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 / Modified / 2
3 / Issue ID / Unchanged / 3
4 / Realization rationale / New
5 / Recovery of capital / Unchanged / 5
6 / Constructive receipt and agent / New
7 / Cash method / Unchanged / 7
8 / Issue ID / New
9 / Original issue discount / New
10 / Original issue discount / Unchanged / 10
11 / Accrual basis and prepaid income / New
12 / Who is the taxpayer? / Unchanged / 12
13 / Who is the taxpayer? / Unchanged / 13
14 / Who is the taxpayer? / Modified / 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 / Unchanged / 21
22 / Issue ID / Unchanged / 22
23 / Annuity / Unchanged / 23
24 / Group-term life insurance / Unchanged / 24
25 / Social Security benefits / Unchanged / 25
26 / Economic versus taxable income / Unchanged / 26
27 / Issue ID / Unchanged / 27
*28 / Gross income: investments / Modified / 28
29 / Gross income / New
30 / Gross income / Unchanged / 30
*31 / Accrual basis versus cash basis / Unchanged / 31
*32 / Accrual basis versus cash basis / Modified / 32
33 / Accrual basis versus cash basis / Unchanged / 33
34 / Accrual method and disputed income / Unchanged / 34
35 / Constructive receipt / Unchanged / 35
*36 / Original issue discount and savings bonds / Modified / 36
37 / Advance payments / Unchanged / 37
38 / Constructive receipt / Unchanged / 38
39 / Prepaid rent and deposits / Unchanged / 39
40 / Who is the taxpayer? / New
41 / Constructive receipt and agent / Unchanged / 41
42 / Partnerships / Unchanged / 42
*43 / Community property / Unchanged / 43
*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 / Unchanged / 51
*52 / Annuity / Unchanged / 52
53 / Prizes and awards / Unchanged / 53
*54 / Group term life insurance / Unchanged / 54
*55 / Unemployment compensation / Unchanged / 55
*56 / Social Security benefits / Unchanged / 56
*57 / Social Security benefits / New
58 / Miscellaneous / Unchanged / 58
*59 / Cumulative / Modified / 59
*60 / Cumulative / Modified / 60
Research
Problem
1 / Gross income / Unchanged / 1
2 / Realization / Unchanged / 2
3 / Imputed interest / Unchanged / 3
4 / Gambling gains and losses / Unchanged / 4
5 / Internet activity / Unchanged / 5
6 / Internet activity / Unchanged / 6
*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.
59. / 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 2004.
Include $110,000 in 2003.
Include $8,000 in 2002.
Include $8,000 in 2003.
$4,416.
$934 interest income on 2-year certificate; $0 interest income on 1year certificate.
Gross income of $1,200 may be deferred until 2003.
Gross income $590 ($140 + $450) in 2003.
Gross income $450 ($1,200 – $750).
Actually received $180,000; constructively received $0.
She may be in a lower tax bracket in 2005.
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.
Refund due $417. / 41.a.
41.b.
41.c.
42.
43.a.
43.b.
43.c.
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.
60. / Corporation recognizes $3,000; Tracy
recognizes $0.
Same as a.
Corporation recognizes $0 in 2003; Tracy recognizes $0 in 2003.
$100,000.
Diego $59,000; Carmen $59,000.
Split evenly.
Diego $48,000; Carmen $70,000.
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 available, 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 $550; compensation expense and interest income to Vito, Inc. $550.
Interest income and dividends paid to the corporation in 2003 $400; interest expense and dividend income to Vito in 2003 $400.
Gross income $9,231.
Gross income $24,000.
Loss $36,923; gross income $9,231.
$110,000.
$75,000.
$0.
Alice $72; Kay $1,500.
$1,500.
$100,440.
$29,750.
No.
$36,900.
Reduction if retire of $7,250.
The $70,000 is taxable.
$7,140 is taxable.
$1,200 is taxable.
Donna must include one-half of husband’ winnings.
Refund due $1,849.

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.The mere appreciation in value of $3,000 ($8,000 – $5,000) is not included in the taxpayer’s gross income. The economist would include $3,000 in income.

b.The economist would include in income the rental value of the owner’s home. Such imputed income is not gross income for tax purposes.

c.The bargain purchase would be considered income under both the accounting and economic concepts of income. For tax purposes, the bargain purchase element probably would be treated as a constructive dividend to the shareholder.

d.The economist would identify no gain on this transaction. The appreciation of the property would have been taken into income by the economist over the past three years. The insurance payment would be an exchange for property of like value which has no effect on the taxpayer’s net worth. For tax purposes a gain of $4,000 would be recognized since property with a basis of $2,000 was given up in exchange for cash of $6,000.

e.Both the economic and tax constructs of income would require recognition of the fair market value of the coins as income when they were found. The taxpayer’s net worth would increase as a result of finding the coins, and for tax purposes, the discovery constitutes a realization event.

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 $73 [(1-.27)($100)] in after-tax income from not working and earnings $100. This reasoning assumes that Tom can paint as fast as someone he would hire (i.e., the time consumed is the same). pp. 4-3 and 4-4

5.Northern should report the amount received as a recovery of capital. It is impossible to determine the cost of the property rights that are being surrendered by Northern. Therefore, if the amount received from the Long Cable Company is less than Northern’s cost of the land, no gain is recognized. pp. 4-6 and 4-7

6.The employer is required to include the $3,000 in gross income in 2003, when the employer’s agent receives the payment from the customer. pp. 4-7 to 4-10 and 4-16

7.a.The income should be reported in 2004. In 2003, 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 18.
• 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 18).

pp. 4-8 to 4-10

9.The certificate of deposit contains original issue discount, which Alyson must include in her gross income each year from 2002 through 2005. 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 2003 because the interest earned in 2002 is added to the principal upon which the compound interest is computed in 2003. p. 14-11 and Example 14

10.a.Bethany’s interest income for 2003 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, 2003 is $4,634 ($4,291 + $343).

c.The interest income will be greater in 2010 than in 2003 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.

pp. 4-11 and 4-12

11.Under Revenue Procedure 71-21, if the services will be provided by the end of the tax year following the year of receipt, the unearned portion in the year of receipt can be deferred until the following year. pp. 4-13 to 4-15

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. 4-15 and 4-16

13.The tree produces the income, the fruit. In the case of services, the provider of the services is the tree and therefore must pay the tax on the income he or she produces. The income from property is taxed to the owner of the property. 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 paid by 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. 4-16 and 4-17

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 2003, 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. 4-17 to 4-19

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. 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 4-22

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. The gift arises because the borrower is deemed to have accrued interest payable to the lender, which the lender forgives. pp. 4-22 to 4-27

21.The other tax effects on the corporation depend upon whether the loan is classified as (a) an employer-employee loan, or (b) a corporation-shareholder loan. The employer-employee loan creates deductible compensation expense for the corporation equal to the corporation’s interest income. The corporation-shareholder loan is treated as a nondeductible dividend paid to the shareholder. 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.All of the payments in the eleventh year must be included in Betty’s gross income. She has recovered her investment of $73,600 as a return of capital over the 10 years (her life expectancy used in calculating the annuity exclusion percentage). pp. 4-27 to 4-30

24.Mary must include in gross income the imputed insurance premium amount on $10,000:

($60,000 – $50,000) / (.43)(12 months) = $51.60
$1,000

Larry did not receive any gross income during the year. He has merely received a promise from his employer. pp. 4-32 and 4-33

25.As an annuity, the recipient would receive return of capital treatment and inclusion in gross income for each dollar received. Individuals with low earnings would be taxed the same as high income individuals. The present formula, with the gross income floor below which the benefits are not taxed, benefits lower income individuals. p. 4-33

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. In addition, under the 2001 tax legislation, marginal tax rates are scheduled to decrease each year through the year 2006. pp. 4-7 to 4-9

28.Alternative a. is superior to alternative b. Alternative a. yields the greater after-tax value.