Chapter 3

Income Sources
Howard Godfrey, Ph.D., CPA UNC Charlotte
Copyright 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]

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 employees 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 Barneys 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 Barneys 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 Barneys gross income.

Gain or loss on sale of Investments Page 3-13

Amount Realized
+ Cash Received + FMV of property received + Sellers liabilities assumed by the buyer - Buyers 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 Allans 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 lump-sum 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 + 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. Veras modified adjusted gross income is $64,000 [$18,000 + $38,000 + ($16,000 x )]. 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 Harrietts 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 borrowers net investment income for the year If borrowers 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 Seths 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 2008: Cost S. Price IBM Big Co. $2,000 $3,000 $8,000 $1,000 $100,000

Overall gain or loss Loss Limit Adjusted gross income?

Capital Gains and Losses-2

Jo had salary of Jo sold stock- bought in 2008: Cost S. Price IBM Big Co. $2,000 $3,000 $1,000 ($6,000) ($3,000) $97,000 $8,000 $1,000 ($7,000) $100,000

Overall gain or loss Loss Limit Adjusted gross income?

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 $0 Yr 1 STCL ($2,400) Yr 1 LTCG $400

Net Net Net Tax Short-T. Long-T. Gain (Loss) Return

Yr 1 LTCL ($3,500) Deduct STCL Deduct LTCL Deduction limit this year Carry over to next year

Individual
Yr 1 STCG $0

Net Net Net Tax Short-T. Long-T. Gain (Loss) Return

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

($3,100) ($5,500)

Yr 1 LTCL ($3,500) Deduct STCL Deduct LTCL Deduction limit this year Carry over to next year

($2,400) ($600) ($3,000) ($2,500)

Cap. Asset Sale-1

Other Income (Other AGI) Net L.T. capital gain or loss Net S.T. capital loss or loss 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

Details

Capital Ordinary Return $68,000 $68,000

$15,000 (24,000)

Cap. Asset Sale - 2

Other Income (Other AGI) Net L.T. capital gain or loss Net S.T. capital loss or loss 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 to next year

Details

Capital Ordinary Return $68,000 $68,000

$15,000 (24,000) (9,000)

(9,000) (3,000) (3,000) $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%. 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 20082012)

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 taxpayers 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 taxpayers ordinary tax rate is lower than 28%, then the lower ordinary rate applies to gain that falls within that tax bracket

Single taxpayers Salary from IBM Exemption Itemized deduct. Net S.T. capital gain Tax rate on gain?

Mike $40,000 (3,700) (16,300) $20,000 $10,000

Mary $120,000 (3,700) (16,300) $100,000 $10,000

Single taxpayers Salary from IBM Exemption Itemized deduct. Net S.T. capital gain Tax rate on gain?

Mike $40,000 (3,650) (16,350) $20,000 $10,000 15%

Mary $120,000 (3,650) (16,350) $100,000 $10,000 28%

Single taxpayers

Mike

Mary

Salary from IBM $40,000 $120,000 Exemption Net L.T. capital gain Tax rate on gain? (3,650) (3,650) (16,350) Itemized deduct. (16,350)

$20,000 $100,000 $10,000 $10,000

Single taxpayers Salary from IBM Exemption Itemized deduct. Net L.T. capital gain Tax rate on gain?

Mike $40,000 (3,700) (16,300) $20,000 $10,000 0%

Mary $120,000 (3,700) (16,300) $100,000 $10,000 15%

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 taxpayers 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, 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

Original Issue Discount

Amount of loan $165,289.26 2011 Interest -10% Book Value-12-31-11 2012 Interest -10% Book Value-12-31-12 Answer 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 $200,000.00 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
82

Accrual Method Problem

On 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 Problem

On 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 - 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, 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-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 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 (nonowners) 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 oneyear 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 [accrual basis taxpayer] leases offices. Hall started business on Jan. 1, 2011. Rent is due in advance on the first day of each month. Not all tenants pay promptly. Hall's records at the end of 2011 show: 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

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 months 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 Balance Sheet-12-31 Rent receivable Unearned revenue $2,500 $1,300 Year 1 $3,100 $2,600 $49,800 $49,300

GAAP Income Statement: Rent Revenue $54,700 Cash Collections from tenants for rent?

Office Rental Inc.-Slide 3 of 6

Year 2 Revenue Earned-Yr 2 Beg. Rent Receivable End. Rent Receivable Beg. Unearned Revenue End. Unearned Revenue Collected from tenants In Year 2, you collected receivables of $3,100 for rent in Year 1, etc. $54,700 3,100 2,500 2,600 1,300 Year 2 $54,700

Office Rental Inc.-Slide 4 of 6

Year 2 Revenue Earned-Yr 2 Beg. Rent Receivable End. Rent Receivable Beg. Unearned Revenue End. Unearned Revenue Collected from tenants of $3,100 for rent in Year 1, etc. $54,700 3,100 2,500 2,600 1,300 Year 2 $54,700 3,100 (2,500) (2,600) 1,300 $54,000

In Year 2, you collected receivables

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 taxpayers 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. Realtys income tax rate is 40%. Year 1 operations: see next slide.

Realty Corporation - Slide 2.

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? GAAP $20,000 (5,000) (10,000) 5,000 40% Tax

Realty Corporation - Slide 2.

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? GAAP $20,000 (5,000) (10,000) 5,000 40% 2,000 Tax $40,000 (5,000) (10,000) 25,000 40%

Realty Corporation - Slide 3.

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 GAAP $20,000 (5,000) (10,000) 5,000 40% 2,000 Tax $40,000 (5,000) (10,000) 25,000 40%

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 Mike's adjusted basis Gross Profit Gross Profit Percentage Collections in 2011 Capital gain for 2011 $100,000 60,000 40,000 40% 20,000 $8,000

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

Bold Co. Installment Sale [2] On 1-1-2010, Bold, Inc. sold land on installment basis. Selling Price $800,000 Basis of land 700,000 Profit on sale 100,000 Profit % Payment in 2010 Profit for 2010

Bold Co. Installment Sale [3] On 1-1-2010, 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 2010 $200,000 Profit for 2010 $25,000 Answer C

Installment Method In 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 Method In 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. 115

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 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

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 (%) 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) 2,000,000 4,000,000 50% $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 1-5-07, 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 $150,000 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 (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.

Co. Q-Percentage-of-Completion Contract price Estimated building cost Projected profit Amount spent Percent of completion Profit recognized $20,000,000 (15,000,000) 5,000,000

Co. Q-Percentage-of-Completion Contract price Estimated building cost Projected profit Amount spent Percent of completion Profit recognized $20,000,000 (15,000,000) 5,000,000 6,000,000 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