Chapter 2
Income Tax Concepts
Murphy & Higgins, Concepts in Federal Taxation, 2010 edition
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Federal Income Taxation

Based on a system of rules

Developed around general concepts
and specific exceptions
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Terminology

Concept - a broad principle
Construct - a means to implement a
concept
 Doctrine - a construct developed by
the courts

Concept
Construct
Doctrine
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General Concepts
Ability to Pay
Tax should be based on an amount
that a taxpayer can afford to pay.
 Constructs used

Deductions
 Exclusions
 Credits
 Progressive tax rates

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General Concepts
Administrative Convenience
The benefit derived from a concept,
construct or doctrine should always
exceed the cost of implementation.
 Constructs used

Standard deduction amounts
 Fringe benefit exclusions

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Administrative Convenience
Example

Bow Company allows its employees
to make copies for personal reasons
without charge on the company copy
machine. The employees are not
required to include the value of the
copies in taxable income.
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General Concepts
Arms-Length Transaction Concept
A transaction between related parties
must reflect economic reality.
 Constructs used

Related-party provisions
 Constructive ownership rules

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Arms-Length Transaction
Example

Gaby sells 100 shares of IBM stock to
her brother for $10,000. The shares
had originally cost Gaby $12,000.
Gaby is not allowed to use the $2,000
loss from the sale to reduce her
taxable income.
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except for use as permitted in a license distributed with a certain product or service or otherwise on a passwordprotected website for classroom use.
2-8
General Concepts
Pay As You Go Concept
Taxpayers are required to pay tax as
they generate income.
 Constructs used

Withholding
 Estimated tax payments

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Accounting Concepts
Entity Concept

Each tax entity must keep separate
records and report operations
separately.
Constructs used
• Taxable entities
• Conduit entities
• Sole Proprietorships
Doctrine used
• Assignment of Income
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Assignment of Income
Doctrine

All income earned from services
provided by an entity or property
owned by an entity are to be taxed to
that entity.
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Assignment of Income
Example

Sage is a self-employed electrician.
She deposits all cash payments she
receives in a bank account in her
son’s name. Sage does not have use
of the funds; however, she is required
to include the amount of the cash
payments in her gross income.
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except for use as permitted in a license distributed with a certain product or service or otherwise on a passwordprotected website for classroom use.
2-12
Accounting Concepts
Annual Accounting Period Concept

Each taxpayer must select

A tax year
• Calendar
• Fiscal

An accounting method
• Cash
• Accrual
• Hybrid
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Annual Accounting Period Concept
Constructs & Doctrines Used

Tax Benefit Rule: If a tax benefit is
derived from a deduction in one year,
any refund received in a subsequent
year must be reported as income.
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Tax Benefit Rule Example

Abner had $4,000 of state income taxes
withheld from his salary during 2008. He
deducted the $4,000 as part of his
itemized deductions on his 2008 federal
return. On May 15, 2009, he received a
refund of $1,000 from the state. When
he files his 2009 federal return, Abner
will be required to report the $1,000 as
income.
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except for use as permitted in a license distributed with a certain product or service or otherwise on a passwordprotected website for classroom use.
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Annual Accounting Period Concept
Constructs & Doctrines Used

Substance-Over-Form Doctrine: A
transaction must be realistic in an
ordinary sense and not contrived
merely to avoid tax.
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Substance Over Form
Example

Jacee “hired” her 4-year old son as
office manager for her real estate firm.
When she filed her federal tax return
she deducted $20,000 as Salary
Expense for him. The IRS disallowed
the deduction when they examined
her return.
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Income Concepts
All-inclusive Income Concept

All income received is taxable unless
a provision of the law specifically
excludes it.
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Income Concepts
Legislative Grace Concept
Any tax relief provided is the result of
specific acts of Congress which are
applied and interpreted strictly.
 Constructs used

Exclusions, deductions and credits
 Special classifications such as capital
assets

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2-19
Income Concepts
Capital Recovery Concept
A taxpayer may recover all invested
capital before income is taxed.
 Constructs used

Basis
 Gains and Losses

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Capital Recovery
Example

Nash sold 200 shares of common
stock for $2,000. Because he had
paid $800 for the shares, he is
required to report only $1,200 as
income.
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Income Concepts
Realization Concept
No income is recognized as taxable
income until it has been realized by
the taxpayer.
 Doctrines used


Claim of Right Doctrine
• applies to accrual basis taxpayers

Constructive Receipt Doctrine
• applies to cash basis taxpayers
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2-22
Realization Concept
Doctrines Used

Claim of Right Doctrine: Realization
does not occur until an amount has
been received without restriction.

Applies when the taxpayer received
payment but there is a dispute
regarding the taxpayer’s right to keep
some or all of it.
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2-23
Claim of Right
Example

Pamala rented her garage apartment
to Mahlon and collected $450, the
first-month’s rent, in advance. She
also collected $500 as a security
deposit that she will return to Mahlon
if he doesn’t damage the apartment.
She must report only $450 as income
because she has no claim of right to
the $500.
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2-24
Realization Concept
Doctrines Used

Constructive Receipt Doctrine


is a modification that prevents cash basis
taxpayers from “turning their backs” on
income.
Realization is deemed to have occurred if



a taxpayer is aware an amount is
available,
the amount is unconditionally available
(even without physical possession), and
receipt of the amount is within the
taxpayer’s control.
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2-25
Constructive Receipt
Example

Gail is a self-employed handyman.
Tacy, one of his customers, brought a
check for $250 on December 30,
2008, to pay for work Gail had
finished. Gail asked her to mail the
check instead, so he could check
“delivery time.” Gail must report the
$250 as income in 2008 even if the
check isn’t delivered until 2009.
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Income Concepts
Wherewithal-to-Pay Concept
Tax should be recognized and paid
when the taxpayer has the resources
to pay.
 Constructs used

Deferrals
 Recognition of unearned income

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2-27
Deduction Concepts
Legislative Grace Concept

Any deduction allowed is the result of
specific acts of Congress which are
applied and interpreted strictly.
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2-28
Deduction Concepts Business
Purpose Concept
Only expenditures made in order to
generate income and for a purpose
other than tax avoidance will be
deductible.
 Examples:

Trade or business expenses
 Investment expenses

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2-29
Business Purpose
Example

Michael may not deduct depreciation
on his personal-use automobile
because he does not use it in his
business
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2-30
Deduction Concepts
Capital Recovery Concept
A taxpayer may deduct the amount of
capital invested before income is
reported.
 Constructs used

Basis
 Capital expenditures

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