What is "Income"?

Tax Code Sec. 61:

"Gross income defined. (a) General definition

Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items:

• (1) Compensation for services, including fees, commissions, fringe benefits, and similar items;
• (2) Gross income derived from business;
• (3) Gains derived from dealings in property;
• (4) Interest;
• (5) Rents;
• (6) Royalties;
• (7) Dividends;
• (8) Alimony and separate maintenance payments;
• (9) Annuities;
• (10) Income from life insurance and endowment contracts;
• (11) Pensions;
• (12) Income from discharge of indebtedness;
• (13) Distributive share of partnership gross income;
• (14) Income in respect of a decedent; and
• (15) Income from an interest in an estate or trust."

Form of receipt

Income need not be money. Can be the receipt of property, services, relief from debt, or generally anything of value, at its "fair market value"

Example: "nonstatutory" stock options. When exercised for employer stock, employee has income equal to market value of stock received, less the price paid to exercise the option

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When is it income? - Timing

The Realization issue

A distinction between "economic", "accounting" and "taxable" income. Income as "ability to pay"

Economic income

The"Haig-Simon" definition arrives at "income" by viewing it as the power to consume now or later. = consumption +/- savings. Although impractical as a measuring device, this ideal definition greatly influenced US tax system design

Accounting income

Traditionally required a realization event with an outside party, so by this measure a change in value of an asset still held isn't income. Now eroding due to rise of mark-to-market analysis.

Taxable income

Close to accounting income, Example: "found" money xx Caesarini case

Sometimes also a "mark to market" requirement.

Mark to market examples: lower of cost/market, straddles, worthless securities

No general book/tax conformity requirement

Different goals of different types of accounting: financial vs. tax xx Thor Power Tool case

Annual measurement

Note that other taxes may use other measurement periods. Consider sales taxes, or the cumulative estate and gift tax.

Tp chooses a "tax year" when filing first return

Income is measured annually, but Tp's (indiv and corps) can choose which annual period to use. Allows flexibility and lets tax correspond with "natural" fiscal years used in measuring financial accounting income.

Year end is last day of a month, except a 52-53 week year

Problem: "mismatched" years used for deferral

example: a 2/1 to 1/31 entity transfers profit at its yearend to a calendar year owner.

To prevent abuse, Partnerships & S-Corps are limited in choice of year -- same as owners, or a tax adjustment that's equivalent to interest on the deferral

Changing a year requires IRS consent

Concern again over "artificial" deferral. A "short year" is used for the changeover. Tp must "annualize" in calculating short year tax (prevents use of lower brackets for tax savings)

Methods of Accounting: Cash or Accrual

A "method" is a consistent way of handling similar transactions. Rules Tp follows as to when income and expenses are recognized.

Cash method accounting

Income when money received, deduction when expense paid. Is not GAAP, because it sacrifices matching for ease of use and showing ability to pay. Almost all individual Tp's and small businesses use cash method. Tp has some timing control, thru speedup or slowdown of billings or payments. Many limits to prevent excessive income distortion.

Limit: Multiyear assets: cash method taxpayers have to depreciate business property and amortize prepayments that extend beyond the following year

Limit: Entity Size: Book/tax conformity not required in practice, but corporations w/ over $5 mm trailing gross receipts must accrue (unless they are professional service corps.)

Limit due to nature of business. Merchandise businesses must take inventories and accrue. Hybrid possibility. (New, uncertain extent exception for small businesses)

Limit: Constructive Receipt: Item is cash method income when available to / under the control of the taxpayer or taxpayer's agent, even if not actually taken into possession

But see xx Horning v. CIR

Limit: Original Issue Discount: Imputed interest from a debt instrument issued below the amount to be paid at maturity must be accrued, even if Tp is otherwise cash method. Exception for certain savigs bonds.

Accrual Tax Accounting

Generally like GAAP, measuring rights and obligations rather than cash flows. Many differences, due to politics or policy.

Prepaid receipts. Generally are income when received, even if earlier than GAAP recognition. Theory is that this assures gov't. of payment. Limited exceptions for goods and services to be delivered in following year.

Already seen incentive to income shifting caused by progressive rate structure

Income from work: taxed to the person doing the work xx Lucas v. Earl

Income from property: taxed to the owner of the property xx Helvering v. Horst

Daily accrual of interest (tho note CD rule); dividends on the record date

Related Party Transactions. Tax Code Sec. 482 allows IRS to reallocate income and deductions among businesses under common control. Most important multinational tax rule