Chapter 2 Income Tax Concepts Kevin Murphy Mark Higgins ©2007 South-Western
Based on a system of rules Developed around general concepts and specific exceptions Federal Income Taxation
Terminology • Concept - a broad principle • Construct - a means to implement a concept • Doctrine - a construct developed by the courts Concept Construct Doctrine
General ConceptsAbility to Pay • Constructs used • Deductions • Exclusions • Credits • Progressive tax rates Tax should be based on an amount that a taxpayer can afford to pay.
General ConceptsAdministrative Convenience The benefit derived from a concept, construct or doctrine should always exceed the cost of implementation. • Constructs used • Standard deduction amounts • Fringe benefit exclusions
Administrative Convenience Example • Bow Company allows its employees to make copies for personal reasons without charge on the company copy machine. The employees are not required to include the value of the copies in taxable income.
General ConceptsArms-Length Transaction Concept A transaction between related parties must reflect economic reality. • Constructs used • Related-party provisions • Constructive ownership rules
Arms-Length Transaction Example • Glenda sells 100 shares of IBM stock to her brother for $10,000. The shares had originally cost Glenda $12,000. Glenda is not allowed to use the $2,000 loss from the sale to reduce her taxable income.
General ConceptsPay As You Go Concept • Constructs used • Withholding • Estimated tax payments Taxpayers are required to pay tax as they generate income.
Each tax entity must keep separate records and report operations separately. Doctrine used Assignment of Income Accounting ConceptsEntity Concept Constructs used • Taxable entities • Conduit entities • Sole Proprietorships
Assignment of Income Doctrine All income earned from services provided by an entity or property owned by an entity are to be taxed to that entity. • Lucas v. Earl, 281 US 111
Assignment of Income Example • Alicia is a self-employed electrician. She deposits all cash payments she receives in a bank account in her son’s name. Alicia does not have use of the funds; however, she is required to include the amount of the cash payments in her gross income.
Accounting ConceptsAnnual Accounting Period Concept • Each taxpayer must select • A tax year • Calendar • Fiscal • An accounting method • Cash • Accrual • Hybrid
Annual Accounting Period ConceptConstructs & Doctrines Used • Tax Benefit Rule: If a tax benefit is derived from a deduction in one year, any refund received in a subsequent year must be reported as income.
Tax Benefit Rule Example • Angelo had $4,000 of state income taxes withheld from his salary during 2006. He deducted the $4,000 as part of his itemized deductions on his 2006 federal return. On May 15, 2007, he received a refund of $1,000 from the state. When he files his 2007 federal return, Angelo will be required to report the $1,000 as income.
Annual Accounting Period ConceptConstructs & Doctrines Used • Substance-Over-Form Doctrine: A transaction must be realistic in an ordinary sense and not contrived merely to avoid tax.
Substance Over Form Example • Janet “hired” her 4-year old son as office manager for her real estate firm. When she filed her federal tax return she deducted $20,000 as Salary Expense for him. The IRS disallowed the deduction when they examined her return.
Income ConceptsAll-inclusive Income Concept All income received is taxable unless a provision of the law specifically excludes it. Example: After buying books at the beginning of the semester, Lori finds a $100 bill in the parking lot. The $100 is part of Lori’s gross income.
Income ConceptsLegislative Grace Concept Any tax relief provided is the result of specific acts of Congress which are applied and interpreted strictly. • Constructs used • Exclusions, deductions and credits • Special classifications such as capital assets
Income ConceptsCapital Recovery Concept A taxpayer may recover all invested capital before income is taxed. • Constructs used • Basis • Gains and Losses
Capital Recovery Example • Nathan sold 200 shares of common stock for $2,000. Because he had paid $800 for the shares, he is required to report only $1,200 as income.
Income ConceptsRealization Concept • Doctrines used • Claim of Right Doctrine • applies to accrual basis taxpayers • Constructive Receipt Doctrine • applies to cash basis taxpayers No income is recognized as taxable income until it has been realized by the taxpayer.
Realization ConceptDoctrines Used • Claim of Right Doctrine: Realization does not occur until an amount has been receivedwithout restriction. • Applies when the taxpayer received payment but there is a dispute regarding the taxpayer’s right to keep some or all of it.
Claim of Right Example • Clara rented her garage apartment to Jared and collected $450, the first-month’s rent, in advance. She also collected $500 as a security deposit that she will return to Jared if he doesn’t damage the apartment. She must report only $450 as income because she has no claim of right to the $500.
Realization ConceptDoctrines Used • Constructive Receipt Doctrine • is a modification that prevents cash basis taxpayers from “turning their backs” on income • Realization is deemed to have occurred if • a taxpayer is aware an amount is available, • the amount is unconditionally available (even without physical possession), and • receipt of the amount is within the taxpayer’s control.
Constructive Receipt Example • Sam is a self-employed handyman. Maria, one of his customers, brought a check for $250 on December 30, 2006, to pay for work Sam had finished. Sam asked her to mail the check instead, so he could check “delivery time.” Sam must report the $250 as income in 2006 even if the check isn’t delivered until 2007.
Income ConceptsWherewithal-to-Pay Concept • Constructs used • Deferrals • Recognition of unearned income Tax should be recognized and paid when the taxpayer has the resources to pay.
Deduction ConceptsLegislative Grace Concept Any deduction allowed is the result of specific acts of Congress which are applied and interpreted strictly.
Deduction ConceptsBusiness Purpose Concept Only expenditures made in order to generate income and for a purpose other than tax avoidance will be deductible. • Examples: • Trade or business expenses • Investment expenses
Business Purpose Example • Michael may not deduct depreciation on his personal-use automobile because he does not use it in his business.
Deduction ConceptsCapital Recovery Concept • Constructs used • Basis • Capital expenditures A taxpayer may deduct the amount of capital invested before income is reported.