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Chapter 2

Income Tax Concepts

2013
Edition Topic Status

Questions
1 Income tax as a system Unchanged

2 Ability-to-pay concept Unchanged

3 Arm’s-length transaction concept Unchanged

4 Relationship of arm’s-length concept and related party construct Unchanged

5 Pay-as-you-go concept Unchanged

6 Taxable entity versus conduit entity Unchanged

7 Tax benefit rule Unchanged

8 Accounting methods Unchanged

9 Capital recovery concept/income recognition Unchanged

10 Basis for calculation of gross income Unchanged

11 Capital gain versus ordinary income Unchanged
 12 Constructive receipt doctrine Unchanged

13 Wherewithal-to-pay concept versus ability-to-pay concept Unchanged

14 Application of business purpose concept to determine Unchanged deductions

15 Capital expenditures Unchanged

16 Legislative grace concept/difference in application to income and Unchanged

deductions

17 Capital recovery concept/difference in application to income and Unchanged

deductions

Problems
18 Ability-to-pay concept - four scenarios Unchanged

19 Ability-to-pay concept - four scenarios Unchanged

20-CT Calculation and comparison of tax paid by single versus married Unchanged
taxpayer/discuss ability-to-pay concept

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

2-1

21-CT Ability-to-pay concept - rationale for difference in tax paid

22 Related parties - individuals, corporations, partnership

23 Related parties - corporations and partnerships Unchanged

24-COMM Related party sale - corporations controlled by same individuals Unchanged

25 Entity concept - segregation of income and expenses Unchanged

26 Entity concept - segregation of income and expenses Unchanged

27 Taxation of conduit entities Unchanged

28 Taxability of corporation versus S corporation Unchanged

29-COMM Use of entities Unchanged

30 Partnership income taxation Unchanged

31 Assignment of income Unchanged

32-COMM Assignment of income Unchanged

33 Income recognition - cash versus accrual Unchanged

 34 Income recognition - cash versus accrual Unchanged

35 Tax benefit rule with an application of state tax refund Unchanged

36 Tax benefit rule Unchanged

37 Substance-over-form application to a loan Unchanged

38 Identification of concepts with actual tax treatments Unchanged

39 Identification of concepts with actual tax treatments Unchanged

40 Calculation of gain/loss on sale of depreciable assets Unchanged

41 Long-term capital gains - maximum tax rate Unchanged

42 Capital losses - effect of annual limitation Unchanged

43 Realization concept - four scenarios Unchanged

44 Realization concept - four scenarios Unchanged

45-CT Claim of right Unchanged

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly a cessible website, in whole or in part

46 Claim of right - four scenarios

47 Claim of right - four scenarios

48 Constructive receipt - contrasting treatments Unchanged

49 Constructive receipt - three scenarios Unchanged

50 Realization-provide rationale for five scenarios Unchanged

51-CT When should income be recognized Unchanged

52 Income recognition - provide rationale for four scenarios Unchanged

53 Mixed-use expenditures -home office Unchanged

54 Deduction concepts - provide rationale for four scenarios Unchanged

55 Deduction concepts - provide rationale for four scenarios Unchanged

56-COMM Business purpose Unchanged

57 Differences in treatment of expenses/business versus personal Unchanged

58-CT Differences in treatment of personal/ investment/ business loss Unchanged

59 Calculation of loss on casualty/effect on basis Unchanged

 60 Capital expenditures - four scenarios Unchanged

61 Basis - four scenarios Unchanged

62-CT Timing of deductions - cash versus accrual Unchanged

IID-63 Related parties - effect of transactions Unchanged

IID-64 Application of entity concept and related parties to 100% owned Unchanged
corporation

IID-65 Assignment of income/substance-over-form Unchanged

IID-66 Deductibility of expenses – substance over form Unchanged

IID-67 Income realization Unchanged

IID-68 Claim of right Unchanged

IID-69 Constructive receipt Unchanged

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

IID-70 Deductibility of mixed-use expenses

IID-71 Mixed-use expenditures - vacation home

72 RIA Research Exercise Unchanged

73 RIA Research Exercise Unchanged

74 INTERNET Unchanged

75 INTERNET Unchanged

76 Research Problem Unchanged

77 Research Problem Unchanged

78-TFP Tax Forms Problem – Preparation of 1040EZ Unchanged

79-DC Deductibility of oil restoration costs/compare financial accounting Unchanged with

tax accounting

80-TPC Substance-over-form application to sale of property Modified

81-TPC A 3-year projection of the tax effect of using a corporation versus Unchanged
a partnership for a new business
 82-EDC Possible under reporting of S corporation income - application of Unchanged SSTS
#3 and SSTS #1

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly a cessible website, in whole or in part
 CHAPTER 2

INCOME TAX CONCEPTS

DISCUSSION QUESTIONS

1. This chapter compared the operation of the income tax system with the operation of other
systems we have devised to govern our everyday lives. Choose an example of a system you
deal with in your everyday life, and explain part of its operation in terms of concepts, constructs,
and exceptions to the general concepts and constructs.

There are several possibilities for student response to this problem. The key point is that they
identify a system, a concept underlying the system with a related construct, and an
exception to the concept. For example, the University Library operates under the general
concept that everyone should have access to the materials in the library. A construct
related to this concept is that some materials may be checked out for a period of time
(two weeks for example), while other types of materials may not be checked out at all
(the exception to the construct). Another exception to the check-out rules may be made
for faculty: faculty may have longer check-out periods and may be able to check out
materials that other users cannot.

2. The chapter stated that the ability-to-pay concept is fundamental to the operation of the income
tax system. What is the ability-to-pay concept, and what two basic aspects of the income tax
system are derived from the concept? What might the tax system be like without this concept?

The ability-to-pay concept states that the tax paid should be related to the amount that the
taxpayer has to pay the tax. This concept is implemented by using taxable income
(income net of deductions) as the tax base for figuring the tax. This gives recognition to
differing levels of income as well as differing levels of deductions by each taxpayer. The
second aspect is the use of progressive tax rates in the calculation of the tax. This rate
structure imposes lower tax rates on lower income levels while taxing higher levels of
income at higher rates.

Without this concept, the income tax could be very different. First, a different tax base could
be used, such as a tax on all income received. In addition, the tax rate structure might
not be progressive. For example, a tax on all income received might be subject to a
single tax rate (proportional tax structure).

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly a cessible website, in whole or in part

2-5

Chapter 2: Income Tax Concepts 3. What is an arm’s-length transaction? What is

its significance to income taxation?

An arm’s-length transaction is one in which the parties to the transaction bargain in good faith
for their individual benefit, not for the mutual benefit of the group. That is, the price of
the transaction is a fair market value.

The importance for income taxation is that transactions not made at arm’s-length are usually
not given their intended tax effect. This has led to the related party rules which define
situations in which entities do not bargain at arm’s-length. Special rules for transactions
between related parties have been developed to discourage such transactions.

4. Explain how the related party construct and the arm’s-length transaction concept interact.

Related parties are defined as certain relatives (children, parents, grandparents) and other
relationships in which one party controls the action of the other party (e.g., greater than
50% ownership of a corporation). In such cases, there is an incentive to cooperate to
structure transactions that have favorable tax effects for the transaction group (i.e.,
related parties may enter into transactions that they would not otherwise enter into with
an unrelated party). Because of this potential for structuring transactions that could lead
to abuse, related parties are deemed not to transact at arm’s-length.

5. Why is the pay-as-you-go concept important to the successful operation of the income tax
system? What other types of taxes are based on this concept?

Because the U.S. income tax system is based on voluntary compliance, it is important that the
system have features that encourage compliance. By having amounts withheld from a
taxpayer’s income as it is earned and requiring a taxpayer not subject to withholding to
make estimated tax payments, the system encourages taxpayers to file returns. That is,
without such a requirement, taxpayers would face very large tax payments when filing
their annual returns. Many taxpayers could not afford to make such a large lump-sum
payment, leading to an incentive either to not file, or to greatly understate their income.
The pay-as-you-go system leaves taxpayers with either a relatively small amount of tax
due or a refund of a portion of their prepaid taxes. This encourages taxpayers to file
their returns and report the correct amount of income.

The most familiar type of tax that is based on the same concept is the sales tax. State income
taxes and Social Security/Self-Employment taxes are also subject to withholding and
estimated payment requirements. In addition, other types of user taxes are typically
collected at point of sale. This would include gasoline taxes, taxes on luxury autos, and
utility taxes.

Chapter 2: Income Tax Concepts

6. What is the difference between a taxable entity and a conduit entity?

A taxable entity is an entity that must pay tax on its income. The two primary taxable
entities are individuals and corporations. The owners of a corporation do not pay
the income tax on the corporation’s taxable income. However, the owner’s are taxed
when the corporation distributes income, in the form of dividends, to the owners.
A conduit entity is a tax reporting entity that reports its results to the government, but does
not pay tax on its income. Rather, the conduit entity’s income flows through to its
owners, who report their share of the conduit entity income on their returns. Thus, the
owners of the conduit entity pay the tax on the conduit’s income, not the conduit entity.

7. Why is the tax benefit rule necessary? That is, which concept drives the need for this construct?
Explain.

The tax benefit rule is necessary because of the annual accounting period concept
requirement that the events of each tax year are to stand alone. Because prior year’s
returns are generally not subject to adjustment under this concept, there is a need for a
construct to determine the proper treatment of items previously deducted that are
recovered in a subsequent year.

8. What are the two basic methods of accounting that may be used by taxpayers? How do the
two basic methods differ?

The two basic accounting methods that are acceptable for tax purposes are the cash method
and the accrual method. The basic difference between the two methods is the criteria
used to determine the timing of the recognition of income and expenses.

The cash method recognizes income when cash or its equivalent is received. Expenses are
deducted when they are paid. That is, it is basically a cash flow system (although capital
expenditures cannot be deducted in total in the period in which they are paid).

The accrual method recognizes income when it is earned (the receipt of cash or its equivalent
is not a factor). Expenses are deducted when all events have occurred that fix the
liability for the payment and the amount of the payment can be reasonably estimated.
The payment of the expense is not a factor for accrual basis taxpayers.

9. What is the effect of the capital recovery concept on income recognition?

The capital recovery concept states that no income is recognized until all capital invested in
an asset has been recovered. Thus, when assets are sold, no income results unless the
sales price is greater than the capital invested in the asset. If the sales price is less than
the amount of capital invested, then the taxpayer has sustained a loss. The amount of
the loss is equal to the capital that was not recovered through the disposition of the
asset.

Chapter 2: Income Tax Concepts

10. Chapter 1 discussed how gross income is equal to all income received, less exclusions. Which
concepts form the basis for this calculation of gross income? Explain.

The all-inclusive income concept provides that all income received is taxable. The legislative
grace concept allows Congress to provide relief from taxes through exclusions and
deductions. Thus, the calculation of gross income is a combination of the two concepts.
11. What is capital gain income? How is it different from ordinary income?

Capital gain income (loss) results from the sale or other disposition of a capital asset. For
individuals, capital assets consist of stocks, bonds, other investment assets, and
personal use property.

Net long-term capital gains of individuals are given special treatment - the tax rate on a net
long-term capital gain is 15%. Net capital loss deductions are limited to $3,000 per year
for individuals. Corporations are only allowed to deduct capital losses against capital
gains.

12. Why does the doctrine of constructive receipt apply only to cash basis taxpayers?

The constructive receipt doctrine is used to determine when a taxpayer has received income.
This is critical for the cash basis taxpayer who recognizes income when it is received.

An accrual basis taxpayer recognizes income when the income has been earned. Recognition
is not contingent upon receipt of the income. Therefore, the constructive receipt
doctrine does not affect income recognition by accrual basis taxpayers.

13. How is the wherewithal-to-pay concept different from the ability-to-pay concept?

The ability-to-pay concept is a general concept that states that each taxpayer should pay a
taxed based on his or her ability to be able to pay the tax. That is, those taxpayers with
the most income should pay relatively more tax. This concept leads to such things as
progressive rate schedules, exemption deductions, etc., that are system-wide
applications.

The wherewithal-to-pay concept is an income recognition concept. It states that the tax on an
income item should be levied in the period in which the taxpayer has the means to pay
the tax. It overrides accounting methods and other concepts (realization) and requires
recognition of income items in the period that the taxpayer has resources from the
transaction to pay the tax. Thus, the concept is applied to specific transactions and is
not a system-wide application.

14. Explain how the business purpose concept provides the basis for determining which expenses
are deductible.

To deduct an expenditure, the business purpose concept requires that the expenditure have
a business or economic purpose that exceeds any tax avoidance motive. A business or
economic purpose is one that involves a profit-seeking activity. The tax law embodies
this concept by allowing the deduction of trade or business expenses and production of
income expenses (i.e., investment expenses), both of which involve profitseeking
activities. Personal expenditures (except those specifically allowed as itemized
deductions) and expenditures that are primarily motivated by tax avoidance are not
deductible.
Chapter 2: Income Tax Concepts
15. What is a capital expenditure?

A capital expenditure is any expenditure that benefits more than one annual accounting
period. That is, the usefulness of the expenditure extends substantially beyond the
end of the tax year in which the expenditure is made. Because of the multiperiod
benefit, capital expenditures generally are not deductible in full in the period they
are paid or incurred. Rather, they must be capitalized as an asset and allocated to
the periods of benefit. Common capital expenditures include fixed asset purchases
(e.g., land, buildings, equipment), prepaid expenses, and purchases of securities.

16. The legislative grace concept is both an income concept and a deduction concept. Explain how
the application of the concept differs for income items and deduction items.

The legislative grace concept states that any tax relief provided is the result of a specific act
of Congress that must be strictly applied and interpreted. Exclusions from income and
deduction allowances are both forms of tax relief and therefore, result from the legislative
grace concept.

The difference in the application of the concept to income and deduction items is the approach
taken in analyzing what is included in income and what is deductible. The allinclusive
income concept states that all income received (earned) is taxable absent some specific
provision in the tax law exempting it from tax. Thus, the approach to income is to
assume that everything is taxable and to look for those provisions that exclude income
from tax (i.e., where legislative grace has provided tax relief).

Deductions are just the opposite. The business purpose concept states that an expenditure
must have a profit motive in order to be deductible. Therefore, when approaching
deductions, the assumption is that items are not deductible and specific provisions must
be found that allow the deduction (i.e., where legislative grace has provided tax relief).

17. The capital recovery concept is both an income concept and a deduction concept. Explain how
the application of the concept differs for income items and deduction items.

The capital recovery concept states that there is no income until all capital invested has been
recovered. The income side of the concept allows the recovery of capital investment
against the selling price of assets in determining the amount of income (loss) from the
disposition of assets.

The deduction side of the concept is a limit on the amount of the deduction. Because income
results from an excess of income over expenses, the maximum amount of any deduction
is the amount of capital invested in the deduction. Therefore, expenses are deducted at
their cost to the taxpayer, not at some other value (e.g., replacement cost, current market
value).
PROBLEMS

18. Which of the following are based on an ability to pay? Explain.

a. State Y collects a sales tax of 5% on all purchases of goods and services.

A flat rate tax on the purchase of all goods and services is not a tax that is
based on the amount that the taxpayer can afford to pay. It is based on the
taxpayer’s consumption of goods and services, which is not specifically
tied to income levels. That is, there is some minimum level of purchases
that all taxpayers incur, regardless of their income level.

b. State X collects a sales tax of 5% on all purchases of goods and services but
gives low-income families a tax credit for sales taxes.

The use of a tax credit for low income families would make the sales tax less
regressive. Properly constructed, such a tax credit could move the sales
tax closer to a tax based on a taxpayer’s ability to pay.

c. Students at State University are given free parking in designated lots. Faculty
and staff members must pay $125 per year for parking at State University.

The fee structure is based somewhat on ability to pay regarding students

versus faculty and staff. However, within each of these categories various
individuals would have greater ability to pay than others. For example, the
University President would have a greater ability to pay than a
maintenance worker. Thus, the tax is not totally based on ability to pay.

d. Barton City charges all customers a flat monthly rate of $10 for garbage pickup.

Flat rate charges without regard to income levels are not based on ability to
pay. All taxpayers pay the fee without regard to their income level.

19. Which of the following are based on an ability to pay? Explain.

a. Local County assesses property taxes at the rate of 1% of assessed value.

Because the property tax is based on the value of the property and is not
related to the taxpayer’s income, it is not based on each taxpayer’s ability
to pay the tax. If it is assumed that there is a correlation between the value
of a taxpayer’s property and his/her income, then the tax takes on the
features of a proportional tax. However, proportional taxes do not
 consider ability to pay because each taxpayer pays the same rate based
on his/her income.

b. The university library lets all students, faculty, and staff members check out books
free. Students who do not return books by the due date are fined $1 for each
day the book is late. Staff members are fined 50 cents for each day a book is late.
Faculty members are not fined when they return books late.

The book fines are not based on ability to pay. Under this fine structure,
those with the least ability to pay, students, pay more than those with the
greatest ability to pay, faculty.

c. The country of Lacyland assesses an income tax based on the following

schedule:

Taxable Income Income Tax

$ -0- to $20,000 20% of taxable income
$ 20,001 to $60,000 $ 4,000 + 15% of taxable income in excess of $20,000 $ 60,001
and above $10,000 + 10% of taxable income in excess of $60,000

This is a regressive tax rate structure - the marginal tax rate is declining as
income is increasing (average tax rate is greater than the marginal tax
rate). Although higher income taxpayers are paying more tax, they are
paying at a lower tax rate. The tax is not based on ability to pay because
higher income taxpayers are presumed to be able to pay tax at a higher
marginal rate than those with lower incomes.

d. State Z imposes a 10-cent-per-gallon tax on gasoline but gives low-income

taxpayers a tax credit for gasoline taxes paid.

A 10-cent per gallon gasoline tax is a proportional tax. Proportional taxes do

not consider ability to pay because all taxpayers pay the same tax rate.
Giving low income taxpayers a tax credit for the taxes they pay provides a
rate differential between high and low income taxpayers and makes the tax
at least partially based on ability to pay. However, for the range of
taxpayers who do not get credit for the gasoline tax they pay, the tax is not
based on ability to pay. Very high income taxpayers will pay the same tax
rate as high income taxpayers.

20. Sheila, a single taxpayer, is a retired computer executive with a taxable income of
$90,000 in the current year. She receives $30,000 per year in tax-exempt
municipal bond interest. Adam and Tanya are married and have no children.
Adam and Tanya’s $90,000 taxable income is comprised solely of wages they
earn from their jobs. Calculate and compare the amount of tax Sheila pays with
Adam and Tanya’s tax. How well does the ability-to-pay concept work in this
situation?
 Sheila’s tax is $18,661. Adam and Tanya’s tax is $14,560.

Single rate schedule:

Sheila $17,442.50 + [28% x ($90,000 - $85,650)] = $18,661

Married rate schedule:

Adam & Tanya $9,735.00 + [25% x ($90,000 - $70,700)] = $14,560

The difference in the tax rate schedules for single and married taxpayers
reflects the greater ability to pay tax by single taxpayers at the same
income level as married taxpayers. However, in this case, the rate
schedules do not adjust for the difference in economic incomes. Sheila’s
economic income is $120,000 ($90,000 taxable income + $30,000
taxexempt income). Her effective tax rate on this income is 15.55%
($18,661 ÷ $120,000) versus a 16.18% ($14,560 ÷ $90,000) effective tax
rate on Adam and Tanya’s economic income. Therefore, even though the
tax rate structures reflect the ability-to-pay concept, other provisions in the
tax law that exclude items from income serve to negate the effect of the tax
rate structures.

21. Andrew and Barbara each receive a salary of $80,000. Neither Andrew nor
Barbara has any other source of income. During the current year, Barbara paid
$800 more in tax than Andrew. What might explain why Barbara paid more tax
than Andrew when they both have the same income?

Factors that could cause taxpayers with the same amount of income to pay
different amounts of tax are:

1. Marital Status - If one taxpayer is married and the other is single, the
single individual will pay more tax on the same amount of income than
a married couple.

2. Deductions - If one taxpayer has more allowable deductions, then he

or she will pay less tax on the same total income. This could be the
result of either one taxpayer having strictly more deductible items, or
one taxpayer itemizing their allowable personal deductions and the
other taking the standard deduction.

3. Dependents - If one taxpayer has more dependents than the other

taxpayer, then his or her taxable income will be less by the amount of
the additional exemptions, resulting in less tax paid.

4. Tax Credits - If one taxpayer has tax credits that the other does not (or
more than the other), then his or her tax will be less.
22. Which of the following are related parties:

Related parties are defined to include members of an individual’s family

(ancestors, lineal descendants, and brothers and sisters) and entities in
which the taxpayer effectively owns more than a 50% interest.

a. Harvey and his sister Janice?

A sister is a related party.

b. Harvey and the Madison Partnership? Harvey owns a 60% interest in the
partnership. Three of Harvey’s friends own the remaining partnership interest.

Because Harvey owns more than 50% of partnership, he and the Madison
Partnership are related parties.

c. Harvey and his grandfather Maurice?

A grandfather is an ancestor; Harvey and Maurice are related parties.

d. Harvey and Noti Corporation? Harvey owns 40% of Noti Corporation. Three
unrelated parties own 20% each.

Harvey does not own (directly or indirectly) more than 50% of the corporation;
Harvey and Noti are not related parties.

e. Harvey and his uncle Elmer?

An uncle is not a related party; Harvey and Elmer are not related parties.

23. In each of the following cases, determine whether Inez is a related party:

a. Inez owns 500 shares of XYZ Corporation’s common stock. XYZ has 50,000
shares of common stock outstanding.

Inez and XYZ are not related parties. For a corporation to be a related party,
the taxpayer must own more than 50% of the stock of the corporation. In
this case, Inez owns only 1% (500 ÷ 50,000) of XYZ Corporation.

b. Inez owns a 40% interest in the Tetra Partnership. The other 60% interest is
owned by 3 of Inez’s friends.
 Inez and Tetra are not related parties. For a partnership to be a related party,
the taxpayer must own more than a 50% interest in the partnership. In this
case, Inez owns 40%. She is not deemed to own the partnership interests
of her friends.

c. Inez owns 40% of the stock in Alabaster Company. Her husband, Bruce, owns
30% and her brother-in-law, Michael, owns the remaining 30%.

Inez and Alabaster are related parties. For a corporation to be a related party,
the taxpayer must own (directly or indirectly) more than 50% of the stock
of the corporation. In this case, Inez owns 40% and her husband owns
30%, for a combined ownership of 70%. Because Inez and her husband
are related parties, Inez is deemed to own the stock of her husband for
purposes of determining related party relationships.

d. Inez is a 100% owner of Nancy Corporation.

Inez and Nancy are related parties. For a corporation to be a related party,
the taxpayer must own more than 50% of the stock of the corporation. In
this case, Inez owns 100% of Nancy Corporation.

24. Doiko Corporation owns 90% of the stock in Nall, Inc. Trebor owns 40% of the
stock of Doiko. Trebor’s sister owns the remaining 60% of Doiko. During the
current year, Trebor purchased land from Nall for $43,000. Nall had purchased
the land for $62,000. Write a memorandum to the controller of Nall, Inc.,
explaining the potential tax problem with the sale of the land to Trebor.

Doiko Corporation and Nall, Inc. are related parties because Doiko owns more
than 50% of the stock in Nall. Although Trebor directly owns only 40% of
Doiko, he is deemed to own his sister’s Doiko shares for purposes of the
related party rules. Therefore, Trebor is deemed to control Doiko, which
controls Nall. This makes Trebor and Nall related parties. Because the sale
to Trebor results in a $19,000 loss, Nall will not be allowed to deduct the
loss because Trebor is a related party. The substance of the transaction
is a sale at fair market value (unknown in the facts), with the difference
being a dividend payment to Trebor. For example, assume the fair market
value of the land is $72,000. The $29,000 ($72,000 - $43,000) difference in
the price Trebor pays for the land is assumed paid to Trebor by Nall. A
payment by a corporation to a shareholder is a dividend. Thus, Nall would
have a $10,000 gain on the sale and Trebor would have $29,000 of dividend
income.
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