Gross Income: Concepts and Inclusions

Gross Income:ConceptsandInclusions 4-1

CHAPTER 4

GROSS INCOME: CONCEPTS AND INCLUSIONS

SOLUTIONS TO PROBLEM MATERIALS

Status: / Q/P
Question/ / Present / in Prior
Problem / Topic / Edition / Edition
1 / Examples of gross income items in the Form 1040 instructions / Unchanged / 1
2 / Economic versus taxable income / New
3 / Issue ID / Unchanged / 3
4 / Realization rationale / Modified / 4
5 / Recovery of capital / New
6 / Constructive receipt and agent / Unchanged / 6
7 / Cash method / Unchanged / 7
8 / Issue ID / Unchanged / 8
9 / Original issue discount / Unchanged / 9
10 / Original issue discount / Unchanged / 10
11 / Accrual basis and prepaid income / Unchanged / 11
12 / Who is the taxpayer? / Unchanged / 12
13 / Who is the taxpayer? / New
14 / Who is the taxpayer? / Unchanged / 14
15 / Who is the taxpayer? / Unchanged / 15
16 / Community property / Unchanged / 16
17 / Transfer of property: divorce / Unchanged / 17
18 / Issue ID / Unchanged / 18
19 / Alimony and property settlement / Unchanged / 19
20 / Below-market loans / Unchanged / 20
21 / Below-market loans / New
22 / Issue ID / Unchanged / 22
23 / Annuity / Modified / 23
24 / Group-term life insurance / New
25 / Social Security benefits / New
26 / Economic versus taxable income / Unchanged / 26
27 / Issue ID / Unchanged / 27
*28 / Gross income: investments / Unchanged / 28
29 / Gross income / Unchanged / 29
30 / Gross income / Unchanged / 30
*31 / Accrual basis versus cash basis / Unchanged / 31
*32 / Accrual basis versus cash basis / Unchanged / 32
33 / Accrual basis versus cash basis / Modified / 33
34 / Accrual method and disputed income / Unchanged / 34
35 / Constructive receipt / Unchanged / 35
*36 / Original issue discount and savings bonds / Unchanged / 36
37 / Advance payments / Unchanged / 37
38 / Constructive receipt / Unchanged / 38
39 / Prepaid rent and deposits / Unchanged / 39
40 / Who is the taxpayer? / Unchanged / 40
41 / Constructive receipt and agent / Unchanged / 41
42 / Partnerships / Modified / 42
*43 / Dividend income / New
*44 / Community property / Unchanged / 44
45 / Alimony, child support, and property transfer / Unchanged / 45
*46 / Alimony and alimony recapture / Unchanged / 46
47 / Alimony and property settlement / Unchanged / 47
48 / Below-market loans / Unchanged / 48
*49 / Below-market loans / Unchanged / 49
50 / Below-market loans / Unchanged / 50
51 / Below-market loans / Modified / 51
*52 / Annuity / Unchanged / 52
53 / Prizes and awards / Modified / 53
*54 / Group term life insurance / Unchanged / 54
*55 / Unemployment compensation / Unchanged / 55
*56 / Social Security benefits / Modified / 56
*57 / Social Security benefits / Modified / 57
58 / Miscellaneous / Unchanged / 58
*59 / Cumulative / Modified / 59
*60 / Cumulative / Unchanged / 60
Research
Problem
1 / Gross income / New
2 / Alimony / New
3 / Internet activity / New
*The solution to this problem is available on a transparency master.

CHECKFIGURES

Gross Income:ConceptsandInclusions 4-1

26.a.
26.b.
26.c.
26.d.
26.e.
26.f.
27.
28.
29.a.
29.b.
29.c.
30.a.
30.b.
30.c.
31.a.
31.b.
31.c.
32.
33.
34.
35.a.
35.b.
35.c.
36.a.
36.b.
37.a.
37.b.
37.c.
38.a.
38.b.
39.a.
39.b.
40.a.
40.b. / Economic gain $1,000; gross income $4,000.
Economic income $15,000; gross income $15,000.
Economic income $0; gross income $800.
Economic income $800; gross income $0.
Economic income $10,000; gross income $0.
Economic income $1,000; gross income $1,000.
Use the cash method.
Alternative a. yields the greater after-tax value.
Gross income $500 ($200 + $300).
Gross income $0.
Gross income $0.
Gross income $1,500.
Gross income $50,000.
Gross income $0.
Cash basis income $150,000.
Accrual basis income $170,000.
Cash method.
Gross profit $145,000.
Accrual method increases gross income by $75,000.
Color should report $800 in 2005.
Include $110,000 in 2004.
Include $8,000 in 2003.
Include $10,000 in 2004.
$4,416.
$934 interest income on 2-year certificate; $0 interest income on 1year certificate.
Gross income of $1,200 may be deferred until 2004.
Gross income $160 ($140 + $20) in 2004.
Gross income $450 ($1,200 – $750).
Actually received $180,000; constructively received $0.
She may be in a lower tax bracket in 2006.
Report in the year of receipt $400 under option 1, $800 under option 2, and $0 under option 3.
Third option.
$12,000 for Gus and $12,000 for corporation.
$12,000 flows through S corporation to Gus. / 41.a.
41.b.
41.c.
42.
43.
44.a.
44.b.
45.a.
45.b.
45.c.
46.a.
46.b.
47.
48.
49.
50.a.
50.b.
50.c.
51.a.
51.b.
52.a.
52.b.
52.c.
53.a.
53.b.
53.c.
54.a.
54.b.
55.
56.a.
56.b.
56.c.
57.
58.a.
58.b.
58.c
58.d.
59.
60. / Corporation recognizes $3,000; Tracy recognizes $0.
Same as a.
Corporation recognizes $0 in 2004; Tracy recognizes $0 in 2004.
$80,000.
$92,000.
Doug $50,800; Liz $54,900.
Doug $52,850; Liz $52,850.
No tax consequences.
Monthly gross income to Nell $1,000; payments are deductible to Kirby.
No tax consequences—child support.
$85,000.
$72,500 alimony recaptured Year 3. Gross income increases $4,500. Accept a zero interest rate loan if a-vailable, otherwise 6% loan from Hal.
Compensation $2,170, interest income $1,273.
$0 imputed interest.
$0 imputed interest.
Imputed interest $225.
Compensation income and interest expense to Vito $480; compensation expense and interest income to Vito, Inc. $480.
Interest income and dividends paid to the corporation in 2004 $320; interest expense and dividend income to Vito in 2004 $320; amount in 2005 is $839.
Gross income $9,231.
Gross income $24,000.
Loss $36,923; gross income $9,231.
$210,000.
$100,000.
$0.
Alice $72; Kay $1,500.
$1,500.
$100,440.
$38,750.
No.
$33,900.
Reduction if retire of $2,825.
The $70,000 is taxable.
$7,140 is taxable.
$1,200 is taxable.
Donna must include one-half of husband’ winnings.
Refund due $520.
Refund due $2,171.

DISCUSSION QUESTIONS

1.The broad concept of gross income has served the Federal income tax system very well. An attempt to provide a complete list would probably be futile and would impede the IRS in addressing new transactions. When a never before encountered transaction or event occurs, the IRS could be bound to apply the list which could result in certain sources of income not being taxed. p. 4-3

2.a.According to the economic concept of income, the taxpayer’s income in the current year is $1,000 (the value at the time of the sale of $8,000 less the value at the beginning of the year of $7,000). Gross income for tax purposes is the difference between the selling price of $8,000 and the taxpayer’s cost of $5,000 = $3,000.

b.Economic income is $8,000, the increase in value during the current year. Gross income for tax purposes is $0 because no income was realized; that is, the taxpayer was providing services to his property.

c.Under both economic income and gross income for tax purposes, the shareholder’s income is $5,000. The gross income would be treated as a dividend to the shareholder.

d.Economic income and gross income for tax purposes both are $25,000.

pp. 4-3 to 4-5

3.Charley received something of value from the casino. Under the broad concept of income, the airfare and hotel accommodations would be considered income. However, Charley could argue that the income should be matched with his $15,000 in gambling losses on the trip, and when the income and losses are combined, the net effect is an economic loss. As will be discussed later in the text, the net loss is not deductible, but at least the gambling losses can be used to offset the income from his gambling activities. pp. 4-3 to 4-5

4. The tax laws encourage do-it-yourself activities. If Tom paints his house, the $90 he saved is not included in gross income. He foregoes only $72 [(1-.28)($100)] in after-tax income from not working and earnings $100. This reasoning assumes that Tom can paint as fast as and as well as someone he would hire (i.e., the time consumed and the quality are the same). pp. 4-3 and 4-4

5.Because Cecil does not know how much he will receive from the sale of automobile parts, and it is impractical to determine the cost of individual automobile parts, he could reason that all sales proceeds are a recovery of capital until he has received his cost of $250, and all subsequent proceeds are included in gross income. The IRS may argue that Cecil should allocate his cost of the car among the various parts, which may be impractical. p. 4-6

6.The employer is required to include the $3,000 in gross income in 2004, when the employer’s agent receives the payment from the customer. pp. 4-7 to 4-10 and 4-17

7.a.The income should be reported in 2005. In 2004, Jared has not received anything of value.

b.The significance of when the income is recognized by Jared relates to (1) the time value of money—if the tax is deferred, the present value of the tax decreases; and (2) the marginal tax rates—the taxpayer may be subject to different rates between years because of changes in the tax law, changes in his or her taxable income, changes in the taxpayer’s filing status, and changes in the entity status.

pp. 4-7 to 4-9

8.a.The following issues are suggested from the facts presented:

• Is the cash method an appropriate accounting method for a farmer? See Chapter 16.
• Does Selma have any income when the hay is harvested?
• Is any income recognized when part of the hay is fed to the cattle?
• Is any income recognized when part of the hay is traded for a piece of equipment?

b.Selma’s gross receipts are $750 and her cost of goods sold is $500 ($1,000 X 50%). Therefore, her gross income is $250 ($750 – $500). She does not recognize any income from the value of the hay she fed her cattle because realization will not occur until she has a transaction with another party (when the animals are sold). Note that the $500 cost of the hay she used to feed her cattle may be currently deducted by the cash basis farmer, although it was in fact a capital expenditure (i.e., see special treatment for farmers in Chapter 16).

pp. 4-7 to 4-10

9.The certificate of deposit contains original issue discount, which Alyson must include in her gross income each year from 2003 through 2006. The annual amount to include in gross income is computed using the compound interest method. Alyson’s amount to include in gross income will be greater in 2004 because the interest earned in 2003 is added to the principal upon which the compound interest is computed in 2004. p. 4-11 and Example 14

10.a.Bethany’s interest income for 2004 is $343 ($4,291 X 8%). The bond has original issue discount of $15,709 ($20,000 – $4,291) which must be amortized over the life of the bond using the effective interest method.

b.Bethany’s basis for the bond on December 31, 2004 is $4,634 ($4,291 + $343).

c.The interest income will be greater in 2011 than in 2004 because the interest is compounding. The interest income recognized each year is added to the original cost of the bond and the 8% interest rate is applied to the cumulative investment.

p. 4-11

11.IRS Notice 2002-79 permits an accrual basis taxpayer to defer recognition of income from advance payments for services to be performed after the end of the tax year of receipt. The portion of the advance payments that relates to services performed in the tax year of receipt is included in gross income in the tax year of receipt. The portion of the advance payment that relates to services to be performed after the tax year of receipt is included in gross income in the tax year following the tax year of receipt of the advance payment. Notice 2002-79 does not apply to prepaid rent or prepaid interest. These items are always taxed in the year of receipt. pp. 4-13 and 4-14

12.If Rex sells the car, he must pay the tax on the gain of $3,800 ($9,000 – $5,200). If Rex gives the automobile to his daughter and she sells it, she will be taxed on the gain of $3,800. Thus, the increase in value that is economically attributable to Rex will become his daughter’s income. If Rex is in a higher marginal tax bracket (probably the case), the family unit will generate tax savings by Rex’s daughter selling the car. Thus, gifts of appreciated property can be a useful tax planning concept. pp. 4-14 and 4-15

13.The recipient of alimony payments reports income and the payer qualifies for a deduction. By allowing a $50,000 deduction to Sarah and requiring Fred to include the $50,000 in his gross income, the fruit (service income) is shifted away from the tree (Sarah as the provider of the service). pp. 4-14 and 4-15

14.The employee is the agent for his or her employer, the principal. The income of $75 per hour is earned by the principal through the agent and the income is attributed to the principal. The employee includes in his or her gross income the compensation received from the employer. p. 4-14

15.The S corporation shareholders and the partners pay the tax on the income earned by the S corporation and the partnership, regardless of whether the income is actually distributed to the owners. pp. 4-17 and 4-18

16.A joint return cannot be filed by Mike and Debbie, unless Debbie can be located and she consents to filing a joint return. Mike cannot qualify as an abandoned spouse because he has no dependent children. On separate income tax returns for 2004, Mike and Debbie each must include one-half of the community’s income. This results because they live together for part of the year. Thus, Mike must include in his gross income his share of Debbie’s earnings for the year, including a share of Debbie’s post-separation earnings. pp. 4-18 to 4-20

17.Considering only taxes, Jean should accept the securities. The high basis in the stock will provide Jean with a tax benefit. She will have a carryover basis of $115,000 in the securities. If she sells the securities for $100,000, she will recognize a $15,000 loss. She will be allowed to offset this loss against other capital gains. If she has no capital gains, she can offset $3,000 of the loss against ordinary income each year, as discussed in Chapter 3. Thus, the loss would offset other income on Jean’s income tax return.
pp. 420 and 4-21

18.The following issues are suggested from the facts presented:

• Will gains and losses from the sale of property pursuant to the divorce be subject to tax?
  
• Are the child care payments deductible?
  
• Would payments with respect to William’s contribution toward her education be taxable to her?
  
• What is their filing status until the divorce has been completed?
  
• Should the payments be arranged so that they are deductible by William and taxable to Abigail? If the payments are taxable to her, what additional amounts should she request in exchange for agreeing to terms that are tax favorable to William?

• Is the daycare that is being provided by the grandparents taxable to either William or Abigail?

• Who will be able to claim April as a dependent?

pp. 4-19 to 4-22

19.Mary should consider the following tax considerations. The receipt of the $12,000 each year for ten years would be taxable to her as alimony, provided the payments cease upon her death within the 10-year period. Otherwise, the $12,000 payments are not alimony. The receipt of the common stock would be a property settlement rather than being alimony. However, to evaluate this option, she needs to know Bob’s basis in the stock because his basis will become her basis. Thus, if she decided to sell the stock, she could have a taxable gain or loss. The installment payments have significant nontax issues such as the risk that Bob will be unable to make the payments. In addition, Mary should compare the present value of the installment payments (on an after-tax basis) with the value ($100,000) of the stock. For example, assuming a 15% marginal tax rate, the after-tax amount received each year is $10,200, and with an after-tax rate of return of 6%, the present value of future payments is only $80,200. pp. 4-20 to 4-23

20.Income is imputed to the lender so as to prevent the lender from shifting income to the borrower who may be taxed at a lower tax rate. The rules presume that the lender would have earned some income from the funds in the absence of making the loan to the relative. By not requiring the relative to pay any interest, the lender has effectively made a gift back to the relative for the amount of interest not charged. pp. 4-22 to 4-27

21.The corporation will have imputed interest income and an offsetting amount for compensation expense. In addition, the corporation may have additional Social Security and Medicare tax and withholding obligations on the additional compensation. If, however, the employee is also a shareholder, the IRS may determine that the loan is instead a corporation-shareholder loan. This would still result in an increase in the corporation’s gross income in the form of imputed interest income. However, the corporation would not be able to deduct the related deemed dividend paid (as opposed to compensation expense being deductible). pp. 4-23 to 4-27 and Concept Summary 4-2

22.The following issues are suggested from the facts presented:

• Is the corporation required to impute interest income on the loan to Brad?
  
• Is Brad required to recognize income from the loan proceeds?
  
• Is Brad required to recognize income in respect to the favorable interest rate?

• Is the loan made to Brad in his capacity as a shareholder or as an employee?
  
• Is the loan subject to the original issue discount rules?

pp. 4-11 and 4-22 to 4-27

23.Betty’s life expectancy used in calculating the annuity exclusion percentage was 10 years. Therefore, all of the payments in the eleventh year (and thereafter) of $8,400 must be included in Betty’s gross income. She has recovered her investment of $75,600 as a return of capital over the 10 years. pp. 4-28 to 4-30

24.Under the broad concept of gross income contained in the Code, premiums on group term life insurance purchased by employers for employees would be included in the employee’s gross income. Therefore, § 79 creates an exclusion of premiums on up to $50,000 of insurance coverage for employees. pp. 4-32 and 4-33

25.The additional income will be, in effect, taxed at a 31.5% rate. That is, each dollar of additional income from other sources will increase the taxable portion of Social Security benefits by 50%. Thus, for each additional dollar of income, the marginal tax rate is 31.5% [1.5 X (15% + 6%)]. Her after-tax earnings on the $3,000 would be $2,055 [1-.315) X $3,000]. pp. 4-33 and 4-34

PROBLEMS

26.a.The taxpayer has a $1,000 economic gain on the sale because the taxpayer’s economic income would be the selling price less the value of the asset as of the beginning of the year. Gross income for tax purposes is $4,000 ($10,000 – $6,000).

b.The $15,000 is economic income and gross income for tax purposes.

c.The use of the automobile does not result in economic income because the taxpayer owns the corporation and thus owns the automobile. For tax purposes, the taxpayer is deemed to have received an $800 dividend from the corporation.

d.The taxpayer has economic income of $800 from the production in her garden. However, for tax purposes no income is realized. The realization requirement is not satisfied because the vegetables are consumed by her and her neighbors, rather than sold to others.

e.The increase in value of $10,000 is economic income but is not gross income for tax purposes because the realization requirement has not been satisfied.

f.The taxpayer realized $1,000 economic income and gross income from discharge of the indebtedness.

pp. 4-3 to 4-5

27.Amos should use the cash method of accounting so that the income from services billed to the insurance company can be deferred until the income is collected. Under the cash method, the amounts billed to the insurance companies will be continuously deferred until the year following his final year of practice. That is, with the cash method of accounting as compared to the accrual method, Amos will enjoy a deferral of two months of billings to insurance companies. Amos’s marginal tax rate may be lower in the first year of practice than in subsequent years. Thus, accelerating income through the use of the accrual method would have some benefit. But the benefit of the lower rates probably would not equal the benefit of deferral. pp. 4-7 to 4-9