CH. 5 - Gross Income & Exclusions Flashcards
Gross Income
Income that taxpayers realize, recognize, and report on their tax returns for the year.
More officially, it is realized income minus excluded and deferred income.
Official definition: all income from whatever source derived, unless excluded by law. Gross income includes income from any form, whether in money, property, or service.
Unless a tax provision clearly states otherwise, gross income includes all income.
What are the three requirements for a taxpayer to recognize gross income?
- they receive an economic benefit
- they realize the income (AKA they actually have the cash in hand) and
- no taxpayer provision allows them to exclude or defer the income from gross income for that year.
Explain what economic benefit is as it relates to gross income
Taxpayers must receive an economic benefit (aka receive an item of value) to have gross income. Common examples include:
-compensation for services (in the form of cash, other property, or even services received)
-proceeds from sale of property (typically cash, property, or debt relief)
-income from investments or business activities (such as business income, rents, interest, and dividends)
When a taxpayer borrows money, is the economic benefit criterion met for gross income?
No, because when a taxpayer borrows money, the funds received are offset by the liability (the debt plus interest).
What is the realization principle as it relates to gross income?
the proposition that income only exists when there is a transaction with another party resulting in a measurable change in property rights.
Aka assets or services are exchanged for cash, claims to cash, or other assets with determinable value.
What are the two major advantages for adopting the realization principle when it comes to gross income?
Parties to the transaction must agree to the value of the exchanged property rights, so the transaction allows the income to be measured objectively.
Secondly, the transaction often provides the taxpayer with the wherewithal to pay taxes. Aka, the transaction itself provides the taxpayer with the funds to pay the taxes generated by the transaction.
Wherewithal to pay
the ability or resources to pay taxes due from a particular transaction.
What is the recognition principle as it pertains to gross income?
Taxpayers who realize an economic benefit must include the benefit in gross income unless a specific provision of the tax code says otherwise.
What is the difference between realized income and recognized income income?
Realized income is that which is earned. If a company ships out goods worth $10,000 and includes an invoice for those goods with 30-day terms, the company doesn’t recognize the $10,000 in income until it has a check in hand for that amount. AKA CASH.
Recognized income, by contrast, is recorded but not necessarily received. If a company ships out $10,000 in goods and sends out an invoice with 30-day terms, it might record that $10,000 as recognized income before it gets paid. AKA CAN BE NON-CASH
Tax basis
If you invest in a company by buying common stock, that amount is considered your tax basis.
Return of capital
the tax basis (ie the amount you originally paid for your shares is excluded from calculating realized income) is excluded when calculating realized income.
Tax benefit rule
Refunds of expenditures deducted in a prior year (usually state income taxes filed with your 1040) are include in gross income to the extent that the refund reduced taxes in the year of the deduction.
accrual method
a method of accounting that generally recognizes income in the period earned and recognizes deductions in the period that liabilities are incurred.
cash method
the method of accounting that recognizes income in the period in which cash, property, or services are received and recognizes deductions in the period paid.
Constructive Receipt Doctrine
the judicial doctrine that provides that a taxpayer must recognize income when it is actually or constructively received. Constructive receipt is deemed to have occurred if the income has been credited to the taxpayer’s account or if 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.
Aka, you shouldn’t delay cashing checks, etc to work in your favor tax wise.
Claim of right doctrine
Informal: when there are no restrictions on the use of income–aka you are the one that is responsible and the one the money is meant to go to (aka no obligation to repay). Aka you can’t pass it off as someone else’s income when it’s really your own.
Formal: judicial doctrine that states that income has been realized if a taxpayer receives income and there are no restrictions on the taxpayer’s use of the income (for example, the taxpayer does not have an obligation to repay the amount).
What is assignment of income?
-The assignment of income doctrine holds that the taxpayer who earns the income from services must recognize the income
-Income from property such as dividends and interest is taxable to the person who actually owns the income producing property.
-To shift income from property to another person, a taxpayer must also transfer the ownership in the property to the other person.
What are community property systems, and in what states are they recognized?
*Recognized in 9 states: (AZ, CA, ID, LA, NV, NM, TX, WA, and WI)
Income earned from services by one spouse is treated as though it were earned equally by both spouses. Also, property acquired by either spouse during the marriage is usually community property and is treated as though it was owned equally by both spouses. Property that a spouse brings into a marriage is treated as the spouse’s separate property.
Define earned income
compensation and other forms of income received for providing goods or services in the ordinary course of business.
Aka income from services (so called because it is generated by the efforts of the taxpayer).
Unearned income
income from property that accrues as time passes without effort on the part of the owner of the property.
Aka income from property, such as gains or losses from the sale of property, dividends, interest, rents, royalties, and annuities.
The tax treatment of unearned income depends on the type of income and, in some circumstances, the type of transaction generating the income.
What is an annuity?
an investment that pays a stream of equal payments over time.
The tax law deems a portion of each annuity payment as a nontaxable return of capital and the remainder as gross income. Taxpayers use the annuity exclusion ratio to determine the portion of each payment that is a nontaxable return of capital.
Annuity exclusion ratio = original investment/expected value of annuity = return of capital percentage.
For fixed annuities, the expected value is the number of payments x the amount of the payment. However, for annuities paid over a persons life, taxpayers must use IRS tables to determine the expected value based upon the taxpayers life expectancy at the start of the annuity.
What are the key facts in regards to the return of capital principle?
-Taxpayers are allowed to recover the capital invested in property tax-free
-Payments from purchased annuities are part income and part return of capital
-When property is sold or disposed of, the realized gain or loss equals the sale proceeds reduced by the tax basis of the property.
Flow-through entities
legal entities, like partnerships, limited liability companies, and S corporations, that do not pay income tax. Income and losses from flow-through entities are allocated to their owners.
That is, the owners of the business report income or deductions as though they operated a portion of the business personally.
Alimony
a support payment of cash made to a former spouse. The payment must be made under a written separation agreement or divorce decree that does not designate the payment as something other than alimony, the payment must be made when the spouses do not live together, and the payments must cease no later than when the recipient dies.
