Ch. 3 Notes from 9/10/07

Chapter 3
Gross Income : Inclusions
I. Gross Income – What is it?
• Definition – Sec.61(a) of the code defines gross income as “all income from whatever source derived.” But the meaning of the term income has been mostly determined by the courts.

o Usually the code in tax law is broad and it is up to the courts to determine what the
meaning is.
• Economic and Accounting Concepts of Income
o The courts have established the principal that for income to be recognized for tax purposes it must be realized, (accounting income), therefore, increases in value, which is known as economic income, would not be taxed until the property is sold or exchanged.
o Governments uses economic income for things like property taxes, is the value of the property goes down the taxes go down
• Comparison of the accounting and tax concepts of income
o Although tax and financial accounting are often parallel to each other, they have different purposes.
• The primary goal of financial accounting is to provide useful information to managers, shareholders, creditors and other interested parties known as stake holders. While the goal of Tax Accounting is the equitable collection of revenue.
• Form of Receipt: Gross Income is not limited to cash received. Income can be realized as money, property or services received.
o If you get married and you get a new house, even as a gift, you have to include this on your taxes.
o If your doctor gives you free medical service.
• The Recovery of Capital Doctrine
o Under this doctrine, the gross receipts from the sale or disposition of property are reduced by the adjusting basis of the property sold to determine gross income.
• Usually required to use the calander year to report taxes, though a fiscal year can be used, however supstantial support must be given to allow the use of fiscal year.
• Accounting Method – 3 Major Method
i Cash - Receipts and disbursements method
ii Accrual method – most corporations use this method – Income is reported in the year it is earned
iii Hybrid Method
• Accural Method
Income is considered earned:
• All events have occurred which fix the right received such income
• The amount of the income can be determine with reasonable accuracy.
• Hybrid Method
 The combination of the cash and accrual method
• Mostly used by small businesses
• Exceptions applicable to Cash Basis Taxpayers
o 1. The Constructive Receipts Doctrine
• Limits and individual’s ability to postpone income recognition.
 If the taxpayer is entitled to receive the income and the amount is made readily available to him or her, it must be included in gross income.
o 2. Income Set Apart or made available is not constructively received if it is subject to substantial restrictions.
o Constructively = received but not realized.
• I.E. an increase in the cash surrender value on ordinary life insurance is not taxes as the policy increases in value.
o 3. When a lender makes a loan with initial issue discount, the accrued interest must be reported each year, regardless of the taxpayers accounting method.
o 4. Interest on U.S. series E or EE savings bonds is usually deferred until the bonds mature. However, a taxpayer may make an election to include the annual increase on the bond’s reduction.
o 5. No income is realized when money is borrowed. Receipt of funds under an obligation to repay is not a taxable event
• Exceptions applicable to Accrual Basis Acounting
o 1. Prepaid Income is generally taxed in year of receipt. Many court cases have been brought against the IRS by tax payers arguing that the proper matching of revenue and expenses, requires that income be recognized only when it is earned, (basically the accrual method) The IRS has modified its position in several areas
o 2. A taxpayer can defer “advance payments for goods if the taxpayer’s method of accounting for the sale is the same for tax and financial accounting purposes.
o 3. The taxpayer can elect to defer advance payments for services to be performed by the end of the tax year following the year of receipt. \
• Income Sources
A. Personal Services Income from personal services must be included in the gross income of the person “ who performs the services>:
B. Income from Property (i.e. In trust, dividends, rent) must be included in the gross income of the owner
C. Income Received by an Agent
• Income received by a taxpayers agent is considered received by the taxpayer. Thus a cash basis taxpayer must recognize income at the time it is received by his/her agent (attorney, accountant)
D. Income from Partnerships
• S-Corporations, Trusts and Estates
• A Partner or or shareholder must “included his or her distributive share of income and deductions” from these entities.
E. Income in Community Property States
• In 9 States
 Louisiana
 Texas
 New Mexico
 California
 Washington
 Idaho
 Nevada
 Wisconsin
Marital rights to the ownership of property apply. In Alaska, spouses can choose to have the community property rules apply. Income from personal services, for example, salaries and wages, is treated as earned equally by both spouses. Income from separate property is taxable to the person who owns the property, except in Texas. Louisiana, Wisconsin and Idaho where the income from separate property is community income.
*New York State is not a community property state.