Chapter 4 – Gross Income

• Cash v Accrual (pages 4-1 to 4-17) …… “exceptions to”

• Community Property• Alimony / Child Support• Annuities• Prizes / Awards• Group Term Life• Gifts to Individuals and Employees• Social Security Benefits

Economic Income (vs Accounting)

• Bought House 1984 for $125,000 ……..

FMV today is $250,000.

Do I have taxable income?

• Bought 1,000 shs of Starbucks in 1992 for $10,000. FMV today is $150,000.

Do I have taxable income?

When is income RECOGNIZED?

There must be a transaction (sale) to have recognized income

Problem 29

Problem 30

Tax YearsCash Basis versus Accrual Basis

• Know the tax year (fiscal or calendar).• Issues: When was the income earned?

When was the payment received?

• Are we (individuals) cash basis taxpayers or accrual basis taxpayers?

Problem 31

Problem 41

Problem 35

Tax YearsCash Basis versus Accrual Basis (con’t)

• Example: Springs Inds. declares a dividend on December 15th (declaration date) for shareholders of record on December 20th (date of record). The dividend is paid on December 30th (payment date).

• Harry Emerson receives the dividend of $1,000 in the mail on January 3rd.

When is the dividend taxable to HBE?

Exceptions to Cash Basis

• Constructive Receipt Doctrine – income has not been received but taxpayer has the right to receive.

• Employee can “contract” for services that he has not yet earned. This is done prior to the beginning of the year.

• Note concept of Substantial Limitation.

Problem 35, 41

Exceptions to Cash Basis (con’t)

• Loans – loans are an exception to the cash basis of accounting and the constructive receipt of doctrine. Loans are not taxable. There is an obligation to repay. What if obligation is relieved?

i.e “forgiveness of indebtedness”

Problem 55

Exception to Accrual Basis

• Prepaid Income – included in income in the year of receipt …….. prepaid rent is the best example. Except for this exception, accrual basis taxpayers would not recognize income until it was “earned”.

• Advance Payment for Services – Income recognition is deferred if payment is made for services to be performed on or before the end of the tax year following receipt, but not more than one tax year beyond year of receipt.

example: Calendar year taxpayer. Payment received on July 1, 2003 for services to be performed over the next 36 months.

Income Sources (p. 3-14 to 3-16)

• Income and the resulting tax liability cannot be “assigned”. Lucas versus Earl

• Services performed by an employee for the employer is considered performed by the employer.

• Interest accrues daily on bonds, so when there is a sale, income has to be allocated.

• Dividends do not accrue daily ….. considered earned on the date of record. Corporations pay tax on earnings. Shareholders pay tax on dividends that are paid to them.

Problem 30

Income Sources (p. 3-14 to 3-16) con’t

• Agents – income received by an agent is considered received by the taxpayer.

• Partnerships, S-Corps, Trusts -- the entity is not taxed. Rather, the income and deductions are passed through to the partners, shareholders or beneficiaries.

Problem 42

Community Property States

• There are 10 “community property” states (mostly western states). The remaining states are “common law” states.

• Separately owned property – either acquired before the marriage or received during the marriage by gift or inheritance.

• Marital Property – All other property; that which is acquired during the marriage.

Problem 44

Community Property States (con’t)

• Wages belong to the community – split 50/50• Unearned income (interest & dividends) on

marital property is split 50/50.• Unearned income on separate property is

treated two different ways:• Texas – income is considered community

property despite the fact that the property is individually owned.

• California – income is not split 50/50, but is taxed to the spouse that owns the property

Alimony

• Income to the recipient and deductible for AGI by the payor.

• Must have characteristics of alimony versus a property settlement.

• Payments must be in cash.• Agreement does not say payments are not

alimony.• Payor and Payee do not live together.• Not required to be paid after death of recipient.

Problem 45

Problem 47

Child Support

• No income recognized by the recipient; no deduction to the payor.

• Payments usually ceases when child reaches majority.

Below Market Loans

• Below market amount is deemed to be income (or gift received) to the recipient and interest expense (or gift paid) by the lender.

• Government publishes going rate (Applicable Federal Rates or AFR). Note 3 different rates.

• Considered to be gifts between family members, compensation (W-2) between ER / EE, and dividend between shareholder / corp.

• Loans whose principle purpose is tax avoidance are not recognized by the Service.

Below Market Loans (page 4-26)

• Exception for loans between individuals of less than $10,000

• Exceptions for loans between individuals of less than $100,000 where investment income of the recipient is < $1,000.

• Exception for loans between corporation and employee where loan is < $10,000.

Annuties

• Purchaser pays a fixed amount for a future stream of payments. Income not recognized until the taxpayer begins to receive payments.

Example: Taxpayer purchases for $100,000 a 20 year annuity from an insurance company. The annuity pays taxpayer $1,000 per month for 24 months.

What is the basis?

What is the profit?

Workbook 10, 11, 12

Problem 23, 52

Recovery of Capital Doctrine – page 4-6

Annuities (continued)

• Same example …………• How much of each payment is includable in

income?• Assume annuity starts on October 15th, 2005.

How much income is included for 2005?

How much income is included for 2006?

• Investment X Annuity Payment = Exclusion

Expected Return

Problem 52

Annuities (continued)

• How do we handle lifetime annuities? (answer: use tables p. 4-29 and 4-30)

• What happens when the recipient outlives the life expectancy?

• What happens when the recipient dies early (what happens tax-wise)?

Age 54. Paid $90,000 for a lifetime annuity of $500 per month.

Taxation of Social Security

• For low income taxapayers (income < $25,000), social security is not taxable.

• For higher income taxpayers (say, income > $44,000), 85% of social security is taxable.

• There is a complicated formula in which part of the social security is taxable. The computer handles this fantastically.

• For purposes of calculating income, inlcude one-half of the social security benefit and tax free interest.

Prizes and Awards

• Generally, included in income.

• Exception:• Prize is in recognition of religious, charitable, et. al.

• Prize given to a nonprofit

• Recipient did not enter contest or apply for the prize

• Recipient not required to perform services.

• 2nd Exception:• Employee Achievement Awards ……… < $400

• Recognition for length of service or safety

Problem 53

Miscellaneous Other (p. 3-31)

• Group Term Life – First $50,000 of premiums tax exempt …… balance is added to W-2. See chart on p. 4-32.

• Unemployment Compensation – taxable

Workbook 15, 16