Chapter 2
Income Tax Concepts
Murphy & Higgins
Concepts in Federal Taxation, 2014 edition
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Federal Income Taxation

Based on a system of rules

Developed around general concepts and specific
exceptions
Once you understand the unifying concepts, you can apply
them to almost every aspect of the system.
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Four Major Groupings of Concepts

General concepts

Accounting concepts

Income concepts

Deduction concepts
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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

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

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
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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use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
General Concepts:
Arms-Length Transaction

Arms-length transaction

A transaction between related parties must reflect economic reality.

Constructs used



Related-party provisions
Constructive ownership rules
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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use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
General Concepts:
Pay as You Go

Pay as you go

Taxpayers are required to pay tax as they generate
income.

Constructs used
 Withholding
 Estimated tax payments
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use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
Accounting Concepts:
Entity

Entity

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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use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
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Accounting Concepts
Assignment of Income

Assignment of income

All income earned from services provided by an entity or property
owned by an entity are to be taxed to that entity

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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use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
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Accounting Concepts:
Annual Accounting Period

Annual accounting period

Each taxpayer must select

A tax year
 Calendar
 Fiscal

An accounting method
 Cash
 Accrual
 Hybrid
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use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
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Accounting Concepts:
Annual Accounting Period Constructs & Doctrines

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

Example

Abner had $4,000 of state income taxes withheld from his salary during 2012. He
deducted the $4,000 as part of his itemized deductions on his 2012 federal return. On
May 15, 2013, he received a refund of $1,000 from the state. When he files his 2013
federal return, Abner will be required to report the $1,000 as income.
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use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
Accounting Concepts:
Annual Accounting Period Constructs & Doctrines

Substance-Over-Form Doctrine

A transaction must be realistic in an ordinary sense and not contrived
merely to avoid tax

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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use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
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Income Concepts:
All-Inclusive Income

All-inclusive income

All income received is taxable unless a provision of the law
specifically excludes it
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use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
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Income Concepts
Legislative Grace

Legislative Grace

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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use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
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Income Concepts:
Capital Recovery

Capital recovery

A taxpayer may recover all invested capital before income is
taxed.

Constructs used:



Basis
Gains and Losses
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

Realization

No income is recognized as taxable income until it has been
realized by the taxpayer.

Doctrines used:

Claim of Right Doctrine
 Applies to both accrual and cash basis taxpayers

Constructive Receipt Doctrine
 Applies only to cash basis taxpayers
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use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
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Income Concepts:
Realization and its Constructs and Doctrines –
Claim of Right

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 restriction the taxpayer’s right to keep some
or all of it
Example

Pamela 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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use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
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Income Concepts:
Realization and its Constructs and Doctrines –
Constructive Receipt

Constructive Receipt Doctrine

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.
Example

Gale is a self-employed handyman. Tracy, one of his customers, brought a
check for $250 on December 30, 2012, to pay for work Gale had finished.
Gale asked her to mail the check instead, so he could check “delivery time.”
Gale must report the $250 as income in 2012 even if the check isn’t
delivered until 2013.
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use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
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Income Concepts:
Wherewithal-to-Pay

Wherewithal-to-pay

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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use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
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Deduction Concepts:
Legislative Grace, Again

Legislative grace

Any deduction allowed is the result of specific acts of Congress
which are applied and interpreted strictly
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use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
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Deduction Concepts

Business purpose

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
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

Capital recovery

A taxpayer may deduct the amount of capital invested
before income is reported.

Constructs used:


Basis
Capital expenditures
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