Accounting discussion
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20150926213647presentation_ch03.pptxDetermining Gross Income
Chapter 3
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What is Gross Income?
Code Section 61(a) defines gross income as
“except as otherwise provided in this subtitle, gross income means all income from whatever source derived...”
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What is Income?
Gross income is realized income that is not excluded
Realization takes place when arm’s-length transaction occurs (sale of goods)
Taxable income is gross income less all deductions
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Tax vs. Financial Accounting
Objectives are not the same
Financial accounting seeks to provide information that decision makers find useful
Tax reporting seeks to collect revenue equitably
Differences fall into two categories
Temporary (timing) differences
Permanent differences
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Temporary Differences
Arise when income is taxed either before or after it is accrued for accounting purposes
Example: prepaid rent generally is taxable when received but is only included in financial accounting income as it is earned
Create a deferred tax asset or deferred tax liability on financial statements
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Permanent Differences
Income that is not taxed but is reported for financial accounting purposes
Example: municipal bond interest generally is not taxed but is recorded as income in financial accounting records
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Return of Capital Principle
Basis = amount invested in an asset
Basis can be recovered tax free
If the taxpayer’s return is more than basis, the taxpayer has a gain
If taxpayer’s return is less than basis, the taxpayer has a loss
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Investment Alternatives
Investments yielding appreciation
Tax deferred until gain is recognized
Gain is frequently taxed at lower capital gains rates
Investments yielding annual income
Interest income is taxed annually at the marginal tax rate for ordinary income; dividends taxed annually but currently at lower capital gains rates
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Tax Rates
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The Tax Year
Calendar year
Individuals
S corporations and partnerships have restrictions on allowable tax years, so usually use a calendar year
Fiscal year
12-month period ending on last day of month other than December
52-to-53-week year (ends on same day)
Corporations freely select tax year
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Short Tax Year
A short-year tax return reports less than 12 months of operating results
Income must be annualized (adjusted to reflect 12 months of operations)
Required by businesses that change their tax year
Not required in year entity begins or ends business
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Accounting Methods
Taxpayers can use different methods for financial accounting and tax
Cash method: receipt of cash or cash equivalents determine income/expense recognition (subject to constructive receipt doctrine)
Accrual method: the all events test determines income/expense recognition
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Cash Method
Income is recognized when cash or cash equivalents received
Cash equivalents broadly defined to include property and services
Cash equivalents included at fair market value
A cash-basis taxpayer must recognize income when an amount is
Credited to the taxpayer’s account
Set apart for the taxpayer, or
Made available in some other way to the taxpayer
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Constructive Receipt Doctrine
Constructive receipt is a modification that prevents cash-basis taxpayers from “turning their backs” on income
Income is not constructively received if:
The taxpayer is not entitled to the income
The payor has insufficient funds from which to make payment, or
There are substantial limitations or restrictions placed on actual receipt
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Limits on Cash Method
Businesses that carry inventory and sell merchandise to customers generally must use the accrual method to account for sales and purchases
Hybrid method – accrual for sales of inventory & cost of goods sold; cash method for other income and expenses
Large corporations (gross receipts of more than $5 million) cannot use cash method
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Accrual Method
Income is recognized when “all events test” is met
All events have occurred that establish the right to the income and
The income amount can be determined with reasonable accuracy
If liability is in dispute, the all events test is not satisfied until dispute is resolved
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Claim of Right Doctrine
Claim of right doctrine modifies the normal recognition rules for accrual-basis taxpayers
Requires taxpayer to recognize income when payment is received, regardless of whether money may have to be repaid later
If taxpayer must return all or part of the income, deduction allowed in repayment year
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Prepaid Income
Prepaid Income is another exception to the accrual method of accounting
Based on wherewithal to pay concept – taxpayer should be taxed when best able to pay the tax
Income must be reported when received
Examples: rent, interest, and royalty payments
Refundable deposits are not prepaid income
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Special Methods
Completed Contract Method – no income is recognized and no deductions taken until contract completion
Percentage-of-Completion Method – income is recognized as contract progresses based on an estimate of actual costs incurred to total projected costs for contract
Installment Method - gain is recognized as proceeds from sale are received
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Assignment of Income Doctrine
A taxpayer cannot assign earned income to a third party to escape taxation
Earned income must be taxed to the taxpayer rendering the services
Community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, Wisconsin)
Allocate half of income to each spouse
Income from property is taxed to taxpayer who owns the property
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Interest Income
Interest income from most sources is taxable, but interest on state and local (municipal) bonds is excluded from gross income
High income taxpayers may have a higher after-tax return on municipal bonds than taxable bonds offering a higher interest rate
Gain on the sale of tax-exempt securities must be included in gross income
Interest from private activity municipal bonds may be subject to AMT
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Original Issue Discount
Some debt instruments are issued at prices below their maturity values
This original issue discount (OID) is effectively interest paid at maturity rather than periodically over the debt instrument’s life
Both cash and accrual basis taxpayers recognize OID income as it accrues
Exception: Series EE and Series I bonds
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Market Discount
Bonds purchased after issue in the open or secondary market at a price below their stated maturity value
Excess of redemption proceeds over cost is recognized as ordinary income in year of redemption
Electively, market discount can be accrued as interest income over life of bond
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Below-Market-Rate Loans
Interest-free or below-market-rate loans are frequently made between related parties
Interest income that is not actually received or accrued may be imputed (treated as received or accrued and taxed) at the applicable federal rate of interest
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Gift Loan Exceptions
Any gift loan of $10,000 or less is exempt from the imputed interest rules
For gift loans greater than $10,000 but less than $100,000
Imputed interest cannot exceed the borrower’s net investment income for the year
If borrower’s net investment income is no more than $1,000, imputed interest is zero
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Other Loans
Loan to employee – loan interest is imputed income to employer, returned to employee as compensation; taxable compensation to employee and deductible by employer
Loan to shareholder – loan interest is imputed income to corporation, returned as dividend to shareholder; taxable dividend to shareholder but no corporate deduction
$10,000 exception if no tax avoidance motive
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Dividend Income
Cash and FMV of other assets distributed by a corporation from earnings and profits (E&P) are treated as dividends includable in the shareholder’s income
Dividend income is taxed at the same rates as long-term capital gains
Distributions in excess of E&P are nontaxable return of capital (reducing stock basis)
Distributions in excess of stock basis are taxed as capital gain (as if stock is sold)
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Mutual Fund Dividends
Distributions to mutual fund shareholders of dividends received on stock they hold
Distributions of gains they realize on the sale of investment assets
These dividends are actually net long-term capital gains and are called capital gains distributions
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Dividend Reinvestment Plans
Treated as if the shareholder received the cash and then purchased additional shares of stock with the dividend income (constructive receipt doctrine)
Value of dividend included in income
Amount included in income becomes the shareholder’s basis for these shares of stock
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Stock Dividends
Stock dividends are distributions of a corporation’s own stock to its shareholders (treated the same as a stock split)
Usually stock dividends are not taxable to the shareholder
Shareholder owns a greater number of shares and the basis in the original shares is divided among all shares of stock now held
If shareholder has option of receiving cash or stock, then dividend is taxable
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Annuity Income
Usually consists of a taxable and nontaxable amount
Nontaxable amount represents a return of capital
Nontaxable amount of a payment is equal to the (Investment in annuity / expected return from annuity) x annuity payment received
If the amounts invested in the annuity were all made by the employer (or by the employee using pre-tax dollars), then the employee’s investment is treated as zero
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Prizes and Awards
Prizes, awards, gambling winnings, and treasure finds are taxable
The fair market value of goods or services received is included in gross income
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Government Transfer Payments
Need-based payments, such as welfare payments, school lunches & food stamps, are excluded from income
Unemployment compensation is taxable because it is a substitute for wages that would be taxable
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Social Security Benefits
Government devised a complex formula that can result in the taxation of up to 85% of social security benefits for taxpayers who have significant other income while leaving benefits completely tax free for those who have little other income
MAGI = AGI before any social security benefits + exempt interest income + ½ of social security benefits
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Social Security Benefits
If MAGI is less than $25,000 for single individuals or $32,000 for married couples, then none of the social security benefits received are taxable
Single taxpayers with MAGI above $34,000 and married taxpayers with income above $44,000 can be taxed on up to 85% of their benefits
Taxpayers between the above thresholds can be taxed on up to 50% of their social security benefits
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Damage Awards
Damages for physical injuries are not taxed (under the return of capital doctrine)
Damages for all other awards are taxed (viewed as substitute for income that would otherwise be taxable income)
Punitive damages are taxable
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Divorce-Related Payments
A property settlement is simply a division of assets (no income, no deduction)
Alimony is a legal shifting of income – taxable income to recipient and deductible by payor
First year’s alimony should not exceed average of 2nd and 3rd-year payments by more than $15,000
Child support fulfills a legal obligation to support a child (no income, no deduction)
Both parties may benefit by negotiating an increase in payment if it qualifies as alimony
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Discharge of Debt
If a legal obligation is satisfied for less than the outstanding debt, the amount of debt forgiven represents an increase in the taxpayer’s wealth and is subject to taxation
Exceptions are provided for debtors who are bankrupt or insolvent
Exceptions for the forgiveness of some student loans when the students work in certain professions
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Discharge of Debt
Mortgage Forgiveness Debt Relief Act of 2007 provided relief for homeowners whose mortgage debt was forgiven
Forgiveness on up to $2 million of qualified debt on a principal residence from 2007 through 2014 is excluded from income
This provision applies to restructuring, short sales, and deeds-in-lieu-of foreclosure
Basis of residence is reduced (but not below zero) for amount excluded
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Tax Benefit Rule
If a taxpayer deducted an expense or loss in one year but recovers the amount deducted in a subsequent year, all or a portion of the amount recovered may have to be included in gross income in the year it is recovered
Amount included in income is limited to the extent the taxpayer benefited from the tax deduction
Example: bad-debt recovery or refund of taxes previously deducted
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Net Investment Income Surtax
3.8% Medicare surtax rate on the lesser of Net Investment Income (NII) or modified AGI above a threshold
$200,000 single & head of household
$250,000 married filing a joint return
$125,000 married filing separately
NII = investment income - investment expenses
Income: dividends, interest, capital gains (LT & ST), royalties, rental income & passive investments
Expenses: investment interest expense, investment advisory & brokerage fees, rental expenses
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Tax Rates with NII Surtax
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Exclusions from Income
Gifts
Inheritances
Life Insurance
Proceeds received are tax free but any interest income on proceeds is taxable
Inside buildup (increase in cash surrender value) is not taxable income unless policy is liquidated for more than premiums paid
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Accident & Health Insurance
Accident & health insurance proceeds are tax free to extent they pay qualified medical or dental expenses; excess benefits taxable if employer provided policy
Disability insurance is a substitute for lost pay if an employee cannot work
If premiums for disability insurance paid by employer, then benefits received are taxable
If premiums paid by employee, exception allows benefits to be received tax free
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Scholarships
Qualified scholarships are excluded from gross income
“Scholarship” includes only tuition, fees, books, supplies, equipment, and related expenses required for courses
Amounts designated or spent for room, board, and laundry are included in taxable income
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Scholarships
Any grant received in return for past, present, or future services must be included in gross income
Funds received by students in return for teaching or research services are taxable
When taxable portion cannot be determined until end of academic year, taxable income can be deferred until the taxable year in which the academic year ends
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Education Benefits
Universities can provide tuition waivers for their employees (and their immediate family members) on a tax-free basis only for undergraduate tuition
This and other employee fringe benefits are discussed in Chapter 4
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Other Exclusions
Improvements made on leased property are excluded from landlord’s income unless improvements made in lieu of paying rent
Exclusion of gain on sale of home (Ch. 7)
$250,000 if single, $500,000 if married and both spouses qualify
Must have owned and lived in home as principal residence for at least 2 of previous 5 years
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International Issues
Source principle - countries tax income earned within their borders but exclude income from activities taking place (sourced) in other countries
Applies to foreign persons and foreign corporations
Residency principle – countries tax worldwide income
Applies to resident individuals and corporations
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International Taxation
A business is usually only taxed in country of residence unless it maintains a permanent establishment (e.g. office) in another country
Source country can tax income earned within its borders when a permanent establishment exists
Double taxation can result when more than one jurisdiction has the right to tax the same income
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Minimizing Double Taxation
Tax treaties and tax credits minimize the impact of this double taxation
A tax treaty is an agreement between two countries that explains how a taxpayer of one country is taxed when conducting business in another country
Foreign tax credits can offset domestic taxes on foreign source income
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Taxpayers Subject to U.S. Tax
U.S. citizens, corporations, and resident aliens are subject to U.S. tax on their worldwide income
Resident alien – individual who is not a U.S. citizen but who has established legal residence in U.S. through
Green card or
Substantial presence test (183 days)
Individuals typically exempt from substantial presence test include diplomats, teachers, students, and certain professional athletes
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Nonresident Aliens and Foreign Corporations
Nonresident alien – individual who is not U.S. citizen and does not satisfy test to be resident alien
Nonresident aliens and foreign corporations are subject to U.S. tax on
Effectively connected income – U.S. business income subject to U.S. income tax
U.S. investment income – taxed at flat 30% (or treaty rate if lower)
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U.S. Corporations Doing Business in a Foreign Country
A U.S. corporation can operate in a foreign country through a branch or a subsidiary
A branch is viewed as an extension of the U.S. corporation
Branch’s income is combined with U.S. operations and subject to U.S. tax (no income deferral)
A controlled foreign corporation (CFC) is a corporation incorporated outside the U.S. that is owned more than 50% by U.S. shareholders
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U.S. Corporations Doing Business in a Foreign Country
A U.S. parent corporation is usually not taxed on the earnings of the foreign subsidiary until the earnings are repatriated to the U.S. as dividends
When the U.S. parent receives a dividend, the dividend is included in its income
The parent is entitled to a foreign tax credit when the dividend is received based on the income tax paid by the foreign corporation
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U.S. Corporations Doing Business in a Foreign Country
If the U.S. parent does not need cash from its overseas operations, it can direct its subsidiary to withhold paying dividends which postpones the payment of U.S. taxes on this income
As long as the parent receives no repatriated earnings, it can postpone the payment of U.S. taxes
Certain foreign source income (Subpart F income) earned by a CFC is subject to U.S. tax when earned
No additional U.S. tax is paid on this income when the parent receives it as a dividend
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State and Local Income Tax
Most states (and some local governments) impose both corporate and individual income taxes on both residents and nonresidents
Nonresidents can only be taxed on
Income derived from business activity within the state and
Income from property located in the state
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State Income Taxes
Most states piggyback on the federal system by starting with federal taxable income and modifying for
State and local income taxes
Interest income earned on state and local bonds
Interest income on federal notes or bonds
Dividends received deduction
Net operating losses
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State Income Taxes
Nexus – the connection between a state and the business that the state is seeking to tax
Nexus can be established through physical presence of corporate property or employees in the state
When there is nexus in several states, each state can tax only the percentage of income based on the business allocated to that state
Most states use the three-factor allocation formula of sales, payroll costs, and tangible property
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State Income Taxes
Nonbusiness income (interest, dividends, rent) is taxed in one state only
Usually the state in which the corporation is domiciled or where property is located or used
Income tax planning usually involves shifting income from high-tax states to low-tax states by eliminating nexus in a state through the outsourcing of functions or shifting assets
A few states subject S corporations to corporate income tax
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Total Effective Tax Rate
For federal tax purposes, state income tax is deductible in computing taxable income
Tax savings from this federal deduction reduce the cost of the state income tax
When a taxpayer pays income tax at both the federal and state levels, it increases the total effective tax rate and decreases the after-tax cash flow
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Sales Taxes
Multistate businesses may have sales taxes imposed on gross receipts from retail sales or leases of tangible personalty
Retailer is responsible for collecting tax
Retailer must determine not only the appropriate tax rate but also which items are subject to tax in each location
A state can require an out-of-state business to collect sales tax only if it has nexus with the state
Nexus for sales tax is not always the same as nexus for income tax
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Use Tax
Use tax – imposed on the use of property purchased out-of-state but brought into a state that levies a sales tax if sales tax was not paid in the state of purchase
A use tax is self-assessed and usually has the same rate as the sales tax
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The End
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