ch 5 - tax accounting

determining income recognition

step 1: Has the taxpayer’s wealth increased?

step 2: Has the taxpayer realized this increase in wealth?

step 3: Does the law not provide a specific exclusion for this type of income?

income received in other forms

• receipt of other property

• receipt of services - include FMV of services received in income

• forgiveness of debt

• canceled payment of expenses

treasure trove principle

an individual who unexpectedly finds property and can legally keep it must include the fmv of the property in taxable income at the time their ownership becomes undisputed

constructive receipt doctrine

concept that requires a cash-basis taxpayer to include the value of property in income in the period in which the taxpayer acquires the right to, or control of, the property if actual receipt would have been taxable

tax benefit rule

requires a taxpayer to include an expense reimbursement in the income if the taxpayer deducted the expense in a prior period and the deduction reduced the taxpayer’s taxable income

claim of right doctrine

requires a taxpayer to include property in income in the period in which an apparent claim to the property materializes if the taxpayer currently controls the property, even though the taxpayer may have to return the property later

assignment of income doctrine

provides that income is taxed to the individual who earned the income, even if the taxpayer directs that the funds be paid to someone else

cash-basis method

taxpayers recognize income in the period they receive cash, property, services, or other benefits in an economic transaction that is taxable

accrual-basis method

taxpayers recognize income when all the events have occurred that fix their right to receive that income and the amount of that income can be determined with reasonable accuracy

prepaid income

taxpayers usually recognize prepaid income, including prepaid interest, when received

exception: if the prepayment is for services the taxpayer will render in the future, a special deferral rule applies. the taxpayer can elect to defer prepaid service income to the following tax year if they treat it the same way for financial reporting purposes. prepaid service income can never be deferred beyond the end of the tax year following the year it is received

recovery of capital

return of the taxpayer’s basis

installment sales

allows the gain from the sale to be spread over the period in which the seller receives payments from the buyer

• applies to gains but not losses

• the amount of income the taxpayer must report each year it is computed as: gross profit/contract price X amount received in year

sole proprietorship

an unincorporated business that has only one owner

• all income from the business is taxed to the owner on schedule C

• major disadvantage of sole proprietorship is that the owner has unlimited liability

limited liability company (LLC)

is an ownership form permitted in all states that allows for one or more owners

• all member have limited liability

single member LLC (SMLLC)

has only one owner and reports all income and expenses on schedule C

• all member have limited liability

rental real estate

income from rental real estate is fully taxable after deducting appropriate expenses, reported on schedule E, pg 1

royalty income: business

royalties derived from writing songs, writing books, creating works of art, and conducting similar activities are considered received from a trade or business and are reported on schedule C

royalty income: investment

royalties from investment activities the taxpayer does not manage are considered investment income and are reported on schedule E pg 1

unlimited liability

the taxpayer is responsible for paying all debts of the business, even if he must use his personal assets to do so

Income from other-pass-through entities:

Partnerships, LLC’s, and S Corporations

the income/loss passes though the business and the owners report their share of the income on their tax return

• owners receive a schedule k-1 at the end of the tax year reporting their ordinary business income/loss and their separately stated items

• ordinary business income/loss is reported on schedule E pg 2