1. Chapter 2 Income Tax Concepts Kevin Murphy Mark Higgins
©2008 South-Western 1

2. Federal Income Taxation
Based on a system of rules
Developed around general concepts and specific exceptions

3. Terminology Concept - a broad principle Concept
Construct - a means to implement a concept
Doctrine - a construct developed by the courts
Concept
Construct
Doctrine

4. General Concepts Ability to Pay
Tax should be based on an amount that a taxpayer can afford to pay.
Constructs used
Deductions
Exclusions
Credits
Progressive tax rates

5. General Concepts Administrative 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

6. 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.

7. General Concepts Arms-Length Transaction Concept
A transaction between related parties must reflect economic reality.
Constructs used
Related-party provisions
Constructive ownership rules

8. 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.

9. General Concepts Pay As You Go Concept
Taxpayers are required to pay tax as they generate income.
Constructs used
Withholding
Estimated tax payments

10. Accounting Concepts Entity Concept
Each tax entity must keep separate records and report operations separately.
Constructs used
Taxable entities
Conduit entities
Sole Proprietorships
Doctrine used
Assignment of Income

11. 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

12. 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.

13. Accounting Concepts Annual Accounting Period Concept
Each taxpayer must select
A tax year
Calendar
Fiscal
An accounting method
Cash
Accrual
Hybrid

14. Annual Accounting Period Concept Constructs & 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.

15. Tax Benefit Rule Example
Angelo had $4,000 of state income taxes withheld from his salary during 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.

16. Annual Accounting Period Concept Constructs & Doctrines Used
Substance-Over-Form Doctrine: A transaction must be realistic in an ordinary sense and not contrived merely to avoid tax.

17. 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.

18. Income Concepts All-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.

19. Income Concepts Legislative 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

20. Income Concepts Capital Recovery Concept
A taxpayer may recover all invested capital before income is taxed.
Constructs used
Basis
Gains and Losses

21. 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.

22. Income Concepts Realization Concept
No income is recognized as taxable income until it has been realized by the taxpayer.
Doctrines used
Claim of Right Doctrine
applies to accrual basis taxpayers
Constructive Receipt Doctrine
applies to cash basis taxpayers

23. Realization Concept Doctrines Used
Claim of Right Doctrine: Realization does not occur until an amount has been received without restriction.
Applies when the taxpayer received payment but there is a dispute regarding the taxpayer’s right to keep some or all of it.

24. 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.

25. Realization Concept Doctrines 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.

26. 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.

27. Income Concepts Wherewithal-to-Pay Concept
Tax should be recognized and paid when the taxpayer has the resources to pay.
Constructs used
Deferrals
Recognition of unearned income

28. Deduction Concepts Legislative Grace Concept
Any deduction allowed is the result of specific acts of Congress which are applied and interpreted strictly.

29. Deduction Concepts Business 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

30. Business Purpose Example
Michael may not deduct depreciation on his personal-use automobile because he does not use it in his business.

31. Deduction Concepts Capital Recovery Concept
A taxpayer may deduct the amount of capital invested before income is reported.
Constructs used
Basis
Capital expenditures