Chapter 5 Gross Income and Exclusions and Discussion Questions PDF

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Chapter 5 Discussion Questions Discussion Questions 1, 4, 6, 9, 11, 14, 17, 18, 19, 20, 26, 27, 33 1.Based on the definition of gross income in §61 and related regulations, what is the general presumption regarding the taxability of income realized?

4. Compare and contrast realization of income with recognition of income.

6. Andre constructs and installs cabinets in homes. Blair sells and installs carpet in apartments. Andre and Blair worked out an arrangement whereby Andre installed cabinets in Blair’s home and Blair installed carpet in Andre’s home. Neither Andre nor Blair believes they are required to recognize any gross income on this exchange because neither received cash. Do you agree with them? Explain.

9. This year Jorge received a refund of property taxes that he deducted on his tax return last year. Jorge is not sure whether he should include the refund in his gross income. What would you tell him?

11. Janet is a cash-method, calendar-year taxpayer. She received a check for services provided in the mail during the last week of December. However, rather than cash the check, Janet decided to wait until the following January because she believes that her delay will cause the income to be realized and recognized next year. What would you tell her? Would it matter if she didn’t open the envelope? Would it matter if she refused to check her mail during the last week of December? Explain.

14. Dewey is a lawyer who uses the cash method of accounting. Last year Dewey provided a client with legal services worth $55,000, but the client could not pay the fee. This year Dewey requested that in lieu of paying Dewey $55,000 for the services, the client could make a $45,000 gift to Dewey’s daughter. Dewey’s daughter received the check for $45,000 and deposited it in her bank account. How much of this income is taxed, if any, to Dewey? Explain.

17. Jim purchased 100 shares of stock this year and elected to participate in a dividend reinvestment program. This program automatically uses dividends to purchase additional shares of stock. This year Jim’s shares paid $350 of dividends, and he used these funds to purchase additional shares of stock. These additional shares are worth $375 at year-end. What amount of dividends, if any, should Jim declare as income this year? Explain.

18. Jerry has a certificate of deposit at the local bank. The interest on this certificate was credited to his account on December 31 of last year, but he didn’t withdraw the interest until January of this year. When is the interest income taxed?

19. Conceptually, when taxpayers receive annuity payments, how do they determine the amount of the payment they must include in gross income?

20. George purchased a life annuity to provide him monthly payments for as long as he lives. Based on IRS tables, George’s life expectancy is 100 months. Is George able to recover his cost of the annuity if he dies before he receives 100 monthly payments? Explain. What happens for tax purposes if George receives more than 100 payments?

26. Rolando purchases a golf cart from his employer, E-Z-Go Golf Carts, for a sizable discount. Explain the rules for determining if Rolando’s purchase results in taxable income for him.

27. When an employer makes a below-market loan to an employee, what are the tax consequences to the employer and employee?

33. Explain how state and local governments benefit from the provisions that allow taxpayers to exclude interest on state and local bonds from their gross income.

Chapter 5 Gross Income and Exclusions Realization and Recognition of Income ●

Gross income is income that taxpayers realize, recognize, and report on their tax returns for the year

What Is Included in Gross Income? ●

gross income means all income from whatever source derived

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Gross income means all income from whatever source derived, unless excluded by law.

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Gross income includes income realized in any form, whether in money, property, or services.

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Taxpayers recognize gross income when 1. they receive an economic benefit 2. they realize the income 3. no tax provision allows them to exclude or defer the income from gross income for that year

Economic Benefit ●

Taxpayers must receive an economic benefit (i.e., receive an item of value) to have gross income.

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Common examples of economic benefit include ○

compensation for services (compensation in the form of cash, other property, or even services received)

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proceeds from property sales (typically cash, property, or debt relief)

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income from investments or business activities (such as business income, rents, interest, and dividends)

Realization Principle ●

Income is realized when 1. a taxpayer engages in a transaction with another party 2. The transaction results in a measurable change in property rights. a. In other words, assets or services are exchanged for cash, claims to cash, or other assets with determinable value

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Adopting the realization principle for defining gross income provides two major advantages 1. Because parties to the transaction must agree to the value of the exchanged property rights, the transaction allows the income to be measured objectively. 2. The transaction often provides the taxpayer with the wherewithal to pay taxes (at least when the taxpayer receives cash in the transaction). a. That is, the transaction itself provides the taxpayer with the funds to pay taxes on income generated by the transaction b. Thus, it reduces the possibility that the taxpayer will be required to sell other assets to pay the taxes on the income from the transaction c. When taxpayers receive property or services in a transaction (instead of cash), realization has also occurred (despite the absence of wherewithal to pay)

Recognition ●

Taxpayers who realize an economic benefit must include the benefit in gross income unless a specific provision of the tax code says otherwise

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That is, taxpayers are generally required to recognize all realized income by reporting it as gross income on their tax returns

Other Income Concepts ●

The tax laws, administrative authority, and judicial rulings have established several other concepts important for determining an individual’s gross income.

Form of Receipt ●

A common misperception is that taxpayers must receive cash to realize and recognize gross income.

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Taxpayers realize income whether they receive money, property, or services in a transaction.

Return of Capital Principle ●

When taxpayers sell assets, they must determine the extent to which they include the sale proceeds in gross income.

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The courts determined that when receiving a payment for property, taxpayers are allowed to recover the cost of the property tax-free.

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Consequently, when taxpayers sell property, they are allowed to reduce the sale proceeds by their unrecovered investment in the property to determine the realized gain from the sale

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Taxpayers argued that a portion of proceeds from a sale represented a return of the cost or capital investment in the underlying property, called tax basis

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Tax basis - the amount of a taxpayer’s unrecovered cost of or investment in an asset

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When the tax basis exceeds the sale proceeds, the return of capital principle generally applies to the extent of the sale proceeds.

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The excess of basis over sale proceeds is generally not considered to be a return of capital, but rather a loss that is deductible only if specifically authorized by the tax code.

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The return of capital principle gets complicated when taxpayers sell assets and collect the sale proceeds over several periods

Recovery of Amounts Previously Deducted ●

A refund is not typically included in gross income because it usually represents a return of capital or reduction in expense.

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Example: $200 refund of a $700 business expense is not included in gross income but instead reduces the net expense to $500.

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However, if the refund is made for an expenditure deducted in a previous year, then under the tax benefit rule, the refund is included in gross income to the extent that the prior deduction produced a tax benefit.

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Tax benefit rule: holds that a refund of an amount deducted in a previous period is only

included in income to the extent that the deduction reduces taxable income ●

Example: Suppose an individual paid a $1,000 business expense claimed as a for AGI deduction in 2020, but $250 of the expense was subsequently reimbursed in 2021. Because the $250 business deduction produced a tax benefit in 2020 (reduced taxable income and corresponding tax liability), the $250 refund in 2021 would be included in income

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The application of the tax benefit rule is more complex for individuals who itemize deductions. 1. itemized deductions are subject to various limitations (e.g., deductible state and local taxes are limited to $10,000; $5,000 for a taxpayer filing married separately), which may eliminate or reduce their tax benefit. 2. an itemized deduction produces a tax benefit only to the extent that total itemized deductions exceed the standard deduction. a. For example, suppose an individual’s total itemized deductions exceeded the standard deduction by $100 b. A refund of $150 of itemized deductions would cause the individual’s itemized deductions to fall $50 below the standard deduction. c. If the refund occurred in the same year as the expense, the individual would have elected the standard deduction, and the refund would have caused taxable income to increase by only $100 (because of the difference between claiming the standard deduction and using the total itemized deductions that would have been claimed in the absence of any refund). d. If the refund occurs the year after the deduction is claimed, then only $100 of the $150 refund would be included in gross income under the tax benefit rule. e. The $100 is added to taxable income in the year of the refund because this is the increment in taxable income that would have resulted if the refund had been issued in the year the itemized deduction was claimed.

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To determine your taxable income, subtract either the standard deduction or your total itemized deductions from your AGI

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In most cases, you can choose whichever gives you the most benefit

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Example: the standard deduction for 2020 tax returns for married couples filing jointly is $24,800 ($25,100 for 2021), so couples whose itemized deductions exceed that amount

would generally opt to itemize, while others would simply take the standard deduction ●

Example: Let's say you had some significant dental expenses during the year that weren't reimbursed by insurance and you've decided to itemize your deductions. You are allowed to deduct the portion of those expenses that exceed 7.5% of your AGI ○

means if you report $12,000 in unreimbursed dental expenses and have an AGI of $100,000, you can deduct the amount that exceeds $7,500, which is $4,500

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However, if your AGI is $50,000, the 7.5% reduction is just $3,750, and you'd be entitled to an $8,250 deduction

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Allowable itemized deductions, sometimes subject to limits, include mortgage interest, charitable gifts, and unreimbursed medical expenses

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Itemized deductions reduce your taxable income. The actual amount saved depends on the filer's tax bracket.

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Example: For example, consider a person filing single, unmarried, who has a gross income of $80,000 and is claiming itemized deductions totaling $15,000. ○

Subtracting those deductions from gross income yields a taxable income of $65,000.

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The actual tax relief in this instance is the deducted amount, $15,000, times the tax rate for a single person in that income bracket, which is 22% in tax years 2020 and 2021

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The amount of tax saved through the deductions in this example is $3,300

When Do Taxpayers Recognize Income? ●

Individual taxpayers generally file tax returns reporting their taxable income for a calendar-year period, whereas corporations often use a fiscal year-end

Accounting Methods ●

Most large corporations use the accrual method of accounting.

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Under the accrual method, income is generally recognized when earned, and expenses are generally deducted in the period when liabilities are incurred.

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Most individuals use the cash method as their overall method of accounting.

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Under the cash method, taxpayers recognize income in the period they receive it (in the form of cash, property, or services), no matter when they actually earn it.

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Likewise, cash-method taxpayers claim deductions when they make expenditures, rather than when they incur liabilities.

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Another advantage of the cash method is that taxpayers may have some control over when income is received and expenses are paid

Constructive Receipt ●

Taxpayers using the cash method of accounting may try to shift income from the current year to the next year when they receive payments near year-end.

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For instance, taxpayers may merely delay cashing a check or avoid picking up a compensation payment until after year-end.

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The courts responded to this ploy by devising the constructive receipt doctrine. ○

The constructive receipt doctrine states that a cash-method taxpayer realizes and recognizes income when it is actually or constructively received.

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Constructive receipt is deemed to occur when the income has been credited to the taxpayer’s account or when the income is unconditionally available to the taxpayer, the taxpayer is aware of the income’s availability, and there are no restrictions on the taxpayer’s control over the income

Claim of Right ●

The claim of right doctrine is another judicial doctrine created to address the timing of income recognition.

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Specifically, this doctrine addresses when a taxpayer receives income in one period but is required to return the payment in a subsequent period.

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The claim of right doctrine states that income has been realized if a taxpayer receives income and there are no restrictions on the taxpayer’s use of the income (e.g., the taxpayer does not have an obligation to repay the amount).

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A common example of the claim of right doctrine is a cash bonus paid to employees based on company earnings.

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Despite potentially having to repay the bonuses (for example, in the case of a “clawback” provision that requires repayment if the company has an earnings restatement), employees would include the bonuses in gross income in the year received because there are no restrictions on their use of the income

Claim of Right ●

The claim of right doctrine is another judicial doctrine created to address the timing of income recognition.

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addresses when a taxpayer receives income in one period but is required to return the payment in a subsequent period.

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The claim of right doctrine states that income has been realized if a taxpayer receives income and there are no restrictions on the taxpayer’s use of the income (e.g., the taxpayer does not have an obligation to repay the amount).

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A common example of the claim of right doctrine is a cash bonus paid to employees based on company earnings.

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Despite potentially having to repay the bonuses (for example, in the case of a “clawback” provision that requires repayment if the company has an earnings restatement), employees would include the bonuses in gross income in the year received because there are no restrictions on their use of the income

Who Recognizes the Income? Assignment of Income ●

The courts developed the assignment of income doctrine to prevent taxpayers from arbitrarily transferring the taxation on their income to others

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In essence, the assignment of income doctrine holds that the taxpayer who earns income from services must recognize the income.

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Likewise, income from property, such as dividends and interest, is taxable to the person who actually owns the income-producing property

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Thus, to shift income from property to another person, a taxpayer must also transfer the ownership in the property to the other person.

Community Property Systems ●

While most states use a common law system, nine states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin) implement community property systems.

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Under community property systems, the income earned from services by one spouse is treated as though it were earned equally by both spouses.

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Property acquired by either spouse during the marriage is usually community property and is treated as though it is owned equally by each spouse.

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Property that a spouse brings into a marriage is treated as that spouse’s separate property.

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For federal income tax purposes, the community property system has the following consequences: ○

Half the income earned from the services of one spouse is included in the gross income of the other spouse.

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Half the income from property held as community property by the married couple is included in the gross income of each spouse.

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In five community property states (Arizona, California, Nevada, New Mexico, and Washington), all the income from property owned separately by one spouse is included in that spouse’s gross income.

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In Idaho, Louisiana, Texas, and Wisconsin, half the income from property owned separately by one spouse is included in the gross income of each spouse.

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In contrast, for federal income tax purposes, the common law system has the following consequences: ○

All the income earned from the services of one spouse is included in the gross income of the spouse who earned it.

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For property owned separately, all the income from the separately owned property is included in that spouse’s gross income.

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For property owned jointly (i.e., not separately), each co-owner is taxed on the income attributable to his or her share of the property.

Types of Income Income from Services ●

Income from labor is one of the most common sources of gross income, and it is rarely exempt from taxation.

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Payments for services including salary, wages, and fees that a taxpayer earns through services in a nonemployee capacity are all considered income from services, and so is unemployment compensation.

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Income from services is often referred to as earned income because it is generated by the efforts of the taxpayer (this also includes business income earned by a taxpay...