Chapter 3
Income Sources
Howard Godfrey, Ph.D., CPA
UNC Charlotte
Copyright © 2013, Dr. Howard Godfrey
Edited August 10, 2013.
1
Part 1. Introduction
Part 2. What constitutes income [income from labor or
capital, increase in wealth, current view]
Part 3. Common income sources [Earned, Unearned (rent,
royalty, annuities), Transfers from others (prizes,
unemployment income, Social Security, Alimony),
Imputed income, Below market loans, Expenses of
others, Bargain purchases]
Part 4. Capital gains and losses
[capital gains, losses, dividends, capital gains and
losses of conduit entities]
Part 5. Effect of Accounting Method [Cash & Accrual
method, Exceptions to accrual method, Hybrid method,
Installment sales, Completed contract method]
Chapter 3. GROSS INCOME
Income Sources.
Introduction
What is Income?
Labor & Capital
Increase in Wealth
What is Income?
Common Sources
Earned Income
Unearned Income
Transfers
Imputed Income
Capital Gain or Loss
Netting
Capital Gains
Dividends
Capital Losses
Conduit gains & losses
Accounting Methods
Cash Method
Accrual Method
Hybrid Method
Exceptions
What is Income?
From Labor & Capital
Increase in Wealth
Current View
Common Income Sources
Earned Income
Unearned Income
Transfers from Others
Imputed Income
Rent and Royalty Income-1
Taxpayer had a salary from IBM
$60,000
Rent received for rental house
12,000
Repairs expense for rental house
1,000
Property tax on rental house
2,000
Depreciation on rental house
10,000
Repairs on personal residence
500
Property tax on personal residence
1,500
What is adjusted gross income?
Rent and Royalty Income
Salary from IBM
$60,000 $60,000
Rent received-rental house
12,000
12,000
Repairs exp. for rental house
1,000
(1,000)
Property tax on rental house
2,000
(2,000)
Depreciation on rental house
10,000 (10,000)
Repairs on personal residence
500
Property tax on personal res.
1,500
What is adj. gross income?
$59,000
Where are rental income & expenses reported
on the income tax return?
Annuities
An annuity is a series of payments.
Typically an individual invests a sum of
money and receives periodic payments
(often monthly) over a period of years,
maybe for as long at the individual lives.
Example: invest $120,000 and receive
$1,000 per month for life, and life
expectancy is 20 years. Half of each
payment is return of investment.
Annuity Example - age 55
Life expectancy- in years
Annuity income per month
Annuity income per year
Income over life expectancy
Cost
Profit expected
Profit percentage
Profit per year
30
$1,000
$270,000
Annuity Example - age 55
Life expectancy- in years
30
Annuity income per month
$1,000
Annuity income per year
$12,000
Income over life expectancy $360,000
Cost
$270,000
Profit expected
$90,000
Profit percentage
25%
Profit per year
$3,000
What happens when he gets to age 86?
Annuity Income.
• Usually includes taxable & nontaxable amounts
– Nontaxable amount is a return of capital
– Nontaxable amount of a payment is equal to:
(the Investment in annuity /
expected return from annuity)
X
annuity payment received
• If the amounts invested in the annuity were all
made by the employer (or by the employee using
pre-tax dollars), then the employee’s investment
is treated as zero
Annuity Example- Susan-Slide 1
Susan, age 62, purchased an
annuity for $30,000. He begins
receiving $500 per month in
January. What amount is included
in his gross income?
From Table 3-1,
the number of payments
to use is _____.
Susan - age 62- Slide 2
Life expectancy-months-Table 3-1
260
Annuity payment per month
$500
Annuity payment per year
$6,000
Payments over life expectancy
$130,000
Cost
$30,000
Profit expected on annuity
$100,000
Monthly exclusion ($30,000/260)
$115.38
Gross income per month
$384.62
Gross income per year
$4,615.38
What happens when she gets to age 86?
Annuities. - Charles
Charles pays $120,000 for a
single-life annuity that pays him
$11,000 a year for life. Assume
Treasury Department tables
estimate his remaining life to be
15 years.
a. How much of each $11,000
payment must Charles report as
gross income?
Annuities.
a. $3,000. If Charles lives for 15 years, he
will receive a total of $165,000 (15 x
$11,000). $120,000 of this represents a
return of his investment; the remaining
$45,000 represents income earned on this
investment and is taxable.
Of each $11,000 payment, $3,000
[($45,000/$165,000) x $11,000] must be
included in income.
The remaining $8,000 is a return of his
investment.
Annuities.
Charles pays $120,000 for a single-life
annuity that pays him $11,000 a year
for life. Treasury Department tables
estimate his remaining life to be 15
years.
b. If Charles dies after receiving
annuity payments totaling $77,000
over seven years, what happens to
the unrecovered cost?
Annuities.
b. If Charles dies after receiving only
$77,000 (7 years at $11,000 per year),
he will have recovered only $56,000
(7 x $8,000) of his investment total
$120,000 investment.
The remaining $64,000 ($120,000 $56,000) can be deducted on his final
tax return.
Annuities.
Barney retired from the Marlin Corp. where he
worked for 25 years. Barney elects to receive his
retirement benefits as an annuity over his
remaining life, resulting in annual payments of
$15,000. His plan balance consists of
$70,000 employer contributions,
$20,000 after-tax employee contributions,
$10,000 pretax employee contributions, and
$22,000 investment earnings. Based on Barney’s
life expectancy, his expected return is $240,000.
Of each $15,000 payment, how much must
Barney report as gross income?
Annuities.
$13,750. All of the contributions to
Barney’s retirement plan except for the
$20,000 from after-tax employee
contributions will be taxable when
received along with excess received over
the total investment.
Thus, of the $240,000 in expected
payments, $220,000 is taxable.
Of each $15,000 payment, $13,750 [$15,000
x ($220,000/$240,000)] must be included in
Barney’s gross income.
Gain or loss on sale
of Investments
Page 3-13
Amount Realized
+ Cash Received
+ FMV of property received
+ Seller’s liabilities assumed by the buyer
- Buyer’s liabilities assumed by the seller
- Selling expenses
= Amount Realized
Realized Gain or Loss
Amount realized
- Adjusted basis of property given up
Realized gain or loss
Recognized Gain or Loss
• Almost all realized gains are recognized
(taxable)
• Losses are usually only recognized
(deductible) if they are
– Incurred in a business
– Incurred in an investment activity
– Casualty or theft losses
Gains and Losses
Allan received $5,000 cash and an auto worth
$15,000 in exchange for a lot that was
encumbered by a $13,000 liability that the
buyer assumed.
a. What is the amount realized on this sale?
b. If Allan had a basis of $34,000 in the land,
what is his gain or loss on the sale?
Gains and Losses
c. If Allen has owned the land for
five years as an investment, what is
the character of the gain or loss?
d. How would your answer to (c)
change if the land had been used by
Allan’s business as a parking lot?
Gains and Losses
a. Amount realized.
$5,000 + $15,000 + $13,000 = $33,000
b. Loss. $33,000 - $34,000 = $1,000 loss
c. Long-term capital loss.
d. If the property had been used in a
business, it would be Section 1231
property and it would be a Section 1231
loss.
Allan's Transactions
Cash received
Other Prop. Received- Auto
Mortgage assumed by buyer
Total Consideration Received
Expenses of sale
Sales commission
Other selling expenses
Total expenses of sale
Amount Realized
Cost of property
Gain (Loss)
$5,000
15,000
13,000
33,000
33,000
(34,000)
($1,000)
Transfers from others:
Prizes & Awards.
Unemployment
Compensation.
Page 3-14
Prizes and Awards.
• Prizes, awards, gambling winnings, and
treasure finds are taxable.
• The fair market value of goods or
services received is included in gross
income.
Income from Lottery Winnings
Julie wins a $15 million lottery payable
over 30 years. In years 1 through 4, she
receives annual installments of $500,000.
At the beginning of year 5, Julie sells her
right to receive the remaining 26
payments to a third-party for a lumpsum payment of $8,900,000.
How much does Julie include in income
each year?
Income from Lottery Winnings
Solution: Julie must include all
$500,000 of each payment received
in years 1 through 4 in income when
received.
When she sells her rights to the
remaining 26 payments for
$8,900,000, the $8,900,000 must be
included in income when received.
Transfers:
Social Security
Benefits.
Divorce payments.
Page 3-15
Social Security Benefits.
• Government devised a complex formula
that can result in the taxation of up to
85% of social security benefits for
taxpayers who have significant other
income while leaving benefits completely
tax free for those who have little other
income
• MAGI = AGI before any social security
benefits + exempt interest income + ½ of
social security benefits
Social Security Benefits
• If MAGI is less than $25,000 for single
individuals or $32,000 for married
couples, then none of the social security
benefits received are taxable
• Single taxpayers with MAGI above
$34,000 and married taxpayers with
income above $44,000 can be taxed on up
to 85% of their benefits
• Taxpayers between the above thresholds
can be taxed on up to 50% of their social
security benefits
Social Security Benefits.
Vera, a single individual, receives
$18,000 of dividend income and
$38,000 of interest income from
tax-exempt bonds.
Vera also receives Social Security
benefits of $16,000. What is
Vera's gross income?
Social Security Benefits.
$31,600. Vera’s modified adjusted gross
income is $64,000
[$18,000 + $38,000 + ($16,000 x ½)].
Because her MAGI exceeds $34,000 by
$30,000, she must include 85 percent of her
Social Security benefits in her income or
$13,600 (85% x $16,000).
Her gross income is $31,600
($18,000 dividend income
+ $13,600 Social Security benefit).
Social Security Benefits.
Although the tax-exempt
bond interest must be
included in determining
modified AGI,
it is not included in
determining gross income
for tax purposes.
Divorce-Related Payments-1.
• A property settlement is simply a division of
assets (no income, no deduction)
• Alimony is a legal shifting of income so it is
taxable income to the person receiving it and
deductible by the person who pays it.
• Child support fulfills a legal obligation to
support a child
(no income to parent receiving,
no deduction for parent paying it)
• Both parties may benefit by negotiating an
increase in payment if it qualifies as alimony.
Tax Consequences of Divorce.
Stu & Harriett divorce after 8 years of
marriage.
Harriett receives a vacation home that had
been held jointly with Stu.
It was acquired 7 years ago at a cost of
$90,000 but is worth $170,000 today.
Stu must pay Harriett $2,000 per month;
$1,300 is for alimony and
$700 is for child support for their 6-year-old
son who lives with Harriett.
a. What is Harriett’s gross income?
b. Will Stu get a tax deduction?
Tax Consequences of Divorce.
a. Harriet must recognize the $1,300
monthly alimony payment as income.
She has no income on the transfer of the
home as part of the divorce settlement or
for the child support payments.
b. Stu is permitted to deduct the monthly
alimony payments of $1,300 in determining
his adjusted gross income.
Imputed income
Low interest loans.
Expense paid by Others.
Bargain Purchases.
Page 3-19+
Below-Market-Rate Loans.
• Certain loans between related parties
(family members, corporation and
stockholder, etc.) may be made at low
interest rates (or even interest-free)
• Interest income that is not actually
received or accrued may be imputed
(treated as received or accrued and
taxed) at the applicable federal rate of
interest
Gift Loan Exceptions.
• Any gift loan of $10,000 or less is
exempt from the imputed interest
rules
• For gift loans of $100,000 or less
– Imputed interest cannot exceed the
borrower’s net investment income for the
year
– If borrower’s net investment income is no
more than $1,000, imputed interest is zero
Gift Loan.
Joshua loans his son, Seth, $100,000
interest-free for five years. Seth uses the
money for a down payment on his home.
Assume that the applicable federal rate of
interest is 5 percent.
a. What are the tax consequences of this
loan to Joshua and to Seth?
b. How would your answer change if Seth
uses the money to invest in corporate
bonds paying 8 percent annual interest?
Gift Loan.
a. There are no tax consequences to
Joshua or Seth because the loan is
not in excess of $100,000 and the
proceeds are used for personal
expenses (rather than investment);
the transaction is not subject to the
imputed interest rules.
Gift Loan.
b. The imputed interest rules
treat the transaction as if Seth
paid $5,000 in interest
($100,000 x 5%) to Joshua each
year with Joshua recognizing
$5,000 of interest income;
Gift Loan.
Joshua would then be assumed to make a
gift of $5,000 annually to Seth.
Thus, Joshua must recognize $5,000 in
interest income (from the interest imputed
at the federal rate) annually and Seth
recognizes $8,000 of interest income (from
his investment in corporate bonds).
If Seth’s net investment income is less
than $5,000, the imputed interest will be
limited to the lower net investment income
amount.
Loan to employee
• Imputed exchange of cash is treated as
taxable compensation (income to
employee and salary deduction for
employer)
Employee also has imputed interest
expense, which may not be deductible.
Loan to shareholder
• Imputed exchange of cash is treated as a
dividend (taxable income to shareholder,
no deduction for corporation)
Employee/Shareholder Loans.
Sheldon Corporation loans $80,000
interest-free for one year to Lynn, an
employee.
Assume that the applicable federal rate of
interest is 5 percent.
Lynn uses the loan to pay for personal
debts. What are the tax consequences of
this loan to Sheldon and to Lynn?
How would your answer change if Lynn
was a shareholder of Sheldon Corp?
Employee/Shareholder Loans.
Solution:
Lynn is assumed to pay Sheldon Corp.
$4,000 in interest (5% x $80,000) on the loan.
Sheldon has $4,000 in interest income.
If Lynn is an employee, Sheldon is assumed
to then return the $4,000 to Lynn as taxable
compensation, deductible by the
corporation.
If Lynn is a shareholder, the return of the
$4,000 is assumed to be taxable dividend
income to Lynn that is not deductible by the
corporation.
Capital Gains.
Capital Assets.
Netting.
Rates –gains and div.
Losses.
Entities.
Page 3-25+
Capital Gains & Losses
Capital Gain-&-Loss Netting
Treatment of Capital Gains
Treatment of Dividends
Treatment of Capital Losses
Rules for Conduits
Capital Assets
• Capital assets include stock, bonds,
land held for appreciation,
collectibles (coins, art), and personaluse assets
• Long-term holding period is more
than one year
• Short-term holding period is one year
or less
Capital Gain & Loss Netting
• Subtract long-term capital losses from longterm capital gains (including net Section 1231
gains)
• Subtract short-term losses from short-term
gains
• Continue netting (subtracting losses from
gains) until only gains or only losses remain
– A (net) short-term capital gain resulting from this
process is taxed at ordinary income rates
– Taxation of (net) long-term capital gains and all
capital losses differs for corporations and
individuals
Capital Losses for Individuals
• $3,000 per year deduction against other
income for capital losses; (net) short-term
capital losses deducted before (net) longterm capital losses
• Remaining (net) capital losses are carried
forward indefinitely (no carry back
permitted)
• Losses on personal-use assets are not
recognized (deductible) even though gains
are recognized (taxable)
Cap. Gains & Losses of C Corporations
• No current deduction for capital losses
from regular income; losses are carried
back 3 years and forward 5 years to use
only against capital gains
• Both long-term and short-term capital
gains taxed as ordinary income
• Benefit of capital gains is limited to
ability to offset capital losses
Capital Gains and Losses-1
Jo had salary of
Jo sold stock- bought in 2011:
Cost S. Price
IBM
$2,000 $3,000
Big Co. $8,000 $1,000
Overall gain or loss
Loss Limit
Adjusted gross income?
$100,000
Capital Gains and Losses-2
Jo had salary of
$100,000
Jo sold stock- bought in 2011:
Cost S. Price
IBM
$2,000 $3,000 $1,000
Big Co. $8,000 $1,000 ($7,000)
Overall gain or loss
($6,000)
Loss Limit
($3,000)
Adjusted gross income?
$97,000
Capital Losses-1
Jo had salary of
She losses on sales of:
$4,000
IBM
$2,000
Big Co.
Sale of land
$5,000
used in Bus.
Loss Deduction
Adjusted gross income?
$100,000
Capital Losses-2
Jo had salary of
She losses on sales of:
$4,000
IBM
$2,000
Big Co.
Sale of land
$5,000
used in Bus.
Loss Deduction
Adjusted gross income?
$100,000
($8,000)
$92,000
Individual
Yr 1 STCG
Net
Net
Net
Tax
Short-T. Long-T. Gain (Loss) Return
$0
Yr 1 STCL ($2,400)
Yr 1 LTCG
$400
Yr 1 LTCL ($3,500)
Deduct STCL
Deduct LTCL
Deduction limit this year
Carry over to next year
Individual
Yr 1 STCG
Net
Net
Net
Tax
Short-T. Long-T. Gain (Loss) Return
$0
Yr 1 STCL ($2,400) ($2,400)
Yr 1 LTCG
$400
Yr 1 LTCL ($3,500)
($3,100)
($5,500)
Deduct STCL
($2,400)
Deduct LTCL
($600)
Deduction limit this year
($3,000)
Carry over to next year
($2,500)
Cap. Asset Sale-1
Details
Other Income (Other AGI)
$68,000
Net L.T. capital gain or loss
$15,000
Net S.T. capital loss or loss
(24,000)
Gain (loss) non-cap. asset:
Gain (Loss)-bus. use asset
Sec. 1231 gain (Cap. Gain.)
Net capital gain or loss
Cap. Loss limited to $3,000
Net capital gain or loss in AGI
Adjusted Gross Income
Carryforward
Capital Ordinary Return
$68,000
Cap. Asset Sale - 2
Details
Capital Ordinary Return
Other Income (Other AGI)
$68,000
Net L.T. capital gain or loss
$15,000
Net S.T. capital loss or loss
(24,000)
$68,000
(9,000)
Gain (loss) non-cap. asset:
Gain (Loss)-bus. use asset
Sec. 1231 gain (Cap. Gain.)
Net capital gain or loss
(9,000)
Cap. Loss limited to $3,000
(3,000)
Net capital gain or loss in AGI
(3,000)
Adjusted Gross Income
Carryforward to next year
$65,000
($6,000)
General Capital Gains Rates for Individuals
• 15% rate applies to most long-term
capital gains – those with marginal
brackets above 15%. Rate is now 20% for
those in 39.6% regular tax bracket.
• 0% rate applies to taxpayers whose
ordinary income is taxed at the 10% and
15% marginal tax brackets to the extent
their long-term gains fall within these
marginal tax brackets.
Special Capital Gains
Rates for Individuals
• 25% rate applies to Sec. 1250 unrecaptured gain on
realty; gain in excess of the recapture amount is
taxed at 15% rate
– If taxpayer’s ordinary income tax rate is lower than
25%, then the lower ordinary income rate applies to
gain that falls within that tax bracket
• Collectibles such as antiques, art objects, and rare
coins are taxed at a 28% rate due to potential
personal enjoyment of asset
– If taxpayer’s ordinary tax rate is lower than 28%, then
the lower ordinary rate applies to gain that falls within
that tax bracket
Single taxpayers
Mike
Mary
Salary from IBM
$40,000
$120,000
Exemption
Itemized deduct.
Net
S.T. capital gain
Tax rate on gain?
(3,700)
(3,700)
(16,300)
(16,300)
$20,000
$100,000
$10,000
$10,000
Single taxpayers
Mike
Mary
Salary from IBM
$40,000
$120,000
Exemption
Itemized deduct.
Net
S.T. capital gain
Tax rate on gain?
(3,650)
(3,650)
(16,350)
(16,350)
$20,000
$100,000
$10,000
$10,000
15%
28%
Single taxpayers
Mike
Mary
Salary from IBM $40,000 $120,000
Exemption
(3,650)
(3,650)
Itemized deduct. (16,350)
(16,350)
Net
L.T. capital gain
Tax rate on gain?
$20,000 $100,000
$10,000
$10,000
Single taxpayers
Mike
Mary
Salary from IBM
$40,000
$120,000
Exemption
Itemized deduct.
Net
L.T. capital gain
Tax rate on gain?
(3,700)
(3,700)
(16,300)
(16,300)
$20,000
$100,000
$10,000
$10,000
0%
15%
Test no. 1. Fall, 2012
An individual had salary income and
capital gains and losses as follows:
2012
2013
Salary
$100,000 $100,000
L-T capital gain
$3,000
$2,000
S-T capital loss
-7,000
She has no deduction for AGI,
other than capital losses.
What is her AGI for 2013?
Accounting Methods
Cash Method
Accrual Method
Hybrid Method
Installment sales
Long-Term contracts
Accounting Methods
Cash Method.
Accrual method.
Exceptions.
Pg. 3-32+
Accounting Methods.
Taxpayers can use different methods
for financial accounting and tax
– Cash method:
receipt of cash or cash equivalents
determine income/expense recognition
(subject to constructive receipt doctrine)
– Accrual method:
the all-events test determines
income/expense recognition
Cash Method.
Income is recognized when cash
or cash equivalents received
– Cash equivalents broadly defined
to include property and services
– Cash equivalents included at fair
market value
Cash Method
A cash-basis taxpayer recognizes
income when an amount is
–Credited to the taxpayer’s account
–Set apart for the taxpayer, or
–Made available in some other way
to the taxpayer
Constructive Receipt Doctrine.
• Constructive receipt
is a rule that prevents cash basis taxpayers
from “turning their backs” on income
• Income is not constructively received if
– The taxpayer is not entitled to the income
– The payor has insufficient funds from which to
make payment
– There are substantial limitations or restrictions
placed on actual receipt
Limits on Cash Method.
• Businesses that carry inventory and sell
merchandise to customers generally
must use the accrual method to account
for sales and purchases
• Hybrid method – accrual for sales of
inventory & cost of goods sold; cash
method for other income and expenses
• Large corporations (gross receipts of
more than $5 million) cannot use cash
method
Original Issue Discount
On Jan. 1, 2013, Local Corp. Borrowed
$165,289.26 from an investor.
The loan matures on December 31, 2014.
At that time Local Corp. will pay the maturity
value of $200,000. The interest rate is 10%.
Annual compounding is required under the
income tax law. How much income is
recognized by the investor for 2013?
a. $16,528.93 b. $17,355.37
c. $18,181.82 d. Other
Original Issue Discount
Amount of loan
$165,289.26
2013 Interest -10%
Book Value-12-31-13
2014 Interest -10%
Book Value-12-31-14
Answer is ?
Original Issue Discount
Amount of loan
$165,289.26
2013 Interest -10%
16,528.93
Book Value-12-31-13 181,818.18
2014 Interest -10%
18,181.82
Book Value-12-31-14 $200,000.00
Answer is C
Accrual Method.
• Income is recognized when “all events
test” is met
–All events have occurred that establish
the right to the income and
–The income amount can be determined
with reasonable accuracy
• If customer disputes the liability, the all
events test is not satisfied until dispute is
resolved
Prepaid Income
• Prepaid Income is another exception to
the accrual method of accounting
• Based on “wherewithal to pay concept”
income must be reported when
received
–Examples: rent, interest, and royalty
payments received in advance
–Refundable deposits are not prepaid
income
83
Accrual Method Problem
On May 1, 2013, Tom, a cash basis taxpayer,
leased office space from Plaza Rentals for
six years beginning July 1, 2013, for $1,000 per
month.
On July 1, 2013, Tom paid $36,000, half of the
total lease amount, to Plaza.
Plaza reports in 2013 income of _________?
a. $-0- b. $6,000 c. $12,000 d. $36,000
Tom reports in 2013 rent expense of ________?
a. $-0- b. $6,000 c. $12,000 d. $36,000
Accrual Method Problem
On May 1, 2013, Tom, a cash basis taxpayer,
leased office space from Plaza Rentals for
six years beginning July 1, 2013, for $1,000 per
month.
On July 1, 2013, Tom paid $36,000, half of the
total lease amount, to Plaza.
Plaza reports in 2013 income of _________?
a. $-0- b. $6,000 c. $12,000 d. $36,000
Tom reports in 2013 rent expense of ________?
a. $-0- b. $6,000 c. $12,000 d. $36,000
Nare, an accrual-basis taxpayer
Nare, an accrual-basis taxpayer, leased a
building to Pine under a five-year lease on
11-1-13. On that date, Pine paid Nare
$10,000 rent for the two months
(November and December), and $5,000 for
the last month's rent.
What amount of rental income should
Nare report for 2013?
a. $10,000 b. $15,000
c. $40,000 d. $45,000
Nare - Continued
The answer is $15,000.
An accrual basis taxpayer recognizes
income with all events have occurred
to establish the right to receive the
income.
Nare has the right to receive $15,000,
even though only $10,000 has been
earned during the taxable year.
Sharon-1
On March 1, 2013, Sharon, a cash basis sole
proprietor, leased a dance studio from Shelby
Renters for 3 years at $1,200 per month.
In 2013, Sharon paid $28,800 on the lease.
In 2014 she paid $6,000.
She paid the remainder of the lease payment in
2015.
What is the amount Sharon can deduct on her
income tax return for 2014?
a. $6,000 b. $11,600 c. $14,400 d. $20,400
Sharon-2
Sharon must capitalize the
payments for rent for future
years and write it off on a
monthly basis.
Answer: $14,400
A consulting firm started in 2013 and adopted the
accrual method.
The firm reported gross income of $90,000 and
expense payments of $60,000 for 2013.
The firm owed salaries payable of $5,000 for
December, 2013.
These salaries were paid to employees (nonowners) in January, 2014.
How much is their taxable income for 2013?
a. $25,000 b. $30,000
c. $35,000 d. Other (CPA)
A consulting firm- continued.
The firm reported net income of
$30,000, but failed to deduct an expense
for salaries earned but not paid.
On the accrual basis, such salaries will
be deducted for the year in which the
employees earned those salaries.
This reduces net income to $25,000.
Mark, who gives music lessons, is a
calendar year taxpayer using the accrual
method of accounting.
On 11-2-13, he received $10,000 for a oneyear contract beginning on that date to
provide 10 lessons.
He gave 2 lessons in 2013.
How much should Mark include in income
in 2013?
a. $--0-b. $2,000
c. $8,000
d. $10,000
Mark-Continued.
This is income received in advance and
would normally be reported entirely in
the year of receipt.
However, this qualifies as an
exception, and the taxpayer can report
the income as earned, not when
payment is received in advance.
Hall [accrual basis taxpayer] leases offices.
Hall started business on Jan. 1, 2013.
Rent is due in advance on the first day of
each month. Not all tenants pay promptly.
Hall's records at the end of 2013 show:
Rentals receivable at 12-31-2013 $6,000
Cash received from tenants
$50,000
Depreciation Expense
($15,000)
Other Expenses
($5,000)
Net Income
$30,000
Hall should report 2013 taxable income of:
a. $24,000 b. $30,000 c. $36,000 d. Other CPA
Accounting Methods
Hall Co., -Continued
The rent receivable of $6,000 must
be included in revenue –
using the accrual method. Corrected
computations:
Revenue
$56,000
Expenses
$20,000
Taxable Income$36,000
Office Rental Inc. – Slide 1 of 6.
Office Rental, Inc. began business in year 1. it
collects rent in advance from some tenants and
bills others at the end of each month for that
month’s rent. Accrual basis income statement
(GAAP) for Yr. 2 shows revenue earned of $54,700.
Rent Receivable was $3,100 at start of Year 2 and
$2,500 at the end of Year 2.
Unearned Revenue Account had a balance of
$2,600 at start of Year 2 & $1,300 at end of Year 2.
What is cash basis revenue for Year 1 and Year 2
(collections from tenants)?
Office Rental Inc.-Slide 2 of 6
Year 2
Year 1
$2,500
$1,300
$3,100
$2,600
GAAP Income Statement:
Rent Revenue
$54,700
$49,800
Cash Collections from
tenants for rent?
$49,300
Balance Sheet-12-31
Rent receivable
Unearned revenue
Office Rental Inc.-Slide 3 of 6
Year 2
Year 2
Revenue Earned-Yr 2
$54,700
$54,700
Beg. Rent Receivable
3,100
End. Rent Receivable
2,500
Beg. Unearned Revenue
2,600
End. Unearned Revenue
1,300
Collected from tenants
In Year 2, you collected receivables
of $3,100 for rent in Year 1, etc.
Office Rental Inc.-Slide 4 of 6
Year 2
Year 2
Revenue Earned-Yr 2
$54,700
$54,700
Beg. Rent Receivable
3,100
3,100
End. Rent Receivable
2,500
(2,500)
Beg. Unearned Revenue
2,600
(2,600)
End. Unearned Revenue
1,300
1,300
Collected from tenants
$54,000
In Year 2, you collected receivables
of $3,100 for rent in Year 1, etc.
Office Rental Inc.-Slide 5 of 6
Revenue-accrual basis-Year 2 tax return?
GAAP Revenue for Year 2
54,700
Beg. Rent Receivable
End. Rent Receivable
Beg. Unearned Revenue
End. Unearned Revenue
Revenue on Tax Return
Tax law follows GAAP for accruing
receivables, but not for reporting
rent income received in advance.
Office Rental Inc.-Slide 6 of 6
Revenue-accrual basis-Year 2 tax return?
GAAP Revenue - Year 2
54,700
Beg. Rent Receivable
End. Rent Receivable
Beg. Unearned Revenue
(2,600)
End. Unearned Revenue
1,300
Revenue on Tax Return
$53,400
Tax law follows GAAP for accruing
receivables, but not for reporting
rent income received in advance.
Claim of Right Doctrine
• Applies whenever the taxpayer
receives income but there is a dispute
regarding the taxpayer’s right to keep
some or all of the income
• Taxpayer must recognize income even
though some of the income may have
to be repaid later
Realty Corp. Rental Income
Realty Co. was organized on Jan-1, year 1.
Realty bought a building on that date for
$400,000, having an estimated 40-year life
with no salvage.
The S/L depreciation method is used for Tax
& GAAP. Depreciation is $10,000 per year on
the tax return and in the GAAP statements.
Realty rented the building to IBM for 2 years
at $20,000 per year. Rent of $40,000 was
received on Jan-1, year 1. Realty’s income tax
rate is 40%. Year 1 operations: see next slide.
Realty Corporation - Slide 2.
GAAP
$20,000
(5,000)
(10,000)
5,000
40%
Tax
Rent Revenue
Cash Expenses
Depreciation Exp.
NIBT/Taxable Income
Income Tax Rate
Income Tax Expense
Income Tax Paid
Net Income
What is the amount of the deferred tax
asset or liability at end of Yr 1?
Realty Corporation - Slide 2.
GAAP
$20,000
(5,000)
(10,000)
5,000
40%
2,000
Tax
$40,000
(5,000)
(10,000)
25,000
40%
Rent Revenue
Cash Expenses
Depreciation Exp.
NIBT/Taxable Income
Income Tax Rate
Income Tax Expense
Income Tax Paid
10,000
Net Income
3,000
What is the amount of the deferred tax
asset or liability at end of Yr 1?
Realty Corporation - Slide 3.
GAAP
$20,000
(5,000)
(10,000)
5,000
40%
2,000
Tax
$40,000
(5,000)
(10,000)
25,000
40%
Rent Revenue
Cash Expenses
Depreciation Exp.
NIBT/Taxable Income
Income Tax Rate
Income Tax Expense
Income Tax Paid
10,000
Net Income
3,000
What is the amount of the deferred tax
asset or liability at end of Yr 1?
8,000
Installment method.
Long-term construction
contracts.
Installment Method
• Gain is recognized proportionately as
proceeds from sale are received
• Use severely restricted – generally
available for casual sales only (excludes
sales of inventory and securities. Limits for
depreciable property)
• May not want to use if
– Marginal tax rate is expected to increase
– Unused losses are expiring
Installment Method
Computing the gain recognized:
– Gain recognized each year is dependent on
the payments received during the year
– Recognized Gain =
(Total gain/contract price) X Payments
Received
– Total gain = selling price less selling expenses
less adjusted basis of property
– Contract price = Sales price less liabilities
assumed by buyer
• Generally is equal to amount (other than interest)
seller will receive from purchaser
Mike's Installment Sale [1]
Mike sold land to Sue on 1-1-2011.
Selling price
$100,000
Mike's adjusted basis
60,000
Down payment (1-1-2011)
20,000
Sue's payment (1-1-2012)
40,000
Sue's payment (1-1-2013)
40,000
Sue also pays applicable interest.
Mike's capital gain in 2011?
a. $8,000 b. $12,000 c. $20,000
Mike's Installment Method [2]
Selling price
Mike's adjusted basis
Gross Profit
Gross Profit Percentage
Collections in 2011
Capital gain for 2011
$100,000
Mike's Installment Method [3]
Selling price
$100,000
Mike's adjusted basis
60,000
Gross Profit
40,000
Gross Profit Percentage
40%
Collections in 2011
20,000
Capital gain for 2011
$8,000
Bold Co. Installment Sale [1]
On 1-1-2013, Bold, Inc., sold for $800,000 a parcel
of land which it owned for five years. The land
had a basis of $700,000.
Under the agreement $200,000 of the selling price
plus appropriate interest will be received each
year for four years, beginning on 12-31-2013.
The amount of gain reported on the installment
basis for 2013 is:
a. $100,000 b. $75,000
c. $25,000 d. $15,000 e. none of these
Bold Co. Installment Sale [2]
On 1-1-2013, Bold, Inc. sold
land on installment basis.
Selling Price
$800,000
Basis of land
700,000
Profit on sale
100,000
Profit %
Payment in 2013
Profit for 2013
Bold Co. Installment Sale [3]
On 1-1-2013, Bold, Inc. sold
land on installment basis.
Selling Price
$800,000
Basis of land
700,000
Profit on sale
100,000
Profit %
12.50%
Payment in 2013 $200,000
Profit for 2013
$25,000
Answer C
Installment Method
In 2013, Marcus sold land that had an adjusted
basis to him of $120,000 to Andrew for $200,000.
Andrew paid $50,000 as a down payment and
agreed to pay $25,000 per year plus interest for
the next six years beginning 1-1-2014.
What is the profit percentage? ______
For 2013, what is the amount of capital gain from
this transaction to be included by Marcus in his
gross income?
a. $11,000
b. $19,000
c. $20,000
d. $26,000
Installment Method
In 2013, Marcus sold land that had an adjusted
basis to him of $120,000 to Andrew for $200,000.
Andrew paid $50,000 as a down payment and
agreed to pay $25,000 per year plus interest for
the next six years beginning 1-1-2014.
What is the profit percentage? 40%
For 2013, what is the amount of capital gain from
this transaction to be included by Marcus in his
gross income?
a. $11,000
b. $19,000
c. $20,000
d. $26,000
Note, the installment sales method is
generally prohibited for dealers in
inventory.
However it is allowed in very limited
circumstances.
The problem on the next slide is
included to help illustrate differences
between accrual accounting and other
revenue recognition methods – and the
impact on deferred taxes.
Wu Co. -Installment Sales – Pg. 3-36
Wu Co. sold a stove for $1,200.
Wu Co. had originally paid $900 for the stove.
Customer bought the appliance on credit,
and agreed to pay $100 per month, beginning
Sept. 1, 2010. The customer made 4 required
payments in 2010.
What is the gross profit to be recognized in
2010, using the installment sales method?
a. $1,200 b. $300 c. $225 d. $100
(Tax law limits the use of Inst. Method for inventory.)
Wu Corporation
Amount
Selling price
$1,200 100%
Cost of refrigerator
(900) -75%
Profit
300 25%
Monthly Payment
Total Received
Profit (25% )
Wu Corporation
Amount
Selling price
$1,200 100%
Cost of refrigerator
(900) -75%
Profit
300 25%
Monthly Payment
100
Total Received
400
Profit (25% )
$100
Installment Sale - Wu Before Sale
After
Cash
$10,000
$10,000
Accounts Receivable
20,000 1,200
21,200
Inventory
40,000 (900)
39,100
Total Assets
$70,000
$70,300
Accounts Payable
$5,000
$5,000
Deferred Revenue
300
300
Common Stock
30,000
30,000
Retained Earnings
35,000
35,000
Total Debt & Equity
$70,000
$70,300
As cash is collected,
deferred revenue is recognized.
[Parenthesis indicates subtraction here.]
Income Tax Accounting
Gross sales in year 1
$500,000
Cost of sales in year 1
250,000
Other Expenses in year 1
100,000
Net Income Before Taxes- Yr 1 $150,000
Year 1 sales collected in:
Year 1
$300,000
Year 2
$200,000
Income Tax Rate
40%
Method used for GAAP:
Accrual
Method used for Tax:
Inst. Sales
Amount of deferred tax asset
or liability at end of Year 1?
Is it a Def. Asset or Liability?
Income Tax Accounting
Gross sales in year 1
$500,000
Cost of sales in year 1 - 50% 250,000
Other Expenses in year 1
100,000
Net Income Before Taxes- Yr 1$150,000
Year 1 sales collected in:
Year 1
$300,000
Year 2
$200,000
Income Tax Rate
40%
Method used for GAAP:
Accrual
Method used for Tax:
Inst. Sales
Amount of deferred tax asset
or liability at end of Year 1? $ 40,000
Is it a Def. Asset or Liability? Liability
On preceding slide,
company deferred revenue of
$200,000.
Cost of inventory is
50% of Selling Price.
Gross profit margin is 50%.
Deferred profit is $100,000.
Tax on $100,000 is $40,000.
Long-Term Contracts
• Completed Contract Method—
no income is recognized and no
deductions taken until contract
completion
• Percentage-of-Completion Method—
income is recognized as contract
progresses based on an estimate of
actual costs incurred to total projected
costs for contract
Long-Term Contracts
Percentage of completion
–A portion of the gross contract price is
included in income each year as the
work progresses
–Amount of revenue accrued:
• (Costs incurred in tax year/total estimated
costs) x contract price = revenue accrued
in tax year
–Current year costs are deductible
Long-Term Contracts [1]
UNCC Construction Co. uses the percentage
of completion method of accounting.
In 2013, UNCC contracted to build an
apartment complex for Roper for
$10,000,000.
UNCC estimated that total cost for the
building would amount to $8,000,000.
UNCC incurred $4,000,000 of construction
costs on this project in 2009. How much
gross profit does UNCC recognize for 2013?
a. $300,000 b. $500,000 c. $187,500 d. $1,000,000
Long-term Construction Contract [2]
Total Contract Price
Projected cost for project
Projected profit on project
Cost incurred to date
Costs incurred to date (%)
Projected profit on project
Costs incurred to date - (%)
Cumulative profit earned
Less: profit earned in prior years
Proft reported this year
$10,000,000
(8,000,000)
Long-term Construction Contract [2]
Total Contract Price
Projected cost for project
Projected profit on project
Cost incurred to date
Costs incurred to date (%)
$10,000,000
(8,000,000)
2,000,000
4,000,000
50%
Projected profit on project
Costs incurred to date - (%)
Cumulative profit earned
Less: profit earned in prior years
Proft reported this year
$2,000,000
50%
$1,000,000
$0
$1,000,000
Long-Term Contracts [3]
UNCC Construction Co. –Continued.
UNCC has spent 50% of the estimated
total cost of the project.
Revenue earned $5,000,000
Cost
$4,000,000
Gross Profit
$1,000,000
Answer is D
Mr. D. Long-Term Contracts. [1]
On 1-5-013, Mr. D, a calendar year taxpayer, contracted
to build a road for $1 million.
The road will be completed on 12-31-14.
Mr. D elected the completed contract method to report
his income.
On 12-31-13, the county engineer certified that 65
percent of the road has been completed. Construction
costs of $500,000 were incurred in 2013 for the
contract.
How much net profit should Mr. D report on this
contract in 2013?
a. $0
b. $50,000
c. $75,000
d. $150,000 e. $650,000
Mr. D. Long-Term Contracts. [2]
On 12-31-08, Mr. D…
completed contract method
No profit is recognized in 2013
because the project is not completed
until 2014.
Mr. D. Long-Term Contracts. [3]
On 1-5-13, Mr. D, a calendar year taxpayer,
contracted to build a road for $1 million.
The road will be completed on 12-31-14.
Mr. D elected the percentage of completion
method to report his income.
On 12-31-13, the county engineer certified that 65
percent of the road has been completed.
Construction costs of $500,000 were incurred in
2013 for the contract.
How much net profit should Mr. D report on this
contract in 2013?
a. $0
b. $50,000
c. $75,000
d. $150,000
e. $650,000
Mr. D. Long-Term Contracts. [4]
On 1-5-13, Mr. D…..
percentage of completion method - Continued
Revenue earned
$650,000
Cost
$500,000
Gross Profit
$150,000
Answer is D
We may use engineering estimates of percentage
completion,
or
look at the percentage of total estimated costs
that have been incurred.
Co. Q - Construction Jobs
Company Q uses the percentage-ofcompletion method. The company agreed
to build a bridge at a price of $20 million.
Estimated costs to construct the bridge are
$15 million. Costs incurred in the first year
of construction (2013) were $6 million.
The amount of gross margin to recognize in
2014 is:
a. $0.
b. $1 million.
c. $5 million.
d. $2 million.
Co. Q-Percentage-of-Completion
Contract price
$20,000,000
Estimated building cost
(15,000,000)
Projected profit
Amount spent
Percent of completion
Profit recognized
5,000,000
Co. Q-Percentage-of-Completion
Contract price
$20,000,000
Estimated building cost
(15,000,000)
Projected profit
5,000,000
Amount spent
6,000,000
Percent of completion
Profit recognized
40%
$2,000,000
Big Co. has contracted to build a
bridge for $600,000.
The bridge will cost $400,000.
$000 omitted
Costs incurred
Payments received
Year 1 Year 2 Total
$300
$100
$400
$400
$200
$600
How much profit would be recognized
each year with these 2 methods?
Year 1 Year 2 Total
Profit recognized:
Completed contract
% of Completion
Percentage of Completion: profit recognized
in proportion to costs incurred.
Big Co. will build bridge for $600,000.
Construction costs will be $400,000.
$000 omitted
Costs incurred
Payments received
Year 1 Year 2 Total
$300
$100
$400
$400
$200
$600
How much profit would be recognized
each year with these 2 methods?
Year 1 Year 2 Total
Profit recognized:
$200 $200
Completed contract
$150
$50 $200
% of Completion
Percent of profit recog.
75%
25% 100%
Note: Construction costs in Yr. 1 were $300,000,
out of total costs of $400,000. This is 75%.
End