Chapters 28 and 29
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Chapters 28 and 29. Tax Accounting Methods. Basic Principles. Taxable Year - period for which taxable income is computed calendar year fiscal year 52- 53-week year short year (if less than 12 months). Basic Principles (continued). Short Taxable Periods §443(a)

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Chapters 28 and 29

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Chapters 28 and 29

Chapters 28 and 29

Tax Accounting Methods


Basic principles

Basic Principles

  • Taxable Year - period for which taxable income is computed

    • calendar year

    • fiscal year

    • 52- 53-week year

    • short year (if less than 12 months)


Basic principles continued

Basic Principles (continued)

  • Short Taxable Periods §443(a)

    • change in taxpayer’s annual period

    • Taxpayer in existence for only part of his taxable year

    • requires taxpayer to annualize taxable income and tax and pay fraction of tax

      • number of months in short year / 12 months


Basic principles continued1

Basic Principles (continued)

  • Accounting Methods §446(c)

    • Cash receipts and disbursement method

    • Accrual method

    • Any other method allowed by the IRC

      • installment method

      • percentage-of-completion method

    • Combination of the above (Hybrid)

  • Must “clearly reflect income” §446(b)


Cash receipts and disbursements method

Cash Receipts andDisbursements Method

  • Requires “all items which constitute gross income to be included in income when actually or constructively received”

    • cash, property, or services

  • Requires expenditures to be deducted when actually paid

    • however, capital expenses must be depreciated


Cash method continued

Cash Method (continued)

  • Constructive Receipt (Reg. §1.446-1(c)(1)(i))

    • cash, property, or services are taxable when “actually or constructively received”

    • “a taxpayer may not deliberately turn his back upon income and thus select the year for which he will report it”

      • uncashed salary checks

      • refusal to accept payment from debtor


Cash method continued1

Cash Method (continued)

  • Factors affecting constructive receipt

    • Distance

    • Knowledge

    • Contractual arrangements

    • Forfeitures/penalties

    • Relationship of taxpayer to payor


Cash method continued2

Cash Method (continued)

  • Cash Equivalency Doctrine (Reg. §1.61-1(a))

    • “gross income includes income in any form, whether in money, property or services”

    • Letters or oral promises (accounts receivable) do not fall within this definition, but checks do.

    • Status of promissory notes is less clear

      • Cowden decision says it is cash equivalent if “is unconditional and assignable, not subject to set-offs, and is of a kind frequently transferred to lenders or investors at a discount not substantially greater than the generally prevailing premium for money…”


Cash method continued3

Cash Method (continued)

  • Economic Benefit Doctrine

    • Gross income includes any economic benefit conferred upon a taxpayer to the extent the benefit has an ascertainable fair market value

      • Most often used with respect to employee compensation and prizes and awards held in trust or escrow


Cash method continued4

Cash Method (continued)

Deferred Compensation

Lottery Prizes

Prepayments


Cash method continued5

Cash Method (continued)

  • Deductions (Reg. §1.446-1(c)(1)(i))

    • Deduction is available when cash paid or property given up and:

      • check is mailed (dropped in the mailbox)

      • amount is charged to credit card

      • payment made with borrowed funds

    • No deduction available

      • when funds are transferred to an agent of taxpayer

      • for deposit of funds in offer of compromise

      • for payment by issuance of own promissory note


Cash method continued6

Cash Method (continued)

  • Prepaid Expenses

    • Reg. §1.461-1(a)(1) – an expenditure by a cash method taxpayer resulting “in the creation of an asset having a useful life which extends substantially beyond the close of the taxable year” may not be deductible when made or may be deductible only in part.”

    • deductible in the years benefited by the expense (i.e., allocation over period of consumption)

  • EXCEPTION for prepaid rents, insurance or services:

    • 100% deductible in year paid if:

      • period for which payment is made does not exceed one year

      • taxpayer is contractually obligated to prepay


Cash method continued7

Cash Method (continued)

  • § 448 prohibits the use of the cash method for:

    • C Corporations and certain Partnerships

      • with average annual gross receipts exceeding $5M

      • exceptions for “qualified personal service corporations”

    • Taxpayers with inventory

      • with average annual gross receipts exceeding $1M


Accrual method

Accrual Method

  • All Events Test (Reg. §1.451-1(a)(1))

    • Income is earned “when all the events have occurred that fix the right to receive such income and the amount thereof can be determined with reasonable accuracy”

      • Exception: prepaid income included when received


Accrual method continued

Accrual Method (continued)

  • Prepaid Income:

    • Prepaid Interest/Rents/Royalties (general rule)

      • included in income when received (i.e., cash basis)

    • Prepaid Service Income (Rev. Proc. 71-21; superseded by Rev. Proc. 2004-34 for tax years on or after 5/6/04)

      • Full Inclusion Method – all in year of receipt

      • Deferral Method - portion included in income in year of receipt as it is earned, remainder included in income in tax year following year of receipt

    • Advance Payment for Goods (Reg. § 1.451-5)

      • included in income when goods are shipped if same method used for financial accounting purposes

    • Prepaid Subscription Income (§ 455)

      • included in income over subscription term


Accrual method continued1

Accrual Method (continued)

  • Economic Performance §461(h)

    • Expense is deducted when all the events establishing the existence of a liability have occurred; and amount determined with reasonable accuracy

      • liability of taxpayer to provide property and services

        • when goods are shipped; when services are performed

      • liability for property or services to the taxpayer

        • when goods are received; when services are provided

      • liability for which payment represents economic performance

        • when award or prize is paid; when warranty work is performed


Accrual method continued2

Accrual Method (continued)

  • Recurring Item Exception §461(h)(3)

    • certain recurring expenses are exempted from the economic performance rules and may be deducted if all of the following conditions are met:

      • all events test is satisfied

      • economic performance occurs within 8 1/2 months of close of taxable year or the filing of the return

      • the item is recurring in nature

      • the item is immaterial or accrual results in better matching of expense with income


Accrual method related parties

Accrual Method &Related Parties

  • Amounts owed by accrual method taxpayer to related cash method taxpayer

    • §267(a)(2) requires matching of deductions and income resulting from payments by a taxpayer to a related party defined in §267(b)

      • accrual method taxpayer may not deduct payment to a related party cash method taxpayer until included in income by the related party


Inventories 471

Inventories §471

  • Inventories must be maintained whenever the production, purchase, or sale of merchandise is an income-producing factor

    • regardless of the taxpayer’s method of accounting

    • basically, accrual method used to account for purchases and sales of inventory

  • Does not prohibit use of cash method to account for other items


Inventories 471 continued

Inventories §471 (continued)

  • Safe Harbor for small businesses

  • Rev. Proc. 2000-22

    • if average annual gross receipts do not exceed $1M, then may elect not to maintain inventories

  • Rev. Proc. 2002-28

    • if average annual gross receipts are between $1M and $10M, then may elect not to maintain inventories


Long term contracts 460

Long-Term Contracts §460

  • Long-Term Contract - any contract for the manufacture, building, installation, or construction of property that is not completed within the same taxable year in which it was entered into

    • manufacture of a unique item not normally carried in finished goods inventory

    • items that normally require more than 12 months to complete


Long term contracts continued

Long-Term Contracts (continued)

  • Taxpayers must use percentage-of-completion method to account for advance payments

  • Exceptions:

    • Contracts of Small Businesses - contracts completed within 2 years and are performed by a contractor whose average annual gross receipts for 3 preceding tax years do not exceed $10M §460(e)(2)

    • Home Construction Contracts - contracts in which 80% of costs are related to buildings containing 4 or fewer dwelling units §460(e)(1)


Changes of accounting methods

Changes of Accounting Methods

  • §446(e) requires taxpayers to obtain IRS consent before changing accounting method

    • Form 3115

  • Certain procedures are provided by IRS to permit changes of accounting methods under an automatic consent rule

  • §481 provides rules for involuntary changes of accounting methods


Chapter 2

Chapter 2

The Meaning of “Income” - Basic Definitional Concepts


Definition of income

Definition of “Income”

§ 61(a) - “gross income” - “all income from whatever source derived including (but not limited to) the following items:…”

Eisner v. Macomber – “gain derived from capital, from labor, or from both combined…”

aside from its direct impact on the taxability of stock dividends, three corollaries have important implications regarding definition of “income”


The fall of eisner

The Fall of Eisner

  • Hawkins v. Commissioner

    • “there may be cases in which taxable income will be judicially found …outside the precise scope of description already given”

  • U.S. v. Kirby Lumber

    • Discharge of debt results in income to debtor

  • Commissioner v. Glenshaw Glass Co

    • Punitive damages are “…undeniable accessions to wealth, clearly realized, over which the taxpayers have complete dominion”

  • Roco v. Commissioner

    • Applied Glenshaw to determine that qui tam payments were income


Cir v glenshaw glass co

CIR v. Glenshaw Glass Co.

CIR v. Glenshaw Glass Co.

Facts:

Issue:

Decision:

Reasons:


Income problems of statutory interpretation

“Income”Problems of Statutory Interpretation

“…gains or profits and income derived from any source whatever.”

  • Any form – whether money, property or services

  • At some point, measurement and administration becomes ridiculous


Realization

Realization

Economic income - increase in taxpayer’s net worth

Rule of administrative convenience and legislative generosity

  • would require annual valuations

  • wherewithal-to-pay the tax

    Any action that significantly alters the taxpayer’s relationship to an asset


Windfall receipts

Windfall Receipts

  • Cesarini v. United States

    • found property - taxable

    • gross income = FMV in year reduced to “undisputed possession”

  • unclaimed deposits and uncashed checks -taxable

  • de minimis receipts - nontaxable


Reimbursement for personal injury

Reimbursement for Personal Injury

§ 104(a) - excludes the amount of any damages (other than punitive damages)…received…on account of personal physical injuries or physical sickness.”

  • does not cover amounts awarded for nonphysical injuries (slander and libel)


Imputed income

Imputed Income

  • Imputed Income from Property

    • Investing in property (buying a home) vs. investing in capital markets

  • Imputed Income from Services

    • Self-help activities that provide economic benefit

    • Full-time household services are the only serious issue

  • Imputed Income from Self-employment

    • Morris v. Commissioner


Bargain purchases

Bargain Purchases

  • Bargain Purchases - a purchase of property for less than FMV

    • Pellar v. Commissioner

      • In general, bargain purchases are NOT gross income

    • Exception: compensation for services


Tax benefit rule

Tax Benefit Rule

“both a rule of inclusion and exclusion: recovery of an item previously deducted must be included in income; that portion of the recovery not resulting in a prior tax benefit is excluded.”


Tax benefit rule continued

Tax Benefit Rule(continued)

Inclusion of Recovered Items

  • collection of debts previously deducted as worthless; refund of previously deducted state and local taxes

    Exclusion of Items Deducted Without Tax Benefit

  • standard deduction vs. itemized deduction

  • Ex. ($300 state inc. tax refund; $3,100 itemized dedn/$3,000 std. dedn)


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