Chapter 2
Income Tax Concepts
Kevin Murphy
Mark Higgins
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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
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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
Glenda sells 100 shares of IBM stock to
her brother for $10,000. The shares
had originally cost Glenda $12,000.
Glenda is not allowed to use the $2,000
loss from the sale to reduce her taxable
income.
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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
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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.
 Lucas v. Earl, 281 US 111
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Assignment of Income Example
Alicia is a self-employed electrician.
She deposits all cash payments she
receives in a bank account in her son’s
name. Alicia 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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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
Angelo had $4,000 of state income
taxes withheld from his salary during
2007. He deducted the $4,000 as part
of his itemized deductions on his 2007
federal return. On May 15, 2008, he
received a refund of $1,000 from the
state. When he files his 2008 federal
return, Angelo will be required to report
the $1,000 as income.
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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
Janet “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.
Example: After buying books at the beginning
of the semester, Lori finds a $100 bill in the
parking lot. The $100 is part of Lori’s gross
income.
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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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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
Nathan 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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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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Claim of Right Example
Clara rented her garage apartment to
Jared and collected $450, the firstmonth’s rent, in advance. She also
collected $500 as a security deposit that
she will return to Jared 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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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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Constructive Receipt Example
Sam is a self-employed handyman.
Maria, one of his customers, brought a
check for $250 on December 30, 2007,
to pay for work Sam had finished. Sam
asked her to mail the check instead, so
he could check “delivery time.” Sam
must report the $250 as income in 2007
even if the check isn’t delivered until
2008.
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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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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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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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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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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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