Wassim Zhani Federal Taxation Chapter 5 Gross Income.pdf

Gross Income
Solutions to Tax Return Problems
5-52 The treatment of the various items is discussed below.
1. David’s salary of $70,000 is taxable and is reported on line 7 of Form 1040. The withholding is
treated as a credit against the taxes owed and is reported on line 54 of Form 1040.
2. The $3,000 bonus is taxable as wages. The bonus is reported in the current year under the doctrine of
constructive receipt. As a practical matter, the bonus should be included with the wages reported on his W-2.
3. The total sales price of the bond must be reduced by the $700 of interest accrued to the date of the
sale. This interest is reported as interest income on line 8. The sale of the bond results in a capital loss
of $1,000 ($9,000 $10,000). This amount should be reported on Schedule D and line 13.
4. The Gibbs report none of the $30 as income because they do not own the bonds. Income from
property is taxed to the owner of the property.
5. The lottery winnings of $50 are fully taxable.
6. The sale of the stock results in a long-term capital loss of $4,000 ($10,000 $14,000). The loss is
reported on Schedule D.
7. Barbara’s income from self-employment of $5,000 is reported on Schedule C along with the deduction
of $100 for the software. The net income of $4,900 is subject to self-employment tax.
8. The medical expenses of $7,468 are deductible to the extent they exceed 7.5% of the couple’s A.G.I. or
$1,820 [$7,468 (7.5% × $75,304 ¼ $5,648)]. The mortgage interest $8,500 on a primary or
secondary residence is fully deductible, as are the property taxes of $5,000, state income taxes of
$3,750 and the charitable contributions of $2,000 for a total of $21,070. Because the itemized
deductions exceeds the standard deduction, it is better for the taxpayers to itemized their deductions.
9. The Gibbs are entitled to the child tax credit since both children are less than 17 years of age and are
claimed as dependents. The credit is $1,000 per child for a total of $2,000. The child tax credit is
phased out if income exceeds a certain threshold but the Gibbs income does exceed this amount so the
phase-out does not apply and consequently the Gibbs are allowed the entire credit of $2,000.
10. The solution ignores the temporary reduction in the self-employment tax in 2011.
5
5-1

Tax Return Problem 5-52
5-2 Chapter 5 Gross Income

Tax Return Problem 5-52 - continued
Solutions to Tax Return Problems 5-3

Solutions to Tax Research Problems
5-53 The taxation of free samples is unclear and has generated little litigation. Under a rigorous application of
the Glenshaw Glass doctrine, which takes an all-inclusive approach to income, the samples would be taxable
even if the taxpayer took the unusual step of returning the sample. It is doubtful whether the courts would
take such an extreme view, however. No doubt the IRS normally assumes that the samples are of such little
value that their taxation is not warranted.
5- Nevertheless, in Revenue Ruling 70-498, 1970-2 C.B. 6, free books provided to a book reviewer were
considered income when the books were given to a charity and a charitable deduction was claimed. The
Seventh Circuit held similarly in Haverly v. U.S. [513 F.2d 224 35 AFTR2d 75-1082, 75-1 USTC {9326
(CA-7, 1975)], where the principal of a public school received sample textbooks sent by publishers and
claimed a charitable contribution deduction for the donation of the books to the school.
5-54 This situation concerns proper identification of the taxpayer. Specifically, to whom is income for personal
services taxable if earned by a person who, under a vow of poverty, is required to turn over the earnings to
a religious order? In Revenue Ruling 76-323, 1976-2 C.B. 18, two taxpayers were members of a religious
order that required them to turn over all of their income while the order paid their living expenses. In this
situation the taxpayers obtained employment as plumber and construction worker respectively and directed
that their earnings be paid to the order. The Court held that the income was taxable to the taxpayers
because it was their income. Although a charitable contribution deduction was allowed for the payments to
the order, it was restricted to the normal percentage limitations (50% adjusted gross income). Also see
Revenue Ruling 77-290, 1977-2 C.B. 26 for a similar holding. In contrast, Revenue Ruling 68-123, 1968-1
C.B. 35 considered a situation where the religious order’s purpose is to supply personnel to missions,
hospitals, and schools. The order negotiated for these jobs on behalf of its members. The order assigned a
nurse to work at a hospital and made all the arrangements for the job. The ruling held that the taxpayer
nurse was an agent of the order and was not taxable on the payments made by the hospital to her.
5- Given these rulings, it would appear that taxation of the earnings to R depends on whether she is
considered an agent of the order. If the order negotiates a job position for her and makes all the necessary
arrangements, the Service would allow R to escape taxation. Conversely, if R finds her own job and simply
directs that her earnings be paid over to the order, she would be taxed on the earnings. (Also see Letter
Ruling 8105008.)
5-55 a. This is a simple illustration of the assignment of income doctrine originally enunciated in Lucas v. Earl
(see footnote 87 on p. 5-35; see also Seatree 25 BTA 396.) According to this doctrine, income is taxed
to the taxpayer who earned the income, which in this case is clearly Dr. A. Under the assignment of
income doctrine, Dr. A is responsible for the income because he earned it. (See p. 5-35.)
b. Whether R has income depends primarily on the extent to which he participated in the contract
negotiations and whether or not he has the right to receive or direct the use of funds. Revenue Ruling
53-71, 1953-1 C.B. 18 indicates that if the individual’s employer or superior makes his services
available to a third party, and the individual neither participates directly in the contractual
arrangements, nor has the right to receive or direct the use of the amounts paid, the amounts will
not be included in income. See also Revenue Ruling 68-503, 1968-2 C.B. 44. See also Revenue Ruling
77-121, 1977-1 C.B. 17, where a pari-mutuel race track that donated “Charity Day” race proceeds to
an exempt charitable organization did not have includible income.
Note that the issue is significant, notwithstanding the fact that R would be entitled to a charitable
contributions deduction if he performed the services, received payment, and then contributed the
proceeds. This is true because the charitable contribution deduction is limited to 50 percent of the
taxpayer’s adjusted gross income.
c. The issue in this situation is whether the power to dispose of income is the equivalent of ownership of
it. Early decisions concerning this question answered in the affirmative. (See, for example, Helvering v.
Horst (footnote 82), and Revenue Ruling 58-127, where a taxpayer submits an entry in a contest and
wins a prize payable to his child.) In Teschner, 38 T.C. 1003 (1962), however, the Court ruled that the
assignment of income doctrine applies only when the assignor is entitled to receive the income, or has
the right to receive it and subsequently assigns it away. An individual cannot escape taxation on
income to which he is entitled by turning his back on the income; however, he must have the right to
receive the income. Here the taxpayer (T) does not have that right, and thus the income is not taxable
to him.

5-56 When property is transferred to satisfy a debt, the transaction is the economic equivalent of a sale of the
property for cash that is used to pay off the debt. The principal question raised in such a situation (which is
the case here) is whether the transfer does in fact trigger recognition of gain. The problem was aptly stated
in the landmark case of U.S. v. Davis, 370 U.S. 65 (1962) where, pursuant to a divorce agreement, the
taxpayer transferred appreciated stock to his spouse in settlement of his marital obligations. According to
the Court, there was little “doubt that Congress, as evidenced by its inclusive definition of income subject to
taxation (i.e., ‘all income from whatever source derived, including … [g]ains derived from dealings in
property’), intended that the economic growth of this stock be taxed. The problem confronting us is simply
when is such accretion to be taxed.”
5- Since the Supreme Court’s decision in Eisner v. Macomber, it is generally presumed that the appreciation
in the value of property is not taxed until it has been “realized” in some manner. However, this principle is
not explicitly adopted in the Code and should not be considered sacrosanct. Many commentators have
indicated that the taxation of unrealized appreciation is not unconstitutional. In this regard, economists have
argued that holding an asset is the functional equivalent of selling the asset and reinvesting the proceeds in the
same asset. Nevertheless, conventional wisdom assumes that the realization principle is implicit in §61(a)(3),
which provides that income includes gains derived from dealings in property. Likewise, § 1001, in prescribing
the method for computing gains and losses, implicitly adopts the realization principle, referring to gains or
losses derived from “the sale or other disposition of property.”
5- It should be emphasized that the Code sections alluded to above should not be construed to mean that
in order for there to be realization there must be a sale of the property. As suggested in the Davis decision,
the term disposition, as well as the all-inclusive definition of gross income contained in §61, are sufficiently
broad to reach all gains regardless of source. Thus, as indicated above, the critical question in this situation
is whether the taxpayer is considered as having “realized” the income.
5- In the absence of specific rules contained in the Code or Regulations, the question of realization in
this instance has been left to the courts. In general, the courts have chosen to distinguish the tax
consequences arising from transfers of appreciated property by gift from those made to satisfy a debt.
With respect to a transfer made to satisfy a debt, the courts have viewed this as being a taxable event
because of its similarity to a sale of the property for cash followed by a payment of the proceeds to the
creditor [see Simms, 28 B.T.A. 988, 1029 (1933)]. This view derives from the implication that the phrase
“sale or disposition” (or alternatively, the term “realization”) suggests that the taxpayer has received
valuable consideration in exchange for his transfer. In contrast, where the transfer is by gift or bequest,
this quid pro quo aspect is lacking.
5- As a general proposition, Congress has chosen not to analogize gifts and bequests to sales. This
approach is suggested most prominently by § 1015(a), which requires that the donee assume the basis of the
donor where appreciated property is transferred. The underlying rationale for this basis provision is that
the transfer of property by gift is not a taxable event. Rather, any gain or loss is to be recognized later when
the property is disposed of by the donee. In the case of a bequest, this same rationale is not so apparent,
since the basis of the property is stepped up or down to its fair market value at date of death. Nevertheless,
Congress has never attempted to tax the appreciation.
5- As suggested above, the courts generally have required the taxpayer to recognize gain when appreciated
property is transferred in satisfaction of a claim or when the court has found the requisite quid pro quo. In
International Freighting Corp., 43-1 USTC {9334, 135 F.2d. 310 (CA-2, 1943), the employer recognized
gain when stock was transferred to employees under a bonus plan, apparently on the theory that the
employer had received the services of the employees in exchange for the property although there was no
preexisting debt. Similarly, in General Shoe Corp., 60-2 USTC 9552, 282 F.2d. 9 (CA-6, 1960), an employer
who contributed real estate to an employees’ trust was required to realize gain. (See also Tasty Baking Co.,
68-1 USTC {9366, 393 F.2d. 993; Rev. Rul. 73-345, 1973-2 C.B. 11; and Rev. Rul. 75-498, 1975-2 C.B. 29.)
In McDougal, 72 T.C. 720 (1974), the taxpayer gave another a 50 percent interest in the capital and profits
of a joint venture (a horse and its winnings) as compensation for services. The Court held that the taxpayer
had realized a gain on the transfer to the extent that the value of the one-half interest exceeded his adjusted
basis. Thus, it would appear clear that the taxpayer in the present situation must recognize gain on the
transfer of property in payment of the claim.
5- Arguably, it could easily follow that the taxpayer should recognize gain on any transfer of appreciated
property. However, the Service generally has recognized the distinction between gifts and payments. As
early as 1920, the IRS ruled in O.D. 667, 3 C.B. 52 (see also Rev. Rul. 55-117, 1955-1 C.B. 233) that a
decedent’s estate did not realize gain on transferring property to the residuary legatees under the will.
Although the legatee could be considered as having a claim against the estate, the claim is not a right to a
specified dollar amount, but a right to receive the property itself, regardless of its value at the time of
distribution. Since the estate is not obliged to pay a specific amount, but rather to distribute the property,
there is no gain or loss inuring to the estate or other beneficiaries, and consequently the distribution is not a
taxable event. In contrast, however, in Suisman v. Eaton, 15 F.Supp. 113 (D. Ct. Conn., 1935), aff’d per
Solutions to Tax Research Problems 5-13

curiam, 83 F.2d. (CA-2, 1936), the distribution of property to satisfy a bequest of a specific dollar amount
was held to be taxable. [See also, Kenan v. Comm., 114 F.2d. 217 (CA-2, 1940).]
5- With this background, it is easy to conclude that, like the satisfaction of a pecuniary bequest, the
satisfaction of a charitable pledge with property is a taxable event. The Service has rejected this argument,
however, in Rev. Rul. 55-410, 1955-1 C.B. 297. According to the ruling, the IRS noted (rather
unsatisfactorily) that it would be inconsistent to treat a charitable gift as both a gift and a satisfaction of
debt. Perhaps the real justification for this position lies in the inequity that would result without the rule.
5- Note that without the rule, the taxpayer would be unintentionally trapped for filling out a pledge card
indicating a gift of a specific dollar amount, then satisfying it with property. This prospect could easily have
been avoided by specifying a gift of particular property. As a result, the taxpayer would not be taxable on
his or her gift of property to the charity.
5- The above ruling provides a great opportunity for taxpayers. Assume that a taxpayer has appreciated
property worth $100, and for simplicity’s sake, a basis of $0. Assume also that he pays taxes at the rate of
70 percent. If the taxpayer sold the property, he would recognize a gain of $100 ($100 $0), pay taxes of
$70 (70% $100), and consequently keep $30 ($100 sales proceeds $70 tax). Had the taxpayer given the
property to the charity, he would have been better off than selling it: the contribution would have produced
a tax savings of $70, which is $40 greater than the $30 that he would have had if he had sold the property.
Because of this possibility, Congress revised the charitable contribution rules in 1970, requiring the taxpayer
to reduce the amount of his charitable contribution by the amount of ordinary income that would be
recognized on the sale. Thus, in the above case there would be no contribution. This rule does not apply
where capital gain property is contributed, however. Consequently, if a taxpayer is planning to give a
certain amount to a charity, he would be well advised to transfer property equal to such amount in lieu of
selling the property and giving the cash. By so doing, he would reduce the cost of his charitable contribution
by the tax he did not have to pay had he sold the property and contributed the proceeds.
5-57 The facts of this situation present two issues that should be addressed: (1) Does the company’s payment of
Sellit’s expenses represent taxable income; and (2) if the payment must be included in gross income, does the
taxpayer have an offsetting deduction for the expenses incurred? The leading cases on this issue are
Patterson v. Thomas, 61-1 USTC {9310, 289 F.2d 108 (CA-5, 1961) rev’g and rem’g 59-2 USTC {9734 (D.
Ct. No. Alabama, 1959) and C.J.D. Rudolph, 62-2 USTC {9543 (USSC, 1962).
5- In Patterson v. Thomas, the taxpayer, J. C. Thomas, was employed by Liberty National Life Insurance
Company as an insurance salesman. By attaining certain standards of this employer, he was invited into the
membership of company’s Torch Club, composed of outstanding field representatives. As part of his
admittance to the membership, he was asked to attend the company’s annual Torch Club Convention.
Although attendance at the convention was not a condition of continued employment, failure to attend was
frowned upon and adversely affected the taxpayer’s future promotion. Thomas and his wife attended the
convention, which was held at a resort hotel. Some of his expenses for attending the convention were paid
directly by the employer, and he received reimbursement for the remainder. On his tax return, Thomas did
not report the reimbursement or direct payment as income nor did he deduct the expenses of his trip. Upon
examination, however, the IRS asserted that the amounts received and paid on his behalf were income, and
more importantly, his expenses were nondeductible. According to the view of the IRS, the trip constituted
the prize in what in substance was an annual sales contest.
5- Upon review, the District Court held for Thomas. In the court’s opinion, attendance at the meeting by
the taxpayer served a bona fide business purpose. The court found that the purpose of the meetings of the
Club and the nature of the programs promoted the professional knowledge, skill, attitude, and morale of
agents and their wives. In addition, it found that the taxpayer was required to attend. Moreover, while at
the meeting he was required to attend the scheduled activities over which he had no control. The fact that
tours and entertainment were provided did not, in the court’s view, detract from the genuine business
character and purpose of the meeting. The court did not view the meeting as some type of bonus or reward.
As a result, it held that the amounts received did not constitute gross income; or if they did, then the
expenses were deductible by the taxpayer as ordinary and necessary business expenses.
5- With respect to the expenses for the wife, the court found that her presence also served a bona fide
business purpose. This was evidenced by the company’s employment practices. The company interviewed
prospective agents’ wives and sent literature to them on how they could help their husbands to become more
successful in the business. The company believed that it was in the best interest of its business to take the
steps necessary to maintain the loyalty of the wife and involve her with her husband’s business. The court
also noted that the wives’ presence at such meetings ensured a better meeting, eliminating the occasional
misconduct that occurs with stag affairs. Accordingly, the court held that the expenses of Mrs. Thomas were
deductible or, alternatively, the reimbursement was not income.
5- The Court of Appeals did not share the District Court’s opinion. At the appellate level, the court first
explained that the treatment of the expenses by the company had no bearing on the treatment by the

taxpayer. It pointed out that an all-expense paid vacation trip to Florida may increase the employee’s
efficiency and be a business expense to the employer, but that this did not change the fact that to the
recipient the trip is solely for pleasure and is in the nature of a bonus or reward.
5- According to the Fifth Circuit, the crucial issue was determination of whether the primary purpose of
the trip was business or pleasure. In determining the purpose, the court examined several factors. First, the
court focused on the amount of time spent on personal activity relative to the amount of time spent on
business. In this regard, it was determined that at most five hours out of 31
=2 days were spent in formal
business meetings. Although the court was somewhat sympathetic to the taxpayer’s argument that while
“playing” he could gain business insights and improve his abilities as a salesman, other factors suggested
otherwise. For example, the court viewed as unfavorable to the taxpayer the fact that the meeting was held
at a resort. Apparently, this factor, when combined with the amount of time spent in formal meetings,
helped to convince the court that the purpose of the meeting was pleasure rather than business. Moreover,
in reviewing the company’s attitude toward the meeting, it found that the company looked on the trip as
one primarily devoted to pleasure. For example, company correspondence indicated that the business was
secondary and the main object was to have a good time. Based on its findings, the Appellate Court
believed that the opinion of the District Court was clearly erroneous and reversed the trial court’s
decision. As a result, the taxpayer was allowed a pro rata deduction for the amount of time spent at the
business meetings, but no deduction was allowed for his travel expenses because the purpose of the trip
was not primarily for business.
5- In a vigorous dissent, Justice Brown characterized the position of the taxpayer as that of an
“organization man” whose expenses were not a voluntary, but an involuntary, part of his business. He
pointed out that the taxpayer had nothing to do with picking out the location. Moreover, the taxpayer had
no choice over whether or not to attend. Instead, in Judge Brown’s view it was an obligatory appearance
over which the taxpayer had no control. Thomas was compelled to take the trip as a matter of business
necessity. Apparently Judge Brown’s argument fell on deaf ears.
5- The Rudolph case presents a fact situation similar to that of Mr. Thomas. In this case, the taxpayer sold
insurance for Southland Life Insurance Company located in Dallas. By having sold a predetermined
amount of insurance, the taxpayer qualified to attend the company’s convention in New York City and, in
line with company policy, to bring his wife with him. The taxpayer along with his wife and others traveled
to and from New York by train, and were housed in a single hotel during their two and one-half day visit.
One morning was devoted to a business meeting and group luncheon, and the rest of the time was spent
seeing New York. The company paid for the trip.
5- The District Court, with guidance from the Alabama District Court’s decision in Patterson v. Thomas,
examined the facts to determine the primary purpose of the trip. According to the court, the fact that the
convention was held in a remote place was in and of itself sufficient to cause the trip to be personal.
Accordingly, the taxpayer’s deduction was denied. Upon appeal to the Fifth Circuit, the court saw no
difference between this and the Thomas case and so held. Justice Brown once again dissented!
5- The taxpayer in Rudolph was allowed a final review by the Supreme Court. At this level, the taxpayer
initially argued that the reach of §61 defining gross income did not extend to such trips and consequently the
payment should not be taxable. According to the taxpayer’s view, the trip was a nontaxable fringe benefit.
The Court rejected this view however, noting little more than that the sweeping scope of § 61 was
established in Glenshaw Glass, 55-1 USTC {9308. The Court emphasized the purpose of § 61 was “to
include as taxable income any economic or financial benefit conferred on the employee as compensation,
whatever the form or mode by which it is effected.” The Court appeared to adopt the view that the trip was
in the nature of a reward or bonus given to employees for excellence in service. Accordingly, given the
Court’s belief that the amount was not a nontaxable fringe benefit but rather taxable income, the remaining
question was whether the taxpayer had an offsetting deduction.
5- According to the Court, the critical question was whether the purpose of the trip was related primarily
to business or was rather primarily personal in nature. The taxpayer used Justice Brown’s lines and argued
that he was an “entrapped organization man,” required to attend such conventions and that his future
promotion depended on his presence. The Court did not share the taxpayer’s opinion, however. Instead, it
agreed with the District Court, which found that the taxpayers regarded the convention as a pleasure trip in
the nature of a vacation.
5- The hard line taken by the courts in the cases above should not be seen as an impossible hurdle. Other
cases have been more receptive to the taxpayer. In Peoples Life Insurance Co. v. U.S., 67-1 USTC {9301
(Ct. Cls., 1967), the court examined the agenda for the meeting and determined that it was primarily related
to business. Moreover, it found that the taxpayer’s attendance at the meeting was motivated by business
intent and the pleasure seeking activities were not consequential. Similarly, in U.S. v. John Gotcher, 68-2
USTC {9546 (CA-5, 1968), the Fifth Circuit took a different approach. Here the taxpayer and his wife
received an expense paid trip to Germany from Volkswagen and his employer so that they might tour the
factories and facilities and make a decision on a purchase of a Volkswagen dealership. One of the key

factors distinguishing Gotcher from Patterson and Rudolph was that the trip was in no way an award for
past service by Mr. Gotcher, since he was not an employee of Volkswagen and did nothing to earn that
part of the trip paid by his employer. In addition, the court was convinced in this case that the agenda
related primarily to business and any sightseeing was inconsequential. Accordingly, Mr. Gotcher was not
subject to tax.
5- As the discussion of the above cases suggests, the ultimate determination depends on the facts and
circumstances of each situation. In the instant case, the taxpayer may be able to demonstrate to the court
that sufficient time was spent on business activities to convince it that the trip was primarily for business.
5-58 The critical issue to be addressed in this fact situation is whether Large may properly rely on its accrual
method of accounting to defer the warranty income until that period when it expects to provide the services.
Alternatively, even if Large is required to report the income when received, the situation could still be
partially salvaged if Large can deduct its estimates of the future costs of warranty work. Unfortunately, it
appears from the relevant authority that Large must report the prepayments currently and it will not be
allowed to accelerate the deduction of future estimated costs.
5- Sections 446 and 451 provide the ground rules for determining when a taxpayer reports income. Section
446 provides the general rules governing methods of accounting, stating that taxable income is computed
under the method of accounting used by the taxpayer in keeping his books. At first glance, it would appear
that this provision would allow Large to defer the income since that is the method it normally uses.
However, §446(b) creates an extremely important exception, giving the IRS the power to require the
taxpayer to use an alternative method if, in its opinion, the taxpayer’s method does not clearly reflect
income. As explained below, the IRS has used this authority in situations involving prepaid income to
require accrual basis taxpayers to report the income when received rather than when it is earned.
5- Section 451 rounds out the statutory authority governing the reporting of income. Under § 451, “the
amount of any item of gross income is included in the gross income for the taxable year in which received
by the taxpayer, unless under the method of accounting used in computing taxable income, such amount is
to be properly accounted for as of a different period.” Regulation § 1.451-1(a) elaborates, stating that an
accrual basis taxpayer reports income when the all-events test is satisfied. Specifically, accrual basis
taxpayers report income when all the events have occurred that fix the taxpayer’s right to receive such
income and the amount thereof can be determined with reasonable accuracy. A quick reading of the all-
events test would suggest that Large must report the income when it is received, given that the rights to such
income are fixed and the amounts are known. However, Reg. § 1.451-5 generally permits the taxpayer to
defer recognition of advance payments for goods until such time when the income is reported for financial
accounting. In Large’s situation, the advance payments are for future services, and unfortunately, the
Regulations are silent on the treatment of prepayments for services.
5- The Service has long taken the position that the reporting of prepayments for services is governed by
the claim of right doctrine. Under this doctrine, established early in the life of the tax law, a taxpayer must
report amounts as income in the year in which they are received and in which such income is not restricted
in use. In other words, earnings received must be included in income if the taxpayer has an unrestricted
claim. The IRS has used this theory consistently to argue that payments for services to be performed in the
future must be reported by an accrual basis taxpayer when received even though such amounts have not
been earned under traditional financial accounting principles.
5- In one of the first key decisions involving prepaid service income, the IRS secured a victory. In
Automobile Club of Michigan [57-1 USTC {9593, 50 AFTR 1967, 353 U.S. 180 (1957)], the taxpayer provided
various automobile-related services such as road maps and highway repairs to its members who paid annual
dues. The Club reported one-twelfth of the dues as income each month but the IRS contended that the income
should be reported as received. The taxpayer asserted that reporting the income when received as required by
the claim of right doctrine did not clearly reflect income since the taxpayer was on the accrual method.
Interestingly, the Court appeared to have agreed with this argument. However, the Court also believed that
the taxpayer’s arbitrary allocation procedure was purely artificial and no better than the method required by
the IRS. Consequently, the Court held that the IRS had not exceeded its authority in requiring the sums to be
reported when received, and consequently, the taxpayer was denied deferral.
5- Two years after the Michigan decision, the Second Circuit Court of Appeals reviewed a similar case
and found a different result. In Bressner Radio, Inc. [59-2 USTC {9496, 267 F.2d 3 AFTR2d 520 (CA-2,
1959)], the corporation sold televisions and entered into written contracts to install and service them for
12 months. Bressner’s experience showed that an average of 8 to 12 service calls would be made during the
term of the contract. Therefore, Bressner treated 25 percent of the contract price as revenue at the time
when the contract amounts were received. The Second Circuit found this method of accounting did clearly
reflect income. It interpreted the Supreme Court’s decision in Michigan as allowing deferral if the method
was not artificial but realistic. After Bressner, it appeared that taxpayers who were able to establish that
their method of allocating income was not merely arbitrary or capricious might be able to defer prepaid

service income. However, the Service quickly denounced this approach in Rev. Rul. 60-85, ruling that
prepaid service income that was received under a claim of right and without restriction as to its disposition
had to be reported as income in the year received. According to the ruling, this approach applied regardless
of whether the period of proration was definite (as in Automobile Club) or indefinite. As one might expect,
the Service did not relent.
5- The Supreme Court examined the issue again in 1961 and 1963. In the first case, American Automobile
Association (AAA) [61-2 USTC {9517, 7 AFTR2d 1618, 367 U.S. 687 (USSC, 1961)] the facts were
virtually identical to Michigan except in AAA the taxpayer presented “expert accounting testimony
indicating that the system used was in accord with generally accepted accounting principles; that its proof of
cost of member service was detailed; and that the correlation between that cost and the period of time over
which the dues were credited as income was shown and justified by proof or experience.” Relying on this
testimony, the taxpayer argued that it had demonstrated that its method of ratable deferral was not
artificial. The Court of Claims rejected this argument and the Supreme Court, recognizing a conflict
between Bressner and AAA decisions, granted certiorari. The Supreme Court upheld the Court of Claims
decision, emphasizing that substantially all services were performed on demand and the taxpayer’s
performance was not related to fixed dates after the tax year. The Court ambiguously dealt with the
taxpayer’s argument that statistical computations provided a rational approach for deferral.
Consequently, some taxpayers as evidenced by the litigation that followed believed that deferral might
be allowed if they could adequately demonstrate when the service income would be earned. Indeed,
shortly after the AAA decision, the Second Circuit noted that its view in Bressner was still valid
[Automobile Club of New York 62-2 USTC {9567, 10 AFTR2d 5001, 304 F.2d 781 (CA-2, 1962)]. In that
case, the court allowed deferral which was based on the taxpayer’s statistics, showing a “definite
monthly business experience and financial expectancy.”
5- The Supreme Court’s third look at the prepayment issue occurred in Schlude [63-1 USTC {9284, 11
AFTR2d 756, 372 U.S. 128 (USSC 1963)]. The taxpayers in Schlude operated dance studios and sold
contracts for a specified number of hours of dance lessons, ranging from five to 1,200. The contracts
specified the period during which the lessons had to be taken but the actual dates of lessons were arranged
from time to time as they were taken. When the taxpayer received the prepayments, a deferred income
account was set up. Then, at the end of each period, income was reported based on the number of lessons
completed to date. In certain cases, such as when there had been no activity in an account for a year, the
entire amount of the deferred income would be reported. The Third Circuit initially upheld the taxpayer’s
view, prior to the Supreme Court’s decision in AAA. On appeal, the Supreme Court (having issued its
decision in AAA), remanded the case back to the Third Circuit, which reversed its original decision.
However, the Supreme Court decided to look at the Third Circuit’s decision “to consider whether the lower
court misapprehended the scope of” AAA. Although the Supreme Court did affirm the Third Circuit’s
holding for the taxpayer, the fact that it reviewed the decision suggested to at least some that the AAA
holding was as broad as perhaps some had thought. The lingering doubt left by the trilogy of Supreme
Court cases offered hope to taxpayers who were willing to test the IRS. For example, in Artnell [68-2 USTC
{9593, 22 AFTR2d 5590, 400 F.2d 981 (CA-7, 1968)], the taxpayer was able to establish with the necessary
accuracy when the prepaid income would be earned and the court permitted deferral. In that case, the
Chicago White Sox baseball organization was able to show that amounts received for season tickets prior to
the end of their fiscal year (May 31) would be earned as each game was played over the balance of the
season. In distinguishing the case from AAA, the Seventh Circuit noted that the date when the services
would be provided was fixed and the services would not be provided on demand.
5- It was not long after Artnell, that the IRS relented somewhat. In Rev. Proc. 71-21, 1971-2 C.B. 549, the
Service allowed accrual basis taxpayers to defer the recognition of prepaid income from services if such
services were performed in the year following the year in which the advance payment was received.
However, § 3.08 of this Rev. Proc. specifically denies such treatment for warranty income. Consequently,
the IRS adhered to its view that warranty income was taxable in the year received.
5- Perhaps the most significant development since the three Supreme Court cases occurred in RCA Corp.
v. U.S. [81-2 USTC {9783, 664 F.2d 881 (CA-2, 1981) reversing 80-2 USTC {9622 (D.C., NY, 1980)].
Interestingly, this case ultimately came before the Second Circuit that had previously rejected a broad
reading of AAA. RCA, an accrual basis taxpayer, contracted with purchasers of its products to provide
service and repairs for a stated period in exchange for prepayment of a single lump sum amount. Under the
contract, the services were provided on demand at any time during the term of the contract. RCA did not
report the income when received. Instead, it deferred the income until that period when it expected to
provide the services, a method which was in acceptance with generally accepted accounting principles. The
postponement of income to a particular period was based on forecasts developed using sophisticated
statistical methods. Perhaps following the lead of the Second Circuit, the District Court agreed with the
taxpayer. According to the District Court, it felt that the language used in AAA was far from clear. The
Court believed that a taxpayer was entitled to rely on reliable statistical projections of anticipated expenses

in determining the extent to which prepaid amounts should be included in gross income. Moreover, it
emphasized that the IRS could not reject a deferral method of accounting simply because the deferred
revenues related to services to be performed at unspecified times in subsequent tax years. The Court also
rejected a second government argument that the IRS could reject any method of accounting that deferred
the inclusion of prepaid income, unless authorized by statute. In so doing, the Court noted that the Code
specifically allows the accrual method of accounting. According to the Court, the ultimate question was
simply whether the taxpayer’s method of accounting clearly reflected income.
5- Although the District Court decision in RCA seemed well-reasoned, the Second Circuit surprisingly
reversed it and thereby rejected its previous position. The Court began its assault on the lower court’s
decision citing Thor Power Tool and noted the vastly different objectives of financial and tax accounting. It
noted that the District Court gave too little weight to the objectives of tax accounting and to the
Commissioner’s wide discretion in implementing those objectives. Moreover, it emphasized that it was the
reviewing court’s job not to determine whether a taxpayer’s method of accounting clearly reflected income
but whether there was adequate basis in law for the Commissioner’s conclusion that it did not. Thus, it
proceeded to examine whether the IRS had abused its discretion.
5- Relying on the Supreme Court’s decision in AAA and Schlude, the court stated that:
5- … when a taxpayer receives income in the form of prepayments in respect of services to
be performed in the future upon demand, it is impossible for the taxpayer to know, at
the outset of the contract the amount of service that his customer will ultimately
require, and, consequently, it is impossible for the taxpayer to predict with certainty the
amount of net income …
5- The Court concluded that warranty income was income in the year of receipt, and, just as important, the
IRS did not abuse its discretion in rejecting the RCA’s method of accounting.
5- An alternative approach that the taxpayer might consider concerns acceleration of the deduction for
estimated costs of the warranty work to the period in which the warranty income was recognized. As a
general rule, an accrual basis taxpayer may deduct expenses if the all-events test is satisfied, that is, the
obligation is fixed and the amount can be determined with reasonable accuracy. Although Large could
arguably deduct its estimated cost under this basic rule, § 461(h) adds an additional requirement. No
deduction can be accrued until economic performance occurs. In the case of services, economic performance
occurs when the taxpayer provides the services. Consequently, § 461(h) eliminates any hope of accelerating
the deduction for estimated warranty costs.
5-59 RT Haulers is an accrual basis taxpayer with a December 31 tax year-end. RT provides delivery services to a
variety of customers. Under the current terms of these agreements, RT’s customers cannot reject RT’s
performance of services without penalty or obligation. However, RT proposes changing its agreements with
its customers to provide for a seven-day acceptance period after performance of transportation services in
which the customers can reject the performance of any services without penalty or any obligation (the “seven-
day acceptance period”). RT has requested guidance regarding how the proposed change in terms, specifically
the offer of a seven-day acceptance period, will affect the Federal income tax treatments of service revenues.
5- As a general rule, under the accrual method of accounting, income is recognized for Federal income tax
purposes when (1) all events have occurred that fix the right to receive such income, and (2) the amount can
be determined with reasonable accuracy. Under this so-called “all events test,” it is the fixed right to receive
the income that is controlling and not whether there has been actual receipt of income.1
5- In the seminal case of U.S. v. General Dynamics2
, the U.S. Supreme Court considered the so-called “all
events test” in the context of determining when expenses for services may be deducted. The court stated that
“[i]t is fundamental to the ’all events test’ that, although expenses may be deductible before they become
due and payable, liability must first be established.” (Italic added.) This statement is critical because,
although the Court in General Dynamics was addressing the application of the “all events test” for purposes
of the timing of deductions, the same “all events test” considered in General Dynamics applies to the timing
of income recognition3
, Therefore, based upon the Court’s reasoning in General Dynamics, it is appropriate
to conclude that although income may be recognized for Federal tax purposes before it becomes due and
payable, the payor’s liability must first be firmly established in order for income to be recognized.
1
Charles Schwab v. Commissioner, 107 TC 282 (1996), aff’d 161 F.3d 1231 (9th Cir. 1998), cert. denied 120 S.Ct. 67 (1999).
2
481 U.S. 239 (1987).
3
Compare Treasury regulations § 1.446-1(c)(1)(ii); § 1.451-1(a); and § 1.461.1(a)(2)(I). See also Revenue Ruling 98-39 and citations
therein, including Schneer, infra.

5-
In General Dynamics, the taxpayer argued that it was entitled to deduct certain employee medical expenses
where the medical services had been performed, but for which the employee had not yet submitted a
request for reimbursement to the taxpayer. The Supreme Court found that the employees’ submissions of
claims for reimbursement, and not the performance of services, gave rise to the taxpayer’s legal obligation
to make payment. Thus, the Supreme Court held that the taxpayer could not deduct employee medical
expenses where the services had been performed but for which the employees had not filed claims for
reimbursement. The Supreme Court observed, “[i]t is fundamental to the ‘all events’ test that, although
expenses may be deductible before they have become due and payable, liability must first be firmly
established.”
5- The General Dynamics decision is important in analyzing when the all events test requires revenue
recognition for revenues generated by the provision of services. In General Dynamics, the all events test was
not met until some time after the underlying services had been performed. That is, the all events test was not
met until the legal obligation to make payment arose, even though the underlying performance of services
had already occurred. The Supreme Court considered the importance of the timing of the performance of
services for purposes of the all events test and observed, “[m]ere receipt of services for which, in some
instances, claims will not be submitted does not, in our judgment, constitute the last link in the chain of events
creating liability for purposes of the ‘all events’ test.” Although the Supreme Court in General Dynamics
considered the all events test in the context of the timing of deductions, the same all events test applies to the
timing of revenue recognition.4
Thus, General Dynamics directly supports the proposition that the all events
test does not require the recognition of services revenue until the legal right to receive payment for such services
arises—even though the legal right arises after the performance of the services.5
5- Several Tax Court decisions have considered the application of the all events test for purposes of
recognizing service revenue. In Schneer v. Commissioner6
, the Tax Court considered the timing of
recognition of income derived from the performance of services. The Tax Court cited the general rule that
“[i]ncome is said to accrue where the right to receive it becomes fixed, that is when there is an enforceable
liability.” The Tax Court added: “The right to receive income cannot become fixed before the obligor has an
obligation to pay.” Further, the Tax Court offered the following example: “Under the accrual method,
income may not be subject to taxation at a time when payment remains subject to the discretion of the
employer, or there is some other factor of uncertainty.” (Citations omitted.)
5- More recently, in Charles Schwab v. Commissioner7
, the Tax Court considered when a securities broker
recognized commission income, at the trade date (i.e., at the time substantial performance had been
completed) or at the settlement date (i.e., at the time all performance was complete). The taxpayer argued
that, under the all events test, its performance was not complete until the settlement date. The government
argued, and the Tax Court held, that the taxpayer’s performance was complete at the time the taxpayer
traded the security for the customer because performance of the trade was the essential service that the
taxpayer performed and was the time at which the taxpayer’s right to receive, and the customer’s obligation
to pay, the taxpayer’s commission arose.
5- The Tax Court cited the U.S. Supreme Court case of Schlude v. Commissioner8
, for the standard for
income recognition and, in particular, recognition of income derived from the provision of services: “The
taxpayer’s right to receive income is fixed upon the earliest of (1) the taxpayer’s receipt of payment,
(2) the contractual due date, or (3) the taxpayer’s performance.” The Tax Court’s use of the Schlude
standard is significant because it include “the performance of services” as one of the events that fixes the
right to income. This is somewhat contrary to the proposition of General Dynamics that the performance of
services is not necessarily an event that fixes that right to income. These two seemingly divergent
propositions can be reconciled if we assume that the performance event set forth by the Schwab court is
complete only after the liability to make payment for the performance arises. This reconciling
interpretation is supported by the court’s analysis in Schwab.
5- The Tax Court in Schwab clearly based its holding against the taxpayer on the fact that the taxpayer’s
right to the income arose at the time of the trade, not at the subsequent time of settlement. For example, in
support of its conclusion, the Tax Court noted:
4
See footnote 2
5
See also Hansen v. Commissioner, 360 U.S. 446 (1959), in which the Supreme Court considered a case where the taxpayer did not
have a present right to compel payment from customers, but did, nonetheless, have an enforceable right to recover payments. The
Court noted that income is not recognized for tax purposes at the point in time when taxpayers can presently compel payment but,
rather, at that time when taxpayers can compel payment (presently or at some future point).
6
97 T.C. 643 (1991).
7
107 T.C. 282 (1996), aff’d 161 F.3d 1231 (9th Cir. 1998).
8
372 U.S. 128, 133, 137 (1963).

5- If petitioner does not receive payment on a purchase or sale order executed for the
customer, it liquidates the customer’s account to collect the amount, including the
commission, determined on the trade date. Upon execution of a customer order, a
written confirmation is generated automatically and is sent to the customer on the next
business day following the trade date. The written confirmation serves as an invoice and
as written notification to the customer of the trade. The confirmation statement itemizes
the total cost of the trade, including the amount of the commission, and lists the total
“amount due.” Petitioner encloses a remittance stub and a return envelope with the
confirmation. The customer does not have the right to cancel an order that petitioner
executes in accordance with the instructions of the customer… We think the above facts
indicate that petitioner’s execution of a trade… fixes petitioner’s right to receive the
commission income. (Italic added.)
5- Thus, it seems clear that the Tax Court in Schwab decided against the taxpayer, and held that income must
be recognized as of the trade date, because the taxpayer’s customers did not have the right to cancel any
obligations to pay for the taxpayer’s service after the trade date.
5- It is also seems clear from the Tax Court’s discussion of the Hallmark case that the Tax Court would
have applied Hallmark in favor of the taxpayer, and allowed the taxpayer to defer recognition of income
derived from services until the settlement date, if the taxpayer’s right to payment from its customers did not
arise until the settlement date. This conclusion is supported by the following discussion of the Hallmark
case by the Tax Court in Schwab:
5- Petitioner argues that this case is governed by Hallmark Cards, Inc. v. Commissioner,
90 T.C. 26 (1988). In Hallmark, a manufacturer and seller of greeting cards shipped its
Valentine merchandise to customers in the year prior to that in which the holiday
occurred. The terms of the sale specified that title and risk of loss did not pass to the
customer until January 1 of the year following the shipment. This Court held that the
taxpayer’s right to income from the sale became fixed only upon passage of title and
risk of loss to the purchasers, notwithstanding that delivery of the goods had occurred
earlier. Id. At 32-22. Petitioner argues that because title to the securities does not pass,
and petitioner is not relieved of its risk of loss until the settlement date, its right to the
commission income is not fixed until the settlement date.
5- Hallmark v. Commissioner, supra., is distinguishable from the instant case. In Hallmark, the taxpayer
was a manufacturer and seller of goods. Thus, passage of title and risk of loss constituted the essence of the
transaction; without such passage, no sale occurred. Conversely, the present case involves a service
provider that executes securities trades as an agent of its customers. We think that the focus in this case
must be on the contractual relationship between petitioner and its customer, not on the relationship
between the customer and purchaser or seller of the securities. The agreement between petitioner and its
customers was that any trade executed by petitioner in accordance with the customer in Hallmark had the
right to return the merchandise without penalty until title passed. Id. At 33. The essence of the transaction
between petitioner and its customer is the execution of a trade on behalf of the customer. (Italic added.)
5- Thus, Tax Court in Schwab relied heavily on its analysis in Hallmark to support its
holding that the taxpayer could not defer the recognition of income beyond the point in
time when its customers became legally obligated to make payment for services.
5- Finally, the Tax Court in Schwab distinguished between conditions precedent, which must occur before
the right to income arises, and conditions subsequent, the occurrence of which will terminate an existing
right to income (i.e., a right created by a condition precedent), but the presence of which does not preclude
the accrual of income for Federal tax purposes. However, it is important to note that, by definition, a
condition precedent creates an obligation to make payment. Thus, although a condition subsequent does
not prevent the recognition of income until after an obligation is created (i.e., after a condition precedent),
there is no recognition of income in the first place unless and until there is an initial obligation.
5- Perhaps the most cogent and compelling description of the importance of the existence of a legal
obligation in determining whether the all events test requires the recognition of include can be found in the
Tax Court case of Hallmark Cards v. Commissioner9
.
5-
9
90 T.C. 26 (1988).

In Hallmark, the Tax Court considered when income from sales of merchandise should be recognized for tax
purposes and held that the “all events test” was not satisfied until title and risk of loss to the merchandise passed to
the customer. The Tax Court noted: “The objective is to determine at what point in time the seller acquired an
unconditional right to receive payment under the contract.” The Tax Court went on to find that the taxpayer had
no right to receive income prior to the passage of title and risk of loss to the customer. In support of its holding, the
Tax Court cited General Dynamics for the proposition:
5- Here … petitioner does not possess any fixed and definite rights to payment at year-end.
The fact that at the stroke of midnight petitioner knows with absolute certainty that in
the next instant these rights will arise cannot compensate for the fact that as of the close
of the old tax year they do not exist. The all events test is based on the existence or non-
existence of legal rights or obligations at the close of a particular accounting period, not
on the probability—or even absolute certainty—that such right or obligation will arise
at some point in the future.10
5- Thus, although Hallmark involved the application of the all events test for recognizing income from the
sale of goods, rather than services, the Tax Court’s language in Hallmark resonates and articulates the
conclusion of General Dynamics, which pertained to services, that income cannot be recognized unless the
taxpayer’s customer has some obligation to make payment or, conversely, the taxpayer has some right to
payment. The fact that Hallmark relies on General Dynamics clearly supports the application of Hallmark
to situations involving the provision of services in addition to the dale of goods.
5- Finally, by providing for a seven-day acceptance period in which customers can reject services already
performed without obligation, Taxpayer is at genuine economic risk. For example, Taxpayer must consider
how the seven-day acceptance period provision will affect the collectibility of disputed receivables. The
economic cost and risk of the acceptance period is the marginal increase in non-collectible receivables
caused by the seven-day acceptance provision. However, it is likely that the collectibility of many of
Taxpayer’s receivables will not be affected by the seven-day acceptance period. The economic cost of the
acceptance period provision should be based only on those receivables that, but for the seven-day no
obligation acceptance period, would have been collectible and actually collected.
5- The real risk of economic loss is the price Taxpayer pays for any tax deferral, and could conceivably
exceed any tax deferral benefits resulting from the change in business terms. This real economic risk and
potential cost gives the seven-day acceptance period economic substance. This economic substance may
prevent, or at least mitigate, a government challenge of the proposed tax treatment of the seven-day
acceptance period based on a form-over-substance argument.
5- Based on the legal authorities discussed above, in most circumstances11
, income derived from the
provision of services must be recognized for Federal tax no earlier than when the recipient of those services
becomes obligated to make payment for such services.
5- Under Taxpayer’s current terms, customers cannot reject performance of services within seven days of
performance without penalty or obligation. Thus, Taxpayer’s performance presumably creates some legal
obligation for the customer to make payment for the services performed. Thus, income must be recognized
when services are completed.
5- However, if the Taxpayer adopts a seven-day “no obligation” acceptance period commencing after
services have been completed and during which customers have absolutely no legal obligation to make
payment for services if they choose to reject such services within the seven-day acceptance period, it appears
more likely than not that Taxpayer will not have to recognize income for Federal income tax purposes until
the lapse of the seven-day acceptance period.
5-60 This research question examines the treatment of reimbursements as income. As discussed in detail in
Chapter 8, reimbursements paid pursuant to an accountable plan as defined in § 62(a)(2)(A) can be excluded
by the employee and, perhaps more importantly, are not subject to employment taxes. On the other hand, if
the payments are not paid pursuant to an accountable plan, the reimbursements are included in the
employee’s wages, are subject to employment taxes and the employee deducts the expenses as miscellaneous
itemized deductions subject to the 2% limitation. Obviously, the difference in treatment is quite dramatic,
particularly with respect to the employment tax obligation of the employer.
5- The problem facing the taxpayer in this situation is similar to that found in Trucks Inc. v. U.S.,
80 AFTR 2d 97-6625, (District Court of the Northern District of Georgia, 1997). In Trucks, the corporation
10
Also citing Decision, Inc. v. Commissioner, 47 T.C. 58 (1966) and Cox v. Commissioner, 43 T.C. 448 (1965).
11
Of course, this conclusion does not apply if the taxpayer recognizes income on the percentage-of-completion (PCM) method.
Further, there is not benefit if the taxpayer is a cash basis taxpayer.

was denied a refund of withholding taxes paid on expense reimbursements issued to over-the-road drivers.
According to the court the reimbursements were not paid pursuant to accountable plan as discussed in
Chapter 8 (§ 62(a)(2)(A)). Therefore the amounts should have been treated as wages included in the W-2s of
the employees subject to withholding and employment taxes. Interestingly, for the years at issue, Trucks
excluded from wages payments that totaled over $1.3 million for 1991, over $2.2 million in 1992, and over
$3.4 for 1993.
5- The court explained that while there was little doubt that the drivers would incur the meals and lodging
expenses in connection with services performed for the corporation, the expense arrangement did not meet
the technical requirements set forth in the applicable provisions. There was no per diem arrangement.
Moreover, there was no per diem arrangement that met the applicable requirements. The employer merely
stated that a certain percentage of the taxpayer’s compensation was for these expenses. Drivers were not
required to substantiate their expenses. While substantiation is not required where there is a qualified per
diem arrangement, no formal per diem arrangement existed. Drivers received the same flat rate regardless of
whether they paid for lodging or slept in their trucks. The drivers’ trip sheets and time logs did not include
lodging; and Trucks did not substantiate expenses with receipts or driver testimony.
5- Based on this case, the taxpayer should be advised to restructure their reimbursement arrangement to
meet the standards set for a qualified accountable plan.

Gross Income
Test Bank
True or False
1. The economist’s definition of income is expressed mathematically as the sum of one’s consumption
during a period plus the change in one’s net worth between the beginning and end of the period.
Consumption and the change in net worth are measured using market values on an accrual basis.
2. Economists recognize income once it has been realized: (1) the earnings process is complete, and (2) an
exchange or transaction has taken place.
3. As a general rule, all income is taxable unless you can locate authority to exclude it from gross
income.
4. MNO Corporation sued XYZ Incorporated for patent infringement and was awarded $100,000
damages. The $100,000 is taxable.
5. B was recently fired from her position as newscaster for NBS, a national television network. She sued
the network for lost wages on the grounds that she was improperly fired. Ms. B won the case and was
awarded $25,000. She must treat the $25,000 as taxable income.
6. G was injured in a car wreck. He sued the driver of the other automobile and was awarded $10,000
for personal injury. In addition, he was awarded $3,000 as punitive damages. G must report $3,000 as
income.
7. Video Games Unlimited Inc. allows its game designers to use, without charge, company cars for their
personal vacations. The employer’s motive for providing the cars is to ensure that these valuable assets
(i.e., the employees) of the business are retained. Because this is a reasonable business purpose, the
employees will recognize no income from their use of the cars.
8. An S corporation is similar to a partnership in that shareholders, like partners, are not taxed on the
income of the entity until it is distributed to them.
9. A taxpayer who reports in conformity with generally accepted accounting principles (GAAP) satisfies
the tax requirement that income must be clearly reflected. For these taxpayers, book income and
taxable income will not vary.
10. Near year-end, FGH Construction Corporation mailed E, a plumbing contractor, a $10,000 check for
services that he had performed on one of the corporation’s projects. On December 27 of this year, the
controller of FGH called E and asked E not to cash the check until after the first of the year, because
there were insufficient funds in the bank to cover it. E must include the $10,000 as income this year.
5
5-23

11. Under the cash equivalent doctrine, the taxpayer reports income from credit sales.
12. Upon graduation, T signed a contract to play professional football. The contract contains the team’s
unsecured promise to pay T $500,000, $200,000 to be paid in his rookie year, with the remaining
$300,000 deferred over the next three years. Assuming all other requirements are satisfied, the
constructive receipt doctrine would require inclusion of the full $500,000 in income this year, since T
was able to control the timing of receipt through a contractual arrangement.
13. Healthy Pools Incorporated, an S corporation, operates a swimming pool business. It has successfully
acquired many of the hotels and motels in the area as customers. It bills monthly for its services.
Assuming the corporation wishes to use the accrual method to account for its billings, it must also use
the accrual method to account for all other receipts and disbursements.
14. Clean Wheels, Inc., a calendar year taxpayer, operates a car wash that is located two blocks from six
car dealerships that use the facility regularly. Clean has set up credit arrangements with each of the
dealerships to allow them to use the car wash and be billed for the services at the end of the month.
During the month of December, Clean billed the dealerships $3,000 for the car wash services. These
bills were paid in January. Clean must accrue and report the $3,000 as income in December.
15. Crash Corporation manufactures hard disk drives for computers. Its gross receipts for the past several
years have averaged less than $2 million. The corporation may use the cash method to account for all
of its receipts and disbursements.
16. A public accounting firm that operates as a professional corporation and has $10 million in gross
receipts may use the cash method.
17. There are no special tax consequences arising from a change in accounting method as long as the
taxpayer is switching from one permissible method to another.
18. T owns a series EE savings bond. In previous years, he elected to report the interest income from the
bond (i.e., the annual increase in redemption value) when he redeemed the bond rather than currently.
This year, T decided that he would be better off to report the income annually rather than defer it. To
accomplish this objective, T must seek the approval of the IRS.
19. Last year, J started his own men’s clothing store business. His small operation did not warrant a
sophisticated accounting system. Consequently, he simply kept track of all his receipts and
disbursements in a checkbook for the business. When he files his return, he indicated that he used the
cash method of accounting. This year he wants to change to the accrual method of accounting in
order to more clearly reflect income. J may change to the accrual method without consent because he
is changing from an erroneous method to a correct method.
20. Several years ago, T started an automotive repair business. His small operation did not warrant a
sophisticated accounting system. Consequently, he simply kept track of all his receipts and
disbursements in a checkbook for the business. When he filed his return, he indicated that he used the
cash method of accounting. This year he wants to change to the accrual method of accounting. J may
change to the accrual method without consent because he is changing to an accounting method that
more clearly reflects income.
21. C is the controller of XYZ Corporation. As C prepared this year’s tax return, she noted that several
errors had been made in posting the accounts in the prior year and were reflected on last year’s tax
return. To correct the errors in the prior year’s return C should seek approval from the IRS since this
is a change in accounting method.
22. G’s accountant recently determined that G should be capitalizing certain costs that he has
traditionally expensed. According to the accountant, G is using a clearly erroneous method of
accounting. A change to the proper method would result in substantial income in the year of the
change. G should consider voluntarily making the change to the proper method because the treatment
is more favorable than if the IRS requires the change.
23. R currently operates a hardware store and uses the cash method of accounting for all income and
expenses. Under the general rules, R may use the cash method.
24. L currently reports income from Series EE savings bonds annually. He is considering switching to the
alternative method. L may change methods without consent from the IRS.

25. Embezzlement proceeds are not taxable because the embezzler has an obligation to repay the funds.
26. S, a cash basis taxpayer, received a $10,000 prepayment for services that he contracted to perform in
the following year. S may report the income in the following year when he earns it.
27. Heat-a-Home, an accrual basis calendar year taxpayer, sells furnaces. With each sale, the corporation
also sells a one-, two-, or three-year contract to turn the furnaces on and off and do routine
maintenance. Assuming the corporation sold a two-year contract on November 1 at a price of $240, it
may report income for this year of $20.
28. Warm-a-Home, an accrual basis calendar year taxpayer, sells furnaces. With each sale, the
corporation also sells a one-, two-, or three-year contract to turn the furnaces on and off and do
routine maintenance. Assuming the corporation sold a one-year contract on November 1 at a price of
$120, it will report income for this year of $20.
29. Cool-a-House, an accrual basis calendar year taxpayer, sells air conditioning units. With each sale, the
corporation also sells a one-, two-, or three-year contract to turn the units on and off and do routine
maintenance. In determining its reporting options, the taxpayer wants to postpone recognition of
income for as long as possible. Assuming the corporation sold a three-year contract on November 1 at
a price $240, it will recognize income as it is earned, reporting $20 of income this year, $120 next year
and $100 in the final year.
30. An accrual basis taxpayer reports prepaid rent (e.g., payments received in advance for the use of
property where the lessor provides no services) when it is earned.
31. Absent any special tax treatment, the claim of right doctrine could be applied to make the following
income taxable in 2011:
Payments received during October 2011 by a skiing corporation for season passes (November, 2011
through April, 2012). The corporation is on the accrual basis, and its tax year is the calendar year.
32. On May 3 of this year, R called his broker and told him to sell all of R’s AZ bonds. R had purchased
the bonds for $9,500 several years ago. The bonds have a $10,000 par value, and pay interest at a rate
of 10 percent semiannually on June 30 and December 31. Ten days after his call R received a check
for $11,000. R should report a capital gain on the sale of $1,500.
33. Income arising from Series EE U.S. Savings Bonds need not be reported on an annual basis.
34. Airco is a manufacturer of airplanes, specializing in jumbo jets. This year it signed a contract with Pan
World Airlines to supply it with 20 jumbo jets. Each jet takes 15 months to build. The contract is a
long-term contract.
35. H signed a contract on October 1 to manufacture 35,000 folding chairs; the manufacturer currently
has 5,000 in stock and estimates that the contract will take 14 months to complete. The contract is a
long-term contract.
36. T Corporation signed an agreement with the city of St. Lansberg to manufacture 50,000 seats for
the city’s new baseball stadium. T does not carry this type of seat in inventory but will custom make
the unique seat to the city’s specifications. Assuming manufacture of the seats is not complete at the
close of T’s taxable year, the contract will be considered a long-term contract.
37. This year, F Corporation contracted to build an office building that it anticipates completing in six
months. Assuming construction is not complete at the end of its taxable year, the corporation must use
the percentage of completion method to account for the income from the contract.
38. This year, G Corporation contracted to build a hotel that it anticipates completing in 10 months.
G Corporation’s annual gross receipts have historically exceeded $15 million. Assuming construction
is not complete at the end of its taxable year, the corporation must use the percentage of completion
method to account for the income from the contract.
39. On October 1 of this year, SBX Construction contracted to build the new Fourth National Bank
office tower. The company began work on October 15 and is expected to finish construction in
30 months. The company must use the percentage of completion method in accounting for the
contract.
Test Bank 5-25

40. During the year, R Corporation entered into a long-term contract to build a nuclear power plant. The
plant will take four years to build. At the close of the current taxable year, the corporation estimated
that it had completed 8 percent of the contract. The corporation must use the percentage of
completion method and must report 8 percent of the estimated contract price as income this year.
41. Corporations using the completed contract method are required to pay interest on the deferred tax
upon completion of the contract.
42. In using the percentage of completion method, annual income to be reported from a contract is
determined in part by comparing actual costs incurred to total estimated costs. If total actual costs are
less than that which were originally estimated, the taxpayer is required to pay the IRS interest.
43. H and W have one child, S. Several years ago, S’s grandparents indicated to H and W that they would
like to help pay for their grandson’s college education. To this end, the grandparents purchased Series
EE savings bonds for their grandson in 2012. In 2012, G enrolled at City University in his hometown.
G derives virtually all of his support from his parents. However, his grandparents cashed in some of
the bonds and paid for G’s tuition, $500. Grandma and grandpa are retired and have income of
$40,000 for the year. A portion of the interest on the bonds should be nontaxable.
44. Interest-free loans of less than $10,000 can be used without restriction to shift income.
45. Assume that the present tax system and its progressive rate structure are replaced by a so-called flat tax
method. Under this system, a single rate would be applied to any type of income regardless of source,
and large exemptions (e.g., $20,000) would be allowed to each taxpayer to eliminate low-income
taxpayers from the tax rolls. One favorable result of such a system is to completely eliminate the
motivation for arrangements when the sole purpose is to split or shift income to lower bracket taxpayers.
Multiple Choice
46. Which of the following does not cause a difference between economic income and income for tax
purposes?
a. The realization concept
b. The treatment of benefits derived in kind from consumer durables
c. The convenience of the employer theory
d. The return of capital doctrine
47. The accountant’s concept of income is distinguished from the economist’s by
a. The principle of accrual
b. The principle of relativity
c. The principle of realization
d. None of the above
48. Arguably, free parking places provided to employees by their employers might be excluded from
taxable income on the grounds that
a. Such items neither satisfy the economic definition of income nor fall within the definition of the
income for tax purposes.
b. Any gain obtained by the employee is secondary or incidental to the employer’s business purpose
that is served by granting such benefit.
c. The value of the benefit obtained by the employee is not determinable.
d. The benefit obtained by the employee is not in the form of cash.
49. LMN Partnership is owned equally by R and S, calendar year taxpayers. The partnership reports on a
fiscal year ending October 31. During the calendar year 2010, the partnership earned $1,000 a month.
During the calendar year 2011, the partnership earned $2,000 a month. During 2010 and 2011, R
withdrew $300 a month. On his personal return for 2011, R will report income from the partnership of
a. $1,800
b. $3,500
c. $11,000
d. $12,000

50. In which of the following situations would the taxpayer not be considered in constructive receipt of
income in 2011? Assume that all of the taxpayers use the cash method of accounting.
a. Al is a self-employed accountant. On December 27, 2011, he received a check for $2,000 for
preparing the November financial statements of one of his clients. Due to illness, he was unable to
deposit the check until January 5, 2012.
b. Ben entered into a contract to sell his rental property on December 3, 2011. On that date, the
down payment, a check for $1,000, was placed in an escrow account. Ben received the check
when the transaction closed on January 20, 2012.
c. Sugar Ray fought Rocky on December 25, 2011, a Christmas fight shown on television all over
the world. On December 28, the fight promoters gave Sugar Ray’s agent, Leo Luciani, a check
for $5 million representing his prize money for the fight. Leo delivered the check to Sugar Ray on
January 12, 2012.
d. On December 20, 2011, Mr. Big received stock worth $10,000 as a bonus from the corporation
for which he worked. He did not sell the stock until January 5, 2012.
e. All of the taxpayers above are in constructive receipt of the income items.
51. Taxpayers must use special accounting methods for inventories if they are an income producing
factor. Which of the following statements is true?
a. The taxpayer is required to accrue the cost of the inventory but may report sales when receivables
are collected.
b. The taxpayer is required to accrue the cost of the inventory and accrue the income from sales of
the inventory.
c. The taxpayer is required to expense the cost of the inventory and accrue the income from sales of
the inventory.
d. None of the above are correct.
52. Dr. Payne Phull is a cash basis taxpayer. Normally, his patients pay his fee on the day they see him in
the office. For some customers, his office processes a medical reimbursement claim and bills the
insurance company for the visit. In the current year, his records reveal the following:
Cash received at time of office visit $70,000
Collections on insurance receivables 88,000
Total accounts receivable, January 1 5,000
Total accounts receivable, December 31 15,000
All of the receivables outstanding at the beginning of the year were collected during the year. What amount
should Dr. Phull report as his income this year?
a. $70,000
b. $158,000
c. $168,000
d. $173,000
e. Some other amount
53. Which of the following businesses must use the accrual method of accounting to account for all or a
part of its operations?
a. F Gas Corporation, a chain of 10 gas stations owned and operated by F. The corporation has
gross receipts of $3 million annually.
b. The Clinic. This corporation is owned and operated by 80 physicians who provide a variety of
health care services to the citizens of Houston. Annual billings to insurance companies and
patients monthly exceed $20 million.
c. Whitewater Rafting of Idaho is a partnership owned by B and T. Gross receipts for the past
several years have averaged $100,000.
d. D Drilling, a partnership owned by J and A. The partnership operates oil drilling rigs all over the
world. Annual gross receipts consistently exceed $8 million.
e. More than one of the above and these are . .
Test Bank 5-27

54. T Corporation manufactures the Banana, a clone of a popular computer. Its gross receipts for the last
several years have averaged $4 million. Indicate which of the following statements is true with respect
to the method of accounting that T can adopt.
a. The corporation may use the cash method to account for all receipts and disbursements.
b. The corporation must use the accrual method to account for all receipts and disbursements.
c. The corporation may use the cash method for some items and the accrual method for other items
as it desires.
d. The corporation may use the cash method for some items but is required to use the accrual
method for other items.
55. The cash method of accounting may not be used by
a. A solely owned personal service corporation in the management consulting business.
b. An individual engaged as a sole proprietor whose annual gross receipts for all prior years exceed
$10 million.
c. A partnership that has gross receipts of $7 million (and no corporate shareholders).
d. Both b. and c.
e. All of the above may use the cash method.
56. R, a cash basis taxpayer, wanted to defer income from 2010 to 2011. Which of the following will serve
that purpose?
a. Purchase of a Treasury Bill in November, 2011 that matures in February, 2012.
b. A signed agreement with his employer that the latter will pay him part of his 2011 salary in 2012.
c. Delay cashing his last salary check for 2011 until 2012.
d. Both a. and b.
e. Both a. and c.
57. The following entities are not involved in the farming or timber business; which of them may not use
the cash method of accounting?
a. An S corporation with average annual gross receipts of $8 million
b. A partnership with average annual gross receipts of $12 million
c. A regular C corporation with average annual gross receipts of $10 million
d. A regular C corporation with average annual gross receipts of $4 million
e. More than one of the above.
58. M operates a lawn maintenance business. In the past, the business has used the cash method of
accounting. This year, M decided to switch to the accrual method. At the beginning of the year, M
had accounts receivable of $50,000 and accounts payable of $20,000. Assuming M requests a change
from the cash to the accrual method, the IRS will require a
a. Net negative adjustment of $30,000
b. Net positive adjustment of $30,000
c. Net negative adjustment of $50,000
d. Net positive adjustment of $50,000
e. None of the above
59. Which of the following statements is true regarding changes in accounting methods?
a. The treatment of a change in accounting method differs depending on who initiates the change.
b. Adjustments arising from a voluntary change in accounting method are generally accounted for in
the year of the change.
c. Taxpayers who change from an incorrect method of accounting to a correct method of
accounting are not required to obtain the consent of the IRS.
d. Corrections due to errors are treated the same as changes in accounting methods.

60. T is switching accounting methods this year. Which of the following statements is true?
a. Assuming T initiates the change, any adjustment normally will be accounted for in the year of the
change.
b. Assuming the IRS initiates the change, any adjustment normally will be accounted for in the year
of the change.
c. There are no special tax consequences arising from a change in accounting method as long as the
taxpayer is switching from one permissible method to another.
61. Fast-Heat, an accrual basis calendar year taxpayer, sells furnaces. With each sale, the corporation also
sells a one-, two-, or three-year contract to service the furnace. On November 1 of this year, the
corporation sold a one-year contract for $120 and a two-year contract for $240. The taxpayer wants
to postpone income for as long as possible. Due to these sales, the corporation will report income for
the current year of
a. $360
b. $140
c. $260
d. $40
62. Ralph, a cash basis taxpayer, owns a five-story office building that he leases to various tenants. During
the year, he signed a three-year lease with a tenant and received a check of $6,000 for the following:
Rent for November 1, 2011 to October 1, 2012 $5,000
Advance rent for last three months of lease 600
Security deposit (refundable) 400
For the current year, 2011, Ralph must report income of
a. $6,000
b. $5,600
c. $5,000
d. $832
63. Lynn O’Leeum is an accrual basis calendar year taxpayer. He operates a flooring company. His
accounting records for 2011 reveal the following:
Collections on accounts receivable $405,000
Sales on account to customers 521,000
Rent received on November 1, 2011
for use of part of his warehouse
from November 1, 2011 to April 30, 2012 12,000
Rent received on February 1, 2011 for use of part of his
warehouse for December 2010 and January 2011 4,000
Of the amounts collected on the accounts receivable, $25,000 was for receivables outstanding at the end of
2009. Lynn will include gross income for 2010 of
a. $421,000
b. $533,000
c. $535,000
d. $537,000
Test Bank 5-29

64. Inconsistencies between the tax and financial methods of accounting for advanced payments for goods
received by an accrual basis taxpayer normally do not occur because
a. The goods for which the payment is made are normally on hand at year end.
b. The payments received are “substantial” (i.e., they exceed the cost of the goods to be sold).
c. Delivery of the goods normally occurs within a short period after the payments become
substantial.
d. According to the Internal Revenue Code, tax methods of accounting for advance payments must
be in conformity with financial methods (GAAP).
65. L purchased ten REX Corporation bonds on March 5 for $11,120. The bonds have a $1,000 par value and
pay interest at an annual rate of 10 percent semiannually on January 1 and July 1. On July 1, L received his
first interest check of $1,000. Immediately after he received the interest payment, which of the following is true?
a. His basis in the bonds is $11,120.
b. His interest income is more than $1,000.
c. His interest income is less than $1,000.
d. His basis in the bonds is more than $11,120.
66. Prepaid interest income
a. Is recognized as income by cash basis taxpayers when it is earned
b. Is recognized as income by accrual basis taxpayers when it is earned
c. Is recognized by accrual basis taxpayers when received
67. Which statement is true concerning Series E or EE issues of U.S. Savings Bonds?
a. The bonds may only be redeemed on or after the final maturity date, at a predetermined price.
b. Interest payments are made semi-annually at the stated rate to the holder of the bond.
c. No interest payments are made to the holder of the bond.
d. The bonds may be redeemed with a penalty before the final maturity date.
e. Both a. and d.
68. JKL Corporation is a large construction company with annual gross receipts, averaging $20 million
annually. This year the corporation signed an agreement to construct a road for $720,000. Total
estimated costs are $600,000. This year the corporation actually incurred costs of $240,000. For the
year, JKL’s gross profit on the contract will be
a. $0
b. $288,000
c. $200,000
d. $48,000
69. RST Corporation is a large construction company with annual gross receipts, averaging $20 million
annually. Last year, the corporation signed an agreement to construct a road for $720,000. Total
estimated costs are $600,000. Last year, the corporation actually incurred costs of $240,000. This year,
the corporation completed the contract and incurred costs of $300,000. For the current year, RST’s
gross profit on the contract will be
a. $48,000
b. $50,000
c. $99,600
d. $132,000

70. Using the following information, decide for which of the following the completed contract method
may be used. Assume the taxable year is the calendar year in all cases.
a. A contract to construct a bridge estimated to be completed in 18 months; the contractor has
average annual gross receipts of $15 million.
b. A contract signed on October 1 to build the residence of John Smith; it is estimated that it will
take six months to complete the job. The contractor has gross receipts of $15 million.
c. A contract to construct a highway estimated to be completed in 36 months; the contractor has
average annual gross receipts of $9 million.
d. More than one of the above.
71. Which of the following contracts would be considered a long-term contract?
a. A contract signed on September 1 with the U.S. Army to manufacture 20 planes estimated to be
completed in 15 months (a single plane takes about one month to complete); the contractor
currently has 12 planes in inventory.
b. A contract to manufacture a telescope custom-made for space flight. The telescope will be the first
of its kind. Estimated time of manufacturing is eight months.
c. A three-year contract signed by JB Systems to provide the design work for the space shuttle.
d. More than one of the above.
72. The famous horticultural metaphor involving the fruit and the tree operates primarily in situations
concerning
a. Bunching of income
b. Splitting of income
c. Deferral of income
d. Contested income
73. Tyler T. Tycoon owns various office buildings and warehouses throughout the city of Dallas. He rents
one building to Kate, Saperstein and Sons, a large department store. The lease is for four years and calls
for a rental of $12,000 a year. Rent is payable in quarterly installments on March 31, June 30, September
30, and December 31. On May 1, Tyler transferred all the rights under the lease to his son, Tex. At that
date, the lease had 44 months to run. This year Tex collected $9,000 of rents. He paid his father the
$1,000 rent received for the month of April during which he was not the owner of the lease. For the year,
Tyler will report rental income of
a. $1,000
b. $3,000
c. $4,000
d. $12,000
74. In April, 2011, P purchased Series EE bonds at a cost of $5,000. This year the value of the bonds
increased by $100. With respect to the $100 increase,
a. The increase is never taxable.
b. P may report the increase as income this year.
c. P may postpone recognition of the income until the bonds are redeemed.
d. Either b. or c.
75. The application of Code § 7872 to interest-free or below-market loans has certain tax consequences for
the lender and borrower. They include
a. The borrower may be allowed an itemized deduction for the interest hypothetically paid to the
lender.
b. The lender is not required to report the hypothetical payment as interest income until the loan is
repaid.
c. The borrower treats the hypothetical payment as earned income.
d. The lender is deemed to have made a completed gift of the loan amount.
Test Bank 5-31

76. Code § 7872 concerns interest-free and below-market loans. To restrict the application of § 7872 to
predominantly abusive situations, Congress carved out several exceptions. They include all of the
following, except
a. Gift loans where the balance outstanding during the year does not exceed $10,000 provided that
the borrower purchases taxable income-producing assets.
b. Loans not in excess of $10,000 made by an employer to an employee or an independent
contractor.
c. Loans not in excess of $10,000 made by a corporation to a shareholder.
d. Loans not in excess of $10,000 made by a partnership to a partner.
e. Both a. and d.
77. F has a son, C, who earns a $50,000 salary and has $500 interest income. During 2011 F loaned C
$95,000 without interest to purchase a boat. Assume interest imputed at the IRS rate is $14,000.
Which of the following statements is true about interest deemed earned by F or the amount of taxable
gift remaining after the annual exclusion?
a. F has interest income of $13,000.
b. F is charged with a taxable gift of $13,000.
c. F has no interest income.
d. F is charged with a taxable gift of $1,000.
e. Both c. and d.
78. Which of the following statements is true?
a. Under the community property system, assets owned before marriage are considered equally
owned by each spouse after marriage.
b. Only a few states use the common law property system.
c. Income from separate property is community property in some community property states.
d. The common law property system denies criminals rights in property.
79. Section 66 provides that a spouse will be taxed only on the earnings attributed to his or her personal
services during the year if certain conditions are met. They include
a. The two married individuals do not live in a community property state at any time.
b. Any transfer of earned income between the spouses does not exceed half their total gross income.
c. The couple files a joint return.
d. The couple does not file a joint return.
e. Both b. and d.
80. Several useful techniques permit an individual taxpayer to postpone income recognition. They include
all the following, except
a. Like-kind exchanges
b. Installment sales of property
c. Deferred compensation arrangements
d. Income on Treasury bills
e. All of the above permit deferral
81. “Substantial tax benefits await the self-sufficient (e.g., an individual who can repair his own
automobile is better off from a tax perspective than someone who cannot).” Select the correct
comment on this statement.
a. The above statement is valid, since such an individual may barter his or her services for those of
another and pay no tax on the services furnished to him.
b. The above statement is valid because the concept of taxable income would exclude the benefit
derived from repairing one’s own automobile.
c. The above statement is valid because the form of benefit principle enables a taxpayer to exclude
gains received in a certain form.
d. The above statement is false—no tax benefits await the self-sufficient.

Gross Income
Solutions to Test Bank
True or False
1. True. (See p. 5-3.)
2. False. Accountants recognize income once it is realized. (See p. 5-5.)
3. True. Income for tax purposes is construed to include any type of gain, benefit, profit, or other increase in
wealth that has been realized and is not exempted by statute. (See p. 5-5 and § 61.)
4. True. The patent infringement award is in lieu of income and is not a return of capital. (See p. 5-9.)
5. True. The amount lost wages is taxable since it is simply a substitution for income, but see the discussion in
Chapter 6 on this issue. (See Example 6 and p. 5-9.)
6. True. The damages awarded for personal physical injury are considered a nontaxable return of capital. In
contrast, punitive damages are taxable except in a wrongful death action. [See p. 5-8 and § 104(a)(2).]
7. False. The employee must show that personal use of the car satisfied a business purpose of the employer
other than to compensate the employee. (See p. 5-10.)
8. False. Partners and S shareholders report their proportionate share of the entity’s income in their tax year in
which the entity’s year ends. Distributions have no effect on the amount of annual income the individual will
report with respect to the entity. The income flows through to the partners or shareholders. (See Example 9
and pp. 5-12 and 5-13.)
9. False. Conformity with GAAP does not ensure that book income will be clearly reflected or identical to
taxable income. There are numerous differences between taxable income and book income (e.g., treatments
differ for interest on state and local bonds and depreciation of property). (See p. 5-15.)
10. False. Although the taxpayer has received the check, he is not treated as having received the income under
the constructive receipt doctrine, because the funds are not available for payment. (See Example 17 and
pp. 5-16 and 5-17.)
11. False. Under the cash equivalent doctrine, the taxpayer reports income when the equivalent of cash is
received. Credit sales resulting in accounts receivable (i.e. unsupported promises to pay) are not considered as
having a fair market value or being the equivalent of cash. (See p. 5-16.)
5
5-33

12. False. T has no legal right to demand payment of the deferred income, and he has not received a negotiable
note equivalent to cash. (See p. 5-16.)
13. False. Whenever inventories are an income producing factor, the accrual method must be used to account for
sales, purchases, and inventories. Because Healthy is primarily a service business where inventories are not an
income producing factor, it may use the accrual method to account for some items and the cash method to
account for other items as long as it does so on a consistent basis. Note that because Healthy is an
S corporation there are no limitations imposed on the method of accounting that it can use. (See p. 5-21.)
14. False. Whenever inventories are an income producing factor, the accrual method must be used to account for
sales, purchases, and inventories. Clean does not maintain inventories and therefore is not required to use the
accrual method to account for sales. (See p. 5-19.)
15. False. Whenever inventories are an income producing factor, the general rules require use of the accrual
method to account for sales, purchases, and inventories. Because Crash is a manufacturing corporation where
inventories are no doubt a material factor, it must use the accrual method to account for sales, purchases and
inventories. It may use the cash method to account for other items. (See p. 5-19.) But see Chapter 10 for a
discussion of certain exceptions to these rules.
16. True. Although corporations generally are prohibited from using the cash method, an exception is created for
qualified personal service corporations (a regular C corporation where substantially all of the activities
consist of the performance of services in one of eight fields and at least 95 percent of its stock is held by the
employees who are providing the services). [See p. 5-18 and § 448(b).]
17. False. The taxpayer must secure the consent of the IRS to change a method of accounting even if the
taxpayer is switching from one acceptable method to another. In this way, the IRS can review the change and
grant approval only if the taxpayer agrees to any adjustments required to avoid omission of income or
duplication of deductions. Taxpayers seeking a change must apply for permission by filing Form 3115,
Application for Change in Accounting Method. (See p. 5-21.)
18. True. This change would be considered a change in an accounting method because it affects when T would
report the income. A taxpayer cannot change an accounting method unless consent is granted by the
IRS. Therefore, T must seek and obtain approval of the change before he can change his current method. (See
pp. 5-21 and 5-22.)
19. False. A taxpayer may change methods of accounting only if consent is granted by the IRS. This is true when
the taxpayer is switching from one permissible method to another permissible method, as is the case in this
question, or even when the taxpayer is switching from an erroneous method of accounting to a correct
method. (See p. 5-21.)
20. False. As a general rule, a taxpayer may change methods of accounting only if consents is granted by the
IRS. Consent is required even if the taxpayer is changing from an improper method to a proper method. (See
p. 5-21.)
21. False. A correction of an error is not a change in an accounting method. C should correct the errors by filing
an amended return. (See p. 5-23.)
22. True. Under Rev. Proc. 97-27, a taxpayer who voluntarily changes a method of accounting is allowed to
spread any positive adjustment over four years. In contrast, if the IRS requires the change, the adjustment is
taken into account all in the year in which the change is required. (See p. 5-22.)
23. False. When a business has inventories which are income producing factors, it normally must use the accrual
method for sales and purchases. (See p. 5-19.) But see Chapter 10 for a discussion of exceptions to this
general rule.
24. False. An accounting method may not be changed unless consent is granted by the IRS to change accounting
methods (See p. 5-22.)
25. False. An embezzler does not recognize an obligation to repay. Thus, the income is taxable under the claim
of right doctrine. (See pp. 5-24 and 5-25.)

Wassim Zhani Federal Taxation Chapter 5 Gross Income.pdf

Wassim Zhani Federal Taxation Chapter 5 Gross Income.pdf

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