Module 7

Gross Income

Module Topics

General concepts Statutory exclusions Special inclusions for business

income Cost of goods sold and inventories Inventory cost flow assumptions,

particularly LIFO The Uniform Capitalization Rules

General Concepts

Key Learning Objectives

§61 Defines gross income Overriding the cash- or accrual-basis

distinctions Note that accounting periods and

methods are discussed in depth in the next module

§61 General DefinitionExcept as otherwise provided in this subtitle, gross income means all income from whatever source derived, including

(but not limited to) the following items:1. Compensation for

services, including fees, commissions, fringe benefits, and similar items;

2. Gross income from business;

3. Gains derived from dealings in property;

4. Interest;5. Rents;6. Royalties;7. Dividends;8. Alimony and

separate maintenance payments;

9. Annuities;

§61 General Definition (con’t)

10. Income from life insurance and endowment contracts;

11. Pensions;12. Income from

discharge of indebtedness;

13. Distributive share of partnership gross income;

14. Income in respect of a decedent; and

15. Income from interest in an estate or trust.

Overriding the Cash- or Accrual-Basis Distinctions

Forms of income The cash equivalent doctrine Constructive receipt doctrine Claim-of-right doctrine

Forms of Income

Substance over formSubstance over form Debt reliefDebt relief In-kind receipt of property or servicesIn-kind receipt of property or services Benefit transferred to anotherBenefit transferred to another Windfall gainsWindfall gains

The Cash Equivalent Doctrine

Cash Property Services

Constructive Receipt Doctrine

Credited to account Set apart or otherwise made available Could have drawn upon it during the

taxable year if notice of intention to withdraw had been given

Not constructive receipt if control is subject to substantial limitations or restrictions.

Claim-of-Right Doctrine

Amount is includable in income at the latest when it is received

Provided that the taxpayer has an unrestricted right to the funds

Even if the amounts are received in error or

The right to such income is contested and subsequent events require repayment

Research Query: When Is A Prepaid Legal Fee Income?

Prepaid legal fees were deposited by a law Prepaid legal fees were deposited by a law partnership in trustee accounts established partnership in trustee accounts established to comply with a state ethics law.to comply with a state ethics law.

Are these fees includible in income when Are these fees includible in income when deposited or earned?deposited or earned?

HINT: Miele, Agatha, (1979) 72 TC 284 HINT: Miele, Agatha, (1979) 72 TC 284

Solution--Research Query: Prepaid Legal FeePrepaid Legal Fee

Whether a cash basis law firm is in receipt Whether a cash basis law firm is in receipt of income when a prepaid legal fee is of income when a prepaid legal fee is received depends on whether the firm received depends on whether the firm received the fee under a claim of right and received the fee under a claim of right and without restriction as to disposition. without restriction as to disposition.

Solution--Research Query: Prepaid Legal FeePrepaid Legal Fee (con’t)

Consequently, a firm has no income of a Consequently, a firm has no income of a prepaid legal fee until an undisputed prepaid legal fee until an undisputed amount is due the firm from the prepaid fee.amount is due the firm from the prepaid fee.

However, once earned, the fees are However, once earned, the fees are includible in income even though the firm includible in income even though the firm leaves the fees in the trustee account.leaves the fees in the trustee account.

Statutory Exclusions

Key Learning Objectives

Statutory exclusions that apply to business income

Special provisions for forgiveness of indebtedness income

The tax benefit rule

Statutory Exclusions (con’t)

§§101-137 “Items specifically excluded from gross income”

§103: Interest on state and local bonds

§109: Improvements by lessee on lessor’s property Unless constructed in lieu of rent

§108: Income From Discharge of Indebtedness

An exclusion for forgiveness of indebtedness if the discharge relates to:

(a) a bankruptcy under Title 11(b) an insolvent taxpayer

limited to the amount by which the taxpayer is limited to the amount by which the taxpayer is insolvent after the forgiveness.insolvent after the forgiveness.

(c) qualified farm indebtedness(d) qualified real property business

indebtedness of noncorporate taxpayer

Special Business Income Inclusion Rules

Key Learning Objectives

Prepaid income Long-term contracts Bad debt expense of service providers

The nonaccrual experience methodThe nonaccrual experience method The installment method for certain

dealers

Advance PaymentsAlmost Always Income

Applies to cash and accrual taxpayers

Does not apply to security deposits Discussed further in Module 8

Long-Term Contracts Construction not completed during the

tax year initiated Must use percentage-of-completion

method At completion, required to recompute

tax liabilities for all years of the contract using actual contract costs and contract revenue

The taxpayer is required to pay interest on any underpayments

Estimating Bad Debts of Accrual Basis Service Providers

The nonaccrual experience method Not available if the taxpayer charges

interest or penalties on late payments Estimated bad debt based on bad

debt experience in prior years Works much like the reserve method

for bad debts

The Installment Method for Certain Dealers

Gross income is reported as installments of the total sales price are received

Available only for (a) property used in the trade or business of

farming(b) residential lots(c) timeshare ownership interests of six weeks or less in residential real property

Inventory--Basic Concepts

Key Learning Objectives

Basic reason for inventories

When required How valued

The Reason for Inventories

Reg. §1.61-3 defines “gross income” for a manufacturing or merchandising business as sales less cost of goods sold plus income from other sources

Ensures that only gain from sale of inventory is taxed

Limits benefits of cash basis method of accounting

When Are Inventories Required?

Whenever in the opinion of the Secretary

Necessary to clearly reflect income when ProductionProduction PurchasePurchase Sale of merchandise Sale of merchandise

Is an income-producing factor

What Must Be Inventoried?

Only raw materials and supplies which have Only raw materials and supplies which have been been Acquired for sale, orAcquired for sale, or Will physically become a part of Will physically become a part of

merchandise intended for salemerchandise intended for sale

Compliance Query: Materials & Supplies

In January, John’s Secretarial Services, a In January, John’s Secretarial Services, a cash basis taxpayer purchased:cash basis taxpayer purchased:

Spare computer partsSpare computer parts $5,000$5,000

Office suppliesOffice supplies 500 500 Items are used internally. John’s keeps no Items are used internally. John’s keeps no

record of consumption or inventory records.record of consumption or inventory records. Can the company deduct these items in full in Can the company deduct these items in full in

the current tax year?the current tax year?

Solution--Compliance Query: Materials & Supplies Reg §1.162-3Reg §1.162-3

Materials and supplies are deductible only in the Materials and supplies are deductible only in the amount actually consumed and used in amount actually consumed and used in operation during the year. operation during the year.

However, incidental materials and supplies. are However, incidental materials and supplies. are deductible if deductible if No record of their consumption is kept No record of their consumption is kept No physical inventory is taken No physical inventory is taken This method may be used only if it clearly This method may be used only if it clearly

reflects income. reflects income.

Solution--Compliance Query: Reg § 1.162-3 (con’t)Reg § 1.162-3 (con’t)

The $5,000 of spare computer parts are The $5,000 of spare computer parts are probably not incidental.probably not incidental. John’s should John’s should do a physical inventory at year end to do a physical inventory at year end to determine the amount to deduct.determine the amount to deduct.

The $500 of office supplies are probably The $500 of office supplies are probably incidental and can be deducted in full. incidental and can be deducted in full.

Valuation of Inventories

CostCost Lower of cost or marketLower of cost or market Cost flow assumptionsCost flow assumptions

+ + Specific identificationSpecific identification

+ Average cost+ Average cost

+ FIFO+ FIFO

+ LIFO+ LIFO

Inventory--Special Issues

Key Learning Objectives

LIFO inventories Dollar-value LIFO methods

Electing LIFO--Pros & Cons

Cushion the impact of price increases in an inflationary economy

Must use for books also

Electing LIFO

Elect by filing Form 970 for change tax year

Prior approval not required Revocation requires prior approval

Cumulative adjustment requiredCumulative adjustment required No new elections for a 10-year period No new elections for a 10-year period

w/out permissionw/out permission

Dollar Value LIFO

Determine inventory cost on the basis of total dollars (for a base year)

Rather than the quantity and price of each inventory item

Simplified Dollar-Value LIFO eliminates many problems of pooling

Uniform Capitalization Rules

Key Learning Objectives General description Who must follow rules Costs that must be capitalized

§263A Uniform Capitalization Rules: An

Overview UNICAP rulesUNICAP rules Apply to producers Apply to producers

and resellers of and resellers of propertyproperty

Extend the concept Extend the concept of absorption of absorption costingcosting

Taxpayers Exempt from the UNICAP Rules

Reseller of personal property with average gross receipts of $10,000,000 or less during the preceding three taxable years

Certain farming businesses Personal use property Research and experimentation

expenditures deductible under §174 Certain costs associated with oil and gas

properties Certain timber and ornamental trees

Category 1 --Costs That

Must Be Inventoried Repairs & maintenance Rent & utilities Indirect labor Production supervisory wages Indirect materials & supplies Small tools & equipment Quality control & inspection

Category 3--Costs That Follow

Financial Statement Treatment

Taxes other than state or local income taxes (e.g..., property)

Financial statement depreciation/depletion Employee benefits for production labor Rework labor, scrap, and spoilage Factory administrative expenses Production officers’ salaries Insurance costs