Chapter 4. Gross Income

Question 1

Income (broadly defined)

Answer 1

Includes all of the taxpayer’s income, both taxable and nontaxable

Question 2

Exclusions

Answer 2

Certain types of income are excluded form the income tax base.

Question 3

Gross Income

Answer 3

“except when otherwise provided intros subtitle, gross income means all income from whatever source derived.

Question 4

deductions

Answer 4

Generally all ordinary and necessary trade or business expenses are deductible by tax paying entities. (cogs, salaries, wages, operating expenses, r and d, interest, taxes, depreciation, amortization, and depletion.

Question 5

Taxable income

Answer 5

determined by subtracting deductions from gross income The tax rates are then applied to determine the tax rate. Tax prepayments and a wide variety of credits are subtracted from the tax to determine the amount due to the federal government or the refund due to the taxpayer.

Question 6

Economic income

Answer 6

determined by the change (increase/decrease) int he fair market value of the entity’s assets (net of liabilities) from the beginning to the end of the year.

Question 7

Windfall income

Answer 7

essentially wealth that you happen upon. Taxable because anything that increases net worth is income and any that that decreases net worth is deductible.

Question 8

How can income be realized? (forms)

Answer 8

1. Cash
2. Services
3. meals
4. accommodations
5. stock or other property

Question 9

Taxable year

Answer 9

Basic component of our tax system. taxpayer generally uses the tax year to report gross income. Fiscal year is allowed is the taxpayer maintains adequate books and records.

Question 10

Cash receipts method

Answer 10

property or services received are included n the tax-payers gross income in the year of actual or constructive receipt by the taxpayer or agent, regardless of whether the income was earned in that year. All that is necessary for income recognition is that property or services received be measurable by fair market value.

Question 11

What taxpayers are not permitted to use the cash method of accounting?

Answer 11

Accrual basis must be used to report income for;

1. Corporations (other than s corporations)
2. partnerships with a corporate partner (other than and S corporation)
3. Business taxpayers that carry inventories
4. tax shelters

Question 12

What businesses can still use the cash method?

Answer 12

1. A farming business
2. a qualified personal service corporation (regardless of gross receipts level)
3. a corporation or partnership with a corporate partner that is not at a tax shelter, whose average annual gross receipts for all prior three year periods are $5 million or less
4. Certain small taxpayers that carry inventories.

Question 13

Accrual method

Answer 13

An item is generally included in gross income fort he year in which it is earned, regardless of when he income is collected.

Income is earned when

1. all events have occurred that fix the right to receive the income
2. the amount to be received can be determined with reasonable accuracy

Question 14

Hybrid method

Answer 14

To simplify record keeping, some taxpayers account for inventory using the accrual method but use the cash method for all other income and deduction items (primarily used by small businesses when the cash method otherwise is not available.

Question 15

Constructive receipt

Answer 15

Income that has not actually been received by the taxpayer is taxed as though it had been received- the income is constructively received -under the following conditions;

1. the amount is made readily available to the taxpayer
2. the taxpayer’s annual receipt is not subject to substantial limitations or restrictions.

rationale: if the income is available, the taxpayer should not be allowed unilaterally to postpone income recognition. (can’t refuse to accept payment until a later date)

Question 16

original issue discount

Answer 16

The difference between the amount due at maturity and the amount of the original loan is actually interest, but is referred to as original issue discount.

The code requires the original issue discount to be reported when it is earned, regardless of the taxpayer’s accounting method. Interest earned is calculated by the effective interest rate method.

Question 17

amounts received under an obligation to repay

Answer 17

In borrowing the taxpayer’s assets and liabilities increase by the same amount, so no income is realized when the borrowed funds are received.

Question 18

Prepaid income (Special rules for accrual basis taxpayers)

Answer 18

Prepaid income is taxed in the year of receipt

Question 19

Deferral of advanced payment for goods (Special rules for accrual basis taxpayers)

Answer 19

Generally, an accrual basis taxpayer can elect to defer recognition of income from advance payments for goods if the method of accounting for the sale is the same for tax and financial reporting purposes.

Question 20

deferral of advanced payments fro services (Special rules for accrual basis taxpayers)

Answer 20

When payments are received for services that will be performed in a later tax year, an accrual basis taxpayer can defer for one year the recognition of income for the services that will be performed later. This method of acct. ,ay also be used for advanced payments received for goods, as well as licensing of intellectual property, and the sale, lease, or license of software.

Advanced payment for prepaid rent or prepaid interest, however are always taxed in the year of receipt.

Question 21

Personal services (Income sources)

Answer 21

Principle of taxation that income from personal services must be included in the gross income of the person who performs the services.

Fruit and tree metaphor: the fruit (income) must be attributed to the tree from which it came (the services).

This metaphor is simply stating that the ASSIGNMENT OF INCOME to another party does not shift the liability for the tax

Question 22

Services of an employee (Income sources)

Answer 22

Performances performed by an employee for the employee’s customers are considered performed by the employer. Thus, the employer is taxed on the income from the services provided to the customer, and the employee is taxed on the compensation received from the employer.

Question 23

Income form property (Income sources)

Answer 23

Income earned from property is included in the gross income of the owner of the property.

Often income producing property is transferred after income from the property has accrued, but before the income is recognized under the transferor’s method of accounting.

Question 24

Interest from property (Income sources)

Answer 24

according to the tax law, interest accrues daily therefore interest for the period that includes the date of an asset transfer is allocated between the transferee based on the number of days during the period that each owned the property.

Question 25

Dividends

Answer 25

A corporation is taxed on its earnings, and the shareholders are taxed on the dividend paid to them from the corporation's after tax earnings Partial relief from the double taxation of dividends has been provided that qualified dividends are taxed at the same marginal rate that is applicable to a net capital gain. distributions that are not qualified dividends are taxed at the rates that apply to ordinary income.

Question 26

Holding period requirement

Answer 26

A holding period requirement must be satisfied for a lower tax rate to apply. Stock that pays the dividends must be held for 60 days during the 121 day period beginning 60 days before the ex dividend date. The purpose of this requirement is to prevent the taxpayer from buying the stock shortly before the dividend is paid, receiving the dividend, and then selling the stock at a short term capital loss after the stock goes ex dividend.

Question 27

What classifies a dividend as a dividend?

Answer 27

A distribution by a corporation to its shareholders is classified as a dividend only if it is paid from the entity's earnings and profits (E&P). If the distribution is not made from E&P, it is treated as a return of the shareholder's investment and generally is not taxed at the time of distributions.

Question 28

Income received by an agent (Income sources)

Answer 28

Income received by the taxpayer's agent is considered to be received by the taxpayer. A cash basis principal must recognize the income at the time it is received by the agent

Question 29

Imputed interest on below-market loans (specific items of gross income)

Answer 29

Imputed interest is calculated using rates that the federal government pays on new borrowings and is compounded semiannually. (adjusted monthly) three federal rates; ``` Short term (not over three years) mid-term (over three but not over 9) long term (over nine) ``` If interest is charged on the loan but is less than the federal rate, the imputed interest is the difference between the amount that would have been charged at the federal rate and the amount actually charged.

Question 30

Tax benefit rule

Answer 30

generally, if a tax payer obtains a deduction for an item in one year and in a later year recovers all or a portion of their prior deduction, the recovery is include in gross income the year received. Limits income recognition when a deduction does not yield a tax benefit in the year it is taken.

Question 31

Interest on certain state and local government obligations (specific items of gross income)

Answer 31

The current exempt status applies solely to state and local government bonds. Thus, income received from the accrual of interest on a condemnation award or an overpayment of state tax is fully taxable. Nor does the exemption apply to gains on the sale of tax exempt securities. Although the code excludes from federal gross income the interest on state and local government bonds, the interest paid on US government bonds is not excluded from the federal tax base.

Question 32

Improvements on leased property (specific items of gross income)

Answer 32

any improvements made to the leased property are excluded from the landlord's gross income unless the improvement is made to the property in lieu of rent

Question 33

Life insurance proceeds (specific items of gross income)

Answer 33

life insurance proceeds paid to the beneficiary because of the death of the insured are exempt from income tax. Because; 1. for family members , life insurance proceeds serve much the same purpose as a nontaxable inheritance 2. in a business context, (and family) life insurance proceeds replace and economic loss suffered by the beneficiary.

Question 34

Exceptions to exclusion treatment

Answer 34

The income tax exclusion applies only when the insurance proceeds are received because of the death of the insured. If the owner cancels the policy and receives the cash surrender value, he or she must recognize gain to the extent of the excess of the amount received over the cost of the policy.

Question 35

Exceptions to the consideration Rule

Answer 35

These exceptions permit exclusion treatment for transfers to the following parties. The first three exceptions facilitate the use of insurance contracts to fund buy-sell agreements 1. A partner of the insured 2. Apartnership in which the insured is a partner 3. a corporation in which the insured is an officer or shareholder 4. a transferee whose basis in the policy is determined by reference to the transferor's basis, such as a gift to a transfer due to divorce 5. insured party under the policy

Question 36

Investment earnings arising from the reinvestment of life insurance proceeds

Answer 36

They are subject to income tax. Interest portion of each installment is included in gross income

Question 37

Income from discharge of indebtedness (specific items of gross income)

Answer 37

gross income is usually generated when a creditor cancels borrower's debt.

Question 38

reduction in debt is excluded in these situations

Answer 38

1. creditor's gift 2. Discharge that occur when the debtor is insolvent 3. discharge under federal bankruptcy law 4.discharge of the farm debt of a solvent taxpayer 5. discharge of qualified real property business indebtedness 6. Seller's cancellation of buyer's indebtedness 7. A shareholders cancellation of a corporations indebtedness 8. Forgiveness of certain loans to students 9. discharge of acquisitions idebteedness on the taxpayer's principal residence that occurs after 2006 and before 2015, and is the result of financial condition of the debtor

Question 39

Creditors' gift

Answer 39

If the creditor reduces the debt as an act of love, respect or generosity, the debtor has simply received a nontaxable gift

Question 40

Insolvency and bankruptcy

Answer 40

cancellation of indebtedness income is excluded when the debtor is insolvent (i,e the debtors liabilities exceed the fair market value of the assets) or when the cancellation of debt results from a bankruptcy proceeding. The debtor must decrease certain tax benefits (capital loss carry forwards, net operating loss carryforwards, some tax credits and suspended passive losses) by the amount of excluded.

Question 41

Capital gains and losses

Answer 41

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Question 42

Shareholder cancellation

Answer 42

If a shareholder cancels the corporations indebtedness to him or her and receives nothing in return, the cancellation usually is considers a contribution to capital to the corporation