South-Western Federal Taxation, 2009 Edition

South-Western Federal Taxation, 2009 Edition Comprehensive Volume ISBN: 0324660529

Chapter 4 Gross Income: Concepts and Inclusions

Accounting income. The accountant’s concept of income is generally based upon the realization principle. Financial accounting income may differ from taxable income (e.g., accelerated depreciation might be used for Federal income tax and straight-line depreciation for financial accounting purposes). Differences are included in a reconciliation of taxable and accounting income on Schedule M–1 or Schedule M–3 of Form 1120 for corporations.

Accounting method. The method under which income and expenses are determined for tax purposes. Important accounting methods include the cash basis and the accrual basis. Special methods are available for the reporting of gain on installment sales, recognition of income on construction projects (the completed contract and percentage of completion methods), and the valuation of inventories (last-in, first-out and first-in, first-out). §§ 446–474.

Accrual method. A method of accounting that reflects expenses incurred and income earned for any one tax year. In contrast to the cash basis of accounting, expenses need not be paid to be deductible, nor need income be received to be taxable. Unearned income (e.g., prepaid interest and rent) generally is taxed in the year of receipt regardless of the method of accounting used by the tax-payer. § 446(c)(2).

Alimony and separate maintenance payments. Alimony deductions result from the payment of a legal obligation arising from the termination of a marital relationship. Payments designated as alimony generally are included in the gross income of the recipient and are deductible for AGI by the payer.

Alimony recapture. The amount of alimony that previously has been included in the gross income of the recipient and deducted by the payor that now is deducted by the recipient and included in the gross income of the payor as the result of front-loading. § 71(f).

Annuity. A fixed sum of money payable to a person at specified times for a specified period of time or for life. If the party making the payment (i.e., the obligor) is regularly engaged in this type of business (e.g., an insurance company), the arrangement is classified as a commercial annuity. A so-called private annuity involves an obligor that is not regularly engaged in selling annuities (e.g., a charity or family member).

Assignment of income. A procedure whereby a taxpayer attempts to avoid the recognition of income by assigning to another the property that generates the income. Such a procedure will not avoid the recognition of income by the taxpayer making the assignment if it can be said that the income was earned at the point of the transfer. In this case, usually referred to as an anticipatory assignment of income, the income will be taxed to the person who earns it.

Cash receipts method. A method of accounting that reflects deductions as paid and income as received in any one tax year. However, deductions for prepaid expenses that benefit more than one tax year (e.g., prepaid rent and prepaid interest) usually must be spread over the period benefited rather than deducted in the year paid. § 446(c)(1). Claim of right doctrine. A judicially imposed doctrine applicable to both cash and accrual basis taxpayers that holds that an amount is includible in income upon actual or constructive receipt if the taxpayer has an unrestricted claim to the payment. For the tax treatment of amounts repaid when previously included in income under the claim of right doctrine, see § 1341.

Community property. Louisiana, Texas, New Mexico, Arizona, California, Washington, Idaho, Nevada, and Wisconsin have community property systems. Alaska residents can elect community property status for assets. The rest of the states are common law property jurisdictions. The difference between common law and community property systems centers around the property rights possessed by married persons. In a common law system, each spouse owns whatever he or she earns. Under a community property system, one-half of the earnings of each spouse is considered owned by the other spouse. Assume, for example, Jeff and Alice are husband and wife and their only income is the $50,000 annual salary Jeff receives. If they live in New York (a common law state), the $50,000 salary belongs to Jeff. If, however, they live in Texas (a community property state), the $50,000 salary is owned one-half each by Jeff and Alice.

Constructive receipt. If income is unqualifiedly available although not physically in the taxpayer’s possession, it is subject to the income tax. An example is accrued interest on a savings account. Under the constructive receipt of income concept, the interest is taxed to a depositor in the year available, rather than the year actually withdrawn. The fact that the depositor uses the cash basis of accounting for tax purposes is irrelevant. See Reg. § 1.451–2.

Economic income. The change in the taxpayer’s net worth, as measured in terms of market values, plus the value of the assets the taxpayer consumed during the year. Because of the impracticality of this income model, it is not used for tax purposes.

Fruit and tree metaphor. The courts have held that an individual who earns income from property or services cannot assign that income to another. For example, a father cannot assign his earnings from commissions to his child and escape income tax on those amounts.

Gross income. Income subject to the Federal income tax. Gross income does not include all economic income. That is, certain exclusions are allowed (e.g., interest on municipal bonds). For a manufacturing or merchandising business, gross income usually means gross profit (gross sales or gross receipts less cost of goods sold). § 61 and Reg. § 1.61–3(a).

Group term life insurance. Life insurance coverage provided by an employer for a group of employees. Such insurance is renewable on a year-to-year basis, and typically no cash surrender value is built up. The premiums paid by the employer on the insurance are not taxed to the employees on coverage of up to $50,000 per person. § 79 and Reg. § 1.79–1(b).

Hybrid method. A combination of the accrual and cash methods of accounting. That is, the taxpayer may account for some items of income on the accrual method (e.g., sales and cost of goods sold) and other items (e.g., interest income) on the cash method.

Imputed interest. For certain long-term sales of property, the IRS can convert some of the gain from the sale into interest income if the contract does not provide for a minimum rate of interest to be paid by the purchaser. The application of this procedure has the effect of forcing the seller to recognize less long-term capital gain and more ordinary income (interest income). § 483 and the related Regulations.

Income. For tax purposes, an increase in wealth that has been realized. Original issue discount. The difference between the issue price of a debt obligation (e.g., a corporate bond) and the maturity value of the obligation when the issue price is less than the maturity value. OID represents interest and must be amortized over the life of the debt obligation using the effective interest method. The difference is not considered to be original issue discount for tax purposes when it is less than one-fourth of 1 percent of the redemption price at maturity multiplied by the number of years to maturity. §§ 1272 and 1273(a) (3).

Partnership. For income tax purposes, a partnership includes a syndicate, group, pool, or joint venture, as well as ordinary partnerships. In an ordinary partnership, two or more parties combine capital and/or services to carry on a business for profit as co-owners. § 7701(a)(2).

Recovery of capital doctrine. When a taxable sale or exchange occurs, the seller may be permitted to recover his or her investment (or other adjusted basis) in the property before gain or loss is recognized.

S corporation. The designation for a small business corporation. See also Subchapter S.

Taxable year. The annual period over which income is measured for income tax purposes. Most individuals use a calendar year, but many businesses use a fiscal year based on the natural business year.