Chapter 2 Income Tax Concepts Instructor PowerPoint Slides Updated-August 9, 2013 Howard Godfrey,...

Chapter 2 Income Tax Concepts

Instructor PowerPoint SlidesUpdated-August 9, 2013

Howard Godfrey, Ph.D., CPA

Professor of Accounting ©Howard Godfrey-2013

Part 1. IntroductionPart 2. General Concepts (ability to pay, administrative convenience, arms-length, pay-as-you-go)Part 3. Accounting Concepts (entity, assignment of income, annual accounting period, accounting method, tax benefit rule, substance-over-form)Part 4. Income Concepts (all inclusive, legislative grace, capital recovery, realization, claim of right, constructive receipt, wherewithal to pay)Part 5. Deduction Concepts (legislative grace, business purpose, capital recovery)

2. General Concepts

Ability-to-Pay

Admin. Convenience

Arm's-Length Trans.

Pay-as-You-Go

Part 2. General Concepts: Ability to pay.Should a person’s tax liability be based on income or ability to pay? Suppose an individual has a salary of $100,000, and has uninsured medical expenses of $80,000. Should the income tax liability be related to $100,000 or $20,000?

Part-2. General Concepts: administrative convenienceMichael coaches a little league baseball team. He uses his employer’s copy machine (with employer consent) to makes 15 copies of the team’s schedule to give to the players. Does Michael include the cost (or value) of the copies in his income?

Part 2. General Concepts: arms-length.Susan purchased a lot for investment purposes. She paid $10,000 for the lot. Three years later she sold the lot to her daughter for its current value of $8,000. May Susan deduct the loss?

Part 2. General Concepts: pay-as-you-go.Thomas earns a salary of $200,000 and $40,000 was withheld from his paycheck for federal income tax.Sally earns interest income of $200,000 per year, but does not have any income tax withheld. How (when) will Sally per her income taxes?

Concepts

Entity

Acct. Period

3. Accounting

Part 3. Accounting Concepts: Entity Concept.Ben paid $60,000 on 1-1-2013 for 5% of the stock of Big Corporation, which is a C corporation.Ben earned a salary of $200,000 from Big Corp. Big Corp. had net income of $100,000 in 2012. Ben received dividends of $1,000 from Big. Corp. Ben paid $30,000 on 1-1-2013 for a 25% interest in BCD partnership, which owns rental property. BCD’s revenue of $90,000 & expenses was $50,000. No salary or guaranteed payment was made to any partner. Ben withdrew $4,000 from BCD. He has no deduction “for AGI?” What is Ben’s AGI a. $204,000 b. $211,000 d. Other

Big Corporation is a C Corporation Ben'sBen paid $60,000 for Big Corp. stock on 1-1-13. ReturnBig Corp. paid salary to Ben $200,000 ?

Ben's ownership of Big Corp. 5%

Big Corporation's net income $100,000 ?

Ben's dividend from Big Corp. $1,000 ?

Ben paid $30,000 for capital in BCD Ptshp on 1-1.BCD Partnership Rent Revenue $90,000

BCD Partnership expenses $50,000

BCD Partnership net income $40,000

Ben's ownership of BCD Ptshp 25% ?

Ben's withdrawal from BCD $4,000

Ben's Adjusted Gross Income ?

(Ignore deduction for self-employment tax.)Ben's basis in corporation at 12-31-2013? ?

Ben's basis in partnership at 12-31-2013? ?

Big Corporation is a C Corporation Ben'sBen paid $60,000 for Big Corp. stock on 1-1-13. ReturnBig Corp. paid salary to Ben $200,000 $200,000


Big Corp's net income $100,000

Ben's dividend from Big Corp. $1,000 $1,000

Ben paid $30,000 for capital in BCD Ptshp on 1-1.BCD Partnership Rent Revenue $90,000



Ben's ownership of BCD Ptshp 25% $10,000


Ben's Adjusted Gross Income $211,000

(Ignore deduction for self-employment tax.)Ben's basis in corporation at 12-31-2013? $60,000

Ben's basis in partnership at 12-31-2013? $36,000

Part 3. Accounting Concepts: Entity Concept.Use the information on the preceding slide. Assume Big Corp. is an “S” corp.What is Ben’s AGI, assuming he has no deduction “for AGI?”a. $215,000 b. $212,000 d. Other

Ben'sPart-2. Acctg Concepts- Entity Facts ReturnBig Corp. paid salary to Ben $200,000 ?


Big Corp's net income $100,000 ?

Ben's dividend from Big Corp. $1,000 ?

BCD Partnership Rent Revenue $90,000



Ben's ownership of BCD Ptshp 25% ?


Ben's Adjusted Gross Income ?

Ignore the deduction for self-employment tax

Big Corporation is an S Corporation

Ben'sPart-2. Acctg Concepts- Entity Facts ReturnBig Corp. paid salary to Ben $200,000 $200,000


Big Corp's net income $100,000 $2,000

Ben's dividend from Big Corp. $1,000

BCD Partnership Rent Revenue $90,000



Ben's ownership of BCD Ptshp 25% $10,000


Ben's Adjusted Gross Income $212,000

Ignore the deduction for self-employment tax

Big Corporation is an S Corporation

Part 3. Accounting Concepts: Assignment of income Sam owns land that he rents to a farmer for $1,000 per month. He received $1,000 each of the first ten months of the year. Sam instructed the farmer to send the last two month's rent to his mother. How much rental income should Sam report for the year?a. $10,000 b. $12,000 c. Other

Part 3. Accounting Concepts- Annual accounting period and method.In Year 1, Jan began a new business called J-Corp. The company’s cash basis fin. statements are on next slide (in $000). At the end of the first year. J-Corp. had Accounts Receivable of $100,000 from customers, and Accounts Payable for utilities of $10,000.(Cash basis – these items not recorded.)What is accrual basis net income for Year 1? a. $130,000 b. $220,000 c. Other

Cash $250 Revenue $900 Land 180 Deprec. exp.100 Bldg. & Equip. 500 Other exp. 670 $770 Accum. Dep. (100) 400 Net Income $130

Total Assets $830 Bank Loan $200 Begin. Balance $0 Capital Stock 500 Net Income 130 Ret. Earnings 130 630 Less: dividends 0 Debt & equity $830 Ending Balance $130

Balance Sheet-12-31-2013 Income Statement-2013

Retained Earn. Statement

J-Corp. ($000)(Cash Basis Statements)

Year-end balances in: 2013Customer Accounts Receivable $100,000Accounts Payable $10,000

Cash basis net income Revenue (cash collected) $900,000Expenses (cash payments) (770,000)

Net Income (cash basis) $130,000Convert to accrual basis

Adjust for ending receivablesAdjust for ending payables

Accrual Basis net income

J-Corp. Ignore income taxes

Year-end balances in: 2013Customer Accounts Receivable $100,000Accounts Payable $10,000

Cash basis net income Revenue (cash collected) $900,000Expenses (cash payments) (770,000)

Net Income (cash basis) $130,000Convert to accrual basis

Adjust for ending receivables $100,000Adjust for ending payables ($10,000)

Accrual Basis net income $220,000

J-Corp. Ignore income taxes

Year-end balances in: 2013 2014Customer Accts. Receivable $100,000 $120,000Accounts Payable $10,000 $7,000

Cash basis net income Revenue (cash collected) $900,000 $990,000Expenses (cash payments) (770,000) (790,000)

Net Income (cash basis) $130,000 $200,000Convert to accrual basis

Adjust for receivables $100,000Adjust for payables ($10,000)

Accrual Basis net income $220,000

Continue J-Corp. Ignore income taxes

Year-end balances in: 2013 2014Customer Accts. Receivable $100,000 $120,000Accounts Payable $10,000 $7,000

Cash basis net income Revenue (cash collected) $900,000 $990,000Expenses (cash payments) (770,000) (790,000)

Net Income (cash basis) $130,000 $200,000Convert to accrual basis

Adjust for receivables $100,000 $20,000Adjust for payables ($10,000) $3,000

Accrual Basis net income $220,000 $223,000


2013 2014 TotalYear-end balances in:

Customer Accts. Rec. $100,000 $120,000Accounts Payable $10,000 $7,000

Cash basis net income $130,000 $200,000 $330,000Convert to accrual basisAdjust for receivables $100,000 $20,000Adjust for payables ($10,000) $3,000

Accrual Basis net income $220,000 $223,000 $443,000

Less Ending Receivables ($120,000)Add Ending Payables $7,000Cash basis net income $330,000


Compare cash basis and accrual basisOver the life of a business, total cash basis net income will equal total accrual basis net income.Differences between cash basis and accrual basis net income in current year are timing differences.A company using the accrual basis in its GAAP financial statements, may find that the tax law requires a modified form of accrual basis on the tax return, causing timing differences. Permanent differences will arise when an expense is never deductible on the tax return, etc. Page C-25

Causes which to be higher?Cash Basis Accrual Basis

Revenue or Expense Amount Net Income Net IncomeRevenue earned this year,

not collected this year $100,000

Revenue collected this year,

not earned this year $100,000

Expense paid this year,

not incurred this year $100,000

Expense incurred this year,

not paid this year $100,000

Increase in deferred revenue $100,000

Compare Accrual & Cash Basis



not collected this year $100,000 $100,000


not earned this year $100,000


not incurred this year $100,000


not paid this year $100,000

Increase in deferred revenue $100,000




not collected this year $100,000 $100,000


not earned this year $100,000 $100,000


not incurred this year $100,000 $100,000


not paid this year $100,000 $100,000

Increase in deferred revenue $100,000 $100,000


Part 3. Accounting Concept: Tax benefit ruleIn 2013, Ms. Jones (single) earned a salary of $60,000. She deducted the following expenses on their 2013 income tax return: state income taxes of $4,000, mortgage interest of $6,000 and real estate taxes amounting to $2,000. She has three small children whom she supports. (see next slide)

She receives a state income tax refund of $1,000 in 2013, for 2014. How much income does she report from this refund? a. $1,000 b. $40 c. Other

Gross income $60,000

Deduct. for AGI

Adj. Gross Income 60,000

Less:

1a. Standard Ded. 8,950

1b. Itemized Ded. 12,000

(12,000)

2. Exemptions 3,900 15,600 (15,600)

Taxable Income $32,400

Tax Before Credits

Ms. Jones (single) 2013

Continue preceding case.Ms. Jones had itemized deductions of $12,000. If she had not deducted the state income taxes of $4,000, her itemized deductions would have been $8,000, and she would have deducted the $8,500 standard deduction. She did not benefit from all of the $4,000 in deduction for the state income tax. Her tax benefit was $3,500.She received a refund of $1,000, all of that is income. If she had received a $3,800 refund, she would include $3,500 in income.

Part 3. Accounting Concepts: Substance-over-formJan asked a friend, Bob, to suggest some individuals who might want to buy from the Jan’s business. Bob gave Jan a list of 20 wealthy individuals. Jan made substantial sales to individuals on that list. In appreciation for his help, Jan gave Bob a $3,000 airline ticket so that Bob could visit Bob’s mother in another country. What are the issues regarding Substance vs. Form here?

4. Income ConceptsAll-InclusiveLegislative GraceCapital RecoveryRealizationWherewithal-to-Pay

Part 4. Income Concepts: All inclusive.Every type of income received is included in gross income-- except where you can identify a provision of the tax law that allows that income to be excluded from gross income.

Part 4. Income Concepts: All inclusive.Juan earns a salary of $50,000. Juan has a garden in which he raises corn, tomatoes, etc.Juan gave a large amount of vegetables to the owner of a lawn service. In return, the lawn company mowed Juan’s yard weekly for 20 weeks, and did not charge its normal fee of $50 per mowing.What is Juan’s gross income for the year? a. $50,000 b. $51,000 c. Other Why?

Part 4. Income Concepts: Legislative graceBen earns a salary of $100,000 from Big Corporation. Ben bought some IBM stock two years ago at a cost of $20,000. This year, Ben sold the IBM stock for $50,000.How is the concept of legislative grace related to the method Ben will use to report this income and compute the applicable income taxes?

Part 4. Income Concepts: Capital recovery Ben earns a salary of $100,000 from Big Corporation. Ben bought some IBM stock two years ago at a cost of $20,000. This year, Ben sold the IBM stock for $50,000.How is the concept of capital recovery related to the method Ben will use to report this income and compute the applicable income taxes?

Part 4. Income Concepts: RealizationBen earns a salary of $100,000 from Big Corporation. Ben bought some IBM stock two years ago at a cost of $20,000. The IBM stock was worth $50,000 at the end of the current tax year.How is the concept of realization related to the method Ben will use to report this income and compute the applicable income taxes?

Part 4. Income Concepts: Claim of right – Slide 1.Realty Co. was organized on Jan-1, year 1.Bought a building on that date for $400,000. Building has 40 yr life.‑S/L depreciation method is used for tax & GAAP.

Part-4. Income Concepts: Claim of right – Slide 2.Depreciation is $10,000 per year for tax return and GAAP. Expense payments for year included prop. tax -$5,000 & insurance -$3,000.IBM rented the building from Realty Co. for 3 years at $25,000 per year. IBM paid $80,000 (rent of $75,000 and damage deposit of $5,000) on Jan-1-yr 1.

What is Realty’s taxable income for yr-1? a. $7,000 b. $32,000 c. $57,000 d. Other

Realty Company - Slide 3 Tax

Part-3. Claim of right Facts ReturnCost of office building $400,000

Building rented to IBM for: 2 Years

Rental from IBM per year $25,000

Cash from IBM inYr. 1 Rent for 3 years $75,000 ?

Damage deposit $5,000

GAAP depreciation per yr $10,000

Tax depreciation per year $10,000 ?

Prop. Tax & Insurance-Yr. 1 $8,000 ?

Taxable income-Yr. 1 ?

Realty Company - Slide 4 Tax

Part-3. Claim of right Facts ReturnCost of office building $400,000

Building rented to IBM for: 3 Years

Rental from IBM per year $25,000

Cash from IBM in Year 1 Rent for 3 years $75,000 $75,000

Damage deposit $5,000

GAAP depreciation per year $10,000

Tax depreciation per year $10,000 ($10,000)

Prop. Tax & Insurance-Yr. 1 $8,000 ($8,000)

Taxable income-Year 1 $57,000

Part 4. Income Concepts: Constructive receiptLee graduated in May, 2013 and began work on June 1, 2013, at a salary of $5,000 per month. Lee received 6 checks (on the last day of the months of June through November). December paycheck was available for Lee on Dec 31, but Lee chose to wait until January 2, 2014, to get the check. What is Lee’s gross income for 2013? a. $30,000 b. $35,000 c. Other

Part 4. Income Concepts: Wherewithal to payLocal Co. was organized on Jan-1, year 1. Local bought a building on that date for $400,000 and immediately rented the building to IBM for 3 years at a rental of $25,000 per year. A check for $75,000 was received on Jan-1, Year-1. What is Local’s gross income for year-1? a. $25,000 b. $50,000 c. $75,000

Part-4. Income Concepts: Wherewithal to payLocal Co. was organized on Jan-1, year 1. Local bought a building on that date for $400,000 and immediately rented the building to IBM for 3 years at a rental of $25,000 per year. A check for $75,000 was received on Jan-1, Year-1. What is Local’s gross income for year-1? a. $25,000 b. $50,000 c. $75,000

End of year-1 do we have:A deferred tax asset?A deferred tax liability?

How much?

Continue case on preceding slide

Fin. statements are prepared using GAAP.

Assume income tax rate is $40%.

End of year-1 do we have:A deferred tax asset? Yes

A deferred tax liability? How much? $20,000

Continue case on preceding slide

Fin. statements are prepared using GAAP.

Assume income tax rate is $40%.

Legislative Grace

Business Purpose

Capital Recovery

5. Deduction Concepts

Part 5. Deduction Concepts: Legislative graceNo deduction is allowed for any expenditure or loss unless the tax law allows the deduction.

Selling DeductibleAsset Basis Price Loss?

Business auto $9,000 $7,000

Rental house $150,000 $140,000

Family auto $9,000 $3,000

Lee sold assets in current year.

What is Lee's total deductible Loss?

Business purpose

Selling DeductibleAsset Basis Price Loss?

Business auto $9,000 $7,000 ($2,000)

Rental house $150,000 $140,000 ($10,000)

Family auto $9,000 $3,000

($12,000)

Lee sold assets in current year.

What is Lee's total deductible Loss?

Business purpose

Description Date Year AmountOriginal cost (bought for cash) Jan. 1 2011 $100,000 Depreciation exp. 2011 $2,000 Added a roomat cost of $40,000 Jan. 1 2012 $40,000 Depreciation exp. 2012 $3,000 Basis of building Jan. 1 2013 $135,000 Selling price Jan. 1 2013 $200,000

Amount of John’s gain on sale?

John sold a building on 1-1-2013.

Capital Recovery

Description Date Year AmountOriginal cost (bought for cash) Jan. 1 2011 $100,000 Depreciation exp. 2011 $2,000 Added a roomat cost of $40,000 Jan. 1 2012 $40,000 Depreciation exp. 2012 $3,000 Basis of building Jan. 1 2013 $135,000 Selling price Jan. 1 2013 $200,000

Amount of John’s gain on sale? $65,000

John sold a building on 1-1-2013.

Capital Recovery

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