Realization Requirements: Timing & Tax Implications

Instructor: Lee Davis

Lee has a BA in Political Science; and my MA is in Political Science with a concentration in International Relations.

This lesson will go over the realization principle of taxation and how it works. We'll go over the definition of realization, how you record these types of payments for taxes, and how you can spread these out over time.

Taxation & Realization

Imagine that you've just invented a new gadget that everyone wants. You start a crowdfunding site and instantly take thousands of orders for this new product. You receive all of the money up front, but cannot deliver the product to the customer for another six months. How do you pay taxes on this? Do you pay tax on the money once they send it, or do you pay the tax when you deliver the product? Let's find out!

What Is Realization?

For federal income tax purposes, realization is a requirement on what should be included as income that is subject to taxation. The federal tax code loosely defines what income is, and there have been several cases to determine what the government means by income that should be taxed. In Commissioner v. Glenshaw Glass Co., the Supreme Court determined that, generally, income is ''undeniable accessions of wealth, clearly realized, and over which the taxpayer has complete dominion.''

In another case, Helvering v. Bruun, the court explains ''the realization of gain need not be in cash derived from the sale of an asset. Gain may occur as a result of exchange of property, payment of the taxpayers' indebtness, relief from a liability, or other profit realized from the completion of a transaction.''

The U.S. Supreme Court states that there are four events that trigger the realization of a gain or loss, including:

  • A property exchange
  • Relief of a legal obligation owed to a third party
  • Relief of a legal obligation owed to the party receiving property
  • Other profit transactions

How Realization Works?

Realization can be a simple concept. For example, with the sale of a good, revenue is recognized once the seller transfers the risk associated with the ownership of the goods to the buyer. In terms of goods being sold on credit, the amount paid each year will be counted as taxable revenue. The same is true for a case of rendering services: revenue is recognized when the service or contract is completed.

This principle reflects the true extent of revenue earned during the period reported. For example, think about a car dealership who takes a down payment for a car from a customer and then allows the customer to finance the rest. The dealership must only pay tax on the down payment. If the rest is financed, say over a five-year period, the dealership will only pay tax each year that money is collected.

As another example, say you bought stock in ABC, Inc. at $10 a share, and by the end of the tax year, the stock is valued at $25 a share. The question is should you be taxed for the $15 gain per share in the stock, despite the fact that you haven't sold the stock? If you had sold the stock, then you would have to pay a tax on it; however, the question remains: should you have to pay tax on the gains, despite the fact that the gains could disappear?

Four Aspects of the Realization Principle

Here's a list of the four aspects of the realization principle in action, each of which triggers taxation once monies are realized or counted as revenue:

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