taxation of business entities c4-1 chapter 4 gross income copyright ©2010 cengage learning taxation...

C4-C4-11Taxation of Business EntitiesTaxation of Business Entities

Chapter 4Chapter 4

Gross IncomeGross Income

Copyright ©2010 Cengage Learning

Taxation of Business Entities


Gross Income (slide 1 of 3)Gross Income (slide 1 of 3)

• Definition: Gross income includes all income from whatever source derived, unless specifically excluded under the Code

• Concept is interpreted broadly by the courts

• Definition: Gross income includes all income from whatever source derived, unless specifically excluded under the Code

• Concept is interpreted broadly by the courts



• Taxability of income follows the realization principle from accounting– Income is recognized (taxed) when realized

• Mere appreciation in wealth (economic income) is not considered realized income

• Taxability of income follows the realization principle from accounting– Income is recognized (taxed) when realized

• Mere appreciation in wealth (economic income) is not considered realized income



• Income is recognized whether it is in the form of cash, or “in-kind” cash equivalents (i.e., property or services)– The amount of income from “in-kind” receipts

is equal to the FMV of the property or services

• Income does not include recovery of the taxpayer’s capital investment

• Income is recognized whether it is in the form of cash, or “in-kind” cash equivalents (i.e., property or services)– The amount of income from “in-kind” receipts

is equal to the FMV of the property or services

• Income does not include recovery of the taxpayer’s capital investment


Accounting PeriodsAccounting Periods

• Taxable year is generally a 12-month period– Taxable year for most individual taxpayers is

the calendar year– Fiscal year can be elected if taxpayer maintains

adequate records• Fiscal year is a 12-month period ending on the last

day of a month other than December– Example: July 1 to June 30

• Taxable year is generally a 12-month period– Taxable year for most individual taxpayers is

the calendar year– Fiscal year can be elected if taxpayer maintains

adequate records• Fiscal year is a 12-month period ending on the last

day of a month other than December– Example: July 1 to June 30


Accounting Methods (slide 1 of 2)Accounting Methods (slide 1 of 2)

• There are 3 primary methods of accounting for tax purposes:– Cash receipts and disbursements method– Accrual method– Hybrid method

• There are 3 primary methods of accounting for tax purposes:– Cash receipts and disbursements method– Accrual method– Hybrid method


Accounting Methods (slide 2 of 2)Accounting Methods (slide 2 of 2)

• In addition to overall accounting methods, taxpayers may choose (elect) tax treatment for various transactions, for example – Taxpayers can elect to use the installment

method – Certain contractors may elect to use either the

percentage of completion method or the completed contract method

• In addition to overall accounting methods, taxpayers may choose (elect) tax treatment for various transactions, for example – Taxpayers can elect to use the installment

method – Certain contractors may elect to use either the

percentage of completion method or the completed contract method


Cash Receipts Method (slide 1 of 2)Cash Receipts Method (slide 1 of 2)

• Income is recognized in the year it is actually or constructively received in cash or cash equivalent

• An amount is constructively received when it is set aside and made available to taxpayer without substantial restrictions

• Income is recognized in the year it is actually or constructively received in cash or cash equivalent

• An amount is constructively received when it is set aside and made available to taxpayer without substantial restrictions


Cash Receipts Method (slide 2 of 2)Cash Receipts Method (slide 2 of 2)

• Example - Constructive receipt – An employer issued a bonus check to an employee on

December 31st but asked her to hold it for a few days until the company could make deposits to cover the check.

• The income was not constructively received on December 31 since the issuer did not have sufficient funds in its account to pay the debt.

• Example - Constructive receipt – An employer issued a bonus check to an employee on

December 31st but asked her to hold it for a few days until the company could make deposits to cover the check.

• The income was not constructively received on December 31 since the issuer did not have sufficient funds in its account to pay the debt.


Exceptions To Cash Receipts Method

Exceptions To Cash Receipts Method

• Original Issue Discount (OID) interest is taxable when earned rather than when interest is received

• Original Issue Discount (OID) interest is taxable when earned rather than when interest is received


Accrual Method (slide 1 of 2)Accrual Method (slide 1 of 2)

• Income is recognized in the year that it is earned regardless of when it is collected

• Income is earned when:– All events have occurred that fix taxpayer’s right to the

income, and– The amount can be determined with reasonable

accuracy

• The accrual method is required for determining purchases and sales when inventory is an income-producing factor

• Income is recognized in the year that it is earned regardless of when it is collected

• Income is earned when:– All events have occurred that fix taxpayer’s right to the

income, and– The amount can be determined with reasonable

accuracy

• The accrual method is required for determining purchases and sales when inventory is an income-producing factor


Accrual Method (slide 2 of 2)Accrual Method (slide 2 of 2)

• Claim of right doctrine – Requires amounts received to be included in

income even though the amount is in dispute and might be returned to the payor at a later date

– If payment has not been received, no income is recognized until the claim is settled

• Claim of right doctrine – Requires amounts received to be included in

income even though the amount is in dispute and might be returned to the payor at a later date

– If payment has not been received, no income is recognized until the claim is settled


Exceptions to Accrual Method (slide 1 of 2)


• Taxpayer can elect to defer recognition of income from advance payment for goods if same method of accounting is used for tax and financial reporting purposes

• Taxpayer can elect to defer recognition of income from advance payment for goods if same method of accounting is used for tax and financial reporting purposes




• Advance payment for services to be performed after year-end is included in income in the year following receipt – The portion of the advance payment that is

earned in the current year is included in income in the year of receipt

• Prepaid rents or interest income are always recognized in the year received rather than when earned

• Advance payment for services to be performed after year-end is included in income in the year following receipt – The portion of the advance payment that is

earned in the current year is included in income in the year of receipt

• Prepaid rents or interest income are always recognized in the year received rather than when earned


Hybrid MethodHybrid Method

• A combination of cash and accrual methods

• Generally, used when inventory is a material income-producing factor– Use accrual method for determining sales and

cost of goods sold – Use cash method for other income and

expenses

• A combination of cash and accrual methods

• Generally, used when inventory is a material income-producing factor– Use accrual method for determining sales and

cost of goods sold – Use cash method for other income and

expenses


Income Sources (slide 1 of 2)Income Sources (slide 1 of 2)

• Income from personal services is taxable to the person who performs the services– Fruit and tree metaphor

• Income from property is taxable to the owner of the property– Assignment of income is not permitted

• Income from personal services is taxable to the person who performs the services– Fruit and tree metaphor

• Income from property is taxable to the owner of the property– Assignment of income is not permitted


Income Sources (slide 2 of 2)Income Sources (slide 2 of 2)

• Interest income accrues daily– If interest bearing instrument (e.g., bonds) is

transferred, must allocate interest income between transferor and transferee based on the number of days during the period that each owned the property

• Interest income accrues daily– If interest bearing instrument (e.g., bonds) is

transferred, must allocate interest income between transferor and transferee based on the number of days during the period that each owned the property


Dividends (slide 1 of 4)Dividends (slide 1 of 4)

• Dividends are generally taxed to the party who is entitled to receive them– Dividends on stock transferred by gift after

declaration date but before record date is generally taxed to the donor

• Dividends are generally taxed to the party who is entitled to receive them– Dividends on stock transferred by gift after

declaration date but before record date is generally taxed to the donor



• The Tax Relief Reconciliation Act of 2003 provides partial relief from double taxation of corporate dividends (extended by the Tax Increase Prevention Act of 2005)

– Generally, dividends received in taxable years beginning after 2002 are taxed at the same marginal rate that is applicable to a net capital gain

• Thus, individuals otherwise subject to the 10% or 15% marginal tax rate pay 0% tax on qualified dividends received

• Individuals subject to the 25, 28, 33, or 35 percent marginal tax rate pay a 15% tax on qualified dividends

• The Tax Relief Reconciliation Act of 2003 provides partial relief from double taxation of corporate dividends (extended by the Tax Increase Prevention Act of 2005)

– Generally, dividends received in taxable years beginning after 2002 are taxed at the same marginal rate that is applicable to a net capital gain

• Thus, individuals otherwise subject to the 10% or 15% marginal tax rate pay 0% tax on qualified dividends received

• Individuals subject to the 25, 28, 33, or 35 percent marginal tax rate pay a 15% tax on qualified dividends



• The following dividends are not eligible for the reduced tax rates– Dividends from certain foreign corporations,– Dividends from tax-exempt entities, and– Dividends that do not satisfy the holding period

requirement• Stock on which the dividend is paid must have been held for

more than 60 days during the 121-day period beginning 60 days before the ex-dividend date to qualify for the reduced tax rates

• The following dividends are not eligible for the reduced tax rates– Dividends from certain foreign corporations,– Dividends from tax-exempt entities, and– Dividends that do not satisfy the holding period

requirement• Stock on which the dividend is paid must have been held for

more than 60 days during the 121-day period beginning 60 days before the ex-dividend date to qualify for the reduced tax rates



• Dividends from foreign corporations are eligible for qualified dividend status only if:– The foreign corporation’s stock is traded on an

established U.S. securities market, or – The foreign corporation is eligible for the

benefits of a comprehensive income tax treaty between its country of incorporation and the United States

• Dividends from foreign corporations are eligible for qualified dividend status only if:– The foreign corporation’s stock is traded on an

established U.S. securities market, or – The foreign corporation is eligible for the

benefits of a comprehensive income tax treaty between its country of incorporation and the United States


Income Received By An AgentIncome Received By An Agent

• 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

• 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


Imputed Interest on Below-Market Loans (slide 1 of 4)


• Interest is imputed, using Federal government rates, when a loan does not carry a market rate of interest– Imputed interest = the difference between the amount

that would have been charged at the Federal rate and the amount actually charged

• Applies to: • Gift loans• Compensation-related loans• Corporate-shareholder loans• Tax avoidance loans

• Interest is imputed, using Federal government rates, when a loan does not carry a market rate of interest– Imputed interest = the difference between the amount

that would have been charged at the Federal rate and the amount actually charged

• Applies to: • Gift loans• Compensation-related loans• Corporate-shareholder loans• Tax avoidance loans




• Gift loans– Exemption for loans of ≤ $10,000 between individuals

• If loan proceeds are used to purchase income-producing property, the following limitation applies

– On loans of $100,000 or less between individuals• Imputed interest is limited to borrower’s net investment

income for year

• No imputed interest if net investment income is $1,000 or less

• Gift loans– Exemption for loans of ≤ $10,000 between individuals

• If loan proceeds are used to purchase income-producing property, the following limitation applies

– On loans of $100,000 or less between individuals• Imputed interest is limited to borrower’s net investment

income for year

• No imputed interest if net investment income is $1,000 or less




• $10,000 exemption also applies to compensation-related and corporation-shareholder loans– No exemption if principal purpose of loan is tax

avoidance• Makes practically all loans of this type suspect

• Interest expense imputed to borrower may be deductible

• $10,000 exemption also applies to compensation-related and corporation-shareholder loans– No exemption if principal purpose of loan is tax

avoidance• Makes practically all loans of this type suspect

• Interest expense imputed to borrower may be deductible


Tax Benefit RuleTax Benefit Rule

• If taxpayer receives a deduction for an item in one year and in a later year recovers all or a portion of the prior deduction, the recovery is included in gross income– Amount included in income is limited to the

amount for which a tax benefit was received

• If taxpayer receives a deduction for an item in one year and in a later year recovers all or a portion of the prior deduction, the recovery is included in gross income– Amount included in income is limited to the

amount for which a tax benefit was received


Interest on State and Local Government Obligations

Interest on State and Local Government Obligations

• Interest from municipal bonds is tax exempt– Reduces borrowing costs of state and local

governments– High-income taxpayers can increase after-tax

yields with municipal bonds– Municipal interest is considered for Social

Security benefits inclusion and may be considered for alternative minimum tax calculation

• Interest from municipal bonds is tax exempt– Reduces borrowing costs of state and local

governments– High-income taxpayers can increase after-tax

yields with municipal bonds– Municipal interest is considered for Social

Security benefits inclusion and may be considered for alternative minimum tax calculation


Improvements on Leased Property

Improvements on Leased Property

• Improvements made to leased property – Excluded from landlord’s gross income unless

the improvement is made to the property in lieu of rent

• Improvements made to leased property – Excluded from landlord’s gross income unless

the improvement is made to the property in lieu of rent


Life Insurance Proceeds (slide 1 of 3)


• Exempt income to beneficiary if paid solely due to death of insured– Relationship to decedent not determinative

• Exempt income to beneficiary if paid solely due to death of insured– Relationship to decedent not determinative




• If owner of life insurance policy cancels the policy and receives the cash surrender value– Gain must be recognized to extent amount

received exceeds premiums paid on policy– Loss is not recognized

• If owner of life insurance policy cancels the policy and receives the cash surrender value– Gain must be recognized to extent amount

received exceeds premiums paid on policy– Loss is not recognized




• Transfers for valuable consideration– If policy is transferred for valuable

consideration, proceeds are taxable to extent they exceed amount paid for policy plus subsequent premiums paid

– Exceptions exist for policy transfers:• To facilitate funding of buy-sell agreements,

• Pursuant to a tax-free exchange, and

• For receipt of a policy by gift

• Transfers for valuable consideration– If policy is transferred for valuable

consideration, proceeds are taxable to extent they exceed amount paid for policy plus subsequent premiums paid

– Exceptions exist for policy transfers:• To facilitate funding of buy-sell agreements,

• Pursuant to a tax-free exchange, and

• For receipt of a policy by gift


Discharge from IndebtednessDischarge from Indebtedness

• Income from the forgiveness of debt is taxable – Certain discharge of indebtedness situations get special

treatment:• Creditors’ gifts• Discharges in bankruptcy and when debtor is insolvent• Discharge of farm debt• Discharge of qualified real property business indebtedness• Seller’s cancellation of buyer’s debt• Shareholder’s cancellation of corporation’s debt• Forgiveness of certain student loans• Discharge of indebtedness on taxpayer’s principal residence

that occurs between Jan. 1, 2007 and Jan. 1, 2013, and is the result of the financial condition of the debtor

• Income from the forgiveness of debt is taxable – Certain discharge of indebtedness situations get special

treatment:• Creditors’ gifts• Discharges in bankruptcy and when debtor is insolvent• Discharge of farm debt• Discharge of qualified real property business indebtedness• Seller’s cancellation of buyer’s debt• Shareholder’s cancellation of corporation’s debt• Forgiveness of certain student loans• Discharge of indebtedness on taxpayer’s principal residence

that occurs between Jan. 1, 2007 and Jan. 1, 2013, and is the result of the financial condition of the debtor


Gains and Losses from Property Transactions (slide 1 of 3)


•In order for gains (losses) to be recognized (included in gross income), they must be realized:

–Realized gain (loss) = amount realized – adjusted basis

•Amount realized = selling price – costs of disposition

•Adjusted basis = cost + capital additions – cost recovery

•In order for gains (losses) to be recognized (included in gross income), they must be realized:

–Realized gain (loss) = amount realized – adjusted basis

•Amount realized = selling price – costs of disposition

•Adjusted basis = cost + capital additions – cost recovery




• All realized gains are recognized unless a specific tax provision provides otherwise (e.g., nontaxable exchanges)

• Realized losses may or may not be recognized depending on the circumstances– Generally, losses on the sale or disposition of

personal use property are not recognized

• All realized gains are recognized unless a specific tax provision provides otherwise (e.g., nontaxable exchanges)

• Realized losses may or may not be recognized depending on the circumstances– Generally, losses on the sale or disposition of

personal use property are not recognized




• Once recognized gains or losses have been determined, they must be classified as ordinary or capital– Ordinary gains are fully taxable– Ordinary losses are fully deductible

• Capital gains and losses are subject to special tax treatment

• Once recognized gains or losses have been determined, they must be classified as ordinary or capital– Ordinary gains are fully taxable– Ordinary losses are fully deductible

• Capital gains and losses are subject to special tax treatment


Gains and Losses from Capital Asset Transactions (slide 1 of 2)


• Capital assets are defined as any property other than:– Inventory,– Accounts Receivable, and– Depreciable property or real property used in a business– Certain other property

• Most personal use assets owned by individuals are capital assets– Losses on these assets are not deductible

• Capital assets are defined as any property other than:– Inventory,– Accounts Receivable, and– Depreciable property or real property used in a business– Certain other property

• Most personal use assets owned by individuals are capital assets– Losses on these assets are not deductible




• Gains and losses from capital asset transactions must be netted– Net gains and losses by holding period– If excess losses result, tax treatment depends on

whether taxpayer is an individual or corporation

• Gains and losses from capital asset transactions must be netted– Net gains and losses by holding period– If excess losses result, tax treatment depends on

whether taxpayer is an individual or corporation


Max Tax Rates for Net Capital Gains of Individuals

Max Tax Rates for Net Capital Gains of Individuals

Classification Maximum RateShort-term gains (held ≤ one year) 35%Long-term gains (held > one year)• Collectibles 28%• Certain depreciable property used

in a trade or business (unrecaptured § 1250 gain) 25%

• All other long-term capital gains 15% /5%/0%

Classification Maximum RateShort-term gains (held ≤ one year) 35%Long-term gains (held > one year)• Collectibles 28%• Certain depreciable property used

in a trade or business (unrecaptured § 1250 gain) 25%

• All other long-term capital gains 15% /5%/0%


Treatment of Capital Losses(slide 1 of 2)


• Net capital losses of individuals are deductible for AGI up to $3,000 yearly– Excess capital losses are carried over to the

next tax year– When carried over, capital losses retain their

classification as short- or long-term

• Net capital losses of individuals are deductible for AGI up to $3,000 yearly– Excess capital losses are carried over to the

next tax year– When carried over, capital losses retain their

classification as short- or long-term




• Corporations must also net capital gains and losses– Net capital gains do not receive special tax

treatment– Capital losses can only offset capital gains

• Excess capital losses may not be deducted against ordinary income

• Unused capital losses can be carried back 3 years and then carried forward 5 years to offset capital gains in those years

• Corporations must also net capital gains and losses– Net capital gains do not receive special tax

treatment– Capital losses can only offset capital gains

• Excess capital losses may not be deducted against ordinary income

• Unused capital losses can be carried back 3 years and then carried forward 5 years to offset capital gains in those years


If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact:

Dr. Donald R. Trippeer, CPA [email protected]

SUNY Oneonta

If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact:

Dr. Donald R. Trippeer, CPA [email protected]

SUNY Oneonta

taxation of business entities c4-1 chapter 4 gross income copyright ©2010 cengage learning taxation...

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