Essentials of taxation 2016 cengage chapter 04

Chapter Gross Income Essentials of Taxation © 2016 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part The Big Picture (slide of 3) • Dr Cliff Payne opens his new dental practice as a qualified personal service corporation – He selects a December 31 year-end and the accrual method of accounting • During the year, Dr Payne billed patients and insurance companies for $385,000 of dental services – At the end of the year, $52,000 of this amount has not been collected • Dr Payne also earns the following: – $500 of interest on a money market account – $500 of interest on bonds issued by the Whitehall School District The Big Picture (slide of 3) • Dr Payne’s salary from his corporation is $10,000 per month – However, he did not cash his December payroll check until January • To help fund his new business, Dr Payne’s parents loaned him $150,000 – They did not charge him any interest • He also owns stock that has increased in value from $7,000 at the beginning of the year to more than $25,000 at the end of the year The Big Picture (slide of 3) • Although Dr Payne took several accounting classes in college, he would like your help in calculating his gross income and the gross income of the corporation • Read the chapter and formulate your response Components Of The Tax Formula (slide of 3) Components Of The Tax Formula (slide of 3) • Income (Broadly Conceived) – Includes all income, both taxable and nontaxable • Essentially equivalent to gross receipts • Does not include – A return of capital, or – Borrowed funds • Exclusions – Certain types of income are excluded from the income tax base • Principal income exclusions that apply to all entities are – Life insurance proceeds – State and local bond interest Components Of The Tax Formula (slide of 3) • Deductions – Generally, all ordinary and necessary trade or business expenses are deductible – Such expenses include • • • • • • • • Cost of goods sold Salaries Wages Operating expenses (such as rent and utilities) Research and development expenditures Interest, Taxes, Cost recovery (Depreciation, amortization, and depletion) Gross Income (slide 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 Gross Income (slide of 3) • 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 Gross Income (slide of 3) • 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 10 Discharge 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 2007 and 2014, and is the result of the financial condition of the debtor 56 Discharge 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 2007 and 2014, and is the result of the financial condition of the debtor 57 Gains and Losses from Property Transactions (slide 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 58 Gains and Losses from Property Transactions (slide of 3) • 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 59 Gains and Losses from Property Transactions (slide of 3) • 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 60 Gains and Losses from Capital Asset Transactions (slide 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 61 Gains and Losses from Capital Asset Transactions (slide of 2) • 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 62 Max Tax Rates for Net Capital Gains of Individuals Classification Maximum Rate Short-term gains (held ≤ one year) 35% Long-term gains (held > one year) 0%/15%/20% 63 Treatment of Capital Losses (slide 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 64 Treatment of Capital Losses (slide of 2) • Corporations must also net capital gains and losses – Net capital gains 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 years and then carried forward years to offset capital gains in those years 65 Refocus On The Big Picture (slide of 4) • Using the accrual method of accounting, the gross income recognized by Dr Cliff Payne’s corporation would be $385,500 – This includes the entire $385,000 of revenue earned from providing services to patients during the year and the $500 of interest income earned on the money market account • The $500 of school district bond interest is excluded from gross income 66 Refocus On The Big Picture (slide of 4) • Dr Payne’s gross income includes $120,000 of salary earned during the year – Even though he did not cash his December paycheck until January • He constructively received the income since it was readily available to him • Dr Payne may be able to reduce his taxable income by the imputed interest expense on the below-market loan from his parents • The increase in value on his stock does not result in gross income until he sells the stock and realizes a gain or loss 67 Refocus On The Big Picture (slide of 4) What If? • Rather than electing the accrual method, what if Dr Payne had chosen to use the cash method of accounting for his business? – Using the cash method is acceptable for certain personal service corporations 68 Refocus On The Big Picture (slide of 4) What If? • While using the cash method would reduce the company’s gross income from $385,000 to $333,000 ($385,000 amount billed less $52,000 still to be received), this is only part of the picture • Using the cash method also might result in some of the corporation’s expenses not being deducted until they are paid in a future year 69 If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr Donald R Trippeer, CPA trippedr@oneonta.edu SUNY Oneonta © 2016 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 70 ... income and the gross income of the corporation • Read the chapter and formulate your response Components Of The Tax Formula (slide of 3) Components Of The Tax Formula (slide of 3) • Income (Broadly... $385,000 of dental services – At the end of the year, $52,000 of this amount has not been collected • Dr Payne also earns the following: – $500 of interest on a money market account – $500 of interest... of 3) • 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