Overview of Taxable Income
and Tax Liability
Individuals
Gross Income
$XX
Less: Above-the-line
Deductions
XX
AGI
$XX
Less: Greater of
Standard or Itemized
Deductions
XX
Less: Exemptions
XX
Taxable Income
$XX
C Corporations
Gross Income
Less: Deductions
Taxable Income
$XX
XX
$XX
Tax Liability
Rate schedule applied
to Taxable Income
Less: Credits
Regular Tax Liability$XX
Pay greater of Regular Tax
Liability or AMT
5-1
$XX
XX
Gross Income Defined
• General Definition. Gross income means
all income from whatever source unless
excluded by law. Gross income includes
income realized in any form, whether in
money, property, or services. Income may
be realized, therefore, in the form of
services, meals, accommodations, stock, or
other property, as well as in cash.
[Source: Reg. Sec. 1.61-1(a)]
5-2
Examples of Taxable
Gross Income
• Which of the following would be included
in gross income?
–
–
–
–
–
–
5-3
Wages, salaries, tips, bonuses
Income from the sale of goods or services
Income from illegal activities
Interest, dividends, rent and royalty income
Income from annuities and conduit activities
Gains from the sale of investments assets
Non-Cash Income
• Receipt of property as compensation for
services results in income equal to the fair
market value of the property received
– FMV = Arm’s-length price
– Issue: How do we determine value?
• Example: Shares of stock in a public
company versus a closely-held company
• Discharge of Indebtedness results in income
to the debtor (unless insolvent)
5-4
Sales and Exchanges
• Gross income includes Gain (Loss) realized
on a sale or exchange of property, to the
extent that the amount realized exceeds (is
less than) the taxpayer’s basis in the property
– A sale occurs when the amount realized is cash
– In an exchange of property for non-cash
consideration, the amount realized equals the fair
market value of the asset received
– Basis, generally equals the taxpayer’s
investment in the property
5-5
Exclusions from Gross Income
- Business Related Items
• Nontaxable returns of capital
– Basis of assets sold or exchanged
– Principal payments received on loans
• Many employee fringe benefits
• Life insurance proceeds
• State and municipal bond interest
5-6
Business Deductions
• All the ordinary and necessary expenses
paid or incurred during the taxable year in
carrying on any trade or business
– Ordinary means common or customary for that
type of business
– Necessary means helpful and appropriate to the
production of business revenues
– Must also be reasonable in amount
5-7
Limits on Deductibility
• Public policy considerations
– Fines, bribes not deductible
– Political contributions, lobbying expenditures
not deductible
– Federal income taxes not deductible
• Expenses to generate tax exempt income
are not deductible
– Premiums paid on key-man life insurance
– Expenses of investing in tax exempt bonds
5-8
Limits on Deductibility
continued
• Meals and Entertainment - must be either:
– ‘Directly related’ to conduct of trade or
business
• Incurred in a business setting with expected business
benefit
– ‘Associated with’ conduct of trade or business
• Clear business purpose
– For entertainment, must directly precede or follow a bona
fide business discussion
– For meals, there must be a bona fide business discussion
during, immediately proceeding or following the meal
– Only 50% of cost is deductible
5-9
Limits on Deductibility
continued
• Travel Expenses:
– Transportation costs are fully deductible, if
business is ‘primary purpose’ of trip
– Lodging, cab fares, etc. during business portion
of trip are fully deductible
– Meals during business portion of trip subject to
50% limit on deductibility
• No deduction for club dues (business,
social, athletic, golf, etc.)
5-10
Business Bad Debts
• Under GAAP, many companies recognize
bad debt expense using the reserve method,
expensing the annual addition to the reserve
(contra-asset) and reducing the reserve for
actual write-offs
– Annual addition based on estimate of accounts
that will be uncollectible
• Business bad debts may be deducted for tax
purposes only when receivable is
determined to be worthlessness and written
off the books
5-11
Timing Issues
• Taxable year
– What types of taxpayers general use a calendar
year?
– What types of taxpayers are allowed to use
another fiscal year? How is such fiscal year
selected?
• Timing also depends on
– Realization versus recognition
– Taxpayer’s method(s) of accounting
5-12
Realization Criteria
• Realization occurs when the earnings process
is complete - requires an external transaction
involving a change in the form or substance
of the taxpayer’s property or property rights
• Under GAAP, income is typically recorded
when realized
• For tax purposes, income is typically
recognized (included in taxable income)
when realized, but there are many
exceptions!
5-13
Methods of Accounting
• General rules:
– taxable income is computed using the overall
method of accounting adopted for financial
accounting purposes
– method of accounting must ‘clearly reflect income’
• What types of taxpayers generally use the cash
method for tax purposes?
• What types of taxpayers generally use the
accrual method?
• What taxpayers are required to use the accrual
method?
5-14
Methods of Accounting
continued
• Hybrid method: accrual method for
inventory, cash method for all else
• Special methods for specific transactions
– Examples:
• Inventory methods (FIFO, LIFO, LCM)
• Installment method
• Completed contract versus percentage-ofcompletion method for long-term contracts
– Some special methods are elective, others are
required if transaction meets qualifications
5-15
Accounting Methods and
Income Issues
• Cash-basis taxpayers must recognize
income in year in which they have
‘constructive receipt’
– Occurs when no substantial barrier exists to the
taxpayer’s control and possession of income
• Accrual-basis taxpayers must recognize
prepaid income in year in which cash is
received, regardless of when earned
5-16
Accounting Methods and
Deductibility Issues
• Expense prepayments by cash-basis
taxpayers must be amortized over useful life
if create an asset which will not be
consumed by the close of the next taxable
year
– Examples: Prepaid rent, bulk purchases of
offices supplies
– Prepaid interest deductible only in year due
5-17
Deductibility Issues continued
• Accrued expenses must meet the all events
test to be currently deductible
– For routine accruals, all events must have
occurred to establish the fact of the taxpayer’s
liability and the amount must be reasonably
determinable
– For nonrecurring or extraordinary accruals,
economic performance must occur before a
deduction is allowed - generally occurs when
services or property are actually provided to or
by the taxpayer
5-18
Deductibility Issues continued
– Economic performance not required if:
• economic performance occurs within the shorter of
8 1/2 months or a reasonable period after the close
of the tax year and
• the expense is recurring and the taxpayer is
consistent in treatment of the accrual and
• the item is not material or accrual results in a more
proper matching of income and expense and
• the item does not arise from a tort, breach of
contract, violation of law, or claim under workman’s
compensation and
• the all events test is met
5-19
Example: Economic
Performance
• Big Oil Co. enters into an offshore oil drilling
lease in 2001. In 2002, Big installs a platform
and commences drilling. The lease obligates
Big to remove its platform and well fixtures
upon abandonment of the well or termination
of the lease. Based on past experience, Big
estimates that the well will be productive for
10 years, at which time it will cost $2 million
for removal. When can Big deduct these costs
for financial accounting purposes? For tax
purposes?
5-20
Deductibility of Losses
• Losses on sales or exchanges of assets
– Generally, losses related to tangible assets used
in the conduct of a trade or business are fully
deductible as ordinary losses
– Losses related to intangible assets or assets held
for investment purposes are capital losses
whose deductibility is subject to special limits
– Losses on sales to related parties generally not
deductible
– Much more coverage of these topics later
5-21
Deductibility of Losses
continued
• Net Operating Loss - excess of allowable
business deductions over business gross
income
– Carried back as a deduction against any taxable
income reported in 2 preceding years
• Results in immediate refund of taxes previously
paid
• Taxpayer may elect to forego carry back
– Any excess may be carried forward for 20 years
5-22
Book/Tax Differences
• Temporary (timing) differences
– Occur when an item of income (expense) is taxable
(deductible) in a different year than when included
in income for book purposes
– Will ‘reverse’ over several years - eventually the
item is included in both book and taxable income
• Permanent differences
5-23
– Occur when an item of income (expense) included
in book income will never be taxable (deductible)
or vice versa
– Never reverse
List of Book/Tax Differences
Permanent Differences
Temporary Differences
• Municipal bond interest
• Prepaid income
• Life insurance proceeds
and related premiums
• Bad debt reserves
• Non-deductible fines,
penalties, political
contributions and
lobbying expenditures
• Federal income taxes
• 50% of meals and
entertainment
5-24
• Accrued expenses
subject to economic
performance rules