Module 7
Gross Income
Module Topics
General concepts
 Statutory exclusions
 Special inclusions for business income
 Cost of goods sold and inventories
 Inventory cost flow assumptions,
particularly LIFO
 The Uniform Capitalization Rules

General Concepts
Key Learning Objectives
§61 Defines gross income
 Overriding the cash- or accrual-basis
distinctions
 Note that accounting periods and
methods are discussed in depth in the
next module

§61 General Definition
Except as otherwise provided in this subtitle,
gross income means all income from whatever
source derived, including (but not limited
to) the following items:
1. Compensation for
services, including
fees, commissions,
fringe benefits, and
similar items;
2. Gross income from
business;
3. Gains derived from
dealings in property;
4. Interest;
5. Rents;
6. Royalties;
7. Dividends;
8. Alimony and
separate
maintenance
payments;
9. Annuities;
§61 General Definition (con’t)
10. Income from life
insurance and
endowment
contracts;
11. Pensions;
12. Income from
discharge of
indebtedness;
13. Distributive share
of partnership
gross income;
14. Income in respect
of a decedent;
and
15. Income from
interest in an
estate or trust.
Overriding the Cash- or
Accrual-Basis Distinctions
Forms of income
 The cash equivalent doctrine
 Constructive receipt doctrine
 Claim-of-right doctrine

Forms of Income
Substance over form
 Debt relief
 In-kind receipt of property or services
 Benefit transferred to another
 Windfall gains

The Cash Equivalent Doctrine
Cash
 Property
 Services

Constructive Receipt Doctrine
Credited to account
 Set apart or otherwise made available
 Could have drawn upon it during the
taxable year if notice of intention to
withdraw had been given
 Not constructive receipt if control is
subject to substantial limitations or
restrictions.

Claim-of-Right Doctrine
Amount is includable in income at the
latest when it is received
 Provided that the taxpayer has an
unrestricted right to the funds
 Even if the amounts are received in
error or
 The right to such income is contested
and subsequent events require
repayment

Research Query: When Is A
Prepaid Legal Fee Income?
Prepaid legal fees were deposited by a law
partnership in trustee accounts established
to comply with a state ethics law.
 Are these fees includible in income when
deposited or earned?
 HINT: Miele, Agatha, (1979) 72 TC 284

Solution--Research Query:
Prepaid Legal Fee

Whether a cash basis law firm is in receipt
of income when a prepaid legal fee is
received depends on whether the firm
received the fee under a claim of right and
without restriction as to disposition.
Solution--Research Query:
Prepaid Legal Fee (con’t)
Consequently, a firm has no income of a
prepaid legal fee until an undisputed
amount is due the firm from the prepaid fee.
 However, once earned, the fees are
includible in income even though the firm
leaves the fees in the trustee account.

Statutory Exclusions
Key Learning Objectives
Statutory exclusions that apply to
business income
 Special provisions for forgiveness of
indebtedness income
 The tax benefit rule

Statutory Exclusions (con’t)
§§101-137 “Items specifically excluded
from gross income”
 §103: Interest on state and local bonds
 §109: Improvements by lessee on
lessor’s property

 Unless
constructed in lieu of rent
§108: Income From
Discharge of Indebtedness
An exclusion for forgiveness of indebtedness
if the discharge relates to:
(a) a bankruptcy under Title 11
(b) an insolvent taxpayer
limited to the amount by which the taxpayer is
insolvent after the forgiveness.
(c) qualified farm indebtedness
(d) qualified real property business
indebtedness of noncorporate taxpayer
Special Business Income
Inclusion Rules
Key Learning Objectives
Prepaid income
 Long-term contracts
 Bad debt expense of service providers

 The

nonaccrual experience method
The installment method for certain
dealers
Advance Payments
Almost Always Income
Applies to cash and accrual taxpayers
 Does not apply to security deposits
 Discussed further in Module 8

Long-Term Contracts




Construction not completed during the tax
year initiated
Must use percentage-of-completion method
At completion, required to recompute tax
liabilities for all years of the contract using
actual contract costs and contract revenue
The taxpayer is required to pay interest on
any underpayments
Estimating Bad Debts of
Accrual Basis Service Providers
The nonaccrual experience method
 Not available if the taxpayer charges
interest or penalties on late payments
 Estimated bad debt based on bad debt
experience in prior years
 Works much like the reserve method for
bad debts

The Installment Method
for Certain Dealers
Gross income is reported as
installments of the total sales price are
received
 Available only for

(a) property used in the trade or business of
farming
(b) residential lots
(c) timeshare ownership interests of six
weeks or less in residential real property
Inventory--Basic Concepts
Key Learning Objectives
Basic reason for
inventories
 When required
 How valued

The Reason for Inventories
Reg. §1.61-3 defines “gross income” for
a manufacturing or merchandising
business as sales less cost of goods
sold plus income from other sources
 Ensures that only gain from sale of
inventory is taxed
 Limits benefits of cash basis method of
accounting

When Are Inventories
Required?
Whenever in the opinion of the
Secretary
 Necessary to clearly reflect income
when

 Production
 Purchase
 Sale

of merchandise
Is an income-producing factor
What Must Be Inventoried?

Only raw materials and supplies which have
been


Acquired for sale, or
Will physically become a part of
merchandise intended for sale
Compliance Query:
Materials & Supplies
In January, John’s Secretarial Services, a
cash basis taxpayer purchased:
Spare computer parts
$5,000
Office supplies
500
 Items are used internally. John’s keeps no
record of consumption or inventory records.
 Can the company deduct these items in full
in the current tax year?

Solution--Compliance Query:
Materials & Supplies Reg §1.162-3
Materials and supplies are deductible only
in the amount actually consumed and used
in operation during the year.
 However, incidental materials and supplies.
are deductible if

No record of their consumption is kept
 No physical inventory is taken
 This method may be used only if it clearly
reflects income.

Solution--Compliance Query:
Reg § 1.162-3 (con’t)

The $5,000 of spare computer parts are
probably not incidental. John’s should do a
physical inventory at year end to determine
the amount to deduct.

The $500 of office supplies are probably
incidental and can be deducted in full.
Valuation of Inventories
Cost
 Lower of cost or market
 Cost flow assumptions
+ Specific identification
+ Average cost
+ FIFO
+ LIFO

Inventory--Special Issues
Key Learning Objectives
LIFO inventories
 Dollar-value LIFO methods

Electing LIFO--Pros & Cons
Cushion the impact of price increases in
an inflationary economy
 Must use for books also

Electing LIFO
Elect by filing Form 970 for change tax
year
 Prior approval not required
 Revocation requires prior approval



Cumulative adjustment required
No new elections for a 10-year period
w/out permission
Dollar Value LIFO
Determine inventory cost on the basis of
total dollars (for a base year)
 Rather than the quantity and price of
each inventory item
 Simplified Dollar-Value LIFO eliminates
many problems of pooling

Uniform Capitalization Rules
Key Learning Objectives
General description
 Who must follow rules
 Costs that must be capitalized

§263A Uniform Capitalization
Rules: An Overview
UNICAP rules
 Apply to producers
and resellers of
property
 Extend the concept
of absorption
costing

Taxpayers Exempt from the
UNICAP Rules






Reseller of personal property with average
gross receipts of $10,000,000 or less during
the preceding three taxable years
Certain farming businesses
Personal use property
Research and experimentation expenditures
deductible under §174
Certain costs associated with oil and gas
properties
Certain timber and ornamental trees
Category 1 --Costs That
Must Be Inventoried
Repairs & maintenance
 Rent & utilities
 Indirect labor
 Production supervisory wages
 Indirect materials & supplies
 Small tools & equipment
 Quality control & inspection

Category 3--Costs That Follow
Financial Statement Treatment

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



Taxes other than state or local income
taxes (e.g..., property)
Financial statement depreciation/depletion
Employee benefits for production labor
Rework labor, scrap, and spoilage
Factory administrative expenses
Production officers’ salaries
Insurance costs