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Most forms of gross income are taxed, but when tax liability is incurred depends on when the income was received and the accounting system that the taxpayer uses. Special rules may also apply to particular types of income. Gross income includes any type of income received: money, property, services, or any other form of compensation. It also includes investment income and gifts, although gifts and bequests are rarely taxed since there is a large tax exemption for both.
The tax code also distinguishes between ordinary income and capital gains, since different tax rates apply to these forms of income. Ordinary income is generally taxed at the taxpayer's marginal rate, while capital gains have special rates that usually do not depend on the taxpayer's income. In some transactions, income received must be decomposed into capital gains and ordinary income. For instance, when a bond is sold between interest payment dates, then the buyer of the bond pays more because of the accrued interest, so part of the income received by the seller is accrued interest and part may be capital gains. The accrued interest must be recognized as ordinary income rather than capital gains.
When money is received in which there is an obligation to repay, such as when a landlord receives a deposit or when a borrower receives a loan, then there is no recognition of income unless the obligation to repay is terminated.
Sometimes, an assignee or agent of the taxpayer receives the income. Nonetheless, the taxpayer is still liable for the tax. An assignment of income does not shift the tax liability to the assignee – it remains with the assignor. Income received by employees working for an employer is taxable to the employer. When a child earns income for personal services, such as acting, then the amount is included in the child's gross income even if the money is paid to the parents.
Income earned from the sale of property is subject to taxation, but the amount taxed is limited by the recovery of capital doctrine — taxable income is equal to the selling price of property minus the purchase price. So if the taxpayer buys $5,000 worth of stock and later sells it for $10,000, then only $5,000 of that amount is taxable, even though $10,000 was received, since the other $5,000 was simply a recovery of the invested capital. Likewise, a buyer of a bond with accrued interest must pay for that accrued interest, so the bondholder can subtract the accrued interest from her interest income for the tax year. The tax basis of the bond is also lowered by the amount of the accrued interest, so when the bondholder sells the bond, the capital gain is increased or the capital loss is decreased by the amount of the subtracted accrued interest.
The tax code also allows different methods for recognizing some income. The installment method allows the income to be recognized over a period of years, even if all of the income had been received in the first year. Contractors, for instance, can use the percentage of completion method which reports income as the work is completed or it can defer all profit until the project is completed, which is known as the completed contract method. However, the completed contract method is only available in restrictive circumstances.
Gross income is only recognized when payment is certain. Dividends, for instance, are taxable to the taxpayer if he was the owner of the stock on the date of record for the dividend payment. Otherwise, dividends do not accrue because whether dividends are paid depends on whether the corporation's board of directors approves the dividend and the taxpayer actually owns the stock on the date of record.
The taxable year is the basic unit of time in which income is totaled and taxed. The taxable year is an important component in determining the tax that an individual or business has to pay, since tax rates change from year to year and because most taxes on earned income are progressive. Most people and businesses use the calendar year to report their income. However, for some businesses, it is more natural to use the fiscal year, which is a taxable year that ends on a month other than December. However, partnerships, S corporations, and personal service corporations cannot use the fiscal year.
Income must be reported when it is constructively received. The constructive receipt doctrine stipulates that income is received when it is available to the taxpayer without limitations or restrictions. So if the taxpayer receives her check in December but she doesn't cash it until the following year, she still must report the income for the previous year. However, if her employer told her to hold off depositing the check because he had insufficient funds, then she can report the income for the following year since it was not available for certain.
Income with substantial restrictions is generally not taxable. For instance, although the cash value of ordinary life insurance increases year after year, it is not taxable to the policyholder, because the policyholder must cancel the policy to actually receive the cash surrender value, when the value would be known for certain. Therefore, the annual increase in the cash value of the policy is not taxable to the policyholder. Likewise, if stock is issued to employees that cannot be sold until later, then the income is not taxable to the employees until the restrictions are removed.
One common exception to the constructive receipt of income is the earning of interest from original issue discount bonds. Many bonds do not pay periodic interest, but are issued at a discount to the face value of the bond. Interest is paid at maturity, which is equal to the par value paid at maturity minus the discounted price. Although the bondholder does not actually receive interest annually, he must report the interest annually, nonetheless. However, interest recognition for original issue discounted bonds does not apply to bonds with a term of one year or less from the date of issue. So if a taxpayer buys a 26-week T-bill in October 2011, then tax liability on the interest is not incurred until the 2012 tax year.
Interest on United States Savings Bonds are exempt from this interest reporting requirement, since taxes are deferred until the bondholder actually receives the interest, unless the taxpayer elects to report the accrued interest, in which case the election applies to all savings bonds that the bondholder owns and to all future purchases of government savings bonds.
Prepaid rent or interest is always taxable in the year received. The income earned from advance payments for goods can be deferred if the method of accounting for the sale is the same for tax and financial reporting purposes.
Accounting methods are the means of determining when income is received and expenses are paid so that profit can be determined for a specific time period. Although accounting methods are based on fundamental accounting principles, different systems do differ in small ways, according to their objective. For instance, financial accounting provides information to management, shareholders, creditors, and other stakeholders. Hence, to protect their interests, financial accountants frequently understate the value of assets or income so as not to mislead stakeholders. However, tax authorities take a dim view of understatement of income since that would reduce the tax. So tax accounting differs in some ways from financial accounting to conform to the requirements of tax law. For instance, prepayments are not treated as income until they are earned according to financial accounting principles, but the income is taxable in the year that it is received.
There are 2 primary methods of accounting that differ in when income and expenses are recognized:
Under the cash receipts method, cash, property, or services are included in the taxpayer's gross income in the year of actual or constructive receipt either by the taxpayer or by the taxpayer's agent.
Under the accrual method, gross income must be reported when it is earned, regardless of when the income is actually collected, because the taxpayer has a right to receive it. The income is earned when the amount is known with reasonable certainty and when everything occurred that was promised in exchange for the income. This includes completing services for the customer or transferring the title of the property to the buyer. However, if there is a dispute as to the payment, then the income does not have to be reported until it is actually received, since the amount of the receipts cannot be determined with reasonable accuracy.
Revenue Procedure 71-21 allows the accrual basis taxpayer to defer recognition of income for advance payments for services if the services have been completed by the following tax year of the prepayment. For instance, if a service corporation sells a 12 month service contract and receives the full amount at the end of June, the corporation only has to recognize one half of that income for the current tax year and one half of the income for the next tax year. However, if the customer prepaid a 24-month contract in June 2011, then the corporation would have to recognize the entire amount in the year received, since by the end of 2012, there will still be unearned income from services provided in 2013.
Most individuals use the simpler cash accounting method while most corporations use the accrual method. However, the hybrid method is sometimes used by businesses with inventory. Tax law requires businesses to use the accrual method of accounting to account for inventory and its sale, but many businesses with inventory also use a cash basis for all other income and expenses because of its simplicity.
One requirement of any accounting method is that the method must accurately reflect income. IRC §446(b) gives the IRS broad authority to determine whether the accounting method used by the taxpayer clearly reflects income. If it does not, then the IRS can calculate taxes for a taxpayer under an accounting method that more accurately reflects the taxpayer's income.