©2009 South-Western, a part of Cengage Learning Chapter 3 Income Sources Kevin Murphy Mark Higgins ©2009 South-Western, a part of Cengage Learning

What is Income? All-inclusive Income Concept Judicial findings Defined by exception: “Except as otherwise provided…” § 61 Judicial findings Income is the gain derived from labor and capital Any increase in wealth that has been realized is income

What is Income? Current View A change in the form and/or substance of the taxpayer’s property, and The involvement of a second party in the income process

Types of Income Earned Unearned Transfer Imputed Capital Gains and Losses

Earned Income: Definition Compensation received for the provision of labor is earned income. Two problems may arise when determining taxability of earned income Cash-equivalent approach Assignment of income

Unearned Income: Definition The earnings from investments and gains from the sale, exchange or disposition of investment assets is unearned income. Examples of unearned income are: Interest and Dividend Income Rental and Royalty Income Annuities

Unearned Income: Annuities An annuity is a series of equal payments received at set time intervals for a determinable period Capital Recovery Concept excludes the amount of original investment from taxable income Must be spread over the time of receipt

Annuity Exclusions If the payment term and amount are fixed: Exclusion Ratio = Cost of the contract Total expected return

Annuity Exclusions If the payment term depends on the life of the taxpayer Must estimate the number of payments Use the “simplified method”

Annuity Exclusions Simplified Method Annuity payments beginning after November 18, 1996 use Tables 3-1 or 3-2 to determine number of payments Excluded portion = Contract Cost Number of payments

Annuity Example George, age 64, purchased an annuity for $30,000. He begins receiving $300 per month in January. What amount is included in his gross income? From Table 3-1, the number of payments to use is 260. $30,000 / 260 = $115 monthly exclusion $115 X 12 = $1,380 excluded per year $300 X 12 = $3,600 amount received $3,600 - $1,380 exclusion = $2,220 gross income

Unearned Income: Gains and Losses Gains or losses may occur upon disposal of investment property. Proceeds from sale or disposition less: Selling expenses Amount realized from disposition less: Adjusted basis of property Gain or loss from disposition

Unearned Income: Income from Conduit Entities Income from a conduit entity is reported by the owners and taxed on the owners’ returns Distributions from conduit entities to the owners are treated as a recovery of capital

Transfer Income: Definition Some amounts of income are neither fully earned nor fully unearned. Prizes and Awards Unemployment Compensation Social Security Benefits Alimony Received

Transfer Income: Prizes and Awards Amounts received as prizes and awards are generally taxable. Exceptions exist for: Scientific and literary achievements must be given by recipient to a qualified charity or government unit Employee achievements must be given to employee for length of service or safety amount is limited to $400 per employee (or $1,600 if qualified plan)

Transfer Income: Unemployment Compensation Amounts received from unemployment compensation plans are considered substitutes for earned income and are always taxable.

Transfer Income: Social Security Benefits A portion of Social Security benefits received may be taxable if modified AGI exceeds certain limits. Adjusted gross income plus: 1/2 social security benefits plus: tax exempt income plus: foreign earned income exclusions Modified AGI

Modified AGI Example A single taxpayer received $3,000 from Social Security payments. Her AGI without the SS is $30,000. Modified AGI = $30,000 + $1,500 = $31,500

Transfer Income: Social Security Benefits - Tier One Unmarried individuals with modified AGI between $25,000 and $34,000, and MFJ individuals with modified AGI between $32,000 and $44,000

Tier One Calculation The taxable portion of Social Security is equal to the lesser of: 1. 1/2 Social Security received, OR 2. 1/2 of the amount by which modified AGI exceeds the base amount. where the base amounts are $25,000 for unmarried individuals, $32,000 for MFJ, and $0 for others

Example continued With modified AGI = $31,500, the taxable portion of her $3,000 Social Security income is the lesser of: 1. $1,500, or 2. 1/2 ($31,500 - $25,000) = $3,250 Therefore, taxable SS is $1,500

Transfer Income: Social Security Benefits - Tier Two For individuals whose income exceeds Tier One amounts . . .

Tier Two Calculation The taxable portion of Social Security is equal to the lesser of: 1. 85% of Social Security received, OR 2. 85% of the amount by which modified AGI exceeds the base amount*, PLUS the smaller of a. the amount of SS benefits included under the 50% formula, or b. $4,500 for unmarried individuals ($6,000 for MFJ) *Where the base amounts are $34,000 for unmarried individuals, $44,000 for MFJ, and $0 for others © 2004 South-Western College Publishing

Example for Tier Two If our taxpayer receives Social Security of $12,000 and has AGI of $50,000 before SS: Modified AGI = $50,000 + $6,000* = $56,000 Taxable SS is $10,200, which is the smaller of: 1. .85( $12,000) = $10,200, or 2. [.85 ($56,000 - $34,000)] + [(1/2 of $12,000 SS) or $4,500] = $18,700 + $4,500 = $23,200.

Transfer Income: Alimony Received Amounts received for alimony payments are taxable income if: the payments are made in cash there is a written agreement the payments are not disguised child support the payments cannot be made to payee’s estate the payer and payee do not live in the same household

Imputed Income: Personal Consumption The value of the goods and services produced by individuals for personal consumption generally are not taxable Realization concept Administrative Convenience concept

Imputed Income: Below Market-Rate Loans Interest income and expense are imputed on below market-rate loans. The relationship between the lender and the borrower determines the tax treatment The lender has imputed interest income The borrower has imputed interest expense Administrative Convenience grants exceptions for loans of $10,000 or less gift loans of $100,000 or less

Imputed Income: Payment of Expense by Others A taxpayer whose expenses are paid by another has realized an increase in wealth. Payments made by family members may be considered nontaxable gifts Payments made by employers are taxable income

Imputed Income: Bargain Purchases When a bargain purchase price does not result from an arms-length transaction, the bargain amount is taxable income.

Capital Gains and Losses: Introduction A capital asset is any asset other than inventory, receivables, and depreciable or real property used in a trade or business. A sale or other disposition of capital assets results in a capital gain or loss Capital gains and losses receive special tax treatment

Capital Gains and Losses: Holding Period The holding period for capital assets is how long the taxpayer owned the asset. Short Term = held for < 12 months Long Term = held for > 12 months Determining holding period is the first step in determining tax treatment.

Capital Gains and Losses: Netting Procedures Long-term gains netted against Long-term losses Net Long-term Gain or Loss = Short-term gains netted against Short-term losses Net Short-term Gain or Loss =

Capital Gains and Losses: Netting Procedures If one is a loss and one is a gain, then: Net Short-term Gain or Loss netted against Net Long-term Gain or Loss Net Capital Gain or Loss = If both are losses or both are gains, no further netting is done.

Tax Treatment for Net Gains Net short-term capital gain is taxed as ordinary income Adjusted net long-term capital gain is taxed at a maximum 15% Adjusted NLTG = NLTG - [28% rate gain - Unrecaptured §1250 gain + Eligible dividends] 28% rate gain = [Net collectibles gain + Small business stock gain - STCL - LTCL carryover]

Tax Treatment for Net Gains Net Collectibles gain and Small Business Stock gain is taxed at a maximum 28% Unrecaptured §1250 gain is taxed at a maximum 25%

Capital Gains and Losses: Holding Period & Maximum Rate

Tax Treatment for Net Losses by Individuals Only $3,000 of net capital losses may be deducted in one year Use short-term losses first Carryover net loss > $3,000 Capital gains and losses of conduit entities flow-through to owners’ returns

When is Income Reported? The Accounting Method chosen by a taxpayer dictates when income is reported. Cash Method taxpayers report income when cash is actually or constructively received Accrual Method taxpayers report income when it is earned Hybrid Method taxpayers mix accrual and cash methods

Accounting Method Cash Cash method taxpayers must follow the Constructive Receipt Concept. Exceptions to the cash method: Taxpayers who sell inventory may not use the cash method for inventory Taxpayers must use the accrual and the effective interest method with Original Issue Discount securities Taxpayers who hold Series EE Bonds may elect to use the accrual method

Accounting Method Accrual Under tax law, income is accrued when All events have occurred that fix the right to receive the income, and The amount of income earned can be determined

Accounting Method Accrual Exceptions Exceptions to the accrual method: The Wherewithal-to-Pay concept requires income be reported in the year pre-payment is received for rents, insurance, interest and royalties One year deferral is allowed for some pre-payments Report amount = Financial Accounting in first year Remainder of amount in full in second year Pre-payments for goods may be accrued if the payment is less than the Cost of Goods Sold.

Accounting Method Hybrid Taxpayers may mix the cash and accrual methods, using accrual for sales of inventories and cash for other revenues and expenses.

Accounting Method Exceptions to All Methods Installment Sales Method: Any time one payment is received after the year of sale, taxpayers must recognize income proportionately as the selling price is received unless they elect to report in the year of sale. Long-term Construction Contracts: The percentage-of-completion method must be used for all long-term construction.