Ch 3 Flashcards
Economic income
Income = consumption + change in wealth
Unrealized gains, gifts and inheritances are income
Economists adjust for inflation
Gross income
All income from whatever source derived
Accounting income
Measured by transaction approach, it’s measured when
Realized in a transaction
Use historical costs as measurement instead of unconfirmed
Estimates of change in market value
Accounting income: realization
Occurs when tax payer sells property
3 conditions for amounts of income to be taxable?
1 must be economic benefit
2 income must be realized
3 income must be recognized as taxable
Administrative convenience
The economic concept of income is too subjective to
determine taxable income
There is need for objectivity in determining tax
Wherewithal to pay concept, ex.
Tax should be collected when taxpayer is in best position
To pay tax
Ex. A tax payer that sold property for cash is in better
Position to pay tax than one that holds property that
Increases in value
Why should taxpayers who are using the cash method of accounting be required to include in gross income the value of property or services received?
If they were not required, many taxpayers would arrange
Their financial affairs so they would receive property and
Services instead of cash
Why is income in a form different from cash difficult to track?
Valuation isn’t as easily determined
Indirect economic receipt, example with employees
Is this taxable for employees?
Security guard patrol employers plant protect employees
Not taxable for employees
Who is responsible for paying tax on income from property?
The owner of the property
For federal tax purposes, Income is allocated between husband and wife depending on…
State of residence
How many states follow common law property system?
How many follow community property system?
41 follow common law
9 follow community property system
How is income taxed under common law property system?
Income is taxed to individual who earns the income through
Labor or capital
Joint income in common law state
Income from jointly owned property
Community income
Considered to belong equally to spouses
1) Separate property
2) Can it occur in community property states?
1 all property owned before marriage and gifts, inheritances,
Acquired after marriage
The year in which the income is taxed depends on the taxpayer’s…
Name 3?
Accounting method
1 cash receipts and disbursements method
2 accrual method
3 hybrid method
Cash receipts and disbursements method
Who uses this method?
Income reported in year taxpayer receives rather than year
Income is earned
Used by most individual taxpayers and many small
businesses
Constructive receipt
Income made available to taxpayer so he can draw upon
It at any time
Small tax payer exception for inventory
Following tax payers at exempt from maintaining inventories
And can use cash method
Taxpayers that have avg. annual gross receipts of $1 million
Or less for prior 3 years ($10 million if principal business is
Not sale of inventory)
When is prepaid income taxable
In year of receipt
Accrual method
When is income considered earned?
Taxpayers report income in year it is earned
Income is considered earned when all events have occurred
To fix right to receive income
Income can be determined with Accuracy
Hybrid method accounting
Combination of cash and accrual methods
Use accrual method for purchase and sale of goods
And cash method for everything else
Why is the cash method generally more favorable for income tax purposes?
Offers greater tax planning opportunity and results in taxes
Being owed when income is actually received
Why are planning opportunities greater under the cash method?
Tax payers can deduct expenses when paid
Accrual can’t
Compensation
Payment for personal services
Includes salaries, wages, fees, commissions, tips, bonuses
Tax law contains 30 non recognition rules, what do these allow
Allow taxpayers to postpone recognition of gains and losses
On certain types of property transactions
Deductions on property losses are limited to?
$3000 per year
Interest
Compensation for use of money
Taxable interest includes interest on 7 things…
1 bank deposits 2 corporate bonds 3 mortgages 4 life insurance policies 5 tax refunds 6 US government obligations 7 foreign government obligations
Tax exempt interest 4 things
Obligations of states, territories US possessions and their
Political subdivisions, counties
Prepaid rents, security deposits
Prepaid rents included in gross income
Security deposit is only included If it is not refunded
Royalties, tax treatment
Proceeds paid to owner by others who do business under
Some right belonging to the owner
Taxable as ordinary income
Improvements made by the lessee that increase the value
Of leased property are included in lessor’s income if the improvements are made in…
Lieu of paying rent or rent is reduced due to improvements
Capital gained dividend 2 definitions? are they short term or Longterm?
Distribution by regulated investment company (mutual fund)
Or capital gains realized from sale of investments in fund
Always long term
Constructive dividends, treatment of constructive dividends when their are excessive?
When employees or company’s land lords, creditors or
vendors are shareholders
Distributions that result in deduction to corporation and
Taxable income of shareholder
Excessive constructive dividends are no longer deducted but
Taxed as dividends
Alimony tax treatment
Tax treatment of child support and property settlement?
Deductible by payor spouse and taxable by payee spouse
Neither child support or property settlements are
Subject to deductions or taxes
3 classifications of payments required for tax purposes in divorce or legal separation
1 alimony
2 child support
3 property settlement
5 requirements to be treated as alimony payments
1 be made in cash (not property)
2 divorce, separation, written agreement btw spouses
3 terminate at death of payee
4 no designated as being other than alimony
5 made btw people living in separate households
Property settlement
Division of property pursuant of divorce
Each spouse entitled to property brought into marriage
And share of property accumulated in marriage
Recapture provision
Established to prevent large property settlement that
Might take place after divorce from being treated as alimony
Deduction for payor
Annuity
Series of regular fixed payments that continue for fixed
Period of time or til death of recipient
Annuity: expected return multiple
Number of years annuity is expected to continue
Annuity: exclusion ratio
Exclusion ratio = investment cost/expected return
Annuity: current year’s exclusion
Current year’s exclusion= exclusion ratio x amt. received during yr
Qualified retirement plan annuities
Distributions from pensions and other retirement plans
Both employer and employee contribute funds to these plans
Retirement plans involving a combination of pretax and after tax contributions are…
Taxed less favorably
Treatment of debt forgiveness
Taxable event
Taxpayer must report amount forgiven as income unless
It meets exceptions
Flow through entities
Income is taxed directly to owners of entities, not entities
Themselves
4 instances of flow through entities
1 distributive share of partnerships income
2 income in respect of descendent
3 income from interest in estate or trust
4 mutual funds and etfs
Tax treatment of gambling winnings
Taxable, losses can only be deducted up to amount won
Unemployment compensation
Taxable income
Tax treatment of social security benefits
Depends on filing status
Define social security benefits
Basic monthly retirement and disability benefits paid under
Social security
Insurance proceeds and court awards are…
4 exceptions?
Taxable
Accident insurance, health insurance,
face amount of life insurance, recovery for damaged property
Recovery of previously deducted amounts
A deduction that leads to a recovery of money must be
Included in gross income the year the money’s recovered
Interest on amount of refunded money is…
Taxable
Claim of right doctrine
Recipient of disputed amount of compensation must
Include amount received in gross income
Included As long as funds are unrestricted
Tax deferred bonds
Generally yield return somewhere close to taxable bonds
Deferred compensation arrangements
Contracts where money is paid in the future when person
is in lower tax bracket
Differed taxes result in tax savings
