Income Taxation II
FUNDAMENTAL ACCOUNTING PRINCIPLES
CASH RECEIPTS AND DISBURSEMENTS METHOD
INCOME / RECEIPTS
Income Steps: (1) Was there cash received in year one; (2) If not, is there cash-equivalent received in year one; (3) If not, is there constructive receipt?
Checks: As a cash-method taxpayer, a check is considered the equivalent to cash if (1) unrestricted and not subject to restrictions AND (2) subsequently honored. Income should be realized on the day taxpayer receives a check even if it could not be cashed that day (Kahler).
Negotiable Instruments: (Promissory Notes / IOUs) are treated like checks. Generally a promissory note is only a promise to pay in the future.
(A) Insolvent Debtor: A promissory note to a cash method taxpayer is not income when the note is received (Williams).
(B) Solvent Debtor: A promissory note is treated as cash equivalent when it is (1) from a solvent payor; (2) with no restrictions (aka, “unconditional”); (3) assignable by payee (aka, “readily transferable”); and (4) where the face discount (or the present value of the note) equals the prevailing interest rate (Warren Jones). A promise to pay by a solvent obligor which is unconditional, assignable, not subject to set-offs, and is of the kind that is frequently transferred to lenders or investors at a small discount will be treated as cash equivalent (Cowden).
Constructive Receipt: (“unfettered control”) A taxpayer has income in the year it is constructively received. Constructive receipt is where a cash method taxpayer has income credited to, set apart, or otherwise made available to the taxpayer (Hornung) (Reg. 1-451-2(A)).
Generally, checks placed in the mail go by actual receipt and are considered income when the taxpayer physically receives the check (Avery). However, on the flip side, if a taxpayer places a check in the mail that is not subject to any restrictions and subsequently honored, it is deemed to be “payment” when the check is mailed (Rev. Rule 1-65). A check must be “readily available” – if delivery is attempted but failed, taxpayer is notified, and the check is left at a closed post office, the check is not readily available (Davis).
DISBURSEMENT / EXPENDITURE
Reg. 1.451 deals with the concept of “receipt” of income for both cash and accrual methods.
General Rule / Deductions: A credit for the amount deducted is taken in the year in which is proper under the taxpayer’s account method (Reg. 461).
A cash method taxpayer may deduct amounts in the year cash is disbursed (461(a)(1)). Even though there may be constructive receipt, it does not follow that there was “constructive payment,” this does not exist (Vander Poel, Francis & Co.).
A check is deemed to be paid when it is delivered if it is unrestricted and subsequently honored (Rev. Rule 54-465 / Rev. Rule 1-65). Payment by check is deemed to be payment when placed in the mail if unrestricted and subsequently honored (Rev. Rule 80-335 / Avery).
Credit Cards:– when you use a three-way card like Visa, Amex, Mastercard, it is equivalent to borrowing money from a third party lender then took the cash to pay an expense (Rev. Rule 78-38 / Grannan). Any time you pay by credit card, you may take the deduction (or claim the amount as income, if the store is the taxpayer) when you sign the credit card receipt, not when you pay the credit card bill.
Prepaid Expenses as Cash-Method Taxpayer: Prepaid expenses must be prorated over the life of the expense (Boyleston Market Assoc.). Anytime you have a prepayment of insurance over multiple years, you must prorate the expense over the time period for which the policy covers (Rev 70-413) aka, “defer the deductible expense over the life of the contract” (Reg 1.461-A(A)(1)). Exception: If a taxpayer prepays rent, he may take a deduction in the current year for the rent for up to eleven months’ rent of the second/subsequent year (Zaninovich, 9th Cir.)
Prepaid interest must be capitalized and deducted over the period for which it relates to the use of money. If you prepay interest and are a cash-method interest, you cannot take the deduction in the year the interest is paid; you only get the amount of interest for the use of the money in the first year but not the second, third, etc. (§ 461(g)(1)). However, a cash method taxpayer may take a current deduction for points paid on indebtedness incurred for purchase of or improvement to a principle residence (§ 461(g)(2) / Cathcart).
INCOME / RECEIPTS
Income Steps: All Events Test; Claim of Right (prepaid income); applicable exceptions.
All Events Test: The “All Events Test” determines when amounts are paid (Reg. 1.446-1(c)(1)(ii) / Reg. 451-1(A)). Generally, an item’s amount is included in gross income for the taxable year in which all the events have occurred that fix the right to income and the amount can be determined with reasonable accuracy. It is the right to receive (and not the actual receipt) that determines whether or not the amount is included in gross income. When the right to receive is a fixed amount, then the right accrues and is includible in gross income (Spring City Foundry). Court judgments are considered income to a taxpayer in the year that judgment is entered into / considered final, not original contract date or upon breach (Rev. Rule 70-151). Note, there is no deduction until economic performance has occurred (see below).
Claim of Right: (Cash or Accrual Method) “Unrestricted and unfettered control over funds” results in income to a taxpayer during the year the taxpayer is entitled to the funds and receives them, regardless of their accounting method (North American Oil Consolidated). Aka, Income is includable in gross income in the year received, for example, a taxpayer’s prepayment of last-months-rent is taxable the year paid under “claim of right” doctrine (New Capital Hotel Inc.) but a taxpayer who collects a security deposit for a lease in year one is not considered income because control is restricted.
Note: income for lifetime membership/club (auto clubs, dance and gym memberships) is includable in year received because there is no way to determine whether services would ever be performed or how long a contract would last – there is no way to compute on a prorated basis.
Note: Although Claim of Right would appear to apply, the Court/Congress has made exceptions for this doctrine:
× Congress enacted § 455, 456, 458 as an exception to this general rule for subscriptions to periodicals which allows this income to be deferred until the item is sold.
× Baseball teams –
= $13,625 Adjusted Basis for Business Use
– $13,000 Depreciation Reduction (§ 1016(a)(2))
(Note, the total $13,000 amount is taken because under this calculation because it is the total amount allowable)
= $625 Final Adjusted Basis
$35,400 (Total Amount Realized when Item was Sold)
X 25% for Business Use
= $8,850 Adjusted Amount Realized for Business Use
Adjusted Amount Realized $8,850 > Final Adjusted Basis $625
Therefore, Taxpayer realizes a Gain of $8,225
Personal Use Calculation
$46,000 Original Cost Basis (§ 1012)
+ $8,500 Capital Improvements (§ 1016(a)(1))
= $54,500 Adjusted Basis
X 75% for Personal Use
= $40,875 Adjusted Basis for Personal Use
(Note, there are no adjustments for depreciation because the item is not depreciable in this calculation – it is used personally and not for any income-producing activity)
$35,400 (Total Amount Realized when Item was Sold)
X 75% for Business Use
= $26,550 Adjusted Amount Realized for Personal Use
Adjusted Amount Realized, $26,550 < Adjusted Basis, $40,875 Therefore, Taxpayer realizes a Loss of $14,325 but it is NOT deductible. There are only three instances an individual may deduct for losses not compensated by insurance up to their adjusted basis: (1) use in trade/business; (2) as investment or for profit; (3) casualty loss – since this loss does not fall under the exception, it is not deductible. Accelerated Cost Recovery System (ACRS): Three tiers for depreciation: (a) Pre 1980 (really § 167), (b) the “Accelerated Cost Recovery System” for assets placed into service from 1981 through 1986, and (c) from 1987-present is the “Modified Accelerated Cost Recovery System” (§ 168). * goes by date placed in service. Income-Generating Personal Property: To stimulate the economy and simplify the “unnecessarily complicated” rules for depreciation, Congress established the Accelerated Cost Recovery System (§ 168) which did away with useful life and salvage-value, and instead placed depreciable assets into various categories of classification and assigned them a “recovery period”. General Rule: So long as the asset is (1) used in a trade/business or other income-producing activity and (2) is the type of asset that is subject to exhaustion, wear/tear, or obsolescence, it is depreciable (Liddle, 3rd Cir. / Simon, 2nd Cir.). The “recovery period” was based on pre-determined, Congressionally-established categories – in general, tangible / personal property was subject to a five-year recovery period.