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

2. Transparency 2-2 © 2008 South-Western Federal Income Taxation vBased on a system of rules FDeveloped around general concepts and specific exceptions

3. Transparency 2-3 © 2008 South-Western Terminology vConcept - a broad principle FConstruct - a means to implement a concept FDoctrine - a construct developed by the courts Concept ConstructDoctrine

4. Transparency 2-4 © 2008 South-Western General Concepts Ability to Pay vConstructs used FDeductions FExclusions FCredits FProgressive tax rates Tax should be based on an amount that a taxpayer can afford to pay.

5. Transparency 2-5 © 2008 South-Western General Concepts Administrative Convenience vConstructs used FStandard deduction amounts FFringe benefit exclusions The benefit derived from a concept, construct or doctrine should always exceed the cost of implementation.

6. Transparency 2-6 © 2008 South-Western Administrative Convenience Example vBow 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. Transparency 2-7 © 2008 South-Western General Concepts Arms-Length Transaction Concept A transaction between related parties must reflect economic reality. vConstructs used F Related-party provisions FConstructive ownership rules

8. Transparency 2-8 © 2008 South-Western Arms-Length Transaction Example vGlenda 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. Transparency 2-9 © 2008 South-Western General Concepts Pay As You Go Concept v Constructs used FWithholding FEstimated tax payments Taxpayers are required to pay tax as they generate income.

10. Transparency 2-10 © 2008 South-Western Accounting Concepts Entity Concept Each tax entity must keep separate records and report operations separately. Doctrine used FAssignment of Income Constructs used FTaxable entities FConduit entities FSole Proprietorships

11. Transparency 2-11 © 2008 South-Western 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. Transparency 2-12 © 2008 South-Western Assignment of Income Example vAlicia 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. Transparency 2-13 © 2008 South-Western Accounting Concepts Annual Accounting Period Concept vEach taxpayer must select F A tax year VCalendar VFiscal F An accounting method VCash VAccrual VHybrid

14. Transparency 2-14 © 2008 South-Western Annual Accounting Period Concept Constructs & Doctrines Used vTax 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. Transparency 2-15 © 2008 South-Western Tax Benefit Rule Example vAngelo had $4,000 of state income taxes withheld from his salary during 2006. 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. Transparency 2-16 © 2008 South-Western vSubstance-Over-Form Doctrine: A transaction must be realistic in an ordinary sense and not contrived merely to avoid tax. Annual Accounting Period Concept Constructs & Doctrines Used

17. Transparency 2-17 © 2008 South-Western Substance Over Form Example vJanet “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. Transparency 2-18 © 2008 South-Western 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. Transparency 2-19 © 2008 South-Western Income Concepts Legislative Grace Concept vConstructs used FExclusions, deductions and credits FSpecial classifications such as capital assets Any tax relief provided is the result of specific acts of Congress which are applied and interpreted strictly.

20. Transparency 2-20 © 2008 South-Western Income Concepts Capital Recovery Concept vConstructs used FBasis FGains and Losses A taxpayer may recover all invested capital before income is taxed.

21. Transparency 2-21 © 2008 South-Western Capital Recovery Example vNathan 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. Transparency 2-22 © 2008 South-Western Income Concepts Realization Concept vDoctrines used FClaim of Right Doctrine Vapplies to accrual basis taxpayers FConstructive Receipt Doctrine Vapplies to cash basis taxpayers No income is recognized as taxable income until it has been realized by the taxpayer.

23. Transparency 2-23 © 2008 South-Western Realization Concept Doctrines Used vClaim of Right Doctrine: Realization does not occur until an amount has been received without restriction. FApplies when the taxpayer received payment but there is a dispute regarding the taxpayer’s right to keep some or all of it.

24. Transparency 2-24 © 2008 South-Western Claim of Right Example vClara 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. Transparency 2-25 © 2008 South-Western vConstructive Receipt Doctrine Fis a modification that prevents cash basis taxpayers from “turning their backs” on income vRealization is deemed to have occurred if Fa taxpayer is aware an amount is available, Fthe amount is unconditionally available (even without physical possession), and Freceipt of the amount is within the taxpayer’s control. Realization Concept Doctrines Used

26. Transparency 2-26 © 2008 South-Western Constructive Receipt Example vSam 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. Transparency 2-27 © 2008 South-Western Income Concepts Wherewithal-to-Pay Concept vConstructs used FDeferrals FRecognition of unearned income Tax should be recognized and paid when the taxpayer has the resources to pay.

28. Transparency 2-28 © 2008 South-Western Deduction Concepts Legislative Grace Concept Any deduction allowed is the result of specific acts of Congress which are applied and interpreted strictly.

29. Transparency 2-29 © 2008 South-Western Deduction Concepts Business Purpose Concept Only expenditures made in order to generate income and for a purpose other than tax avoidance will be deductible. vExamples: FTrade or business expenses FInvestment expenses

30. Transparency 2-30 © 2008 South-Western Business Purpose Example vMichael may not deduct depreciation on his personal-use automobile because he does not use it in his business.

31. Transparency 2-31 © 2008 South-Western Deduction Concepts Capital Recovery Concept vConstructs used FBasis FCapital expenditures A taxpayer may deduct the amount of capital invested before income is reported.