TaxChapter5.docx

TaxChapter5.docx

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TaxChapter5

Chapter5

GrossIncomeandExclusions

SOLUTIONSMANUAL

DiscussionQuestions:

1.[LO1]Explainhowthedefinitionofgrossincomein§61mightinfluencewhetheraparticularcashflowisincludedingrossincome.

Taxpayersmustpresumethat,absentaspecificprovisiontothecontrary,allincomeistaxableandnoexpensesaredeductible.ThisassumptionisnecessarybecauseCongressintendedtofullyutilizeitstaxingauthoritytoconstructataxformulathatachievesabroadtaxbase.Thisintentisexpressedintheallinclusivedefinitionofincomein§61,whereCongressstatedthat“exceptasotherwiseprovided…,grossincomemeansallincomefromwhateversourcederived…”Deductionsarenotpermittedunlessspecificallyauthorizedbythetaxlaws.

2.[LO1]Discusswhyitmightbedifficulttodeterminetaxableincomeusinganeconomist’sdefinitionofincome.

Economicincomedependsuponmeasuringchangesinwealthoverayear.Thiswouldimposetremendousburdensontaxpayersbecauseassetswouldneedtobeinventoriedandappraisedeachyear.Moreover,administrationofthelawwouldalsobedifficultbecausemanyassetsareverydifficulttovalueandtheappraisalprocesscouldbeverysubjectiveandpronetomanipulation.

3.[LO1]Describetheconceptofrealizationfortaxpurposes.

Realizationisajudicialconceptthatdetermineswhenincomeisgenerated（“realized”）.Realizationrequiresverificationforincometoexisttherebyfacilitatingthemeasurementoftheamountofincome.Realizationisgenerallysatisfiedbyatransactionwithanotherpartyresultinginameasurablechangeinpropertyrights.Atransactionreducestheuncertaintyassociatedwithdeterminingincomebecauseachangeinrightscantypicallybetracedtoaspecificmomentintimeandisaccompaniedbylegaldocumentation.Moreover,atransactionreducestheneedforappraisalsbecausethepartiesmustagreeonthevalueoftheexchangedpropertyrights.

4.[LO1]Explainwhythedefinitionofgrossincomefortaxpurposesmightvaryfromthedefinitionofincomeforfinancialaccountingincome.

Thedefinitionofincomedependsuponrealizationwhichisarelativelyvagueconcept.Realizationformeasuringfinancialaccountingincomeisgenerallyconstruedtomeasureincomeconservativelysoastoavoidmisleadinginvestors.Incontrast,realizationformeasuringtaxableincomeisgenerallydefinedbyCongressinamannertomaximizeincomeandtherebymaximizegovernmentalrevenues.

5.[LO1]Compareandcontrastrealizationofincomewithrecognitionofincome.

Realizationisajudicialconceptthatdeterminestheperiodinwhichincomeisgenerated,whereas,recognitionisastatutoryconceptthatdetermineswhetherrealizedincomeisgoingtobeincludedingrossincomeduringtheperiod.Realizationisaprerequisitetorecognition,andabsentanexclusionordeferralprovision,recognitionisautomatic.

6.[LO1]Timisaplumberwhojoinedabarterclub.ThisyearTimexchangesplumbingservicesforanewroof.Theroofisproperlyvaluedat$2,500,butTimwouldhaveonlybilled$2,200fortheplumbingservices.WhatamountofincomeshouldTimrecognizeontheexchangeofhisservicesforaroof?

WouldyouranswerchangeiftheTimwouldhavenormallybilled$3,000forhisservices?

Assumingtheroofisproperlyvalued,thetaxpayershouldrecognizethevalueofthepropertyreceivedor$2,500regardlessoftheamounthewouldhavebilled.Thevalueoftheplumbingservices,however,wouldhelpdeterminethevalueoftheroof.

7.[LO1]Andreconstructsandinstallscabinetsinhomes.Blairsellsandinstallscarpetinapartments.AndreandBlairworkedoutanarrangementwherebyAndreinstalledcabinetsinBlair’shomeandBlairinstalledcarpetinAndre’shome.NeitherAndrenorBlairbelievestheyarerequiredtorecognizeanygrossincomeonthisexchangebecauseneitherreceivedcash.Doyouagreewiththem?

Explain.

BothAndreandBlairarerequiredtorecognizegrossincomeequaltothevalueofthegoodsandservicestheyreceived.Reg.§1.61-（a）indicatesthattaxpayersrealizeincomewhethertheyreceivemoney,property,orservicesinatransaction.Thatis,theformofthereceiptdoesnotmatter.Inthiscase,AndreshouldreportgrossincomeequaltothecarpethereceivedandBlairshouldreportgrossincomeequaltothevalueofthecabinetshereceived.

8.[LO1]Whatissueprecipitatedthereturnofcapitalprinciple?

Explain.

Theissuewastheamountofincometaxpayersmustrealizewhentheysellproperty.Shouldtheyberequiredtorealizealltheproceedsfromthesale,orshouldtheyberequiredtorealizeonlytheproceedsinexcessofthecostofthepropertybeingsold?

ThiswasnotclearundertheallinclusivedefinitionadoptedbyCongress.TheIRSwasconvincedthatCongress’allinclusivedefinitionofincomerequiredallsaleproceedstobeincludedinincomeandthattheoriginalcostofthepropertyshouldnotreducetheproceedsunlessCongressexplicitlyauthorizedadeductionforthecost.Taxpayersargued

thatincomeshouldbedefinedasanincrementtowealthandthatgrossincomeshouldonlyincludetheproceedsinexcessoftheoriginalcostorinvestmentinthepropertybeingsold（thenetgainafterareturnoftheoriginalcost—notethatifthetaxpayerexperiencesanetloss,thelossgenerallydoesnotreducegrossincome.Ifthetaxlawsspecificallysaythelossisallowedasadeduction,thelosswillreducethetaxpayer’staxableincomebutnotgrossincome.）.Thecourtsdecidedtheissueinfavorofthetaxpayers.

9.[LO1]Comparehowthereturnofcapitalprincipleapplieswhen

（1）ataxpayersellsanassetandcollectsthesaleproceedsallimmediatelyand

（2）ataxpayersellsanassetandcollectsthesaleproceedsoverseveralperiods（installmentsales）.IfCongresswantedtomaximizerevenuefrominstallmentsales,howwouldtheyhaveappliedthereturnofcapitalprincipleforinstallmentsales?

Thereturnofcapitalprinciplestatesthattheproceedsfromasalearenotincometotheextentofthetaxpayer’scostorinvestmentintheasset.Whentheproceedsarecollectedoverseveralperiods,thereturnofcapitalprincipleisusuallymodifiedbythelawtoprovidethatthereturnofcapitaloccursevenly（prorata）overthecollectionperiod.Tomaximizerevenues,thegovernmentmightrequireforthereturnofcapitaltooccurattheendofthecollection;whereas,taxpayersnormallypreferforthereturnofcapitaltooccuratthebeginningofthecollectionperiodtoallowthemtodeferrecognizingincomefromthetransaction.

10.[LO1]ThisyearJorgereceivedarefundofpropertytaxesthathedeductedonhistaxreturnlastyear.Jorgeisnotsurewhetherheshouldincludetherefundinhisgrossincome.Whatwouldyoutellhim?

Thetaxbenefitruleprovidesthatataxpayerreceivingarefundofanamounthepreviouslydeductedisrequiredtoincludetherefundingrossincomewhenhereceivesit.Inthiscase,ifJorgedeductedthestatetaxes（andreceivedataxbenefitortaxsavingsfromthededuction）onhisprioryeartaxreturn,hemustincludetherefundinhisgrossincomethisyear.Ifhedidnotdeductstatetaxesonhistaxreturnlastyear,heisnotrequiredtoincludetherefundinhisgrossincome.

11.[LO1]Describeingeneralhowthecashmethodofaccountingdiffersfromtheaccrualmethod.

Underthecashmethodtaxpayersrecognizeincomeintheperiodtheyreceiveit.Undertheaccrualmethod,theyrecognizeincomewhentheyearnitratherthanwhentheyreceiveit.Likewise,cashbasistaxpayersareentitledtoclaimdeductionswhentheymakeexpenditures.Undertheaccrualmethod,taxpayersdeductexpenseswhentheyincuroraccruetheassociatedexpenditure.

12.[LO1]Janetisacash-basiscalendar-yeartaxpayer.ShereceivedacheckforservicesprovidedinthemailduringthelastweekofDecember.However,ratherthancashthecheck,JanetdecidedtowaituntilthefollowingJanuarybecauseshebelievesthatherdelaywillcausetheincometoberealizedandrecognizednextyear.Whatwouldyoutellher?

Woulditmatterifshedidn’topentheenvelope?

WoulditmatterifsherefusedtocheckhermailduringthelastweekofDecember?

Explain.

Theconstructivereceiptdoctrineholdsthatincomeisrecognizedunderthecashmethodofaccountingintheyearinwhichtaxpayersacquiretherightto,orcontrolover,property.Inotherwords,thetaxpayerisdeemedtohavereceivedthepropertyunlesstherearesubstantialrestrictionsonaccesstooruseofproperty.ThisdoctrinepreventsJanet,acashbasistaxpayer,fromarbitrarilyshiftingincometoalaterperiodbypostponingthedeliveryoracceptanceofapayment.Itdoesnotmatterifsherefusestoopentheenvelopeorcheckhermail,becauseshehascontroloverthepayment.

13.[LO1]Thecashmethodofaccountingmeansthattaxpayersdon’trecognizeincomeunlesstheyreceivecashorcashequivalents.Trueorfalse?

Explain.

False-thecashmethodofaccountingrequirestaxpayerstorecognizeincomewhenpropertyisreceived,ifthepropertyiscapableofbeingvalued.Inotherwords,incomerecognitionoccurswhenpaymentisreceivedwhetherthepaymentisincashorproperty.

14.[LO1]Deweyisalawyerwhousesthecashmethodofaccounting.LastyearDeweyprovidedaclientwithlegalservicesworth$55,000,buttheclientcouldnotpaythefee.ThisyearDeweyrequestedthatinlieuofpayingDewey$55,000fortheservices,theclientcouldmakea$45,000gifttoDewey’sdaughter.Dewey’sdaughterreceivedthecheckfor$45,000anddepositeditinherbankaccount.Howmuchofthisincomeistaxed,ifany,toDewey?

Explain.

Acashmethodtaxpayerrecognizesincomeonthev