Chapter 2 Income Tax Concepts ©2008 South-Western Kevin Murphy Mark Higgins Kevin Murphy Mark...

Chapter 2Chapter 2

Income Tax ConceptsIncome Tax Concepts

©2008 South-Western©2008 South-Western©2008 South-Western©2008 South-Western

Kevin MurphyKevin MurphyMark HigginsMark Higgins

Kevin MurphyKevin MurphyMark HigginsMark Higgins

Transparency 2-2Transparency 2-2© 2008 South-Western© 2008 South-Western

Federal Income TaxationFederal Income Taxation

Based on a system of rules Developed around general concepts and

specific exceptions


TerminologyTerminology

Concept - a broad principleConstruct - a means to implement a

conceptDoctrine - a construct developed by the

courts

Concept

Construct Doctrine


General ConceptsAbility to Pay

General ConceptsAbility to Pay

Constructs usedDeductionsExclusionsCreditsProgressive tax rates

Tax should be based on an amount that a taxpayer can afford to pay.


General ConceptsAdministrative Convenience

General ConceptsAdministrative Convenience

Constructs used Standard deduction amountsFringe benefit exclusions

The benefit derived from a concept, construct or doctrine should always exceed the cost of implementation.


Administrative Convenience Example

Administrative Convenience Example

Bow Company allows its employees to make copies for personal reasons without charge on the company copy machine. The employees are not required to include the value of the copies in taxable income.


General ConceptsArms-Length Transaction

Concept

General ConceptsArms-Length Transaction

ConceptA transaction between related parties must reflect economic reality.

Constructs used Related-party provisionsConstructive ownership rules


Arms-Length Transaction Example

Arms-Length Transaction Example

Glenda sells 100 shares of IBM stock to her brother for $10,000. The shares had originally cost Glenda $12,000. Glenda is not allowed to use the $2,000 loss from the sale to reduce her taxable income.


General ConceptsPay As You Go Concept

General ConceptsPay As You Go Concept

Constructs usedWithholdingEstimated tax payments

Taxpayers are required to pay tax as they generate income.


Accounting ConceptsEntity Concept

Accounting ConceptsEntity Concept

Each tax entity must keep separate records and report operations separately.

Doctrine usedAssignment of

Income

Constructs usedTaxable entitiesConduit entitiesSole Proprietorships


Assignment of Income Doctrine

Assignment of Income Doctrine

All income earned from services provided by an entity or property owned by an entity are to be taxed to that entity.

Lucas v. Earl, 281 US 111


Assignment of Income Example

Assignment of Income Example

Alicia is a self-employed electrician. She deposits all cash payments she receives in a bank account in her son’s name. Alicia does not have use of the funds; however, she is required to include the amount of the cash payments in her gross income.


Accounting ConceptsAnnual Accounting Period

Concept

Accounting ConceptsAnnual Accounting Period

Concept Each taxpayer must select

A tax year Calendar Fiscal

An accounting method Cash Accrual Hybrid


Annual Accounting Period Concept

Constructs & Doctrines Used


Constructs & Doctrines Used Tax Benefit Rule: If a tax benefit is

derived from a deduction in one year, any refund received in a subsequent year must be reported as income.


Tax Benefit Rule ExampleTax Benefit Rule Example

Angelo had $4,000 of state income taxes withheld from his salary during 2006. He deducted the $4,000 as part of his itemized deductions on his 2006 federal return. On May 15, 2007, he received a refund of $1,000 from the state. When he files his 2007 federal return, Angelo will be required to report the $1,000 as income.


Substance-Over-Form Doctrine: A transaction must be realistic in an ordinary sense and not contrived merely to avoid tax.






Substance Over Form Example

Substance Over Form Example

Janet “hired” her 4-year old son as office manager for her real estate firm. When she filed her federal tax return she deducted $20,000 as Salary Expense for him. The IRS disallowed the deduction when they examined her return.


Income ConceptsAll-inclusive Income Concept

Income ConceptsAll-inclusive Income Concept

All income received is taxable unless a provision of the law specifically excludes it.

Example: After buying books at the beginning of the semester, Lori finds a $100 bill in the parking lot. The $100 is part of Lori’s gross income.


Income ConceptsLegislative Grace Concept

Income ConceptsLegislative Grace Concept

Constructs usedExclusions, deductions and creditsSpecial classifications such as capital

assets

Any tax relief provided is the result of specific acts of Congress which are applied and interpreted strictly.


Income ConceptsCapital Recovery Concept

Income ConceptsCapital Recovery Concept

Constructs usedBasisGains and Losses

A taxpayer may recover all invested capital before income is taxed.


Capital Recovery ExampleCapital Recovery Example

Nathan sold 200 shares of common stock for $2,000. Because he had paid $800 for the shares, he is required to report only $1,200 as income.


Income ConceptsRealization ConceptIncome Concepts

Realization Concept

Doctrines usedClaim of Right Doctrine

applies to accrual basis taxpayers

Constructive Receipt Doctrine applies to cash basis taxpayers

No income is recognized as taxable income until it has been realized by the taxpayer.


Realization ConceptDoctrines Used


Claim of Right Doctrine: Realization does not occur until an amount has been received without restriction.Applies when the taxpayer received payment but

there is a dispute regarding the taxpayer’s right to keep some or all of it.


Claim of Right ExampleClaim of Right Example

Clara rented her garage apartment to Jared and collected $450, the first-month’s rent, in advance. She also collected $500 as a security deposit that she will return to Jared if he doesn’t damage the apartment. She must report only $450 as income because she has no claim of right to the $500.


Constructive Receipt Doctrine is a modification that prevents cash basis

taxpayers from “turning their backs” on income

Realization is deemed to have occurred ifa taxpayer is aware an amount is available, the amount is unconditionally available (even

without physical possession), and receipt of the amount is within the taxpayer’s

control.




Constructive Receipt Example

Constructive Receipt Example

Sam is a self-employed handyman. Maria, one of his customers, brought a check for $250 on December 30, 2006, to pay for work Sam had finished. Sam asked her to mail the check instead, so he could check “delivery time.” Sam must report the $250 as income in 2006 even if the check isn’t delivered until 2007.


Income ConceptsWherewithal-to-Pay Concept

Income ConceptsWherewithal-to-Pay Concept

Constructs usedDeferralsRecognition of unearned income

Tax should be recognized and paid when the taxpayer has the resources to pay.


Deduction ConceptsLegislative Grace Concept

Deduction ConceptsLegislative Grace Concept

Any deduction allowed is the result of specific acts of Congress which are applied and interpreted strictly.


Deduction ConceptsBusiness Purpose Concept

Deduction ConceptsBusiness Purpose Concept

Only expenditures made in order to generate income and for a purpose other than tax avoidance will be deductible.

Examples:Trade or business expensesInvestment expenses


Business Purpose ExampleBusiness Purpose Example

Michael may not deduct depreciation on his personal-use automobile because he does not use it in his business.


Deduction ConceptsCapital Recovery Concept

Deduction ConceptsCapital Recovery Concept

Constructs usedBasisCapital expenditures

A taxpayer may deduct the amount of capital invested before income is reported.

Chapter 2 Income Tax Concepts ©2008 South-Western Kevin Murphy Mark Higgins Kevin Murphy Mark...

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