1. Chapter 2 Income Tax Concepts Instructor PowerPoint Slides Updated-August 9, 2013 Howard Godfrey, Ph.D., CPA Professor of Accounting ©Howard Godfrey-2013

2. Part 1. Introduction Part 2. General Concepts (ability to pay, administrative convenience, arms- length, pay-as-you-go) Part 3. Accounting Concepts (entity, assignment of income, annual accounting period, accounting method, tax benefit rule, substance-over-form) Part 4. Income Concepts (all inclusive, legislative grace, capital recovery, realization, claim of right, constructive receipt, wherewithal to pay) Part 5. Deduction Concepts (legislative grace, business purpose, capital recovery)

4. Part 2. General Concepts: Ability to pay. Should a person’s tax liability be based on income or ability to pay? Suppose an individual has a salary of $100,000, and has uninsured medical expenses of $80,000. Should the income tax liability be related to $100,000 or $20,000?

5. Part-2. General Concepts: administrative convenience Michael coaches a little league baseball team. He uses his employer’s copy machine (with employer consent) to makes 15 copies of the team’s schedule to give to the players. Does Michael include the cost (or value) of the copies in his income?

6. Part 2. General Concepts: arms-length. Susan purchased a lot for investment purposes. She paid $10,000 for the lot. Three years later she sold the lot to her daughter for its current value of $8,000. May Susan deduct the loss?

7. Part 2. General Concepts: pay-as-you-go. Thomas earns a salary of $200,000 and $40,000 was withheld from his paycheck for federal income tax. Sally earns interest income of $200,000 per year, but does not have any income tax withheld. How (when) will Sally per her income taxes?

9. Part 3. Accounting Concepts: Entity Concept. Ben paid $60,000 on 1-1-2013 for 5% of the stock of Big Corporation, which is a C corporation. Ben earned a salary of $200,000 from Big Corp. Big Corp. had net income of $100,000 in 2012. Ben received dividends of $1,000 from Big. Corp. Ben paid $30,000 on 1-1-2013 for a 25% interest in BCD partnership, which owns rental property. BCD’s revenue of $90,000 & expenses was $50,000. No salary or guaranteed payment was made to any partner. Ben withdrew $4,000 from BCD. He has no deduction “for AGI?” What is Ben’s AGI a. $204,000 b. $211,000 d. Other

12. Part 3. Accounting Concepts: Entity Concept. Use the information on the preceding slide. Assume Big Corp. is an “S” corp. What is Ben’s AGI, assuming he has no deduction “for AGI?” a. $215,000 b. $212,000 d. Other

15. Part 3. Accounting Concepts: Assignment of income Sam owns land that he rents to a farmer for $1,000 per month. He received $1,000 each of the first ten months of the year. Sam instructed the farmer to send the last two month's rent to his mother. How much rental income should Sam report for the year? a. $10,000 b. $12,000 c. Other

16. Part 3. Accounting Concepts- Annual accounting period and method. In Year 1, Jan began a new business called J-Corp. The company’s cash basis fin. statements are on next slide (in $000). At the end of the first year. J-Corp. had Accounts Receivable of $100,000 from customers, and Accounts Payable for utilities of $10,000. (Cash basis – these items not recorded.) What is accrual basis net income for Year 1? a. $130,000 b. $220,000 c. Other

23. Compare cash basis and accrual basis Over the life of a business, total cash basis net income will equal total accrual basis net income. Differences between cash basis and accrual basis net income in current year are timing differences. A company using the accrual basis in its GAAP financial statements, may find that the tax law requires a modified form of accrual basis on the tax return, causing timing differences. Permanent differences will arise when an expense is never deductible on the tax return, etc. Page C-25

27. Part 3. Accounting Concept: Tax benefit rule In 2013, Ms. Jones (single) earned a salary of $60,000. She deducted the following expenses on their 2013 income tax return: state income taxes of $4,000, mortgage interest of $6,000 and real estate taxes amounting to $2,000. She has three small children whom she supports. (see next slide) She receives a state income tax refund of $1,000 in 2013, for 2014. How much income does she report from this refund? a. $1,000 b. $40 c. Other

29. Continue preceding case. Ms. Jones had itemized deductions of $12,000. If she had not deducted the state income taxes of $4,000, her itemized deductions would have been $8,000, and she would have deducted the $8,500 standard deduction. She did not benefit from all of the $4,000 in deduction for the state income tax. Her tax benefit was $3,500. She received a refund of $1,000, all of that is income. If she had received a $3,800 refund, she would include $3,500 in income.

30. Part 3. Accounting Concepts: Substance-over-form Jan asked a friend, Bob, to suggest some individuals who might want to buy from the Jan’s business. Bob gave Jan a list of 20 wealthy individuals. Jan made substantial sales to individuals on that list. In appreciation for his help, Jan gave Bob a $3,000 airline ticket so that Bob could visit Bob’s mother in another country. What are the issues regarding Substance vs. Form here?

32. Part 4. Income Concepts: All inclusive. Every type of income received is included in gross income-- except where you can identify a provision of the tax law that allows that income to be excluded from gross income.

33. Part 4. Income Concepts: All inclusive. Juan earns a salary of $50,000. Juan has a garden in which he raises corn, tomatoes, etc. Juan gave a large amount of vegetables to the owner of a lawn service. In return, the lawn company mowed Juan’s yard weekly for 20 weeks, and did not charge its normal fee of $50 per mowing. What is Juan’s gross income for the year? a. $50,000 b. $51,000 c. Other Why?

34. Part 4. Income Concepts: Legislative grace Ben earns a salary of $100,000 from Big Corporation. Ben bought some IBM stock two years ago at a cost of $20,000. This year, Ben sold the IBM stock for $50,000. How is the concept of legislative grace related to the method Ben will use to report this income and compute the applicable income taxes?

35. Part 4. Income Concepts: Capital recovery Ben earns a salary of $100,000 from Big Corporation. Ben bought some IBM stock two years ago at a cost of $20,000. This year, Ben sold the IBM stock for $50,000. How is the concept of capital recovery related to the method Ben will use to report this income and compute the applicable income taxes?

36. Part 4. Income Concepts: Realization Ben earns a salary of $100,000 from Big Corporation. Ben bought some IBM stock two years ago at a cost of $20,000. The IBM stock was worth $50,000 at the end of the current tax year. How is the concept of realization related to the method Ben will use to report this income and compute the applicable income taxes?

37. Part 4. Income Concepts: Claim of right – Slide 1. Realty Co. was organized on Jan-1, year 1. Bought a building on that date for $400,000. Building has 40 ‑ yr life. S/L depreciation method is used for tax & GAAP.

38. Part-4. Income Concepts: Claim of right – Slide 2. Depreciation is $10,000 per year for tax return and GAAP. Expense payments for year included prop. tax -$5,000 & insurance -$3,000. IBM rented the building from Realty Co. for 3 years at $25,000 per year. IBM paid $80,000 (rent of $75,000 and damage deposit of $5,000) on Jan-1-yr 1. What is Realty’s taxable income for yr-1? a. $7,000 b. $32,000 c. $57,000 d. Other

41. Part 4. Income Concepts: Constructive receipt Lee graduated in May, 2013 and began work on June 1, 2013, at a salary of $5,000 per month. Lee received 6 checks (on the last day of the months of June through November). December paycheck was available for Lee on Dec 31, but Lee chose to wait until January 2, 2014, to get the check. What is Lee’s gross income for 2013? a. $30,000 b. $35,000 c. Other

42. Part 4. Income Concepts: Wherewithal to pay Local Co. was organized on Jan-1, year 1. Local bought a building on that date for $400,000 and immediately rented the building to IBM for 3 years at a rental of $25,000 per year. A check for $75,000 was received on Jan-1, Year-1. What is Local’s gross income for year-1? a. $25,000 b. $50,000 c. $75,000

43. Part-4. Income Concepts: Wherewithal to pay Local Co. was organized on Jan-1, year 1. Local bought a building on that date for $400,000 and immediately rented the building to IBM for 3 years at a rental of $25,000 per year. A check for $75,000 was received on Jan-1, Year-1. What is Local’s gross income for year-1? a. $25,000 b. $50,000 c. $75,000

47. Part 5. Deduction Concepts: Legislative grace No deduction is allowed for any expenditure or loss unless the tax law allows the deduction.

52. End