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FSA Chapter 5
Terms in this set (20)
Business Purpose Doctrine (1935)
A transaction will not be effective for income tax purposes unless it is intended to achieve a genuine business purpose
- If the transaction has no substantial business purpose other than the avoidance or reduction of tax, the IRS will disregard the transaction
**A high tax-bracket, individual taxpayer contributes an asset to a newly formed C corporation solely to take advantage of the lower marginal tax rate afforded to corporations on the sale or disposal of assets
("Smoke and Mirrors")
The IRS can look through the legal formalities to determine the economic substance (if any) of a transaction
- A transaction must be REAL and BONA FIDE
**If the substance differs from the form, the IRS will base the tax consequences of the transaction on reality rather than illusion
Step Transaction Doctrine
("Piercing the veil")
The IRS can collapse a series of apparently unrelated transactions into one transaction to determine the tax consequences
- This doctrine is applied in instances when each transaction viewed separately has one overall result but considering the transactions together yields a different result
** An example is where a corporation sells property to an unrelated purchaser who subsequently resells the property to a wholly-owned subsidiary of the corporation ("Strawman transaction")
- Transactions that occur more than 12 months apart are presumed to be independent ("The transaction has "whiskers")
Assignment of Income Doctrine
As long as a taxpayer retains control over the source of the income (the tree), he or she will be taxed on the receipt of that income (the fruit) even though he or she has assigned all the rights to the income to someone else
- This doctrine is sometimes referred to as the "fruit and the tree"
**An example is where a self-employed person, who receives a $20,000 check in payment for services rendered on behalf of a client, cannot avoid reporting the $20,000 as income by endorsing the check to his adult son who would then claim this as income.
What are some of the reasons profits hold such an exalted place in the business world and economic theory?
a. It fosters cost reducing innovations, which promote the efficient use of scarce resources
b. It encourages savings and risk taking
c. It is a yardstick by which businesspeople can measure their achievement and justify their claims to compensation
Under what conditions is there a universally agreed upon definition of profit?
a. Profit = Revenue - Cost
For the analysis of financial statements, what is the most important distinction to understand?
a. The distinction between bona fide profits and accounting profits
b. What is revenue?
c. What costs count now and which costs count later?
What is the litmus test that a calculation of bona fide profits must pass?
a. After a company earns a bona fide profit, its owners are wealthier than they were beforehand
For financial analysts, what is the practical definition of accounting profit?
a. An accounting profit is whatever the accounting rules say it is
How can Salsa Meister International show a profit when the franchised restaurants consistently lose money?
a. Salsa Meister's revenue is derived from franchise fees
b. Salsa Meister sells stock to the public and then lends these proceeds to the franchises, which in turn pay franchise fees
How can the riddle of a franchiser's profits and franchisee's losses be resolved?
By cutting through the FORM of the transaction to the SUBSTANCE of the transaction
Why should the astute analyst be troubled by the way Salsa Meister International converts losses into profits?
Merely circulating the same funds does not increase wealth
Why and how will the way Salsa Meister International converts losses into profits end?
Sooner or later, investors will realize what is going on and Salsa Meister International will lose its ability to manufacture profits by selling stock
What is depreciation and what is the objection to the relevance of depreciation when calculating earnings?
a. *Depreciation is an accounting procedure that recognizes certain types of property decline in value over time due to WEAR and TEAR or OBSOLESCENCE and recognizes this property must eventually be replaced
b. Rather than calculating bona fide profits, some companies suggest financial analysts should add back depreciation to its net profit (traditional cash flows)
What inspired the attack on the accrual accounting treatment of depreciation?
Companies can raise or lower its reported earnings (financial vs. tax reporting) by using at the latitude of assuming shorter or longer average lives for its depreciable assets
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