t11f chp 03 1 income sources 2011

1

Chapter 3

Income Sources Howard Godfrey, Ph.D., CPA

UNC CharlotteCopyright © 2011, Dr. Howard Godfrey

Edited August 30, 2011.

Part-1. What constitutes income [income from labor or capital, increase in wealth, current view]

Part-2. 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-3. Capital gains and losses [capital gains, dividends, capital losses, capital gains and losses of conduit entities]

Part-4. Effect of Accounting Period [Cash method, Accrual method, Exceptions to accrual method, Hybrid method, Installment sales, Completed contract method]

Income Sources. Capital Gain or LossIntroduction NettingWhat is Income? Capital GainsLabor & Capital DividendsIncrease in Wealth Capital LossesWhat is Income? Conduit gains & losses

Common Sources Accounting MethodsEarned Income Cash MethodUnearned Income Accrual MethodTransfers Hybrid MethodImputed Income Exceptions

Chapter 3. GROSS INCOME

What is Income?From Labor & CapitalIncrease in WealthCurrent View

Common Income SourcesEarned IncomeUnearned Income Transfers from OthersImputed Income

Taxpayer had a salary from IBM $60,000Rent received for rental house 12,000Repairs expense for rental house 1,000Property tax on rental house 2,000Depreciation on rental house 10,000Repairs on personal residence 500Property tax on personal residence 1,500What is adjusted gross income?

Rent and Royalty Income-1

Salary from IBM $60,000 $60,000Rent received-rental house 12,000 12,000Repairs 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 500Property tax on personal res. 1,500What is adj. gross income? $59,000

Rent and Royalty Income

Where are rental income & expenses reportedon the income tax return?

AnnuitiesAn 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.

Life expectancy- in years 30Annuity income per month $1,000Annuity income per yearIncome over life expectancy

Cost $270,000Profit expectedProfit percentageProfit per year

Annuity Example - age 55

Life expectancy- in years 30Annuity income per month $1,000Annuity income per year $12,000Income over life expectancy $360,000Cost $270,000Profit expected $90,000Profit percentage 25%Profit per year $3,000What happens when he gets to age 86?

Annuity Example - age 55

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 _____.

Life expectancy-months-Table 3-1 260Annuity payment per month $500Annuity payment per year $6,000Payments over life expectancy $130,000Cost $30,000Profit expected on annuity $100,000Monthly exclusion ($30,000/260) $115.38Gross income per month $384.62Gross income per year $4,615.38What happens when she gets to age 86?

Susan - age 62- Slide 2

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

+ Cash Received

+ FMV of property received

+ Seller’s liabilities assumed by the buyer

- Buyer’s liabilities assumed by the seller

- Selling expenses

= Amount Realized

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 LossesAllan 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 Lossesc. 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 lossc. 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.

Cash received 5,000$ Other Prop. Received- Auto 15,000 Mortgage assumed by buyer 13,000 Total Consideration Received 33,000 Expenses of sale

Sales commission - Other selling expenses -

Total expenses of sale - Amount Realized 33,000 Cost of property (34,000)Gain (Loss) (1,000)$

Allan's Transactions

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 WinningsJulie 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 lump-sum payment of $8,900,000. How much does Julie include in income each year?

Income from Lottery WinningsSolution: 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 & LossesCapital 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 personal-use 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 long-

term 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) long-term 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

$100,000

Cost S. Price

IBM $2,000 $3,000

Big Co. $8,000 $1,000

Adjusted gross income?

Jo had salary of

Jo sold stock- bought in 2008:

Capital Gains and Losses-1

Loss Limit

Overall gain or loss

$100,000

Cost S. Price

IBM $2,000 $3,000 $1,000

Big Co. $8,000 $1,000 ($7,000)

($6,000)

($3,000)

$97,000Adjusted gross income?

Jo had salary of

Jo sold stock- bought in 2008:

Capital Gains and Losses-2

Loss Limit

Overall gain or loss

$100,000

IBM $4,000Big Co. $2,000Sale of land used in Bus. $5,000

Adjusted gross income?

Jo had salary ofShe losses on sales of:

Capital Losses-1

Loss Deduction

$100,000

IBM $4,000Big Co. $2,000Sale of land used in Bus. $5,000

($8,000)$92,000Adjusted gross income?

Jo had salary ofShe losses on sales of:

Capital Losses-2

Loss Deduction

Net Net Net TaxShort-T. Long-T. Gain (Loss) Return

Yr 1 STCG $0

Yr 1 STCL ($2,400)

Yr 1 LTCG $400

Yr 1 LTCL ($3,500)

Individual

Deduct STCL

Deduct LTCL

Carry over to next year

Deduction limit this year

Net Net Net TaxShort-T. Long-T. Gain (Loss) Return

Yr 1 STCG $0

Yr 1 STCL ($2,400) ($2,400)

Yr 1 LTCG $400

Yr 1 LTCL ($3,500) ($3,100)

($5,500)

($2,400)

($600)

($3,000)

($2,500)

Individual

Deduct STCL

Deduct LTCL

Carry over to next year

Deduction limit this year

Cap. Asset Sale-1 Details Capital Ordinary Return

Other Income (Other AGI) $68,000 $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

Cap. Asset Sale - 2 Details Capital Ordinary Return

Other Income (Other AGI) $68,000 $68,000

Net L.T. capital gain or loss $15,000

Net S.T. capital loss or loss (24,000) (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 $65,000

Carryforward to next year ($6,000)

General Capital Gains Rates for Individuals• 15% rate applies to most long-term

capital gains – those with marginal brackets above 15%.

• 5% 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 (or 0% in 2008-2012)

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 (3,700) (3,700)

Itemized deduct. (16,300) (16,300)

Net $20,000 $100,000

S.T. capital gain $10,000 $10,000

Tax rate on gain?

Single taxpayers Mike Mary

Salary from IBM $40,000 $120,000

Exemption (3,650) (3,650)

Itemized deduct. (16,350) (16,350)

Net $20,000 $100,000

S.T. capital gain $10,000 $10,000

Tax rate on gain? 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 $20,000 $100,000

L.T. capital gain $10,000 $10,000

Tax rate on gain?

Single taxpayers Mike Mary

Salary from IBM $40,000 $120,000

Exemption (3,700) (3,700)

Itemized deduct. (16,300) (16,300)

Net $20,000 $100,000

L.T. capital gain $10,000 $10,000

Tax rate on gain? 0% 15%

Accounting MethodsCash MethodAccrual MethodHybrid MethodInstallment salesLong-Term contracts

Accounting MethodsCash 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 DiscountOn Jan. 1, 2011, Local Corp. Borrowed $165,289.26 from an investor. The loan matures on December 31, 2012. 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 2011?a. $16,528.93 b. $17,355.37 c. $18,181.82 d. Other

Amount of loan $165,289.262011 Interest -10%Book Value-12-31-112012 Interest -10%Book Value-12-31-12Answer is ?

Original Issue Discount

Amount of loan $165,289.26 2011 Interest -10% 16,528.93 Book Value-12-31-11 181,818.18 2012 Interest -10% 18,181.82 Book Value-12-31-12 $200,000.00Answer is C

Original Issue Discount

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

82

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

Accrual Method ProblemOn May 1, 2010, Tom, a cash basis taxpayer, leased office space from Plaza Rentals for six years beginning July 1, 2010, for $1,000 per month. On July 1, 2010, Tom paid $36,000, half of the total lease amount, to Plaza. Plaza reports in 2010 income of _________?a.$ 0 b. $6,000 c. $12,000 d. $36,000 ‑ ‑Tom reports in 2010 rent expense of ________?a. $ 0 b. $6,000 c. $12,000 d. $36,000 ‑ ‑

Accrual Method ProblemOn May 1, 2010, Tom, a cash basis taxpayer, leased office space from Plaza Rentals for six years beginning July 1, 2010, for $1,000 per month. On July 1, 2010, Tom paid $36,000, half of the total lease amount, to Plaza. Plaza reports in 2010 income of _________?a.$ 0 b. $6,000 c. $12,000 ‑ ‑ d. $36,000 Tom reports in 2010 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 ‑11-1-11. 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 2011?a. $10,000 b. $15,000 c. $40,000 d. $45,000

Nare - ContinuedThe 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-1On March 1, 2010, Sharon, a cash basis sole proprietor, leased a dance studio from Shelby Renters for 3 years at $1,200 per month. In 2010, Sharon paid $28,800 on the lease. In 2011 she paid $6,000. She paid the remainder of the lease payment in 2012. What is the amount Sharon can deduct on her income tax return for 2011?a. $6,000 b. $11,600 c. $14,400 d. $20,400

Sharon-2Sharon 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 2011 and adopted the accrual method. The firm reported gross income of $90,000 and expense payments of $60,000 for 2011. The firm owed salaries payable of $5,000 for December, 2011. These salaries were paid to employees (non-owners) in January, 2012. How much is their taxable income for 2011?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 11-2-11, he received $10,000 for a one-year contract beginning on that date to provide 10 lessons. He gave 2 lessons in 2011. How much should Mark include in income in 2011?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 started business on Jan. 1, 2011.

Rentals receivable at 12-31-2011 $6,000

Cash received from tenants $50,000

Depreciation Expense ($15,000)Other Expenses ($5,000)Net Income $30,000 Hall should report 2011 taxable income of:a. $24,000 b. $30,000 c. $36,000 d. Other CPA

Hall [accrual basis taxpayer] leases offices.

Rent is due in advance on the first day ofeach month. Not all tenants pay promptly.Hall's records at the end of 2011 show:

Accounting MethodsHall Co., -ContinuedThe 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)?

Year 2 Year 1

Balance Sheet-12-31Rent receivable $2,500 $3,100Unearned revenue $1,300 $2,600

GAAP Income Statement:Rent Revenue $54,700 $49,800

Cash Collections from tenants for rent? $49,300

Office Rental Inc.-Slide 2 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 3 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 4 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 ReturnTax law follows GAAP for accruing receivables, but not for reportingrent income received in advance.

Office Rental Inc.-Slide 5 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 $53,400Tax law follows GAAP for accruing receivables, but not for reportingrent income received in advance.

Office Rental Inc.-Slide 6 of 6

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.

GAAP TaxRent Revenue $20,000Cash Expenses (5,000)Depreciation Exp. (10,000)NIBT/Taxable Income 5,000Income Tax Rate 40%Income Tax ExpenseIncome Tax PaidNet Income

asset or liability at end of Yr 1?

Realty Corporation - Slide 2.

What is the amount of the deferred tax

GAAP TaxRent Revenue $20,000 $40,000Cash Expenses (5,000) (5,000)Depreciation Exp. (10,000) (10,000)NIBT/Taxable Income 5,000 25,000Income Tax Rate 40% 40%Income Tax Expense 2,000Income Tax Paid 10,000Net Income 3,000

asset or liability at end of Yr 1?

Realty Corporation - Slide 2.

What is the amount of the deferred tax

GAAP TaxRent Revenue $20,000 $40,000Cash Expenses (5,000) (5,000)Depreciation Exp. (10,000) (10,000)NIBT/Taxable Income 5,000 25,000Income Tax Rate 40% 40%Income Tax Expense 2,000Income Tax Paid 10,000Net Income 3,000

asset or liability at end of Yr 1? 8,000

Realty Corporation - Slide 3.

What is the amount of the deferred tax

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 MethodComputing 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

Selling price $100,000Mike's adjusted basis 60,000Down payment (1-1-2011) 20,000Sue's payment (1-1-2012) 40,000Sue's payment (1-1-2013) 40,000

Mike's capital gain in 2011?

Mike's Installment Sale [1]Mike sold land to Sue on 1-1-2011.

Sue also pays applicable interest.

a. $8,000 b. $12,000 c. $20,000

Selling price $100,000

Mike's adjusted basis

Gross Profit

Gross Profit Percentage

Collections in 2011

Capital gain for 2011

Mike's Installment Method [2]

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

Mike's Installment Method [3]

Bold Co. Installment Sale [1]On 1-1-2010, 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 12-31-2010. The amount of gain reported on the installment basis for 2010 is:a. $100,000 b. $75,000 c. $25,000 d. $15,000 e. none of these

On 1-1-2010, Bold, Inc. sold land on installment basis. Selling Price $800,000Basis of land 700,000Profit on sale 100,000Profit % Payment in 2010Profit for 2010

Bold Co. Installment Sale [2]

On 1-1-2010, Bold, Inc. sold land on installment basis. Selling Price $800,000Basis of land 700,000Profit on sale 100,000Profit % 12.50%Payment in 2010 $200,000Profit for 2010 $25,000Answer C

Bold Co. Installment Sale [3]

Installment MethodIn 2007, 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 1-1-2008. What is the profit percentage? ______For 2007, 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 MethodIn 2007, 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 1-1-2008. What is the profit percentage? 40%For 2007, 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. 115Wu 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.)

AmountSelling price $1,200 100%Cost of refrigerator (900) -75%Profit 300 25%Monthly PaymentTotal ReceivedProfit (25%)

Wu Corporation

AmountSelling price $1,200 100%Cost of refrigerator (900) -75%Profit 300 25%Monthly Payment 100Total Received 400Profit (25%) $100

Wu Corporation

Installment Sale - Wu Before Sale AfterCash $10,000 $10,000Accounts Receivable 20,000 1,200 21,200Inventory 40,000 (900) 39,100Total Assets $70,000 $70,300Accounts Payable $5,000 $5,000Deferred Revenue 300 300Common Stock 30,000 30,000Retained Earnings 35,000 35,000Total Debt & Equity $70,000 $70,300As cash is collected, deferred revenue is recognized.[Parenthesis indicates subtraction here.]

Gross sales in year 1 $500,000Cost of sales in year 1 250,000Other Expenses in year 1 100,000Net Income Before Taxes- Yr 1 $150,000Year 1 sales collected in:

Year 1 $300,000Year 2 $200,000

Income Tax Rate 40%Method used for GAAP: AccrualMethod used for Tax: Inst. SalesAmount 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 $500,000Cost of sales in year 1 - 50% 250,000Other Expenses in year 1 100,000Net Income Before Taxes- Yr 1$150,000Year 1 sales collected in:

Year 1 $300,000Year 2 $200,000

Income Tax Rate 40%Method used for GAAP: AccrualMethod used for Tax: Inst. SalesAmount of deferred tax asset

or liability at end of Year 1? 40,000$ Is it a Def. Asset or Liability? Liability

Income Tax Accounting

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 2009, 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 2009?a. $300,000 b. $500,000 c. $187,500 d. $1,000,000

Total Contract Price $10,000,000Projected cost for project (8,000,000)Projected profit on projectCost incurred to dateCosts incurred to date (%)

Projected profit on projectCosts incurred to date - (%)Cumulative profit earnedLess: profit earned in prior yearsProft reported this year

Long-term Construction Contract [2]

Total Contract Price $10,000,000Projected cost for project (8,000,000)Projected profit on project 2,000,000Cost incurred to date 4,000,000Costs incurred to date (%) 50%

Projected profit on project $2,000,000Costs incurred to date - (%) 50%Cumulative profit earned $1,000,000Less: profit earned in prior years $0Proft reported this year $1,000,000

Long-term Construction Contract [2]

Long-Term Contracts [3]UNCC Construction Co. –Continued.UNCC has spent 50% of the estimated total cost of the project.Revenue earned $5,000,000Cost $4,000,000Gross Profit $1,000,000Answer is D

Mr. D. Long-Term Contracts. [1]On 1-5-07, Mr. D, a calendar year taxpayer, contracted to build a road for $1 million. The road will be completed on 12-31-08. Mr. D elected the completed contract method to report his income. On 12-31-07, the county engineer certified that 65 percent of the road has been completed. Construction costs of $500,000 were incurred in 2007 for the contract. How much net profit should Mr. D report on this contract in 2007? 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 2007 because the project is not completed until 2008.

Mr. D. Long-Term Contracts. [3]On 1-5-07, Mr. D, a calendar year taxpayer, contracted to build a road for $1 million. The road will be completed on 12-31-08.Mr. D elected the percentage of completion method to report his income. On 12-31-07, the county engineer certified that 65 percent of the road has been completed. Construction costs of $500,000 were incurred in 2007 for the contract. How much net profit should Mr. D report on this contract in 2007? a. $0 b. $50,000 c. $75,000 d. $150,000 e. $650,000

Mr. D. Long-Term Contracts. [4]On 1-5-06, Mr. D…..percentage of completion method - Continued

Revenue earned $650,000 Cost $500,000 Gross Profit $150,000Answer is DWe may use engineering estimates of percentage completion, or look at the percentage of total estimated costs that have been incurred.

Co. Q - Construction JobsCompany Q uses the percentage-of-completion 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 (2011) were $6 million. The amount of gross margin to recognize in 2008 is:a. $0. b. $1 million. c. $5 million. d. $2 million.

Contract price $20,000,000

Estimated building cost (15,000,000)

Projected profit 5,000,000

Amount spent

Percent of completion

Profit recognized

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 40%

Profit recognized $2,000,000

Co. Q-Percentage-of-Completion

The bridge will cost $400,000.$000 omitted Year 1 Year 2 TotalCosts incurred $300 $100 $400Payments received $400 $200 $600

How much profit would be recognized each year with these 2 methods?

Profit recognized: Year 1 Year 2 TotalCompleted contract% of CompletionPercentage of Completion: profit recognizedin proportion to costs incurred.

Big Co. has contracted to build abridge for $600,000.

Construction costs will be $400,000.$000 omitted Year 1 Year 2 Total

Costs incurred $300 $100 $400Payments received $400 $200 $600

How much profit would be recognizedeach year with these 2 methods?

Profit recognized: Year 1 Year 2 TotalCompleted contract $200 $200% of Completion $150 $50 $200Percent 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%.

Big Co. will build bridge for $600,000.

End