Performance Pay and Top-Management Incentives By: Michael Jensen, and Kevin Murphy.
Chapter 2 Income Tax Concepts ©2008 South-Western Kevin Murphy Mark Higgins Kevin Murphy Mark...
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Transcript of Chapter 2 Income Tax Concepts ©2008 South-Western Kevin Murphy Mark Higgins Kevin Murphy Mark...
Chapter 2Chapter 2
Income Tax ConceptsIncome Tax Concepts
©2008 South-Western©2008 South-Western©2008 South-Western©2008 South-Western
Kevin MurphyKevin MurphyMark HigginsMark Higgins
Kevin MurphyKevin MurphyMark HigginsMark Higgins
Transparency 2-2Transparency 2-2© 2008 South-Western© 2008 South-Western
Federal Income TaxationFederal Income Taxation
Based on a system of rules Developed around general concepts and
specific exceptions
Transparency 2-3Transparency 2-3© 2008 South-Western© 2008 South-Western
TerminologyTerminology
Concept - a broad principleConstruct - a means to implement a
conceptDoctrine - a construct developed by the
courts
Concept
Construct Doctrine
Transparency 2-4Transparency 2-4© 2008 South-Western© 2008 South-Western
General ConceptsAbility to Pay
General ConceptsAbility to Pay
Constructs usedDeductionsExclusionsCreditsProgressive tax rates
Tax should be based on an amount that a taxpayer can afford to pay.
Transparency 2-5Transparency 2-5© 2008 South-Western© 2008 South-Western
General ConceptsAdministrative Convenience
General ConceptsAdministrative Convenience
Constructs used Standard deduction amountsFringe benefit exclusions
The benefit derived from a concept, construct or doctrine should always exceed the cost of implementation.
Transparency 2-6Transparency 2-6© 2008 South-Western© 2008 South-Western
Administrative Convenience Example
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.
Transparency 2-7Transparency 2-7© 2008 South-Western© 2008 South-Western
General ConceptsArms-Length Transaction
Concept
General ConceptsArms-Length Transaction
ConceptA transaction between related parties must reflect economic reality.
Constructs used Related-party provisionsConstructive ownership rules
Transparency 2-8Transparency 2-8© 2008 South-Western© 2008 South-Western
Arms-Length Transaction Example
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 ConceptsPay As You Go Concept
General ConceptsPay As You Go Concept
Constructs usedWithholdingEstimated tax payments
Taxpayers are required to pay tax as they generate income.
Transparency 2-10Transparency 2-10© 2008 South-Western© 2008 South-Western
Accounting ConceptsEntity Concept
Accounting ConceptsEntity Concept
Each tax entity must keep separate records and report operations separately.
Doctrine usedAssignment of
Income
Constructs usedTaxable entitiesConduit entitiesSole Proprietorships
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Assignment of Income Doctrine
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
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 ConceptsAnnual Accounting Period
Concept
Accounting ConceptsAnnual Accounting Period
Concept Each taxpayer must select
A tax year Calendar Fiscal
An accounting method Cash Accrual Hybrid
Transparency 2-14Transparency 2-14© 2008 South-Western© 2008 South-Western
Annual Accounting Period Concept
Constructs & Doctrines Used
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 ExampleTax Benefit Rule Example
Angelo had $4,000 of state income taxes withheld from his salary during 2006. He deducted the $4,000 as part of his itemized deductions on his 2006 federal return. On May 15, 2007, he received a refund of $1,000 from the state. When he files his 2007 federal return, Angelo will be required to report the $1,000 as income.
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Substance-Over-Form Doctrine: A transaction must be realistic in an ordinary sense and not contrived merely to avoid tax.
Annual Accounting Period Concept
Constructs & Doctrines Used
Annual Accounting Period Concept
Constructs & Doctrines Used
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Substance Over Form Example
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 ConceptsAll-inclusive Income Concept
Income ConceptsAll-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 ConceptsLegislative Grace Concept
Income ConceptsLegislative Grace Concept
Constructs usedExclusions, deductions and creditsSpecial classifications such as capital
assets
Any tax relief provided is the result of specific acts of Congress which are applied and interpreted strictly.
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Income ConceptsCapital Recovery Concept
Income ConceptsCapital Recovery Concept
Constructs usedBasisGains and Losses
A taxpayer may recover all invested capital before income is taxed.
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Capital Recovery ExampleCapital 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 ConceptsRealization ConceptIncome Concepts
Realization Concept
Doctrines usedClaim of Right Doctrine
applies to accrual basis taxpayers
Constructive Receipt Doctrine applies to cash basis taxpayers
No income is recognized as taxable income until it has been realized by the taxpayer.
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Realization ConceptDoctrines Used
Realization ConceptDoctrines 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 ExampleClaim of Right Example
Clara rented her garage apartment to Jared and collected $450, the first-month’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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Constructive Receipt Doctrine is a modification that prevents cash basis
taxpayers from “turning their backs” on income
Realization is deemed to have occurred ifa 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.
Realization ConceptDoctrines Used
Realization ConceptDoctrines Used
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Constructive Receipt Example
Constructive Receipt Example
Sam is a self-employed handyman. Maria, one of his customers, brought a check for $250 on December 30, 2006, 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 2006 even if the check isn’t delivered until 2007.
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Income ConceptsWherewithal-to-Pay Concept
Income ConceptsWherewithal-to-Pay Concept
Constructs usedDeferralsRecognition of unearned income
Tax should be recognized and paid when the taxpayer has the resources to pay.
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Deduction ConceptsLegislative Grace Concept
Deduction ConceptsLegislative Grace Concept
Any deduction allowed is the result of specific acts of Congress which are applied and interpreted strictly.
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Deduction ConceptsBusiness Purpose Concept
Deduction ConceptsBusiness 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 expensesInvestment expenses
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Business Purpose ExampleBusiness 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 ConceptsCapital Recovery Concept
Deduction ConceptsCapital Recovery Concept
Constructs usedBasisCapital expenditures
A taxpayer may deduct the amount of capital invested before income is reported.