Chapter 5 Flashcards
Gross Income and Exclusions
Return of capital principle
When selling property, taxpayers allowed to reduce sale proceeds by the unrecovered investment in property to determine realized gain from sale. When tax basis exceeds sale proceeds, ROC principle generally applies to extent of sales proceeds. Basis over proceeds is a loss that is deductible only if authorized by tax code.
Complicated when taxpayers sell assets and collect proceeds over several periods. ROC occurs pro rata; discussed more in annuities.
How does recovery of amounts previously deducted work?
Typically not included in gross income; usually is ROC. However, refund made for expenditure in previous year included in gross income to extent that prior deduction produced a tax benefit. (Look at short section on itemized v standard, too long to sum).
Constructive receipt
Response to taxpayers using cash method of accounting to shift income to the next year (waiting to pick up checks until 1/2, delaying cashing a check). A taxpayer recognizes and realizes income when it is actually or constructively received. Occurs when:
Income credited to taxpayer’s account or is unconditionally available to them.
Taxpayer is aware of income’s availability.
No restrictions on taxpayer’s control over income.
Claim of right doctrine
Judicial doctrine that addresses timing of income recognition. Situations where taxpayer receives income in one period but required to return payment in a subsequent period. Income has been realized if taxpayer receives income and there are no restrictions on taxpayer’s use. (Bonus is a good example).
Tax benefit rule
Refund of an amount deducted in a previous period only included in income to the extent that deduction reduced taxable income.
Wherewithal to pay
Because parties to transaction must agree to value of exchanged property rights, transaction allows income to be measured objectively. Secondly, because transaction itself provides taxpayer with funds to pay taxes on income generated by transaction, they have wherewithal to pay.
(When taxpayers receive property/services in a transaction, realization occurs despite lack of wherewithal to pay.)
Assignment of income doctrine
Taxpayer who earns income from services must recognize income. Income from property, such as dividends and interest, is taxable to person who actually owns income-inducing property. E.g., interest income from a bond is taxable to person who owns bond during time interest income accrues. In order to shift income to another person, taxpayer must also shift property ownership to another person.
What is an annuity? Why do people usually purchase them? What types are there?
An investment that pays a stream of equal payments over time. Usually to generate a means of a fixed income stream during time. 1) Annuities paid over a fix period. 2) Annuities paid over a person’s life (or as long as the person lives).
Annuity exclusion ratio
Determines amount of each payment that is a nontaxable return of capital.
What are the two types of stock options? What are two dates associated with stock options?
Nonqualified options (NQOs) and incentive stock options (ISOs). Employees experience no tax consequences on grant date (date options are allocated to employees) or vesting date (date when options can be exercised).
What do employees do when they exercise NQOs?
Report income equal to the bargain element of the stock acquired (difference in fair market value of the stock acquired and purchase price). Basis in stock is fair market value (sum of amount paid for stock: exercise price) and the bargain element.
What do employees do when they exercise ISOs?
Don’t report any income for tax purposes (as long as they don’t immediately sell shares). Basis in shares acquired is exercising price. (Bargain element included in income for AMT purposes).
Wash sale (and rule)
An investor sells or trades stocks or securities at a loss and within 30 days either before or after the day of sales buys substantially identical stocks or securities. 61-day window during which wash sale provisions may apply.
Rule - Realized losses on sale of stock not recognized; instead, the amount of unrecognized loss is added to the basis of the newly acquired stock.
Capital gains and losses (netting)
After completing netting process, taxpayers must calculate tax consequences of resulting outcomes. NSTCG includes in gross income and taxes as ordinary income. NLTCG included in GI and usually taxed at 0, 15 or 20% depending on taxpayer’s taxable income and tax brackets for preferentially taxed capital gains and dividends.
How much of net capital losses can taxpayers deduct against ordinary income?
Up to $3,000 ($1,500 if MFS) of NCL against ordinary income. In excess retain their short- or long-term character and are carried forward and treated as though incurred in subsequent year. Short-term losses are applied first to reduce ordinary income when taxpayer recognizes both short- and long-term net capital losses. Capital loss carryovers for individuals never expire.
