For each tax treatment described below, explain the income tax concept(s) which is (are) responsible for the treatment

Question

a. Atlas Construction Inc., an accrual basis taxpayer, billed a client $12,000 for services performed in December 2017 . In March 2018, Atlas Construction receives a check from the client for $10,000 . Included with the check is a letter indicating that some of the services had not been performed to specifications. After investigating the matter, Atlas Construction determined that the customer was right and corrected its account receivable with the client. Atlas Construction must include $12,000 in its 2017 income and takes a deduction for $2,000 in 2018.
b. Katie is the Mayor of Coal Creek. During the current year, she accepts $5,000 from a local banker for her promise that the banker would receive the contract for a new city bond issue. The payment is illegal under state law and will have to be returned if discovered. Katie must include the $5,000 in her gross income.
c. Little Company purchased machinery in 2012 at a cost of $40,000 . In 2012 through 2017, Little properly deducts $14,000 in depreciation on the machinery. In 2017, the machinery is sold for $20,000 . Little is allowed to deduct a $6,000 loss on the sale of the machinery.
d. In 2017 Raptor Corporation properly deducted a $5,000 expense it paid to Colfax Inc. In 2018 Raptor receives a $500 check from Colfax. A letter accompanying the check indicates that Colfax overcharged Raptor and the $500 refund was made to correct the overcharge. Raptor must include the $500 in its 2017 gross income.

Answer 1

a. Atlas Construction's accounting method (accrual basis) requires it to recognize income as it is earned. Because the $12,000 was billed (and not corrected) before the end of the year, the $12,000 must be included in 2017 income. Under the Annual Accounting Period Concept, each tax year stands separate and apart from all other tax years. Events of each year are accounted for separately and prior year's returns are not amended based on new information (only actual errors are corrected). In this case, the amount included in gross income for 2017 was correct as of the end of the year. The subsequent adjustment is taken up in 2018 as a deduction to adjust the over reporting of the 2017 income.

b. The All-Inclusive Income Concept requires all increases in wealth to be included in income, unless specifically excluded. There is no exclusion from income for bribes or kickbacks. Katie has a Claim of Right to the $5,000 when it is received. There is no definitive obligation to repay the $5,000 - it will only be repaid if discovered.

c. The Capital Recovery Concept allows Little to recover the $40,000 cost of its investment in the machinery. The $14,000 in depreciation is a capital recovery that reduces the adjusted basis of the machinery to $26,000 . The sale results in a loss of $6,000 ($20,000 - $26,000). The $6,000 loss is unrecovered capital investment. Because Little is a trade or business, the Business Purpose Concept allows the deduction of the loss.

d. The Annual Accounting Period Concept requires the events of each year to stand separate and apart from other years. Because Raptor deducted the $500 in 2017, the $500 receipt in 2018 must be included in 2018 income under the Tax Benefit Rule. The prior year's deduction is not adjusted directly.