Income Tax Concepts and Their Explanation
The concept of arm’s length transaction states that the people who are involved in the transaction should bargain in order to benefit themselves as individuals but not members of the group. In addition, transactions not made at arm’s length involve an element of related party provisions or relationships such as individuals and their family members, for example, the wife, the brother as well as the son. It is also paramount to note that all the relationships have the potential of self-dealing either because of a family relationship or because of substantial ownership interest in an entity. The most common party relationships are a corporation and partnership if the same person has more than 50% of both the corporation and partnership, an individual and a corporation or a partnership if the same individual owns more than 50% of the corporation or partnership and individuals and their families.
In order to differentiate between the ability to pay tax and the income recognition, we use the wherewithal-to-pay concept, which states income should be recognized and a tax paid on the income when the taxpayer has the resources to pay the tax. This concept applies to both cash and the accrual basis taxpayers and is effective. Accrual basis taxpayers recognize income during the tax period in which the income is earned, without consideration on when the actual cash payment is made. However, when he or she receives advance payment of goods and services, the taxpayer is due to tax payment during the period of cash receipt rather than when it is earned.
The concept of capital recovery states that income generated is taxed after the capital that was used for purchasing the assets has been recovered. When an item is purchased, all the expenses that are incurred on it are recorded for accountability in the future. This is made to determine the amount of profit or loss that is made when an item is sold. The entire amount that is invested in an asset is known as the basis.
The realization concept does not allow any income to be taxed until the person who is supposed to pay tax realizes it. Realization is done mostly when the arm’s length transaction is made. According to this concept, one question that the taxpayer asks him or herself is at which accounting period income items should be taxed. This provides reliable information so that the taxpayer does not have a tax that has accumulated without being paid. We fail to recognize that an income has to be taxed at which rate and when. The realization concept, among other tax concepts, gives guidance to this and is significant for accounting purposes.