from a transaction giving up ownership rights)

A realization event occurs if there is:

1. Taxpayers engages in a transaction with another party, and

2. Transaction results in a measurable change in ownership rights

Benefits of realization event:

1. Parties agree on price, so income is measured objectively

2. Transaction often provides taxpayer the wherewithal to pay tax

Recognition – Once realized, the reporting of income is mandatory unless specific provision of Code says otherwise.

Form of receipt – income does not have to be in the form of cash. It can be property, services, bartering, etc. as long as the item received as economic value.

EXAMPLE 1:

Hogwart Corporation invests $100,000 in stocks, at the end of the year the stocks have appreciated to $150,000.

a) What is Hogwart Corp’s economic income with regards to the stock?

b) Does Hogwart Corp have to report any income to the IRS?

Assume Hogwart Corp sold the stocks at the year end.

c) What is Hogwart Corp’s realized income?

d) How much does Hogwart Corp have to recognized on its tax return?

EXAMPLE 1 cont’d

Instead of selling the stock, assume Hogwart Corp transferred the stock at year end to the CEO as part of her compensation package. CEO plans to retain stock for the long-term.

e) What are the tax consequences for Hogwart Corp from the transfer?

f) Are there any tax consequences for the CEO?

Return of capital principle – Repayment of principal or the recovery of capital invested in property is not considered income.

This will be a very important principle in Chapters 7 and 8 when we look at property transactions

EXAMPLE 2:

Megan LLP purchased a piece of land for $10,000 in 2003. In 2015, Megan LLP sold the land in an arm’s length transaction for $18,000. What is the gain on the transaction?

EXAMPLE 3:

Brooks Corporation sells designer luggage to the US market. In 2015, Brooks generates sales of $350,000 on luggage with cost of $190,000. What is Brooks Corporation’s income for the year for tax purposes?

Tax benefit rule - If a taxpayer receives a refund for deduction she claimed in a prior year, then that refund is reported as income to the extent the taxable income in the prior year would have been higher had she not claimed the deduction

For example, if you took a deduction for medical expenses last year, and the hospital refund you $1,000 this year, then you report the $1,000 as income on this year’s tax return to the extent your taxable income would have been $1,000 higher had you not claimed that $1,000. You do not amend the prior year’s tax return.

General rule, (1) figure out how much higher your taxable income would have been if you had not claimed the refunded amount in the prior year, this is referred to as the tax benefit. then (2) recognize/report the lesser of the tax benefit or the amount of money refunded on your current year tax return.

EXAMPLE 4:

In 2014, MegaCorp, an accrual taxpayer, deducted as a loss a $1,000 receivable from a customer when it appeared the amount would never be collected. In 2015, the customer paid $800 on the receivable.

a) What are the tax consequences to MegaCorp in 2015?

b) What are the tax consequences in 2015 if MegaCorp had made