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Chapter 5
SOLUTIONS MANUAL
Discussion Questions
1. [LO 1] Based on the definition of gross income in §61 and related regulations, what is the general presumption regarding the taxability of income realized?
§61(a) defines gross income as all income from whatever source derived. Reg. §1.61-(a) provides further insight into the definition of gross income as follows: Gross income means all income from whatever source derived, unless excluded by law. Gross income includes income realized in any form, whether in money, property, or services. Thus, the general presumption regarding any income realized is that it is taxable, unless otherwise excluded by law.
2. [LO 1] Based on the definition of gross income in §61, related regulations, and judicial rulings, what are the three criteria for recognizing taxable income?
Based on §61(a), Reg. §1.61-(a), and various judicial rulings, taxpayers recognize gross income when (1) they receive an economic benefit, (2) they realize the income, and (3) no tax provision allows them to exclude or defer the income from gross income for that year.
3. [LO 1] Describe the concept of realization for tax purposes.
As indicated in Reg. §1.61-(a), the tax definition of income adopts the realization principle. Under this principle, income is realized when (1) a taxpayer engages in a transaction with another party, and (2) the transaction results in a measurable change in property rights. In other words, assets or services are exchanged for cash, claims to cash, or other assets with determinable value. The concept of realization for tax purposes closely parallels the concept of realization for financial accounting purposes. Requiring a transaction to trigger realization reduces the uncertainty associated with determining the amount of income because a change in rights can typically be traced to a specific moment in time and is generally accompanied by legal documentation.
4. [LO 1] Compare and contrast realization of income with recognition of income.
Realization is a judicial concept that determines the period in which income is generated, whereas, recognition is a statutory concept that determines whether realized income is going to be included in gross income during the period. Realization is a prerequisite to recognition and absent an exclusion or deferral provision, recognition is automatic.
5. [LO 1] Tim is a plumber who joined a barter club. This year Tim exchanges plumbing services for a new roof. The roof is properly valued at $2,500, but Tim would have only billed $2,200 for the plumbing services. What amount of income should Tim recognize on the exchange of his services for a roof? Would your answer change if Tim would have normally billed $3,000 for his services?
Assuming the roof is properly valued, the taxpayer should recognize the value of the property received or $2,500 regardless of the amount he would have billed. The value of the plumbing services, however, would help determine the value of the roof.
6. [LO 1] Andre constructs and installs cabinets in homes. Blair sells and installs carpet in apartments. Andre and Blair worked out an arrangement whereby Andre installed cabinets in Blair’s home and Blair installed carpet in Andre’s home. Neither Andre nor Blair believes they are required to recognize any gross income on this exchange because neither received cash. Do you agree with them? Explain.
Both Andre and Blair are required to recognize gross income equal to the value of the goods and services they received. Reg. §1.61-(a) indicates that taxpayers realize income whether they receive money, property, or services in a transaction. That is, the form of the receipt does not matter. In this case, Andre should report gross income equal to the carpet he received and Blair should report gross income equal to the value of the cabinets he received.
7. [LO 1] What issue precipitated the return of capital principle? Explain.
The issue was the amount of income taxpayers must realize when they sell property. Initially, the IRS was convinced that Congress’s all-inclusive definition of income required taxpayers to include all sale proceeds in gross income. Taxpayers, on the other hand, argued that a portion of proceeds from a sale represented a return of the cost or capital investment in the underlying property (called tax basis). The courts determined that when receiving a payment for property, taxpayers are allowed to recover the cost of the property tax free. Consequently, when taxpayers sell property, they are allowed to reduce the sale proceeds by their unrecovered investment in the property to determine the realized gain from the sale. When the tax basis exceeds the sale proceeds, the return of capital principle generally applies to the extent of the sale proceeds. The excess of basis over sale proceeds is generally not considered to be a return of capital, but rather a loss that is deductible only if specifically authorized by the tax code.
8. [LO 1] Compare how the return of capital principle applies when (1) a taxpayer sells an asset and collects the sale proceeds all immediately and (2) a taxpayer sells an asset and collects the sale proceeds over several periods (installment sales). If Congress wanted to maximize revenue from installment sales, how would they have applied the return of capital principle for installment sales?
The return of capital principle states that the proceeds from a sale are not income to the extent of the taxpayer’s cost or investment in the asset. When the proceeds are collected over several periods, the return of capital principle is usually modified by the law to provide that the return of capital occurs evenly (pro rata) over the collection period. To maximize revenues, the government might require for the return of capital to occur at the end of the collection; whereas, taxpayers normally prefer for the return of capital to occur at the beginning of the collection period to allow them to defer recognizing income from the transaction.
9. [LO 1] This year Jorge received a refund of property taxes that he deducted on his tax return last year. Jorge is not sure whether he should include the refund in his gross income. What would you tell him?
If the refund is made for an expenditure deducted in a previous year, then under the tax benefit rule the refund is included in gross income to the extent that the prior deduction produced a tax benefit. In this case, if Jorge deducted the property taxes (and received a tax benefit or tax savings from the deduction) on his prior year tax return, he must include the refund in his gross income this year to the extent the property taxes resulted in a tax benefit. If he did not deduct the property taxes on his tax return last year, he is not required to include the refund in his gross income.
10. [LO 1] Describe in general how the cash method of accounting differs from the accrual method.
Under the cash method taxpayers recognize income in the period they receive it. Under the accrual method, they recognize income when they earn it rather than when they receive it. Likewise, cash basis taxpayers are entitled to claim deductions when they make expenditures. Under the accrual method, taxpayers deduct expenses when they incur or accrue the associated expenditure.
11. [LO 1] Janet is a cash-basis calendar-year taxpayer. She received a check for services provided in the mail during the last week of December. However, rather than cash the check, Janet decided to wait until the following January because she believes that her delay will cause the income to be realized and recognized next year. What would you tell her? Would it matter if she didn’t open the envelope? Would it matter if she refused to check her mail during the last week of December? Explain.
The constructive receipt doctrine states that a taxpayer realizes and recognizes income when it is actually or constructively received. Constructive receipt is deemed to occur when the income has been credited to the taxpayer’s account or when the income is unconditionally available to the taxpayer, the taxpayer is aware of the income’s availability, and there are no restrictions on the taxpayer’s control over the income. This doctrine prevents Janet, a cash basis taxpayer, from arbitrarily shifting income to a later period by postponing the delivery or acceptance of a payment. It does not matter if she refuses to open the envelope or check her mail, because the income is unconditionally available to her, she is aware of the income’s availability, and there are no restrictions on her control over the income.
12. [LO 1] The cash method of accounting means that taxpayers don’t recognize income unless they receive cash or cash equivalents. True or false? Explain.
False - under the cash method, taxpayers recognize income in the period they receive it (in the form of cash, property, or services).
13. [LO 1] Contrast the constructive receipt doctrine with the claim of right doctrine.
The constructive receipt doctrine states that a taxpayer realizes and recognizes income when it is actually or constructively received. Constructive receipt is deemed to occur when the income has been credited to the taxpayer’s account or when the income is unconditionally available to the taxpayer, the taxpayer is aware of the income’s availability, and there are no restrictions on the taxpayer’s control over the income. In contrast, the claim of right doctrine states that income has been realized if a taxpayer receives income and there are no restrictions on the taxpayers use of the income (for example, the taxpayer does not have an obligation to repay the amount). Thus, the constructive receipt applies where the taxpayer has not yet actually received income (but it has been credited to the taxpayer’s account or is unconditionally available), whereas the claim of right doctrine applies when the taxpayer has received an item of income and the question is whether the taxpayer has an unrestricted right to the income.
14. [LO 1] Dewey is a lawyer who uses the cash method of accounting. Last year Dewey provided a client with legal services worth $55,000, but the client could not pay the fee. This year Dewey requested that in lieu of paying Dewey $55,000 for the services, the client could make a $45,000 gift to Dewey’s daughter. Dewey’s daughter received the check for $45,000 and deposited it in her bank account. How much of this income is taxed, if any, to Dewey? Explain.
A cash method taxpayer recognizes income on the value of property received, so $45,000 of income will be recognized in this year. The assignment of income doctrine holds that earned income is taxed to the taxpayer providing the goods or services. Hence, Dewey and not his daughter is taxed on the entire amount of service income. Because the money went to Dewey’s daughter, his daughter will be treated as though she received a gift from Dewey.
15. [LO 1] Clyde and Bonnie were married this year. Clyde has a steady job that will pay him about $37,000 while Bonnie does odd jobs that will produce about $28,000 of income. They also have a joint savings account that will pay about $400 of interest. If Clyde and Bonnie reside in a community property state and file married-separate tax returns, how much gross income will Clyde and Bonnie each report? Any difference if they reside in a common law state? Explain.
In a community property state each spouse will report exactly half of the income earned by the other. Hence, Bonnie and Clyde will each report $32,700 ($18,500+$14,000+$200). In a common law state, Bonnie will report $28,200 which is her separate income ($28,000) plus half of the joint income ($200). Likewise, Clyde will report $37,200.
16. [LO 2] Distinguish earned income from unearned income, and provide an example of each.
Earned income is income derived from services and includes compensation and other forms of business income received by a taxpayer even if the taxpayer’s business is selling inventory. In contrast, unearned income is income derived from property. Salary is a good example of earned income whereas interest is an example of unearned income.
17. [LO 2] From an employee perspective, how are incentive stock options treated differently than nonqualified stock options for tax purposes? In general, for a given number of options, which type of stock option should employees prefer?
Unlike nonqualified stock options, the bargain element of incentive stock options is not included in the employee’s regular taxable income on the exercise date. Instead, the bargain element present on the exercise date is deferred until the stock acquired from the option exercise is sold. Further, with incentive stock options, the bargain element is treated as long-term capital gain rather than ordinary income when the stock is sold. For these reasons, employees generally prefer incentive stock options over an equivalent number of nonqualified options.
18. [LO 2] Jim purchased 100 shares of stock this year and elected to participate in a dividend reinvestment program. This program automatically uses dividends to purchase additional shares of stock. This year Jim’s shares paid $350 of dividends and he used these funds to purchase shares of stock. These additional shares are worth $375 at year-end. What amount of dividends, if any, should Jim declare as income this year? Explain.
Jim is taxed on $350 of dividend income because under constructive receipt he had the ability or power to obtain or control the dividend income. That is, the tax laws treat the dividend as though Jim received the dividend and then used it to acquire the new stock. The value of the stock at the end of the year is not relevant, because Jim has not realized the appreciation on the stock he purchased.