Individual Income Taxes C4-1 Chapter 4 Gross Income: Concepts and Inclusions Gross Income: Concepts and Inclusions Copyright ©2009 Cengage Learning Individual Income Taxes

C4-2 Gross Income (slide 1 of 3) Definition: Gross income includes all income from whatever source derived, unless specifically excluded under the Code Concept is interpreted broadly by the courts Definition: Gross income includes all income from whatever source derived, unless specifically excluded under the Code Concept is interpreted broadly by the courts

Individual Income Taxes C4-3 Gross Income (slide 2 of 3) Taxability of income follows the realization principle from accounting –Income is recognized (taxed) when realized Mere appreciation in wealth (economic income) is not considered realized income Taxability of income follows the realization principle from accounting –Income is recognized (taxed) when realized Mere appreciation in wealth (economic income) is not considered realized income

Individual Income Taxes C4-4 Gross Income (slide 3 of 3) Income is recognized whether it is in the form of cash, or “in-kind” cash equivalents (i.e., property or services) –The amount of income from “in-kind” receipts is equal to the FMV of the property or services Income does not include recovery of the taxpayer’s capital investment Income is recognized whether it is in the form of cash, or “in-kind” cash equivalents (i.e., property or services) –The amount of income from “in-kind” receipts is equal to the FMV of the property or services Income does not include recovery of the taxpayer’s capital investment

Individual Income Taxes C4-5 Accounting Periods Taxable year is generally a 12-month period –Taxable year for most individual taxpayers is the calendar year –Fiscal year can be elected if taxpayer maintains adequate records Fiscal year is a 12-month period ending on the last day of a month other than December –Example: July 1 to June 30 Taxable year is generally a 12-month period –Taxable year for most individual taxpayers is the calendar year –Fiscal year can be elected if taxpayer maintains adequate records Fiscal year is a 12-month period ending on the last day of a month other than December –Example: July 1 to June 30

Individual Income Taxes C4-6 Accounting Methods (slide 1 of 2) There are 3 primary methods of accounting for tax purposes: –Cash receipts and disbursements method –Accrual method –Hybrid method There are 3 primary methods of accounting for tax purposes: –Cash receipts and disbursements method –Accrual method –Hybrid method

Individual Income Taxes C4-7 Accounting Methods (slide 2 of 2) In addition to overall accounting methods, taxpayers may choose (elect) tax treatment for various transactions, for example –Taxpayers can elect to use the installment method –Certain contractors may elect to use either the percentage of completion method or the completed contract method In addition to overall accounting methods, taxpayers may choose (elect) tax treatment for various transactions, for example –Taxpayers can elect to use the installment method –Certain contractors may elect to use either the percentage of completion method or the completed contract method

Individual Income Taxes C4-8 Cash Receipts Method (slide 1 of 2) Income is recognized in the year it is actually or constructively received in cash or cash equivalent An amount is constructively received when it is set aside and made available to taxpayer without substantial restrictions Income is recognized in the year it is actually or constructively received in cash or cash equivalent An amount is constructively received when it is set aside and made available to taxpayer without substantial restrictions

Individual Income Taxes C4-9 Cash Receipts Method (slide 2 of 2) Example - Constructive receipt –An employer issued a bonus check to an employee on December 31 st but asked her to hold it for a few days until the company could make deposits to cover the check. The income was not constructively received on December 31 since the issuer did not have sufficient funds in its account to pay the debt. Example - Constructive receipt –An employer issued a bonus check to an employee on December 31 st but asked her to hold it for a few days until the company could make deposits to cover the check. The income was not constructively received on December 31 since the issuer did not have sufficient funds in its account to pay the debt.

Individual Income Taxes C4-10 Exceptions To Cash Receipts Method Original Issue Discount (OID) interest is taxable when earned rather than when interest is received Series E and EE bonds are not subject to the OID rules –However, a cash basis taxpayer may elect to recognize the interest when earned Original Issue Discount (OID) interest is taxable when earned rather than when interest is received Series E and EE bonds are not subject to the OID rules –However, a cash basis taxpayer may elect to recognize the interest when earned

Individual Income Taxes C4-11 Accrual Method (slide 1 of 2) Income is recognized in the year that it is earned regardless of when it is collected Income is earned when: –All events have occurred that fix taxpayer’s right to the income, and –The amount can be determined with reasonable accuracy The accrual method is required for determining purchases and sales when inventory is an income- producing factor Income is recognized in the year that it is earned regardless of when it is collected Income is earned when: –All events have occurred that fix taxpayer’s right to the income, and –The amount can be determined with reasonable accuracy The accrual method is required for determining purchases and sales when inventory is an income- producing factor

Individual Income Taxes C4-12 Accrual Method (slide 2 of 2) Claim of right doctrine –Requires amounts received to be included in income even though the amount is in dispute and might be returned to the payor at a later date –If payment has not been received, no income is recognized until the claim is settled Claim of right doctrine –Requires amounts received to be included in income even though the amount is in dispute and might be returned to the payor at a later date –If payment has not been received, no income is recognized until the claim is settled

Individual Income Taxes C4-13 Exceptions to Accrual Method (slide 1 of 2) Taxpayer can elect to defer recognition of income from advance payment for goods if same method of accounting is used for tax and financial reporting purposes

Individual Income Taxes C4-14 Exceptions to Accrual Method (slide 2 of 2) Advance payment for services to be performed after year-end is included in income in the year following receipt –The portion of the advance payment that is earned in the current year is included in income in the year of receipt Prepaid rents or interest income are always recognized in the year received rather than when earned Advance payment for services to be performed after year-end is included in income in the year following receipt –The portion of the advance payment that is earned in the current year is included in income in the year of receipt Prepaid rents or interest income are always recognized in the year received rather than when earned

Individual Income Taxes C4-15 Hybrid Method A combination of cash and accrual methods Generally, used when inventory is a material income-producing factor –Use accrual method for determining sales and cost of goods sold –Use cash method for other income and expenses A combination of cash and accrual methods Generally, used when inventory is a material income-producing factor –Use accrual method for determining sales and cost of goods sold –Use cash method for other income and expenses

Individual Income Taxes C4-16 Income Sources (slide 1 of 2) Income from personal services is taxable to the person who performs the services –Fruit and tree metaphor Income from property is taxable to the owner of the property –Assignment of income is not permitted Income from personal services is taxable to the person who performs the services –Fruit and tree metaphor Income from property is taxable to the owner of the property –Assignment of income is not permitted

Individual Income Taxes C4-17 Income Sources (slide 2 of 2) Interest income accrues daily –If interest bearing instrument (e.g., bonds) is transferred, must allocate interest income between transferor and transferee based on the number of days during the period that each owned the property Interest income accrues daily –If interest bearing instrument (e.g., bonds) is transferred, must allocate interest income between transferor and transferee based on the number of days during the period that each owned the property

Individual Income Taxes C4-18 Dividends (slide 1 of 4) Dividends are generally taxed to the party who is entitled to receive them –Dividends on stock transferred by gift after declaration date but before record date is generally taxed to the donor Dividends are generally taxed to the party who is entitled to receive them –Dividends on stock transferred by gift after declaration date but before record date is generally taxed to the donor

Individual Income Taxes C4-19 Dividends (slide 2 of 4) The Tax Relief Reconciliation Act of 2003 provides partial relief from double taxation of corporate dividends (extended by the Tax Increase Prevention Act of 2005) –Generally, dividends received in taxable years beginning after 2002 are taxed at the same marginal rate that is applicable to a net capital gain Thus, individuals otherwise subject to the 10% or 15% marginal tax rate in 2008 pay 0% tax on qualified dividends received Individuals subject to the 25, 28, 33, or 35 percent marginal tax rate pay a 15% tax on qualified dividends The Tax Relief Reconciliation Act of 2003 provides partial relief from double taxation of corporate dividends (extended by the Tax Increase Prevention Act of 2005) –Generally, dividends received in taxable years beginning after 2002 are taxed at the same marginal rate that is applicable to a net capital gain Thus, individuals otherwise subject to the 10% or 15% marginal tax rate in 2008 pay 0% tax on qualified dividends received Individuals subject to the 25, 28, 33, or 35 percent marginal tax rate pay a 15% tax on qualified dividends

Individual Income Taxes C4-20 Dividends (slide 3 of 4) The following dividends are not eligible for the reduced tax rates –Dividends from certain foreign corporations, –Dividends from tax-exempt entities, and –Dividends that do not satisfy the holding period requirement Stock on which the dividend is paid must have been held for more than 60 days during the 120-day period beginning 60 days before the ex-dividend date to qualify for the reduced tax rates The following dividends are not eligible for the reduced tax rates –Dividends from certain foreign corporations, –Dividends from tax-exempt entities, and –Dividends that do not satisfy the holding period requirement Stock on which the dividend is paid must have been held for more than 60 days during the 120-day period beginning 60 days before the ex-dividend date to qualify for the reduced tax rates

Individual Income Taxes C4-21 Dividends (slide 4 of 4) Dividends from foreign corporations are eligible for qualified dividend status only if: –The foreign corporation’s stock is traded on an established U.S. securities market, or –The foreign corporation is eligible for the benefits of a comprehensive income tax treaty between its country of incorporation and the United States Dividends from foreign corporations are eligible for qualified dividend status only if: –The foreign corporation’s stock is traded on an established U.S. securities market, or –The foreign corporation is eligible for the benefits of a comprehensive income tax treaty between its country of incorporation and the United States

Individual Income Taxes C4-22 Income Received By An Agent Income received by the taxpayer’s agent is considered to be received by the taxpayer –A cash basis principal must recognize the income at the time it is received by the agent Income received by the taxpayer’s agent is considered to be received by the taxpayer –A cash basis principal must recognize the income at the time it is received by the agent

Individual Income Taxes C4-23 Income From Partnerships A partnership is not a separate taxable entity –Files an information return (Form 1065) Provides data necessary for determining each partner’s distributive share of partnership’s income and deductions Each partner reports distributive share of partnership income and deductions –Reported in year earned, even if not actually distributed Because a partner pays tax on income as the partnership earns it, distributions are treated under the recovery of capital rules A partnership is not a separate taxable entity –Files an information return (Form 1065) Provides data necessary for determining each partner’s distributive share of partnership’s income and deductions Each partner reports distributive share of partnership income and deductions –Reported in year earned, even if not actually distributed Because a partner pays tax on income as the partnership earns it, distributions are treated under the recovery of capital rules

Individual Income Taxes C4-24 Income From S Corporations A small business corporation may elect to be taxed similarly to a partnership –Referred to as an S corporation The shareholders, rather than the corporation, pay the tax on the corporation’s income Generally, shareholders report their share of the corp’s income and deductions for the year, even if not actually distributed A small business corporation may elect to be taxed similarly to a partnership –Referred to as an S corporation The shareholders, rather than the corporation, pay the tax on the corporation’s income Generally, shareholders report their share of the corp’s income and deductions for the year, even if not actually distributed

Individual Income Taxes C4-25 Income From Estates And Trusts Beneficiaries of estates and trusts –Generally, taxed on the income earned by the estates or trusts that is actually distributed or required to be distributed to them –Any income not taxed to the beneficiaries is taxable to the estate or trust Beneficiaries of estates and trusts –Generally, taxed on the income earned by the estates or trusts that is actually distributed or required to be distributed to them –Any income not taxed to the beneficiaries is taxable to the estate or trust

Individual Income Taxes C4-26 Income In Community Property States All property is deemed either to be separately owned by the spouse or to belong to the marital community –Community income is allocable equally to each spouse –Separate income may be allocable to owner-spouse Separate property may produce community income (e.g., TX, LA) No allocation of community income for some spouses living apart for entire year and filing separately All property is deemed either to be separately owned by the spouse or to belong to the marital community –Community income is allocable equally to each spouse –Separate income may be allocable to owner-spouse Separate property may produce community income (e.g., TX, LA) No allocation of community income for some spouses living apart for entire year and filing separately

Individual Income Taxes C4-27 Alimony and Separate Maintenance Payments (slide 1 of 4) Alimony is: –Deductible by payor –Includible in gross income of recipient Alimony is: –Deductible by payor –Includible in gross income of recipient

Individual Income Taxes C4-28 Alimony and Separate Maintenance Payments (slide 2 of 4) Payments may qualify as alimony if: 1.Payments are in cash 2.Agreement or decree does not specify that the payments are not alimony 3.Payor and payee are not members of the same household at the time the payments are made 4.There is no liability to make the payments for any period after the death of the payee Payments may qualify as alimony if: 1.Payments are in cash 2.Agreement or decree does not specify that the payments are not alimony 3.Payor and payee are not members of the same household at the time the payments are made 4.There is no liability to make the payments for any period after the death of the payee

Individual Income Taxes C4-29 Alimony and Separate Maintenance Payments (slide 3 of 4) Property settlements –Transfer of property to former spouse –No deduction or recognized gain or loss for transferor –No gross income and carryover of transferor’s basis for transferee –Front-loading of alimony payments Alimony recapture (gross income) for payor Deduction from gross income for recipient Property settlements –Transfer of property to former spouse –No deduction or recognized gain or loss for transferor –No gross income and carryover of transferor’s basis for transferee –Front-loading of alimony payments Alimony recapture (gross income) for payor Deduction from gross income for recipient

Individual Income Taxes C4-30 Alimony and Separate Maintenance Payments (slide 4 of 4) Child support payments –Payments made to satisfy legal obligation to support child of taxpayer –Nondeductible by payor and not taxed to recipient (or child) May be difficult to determine whether an amount received is alimony or child support –If amount of payment would be reduced due to some future event related to the child (e.g., child reaches age 21), such reduction is deemed child support Child support payments –Payments made to satisfy legal obligation to support child of taxpayer –Nondeductible by payor and not taxed to recipient (or child) May be difficult to determine whether an amount received is alimony or child support –If amount of payment would be reduced due to some future event related to the child (e.g., child reaches age 21), such reduction is deemed child support

Individual Income Taxes C4-31 Imputed Interest on Below- Market Loans (slide 1 of 4) Interest is imputed, using Federal government rates, when a loan does not carry a market rate of interest –Imputed interest = the difference between the amount that would have been charged at the Federal rate and the amount actually charged Applies to: Gift loans Compensation-related loans Corporate-shareholder loans Tax avoidance loans Interest is imputed, using Federal government rates, when a loan does not carry a market rate of interest –Imputed interest = the difference between the amount that would have been charged at the Federal rate and the amount actually charged Applies to: Gift loans Compensation-related loans Corporate-shareholder loans Tax avoidance loans

Individual Income Taxes C4-32 Imputed Interest on Below- Market Loans (slide 2 of 4)

Individual Income Taxes C4-33 Imputed Interest on Below- Market Loans (slide 3 of 4) Gift loans –Exemption for loans of ≤ $10,000 between individuals If loan proceeds are used to purchase income-producing property, the following limitation applies –On loans of $100,000 or less between individuals Imputed interest is limited to borrower’s net investment income for year No imputed interest if net investment income is $1,000 or less Gift loans –Exemption for loans of ≤ $10,000 between individuals If loan proceeds are used to purchase income-producing property, the following limitation applies –On loans of $100,000 or less between individuals Imputed interest is limited to borrower’s net investment income for year No imputed interest if net investment income is $1,000 or less

Individual Income Taxes C4-34 Imputed Interest on Below- Market Loans (slide 4 of 4) $10,000 exemption also applies to compensation-related and corporation- shareholder loans –No exemption if principal purpose of loan is tax avoidance Makes practically all loans of this type suspect Interest expense imputed to borrower may be deductible $10,000 exemption also applies to compensation-related and corporation- shareholder loans –No exemption if principal purpose of loan is tax avoidance Makes practically all loans of this type suspect Interest expense imputed to borrower may be deductible

Individual Income Taxes C4-35 Annuity Income (slide 1 of 6) Purchaser pays fixed amount for the right to receive a future stream of payments –Generally, early collections and loans against annuity ≤ increases in cash value are included in gross income Amounts > increases in cash value are treated as a recovery of capital until cost recovered; additional amounts are included in income –Early distributions may also be subject to a 10% penalty Purchaser pays fixed amount for the right to receive a future stream of payments –Generally, early collections and loans against annuity ≤ increases in cash value are included in gross income Amounts > increases in cash value are treated as a recovery of capital until cost recovered; additional amounts are included in income –Early distributions may also be subject to a 10% penalty

Individual Income Taxes C4-36 Annuity Income (slide 2 of 6) The exclusion ratio is applied to annuity payments received under contract to determine amount excludable: Exclusion ratio = Investment in contract Expected return under contract Once investment is recovered, remaining payments are taxable in full The exclusion ratio is applied to annuity payments received under contract to determine amount excludable: Exclusion ratio = Investment in contract Expected return under contract Once investment is recovered, remaining payments are taxable in full

Individual Income Taxes C4-37 Annuity Income (slide 3 of 6) Examples: –Taxpayer pays $10,000 for annuity that will pay $1,000 a year A: For a term of 15 years B: For lifetime (life expectancy = 15 years) –Exclusion ratio for A & B = $10,000 =.667 $15,000 Examples: –Taxpayer pays $10,000 for annuity that will pay $1,000 a year A: For a term of 15 years B: For lifetime (life expectancy = 15 years) –Exclusion ratio for A & B = $10,000 =.667 $15,000

Individual Income Taxes C4-38 Annuity Income (slide 4 of 6) Example (cont’d) –A: 15 years of annuity payments Years 1-15: $333 taxable and $667 excludable Example (cont’d) –A: 15 years of annuity payments Years 1-15: $333 taxable and $667 excludable

Individual Income Taxes C4-39 Annuity Income (slide 5 of 6) Example (cont’d) –B: Lifetime payments and taxpayer lives 18 years Years 1-15: $333 taxable and $667 excludable Years 16-18: $1,000 taxable –B: Lifetime payments and taxpayer lives 10 years Years 1-10: $333 taxable and $667 excludable, and $3,330 deduction on final return Example (cont’d) –B: Lifetime payments and taxpayer lives 18 years Years 1-15: $333 taxable and $667 excludable Years 16-18: $1,000 taxable –B: Lifetime payments and taxpayer lives 10 years Years 1-10: $333 taxable and $667 excludable, and $3,330 deduction on final return

Individual Income Taxes C4-40 Annuity Income (slide 6 of 6) The simplified method is required for annuity distributions from a qualified retirement plan –Exclusion amount is investment in contract divided by number of anticipated monthly payments (table amount based on age) The simplified method is required for annuity distributions from a qualified retirement plan –Exclusion amount is investment in contract divided by number of anticipated monthly payments (table amount based on age)

Individual Income Taxes C4-41 Prizes and Awards General rule: FMV of item is included in income Exceptions: Taxpayer designates qualified organization to receive prize or award (subject to other requirements) Employee achievement awards of tangible personal property made in recognition of length of service or safety achievement (limits apply) General rule: FMV of item is included in income Exceptions: Taxpayer designates qualified organization to receive prize or award (subject to other requirements) Employee achievement awards of tangible personal property made in recognition of length of service or safety achievement (limits apply)

Individual Income Taxes C4-42 Group Term Life Insurance Exclude premiums paid by employer on first $50,000 of coverage Premiums on excess coverage are included in gross income –Inclusion amount based on IRS provided tables Exclude premiums paid by employer on first $50,000 of coverage Premiums on excess coverage are included in gross income –Inclusion amount based on IRS provided tables

Individual Income Taxes C4-43 Unemployment Compensation Taxable in full

Individual Income Taxes C4-44 Social Security Benefits (slide 1 of 6) Up to 85% of benefits may be taxable Taxability based on taxpayer’s modified adjusted gross income (MAGI) –MAGI = AGI (excluding Social Security) + foreign earned income exclusion + tax exempt interest Two formulas for computing taxable benefits Up to 85% of benefits may be taxable Taxability based on taxpayer’s modified adjusted gross income (MAGI) –MAGI = AGI (excluding Social Security) + foreign earned income exclusion + tax exempt interest Two formulas for computing taxable benefits

Individual Income Taxes C4-45 Social Security Benefits (slide 2 of 6) Formula 1 - If MAGI plus ½ of Social Security benefits exceeds the base amounts below, but not the second set of base amounts, Include in income the lesser of:.50 (Social Security Benefits), or.50 [MAGI +.50 (SSB) - base amount] Base amounts: – $32,000 MFJ, – $0 MFS and not living apart, – $25,000 for all other taxpayers Formula 1 - If MAGI plus ½ of Social Security benefits exceeds the base amounts below, but not the second set of base amounts, Include in income the lesser of:.50 (Social Security Benefits), or.50 [MAGI +.50 (SSB) - base amount] Base amounts: – $32,000 MFJ, – $0 MFS and not living apart, – $25,000 for all other taxpayers

Individual Income Taxes C4-46 Social Security Benefits (slide 3 of 6) Formula 2 - If MAGI plus ½ of Social Security benefits exceeds the base amounts below Include in income the lesser of :.85(Social Security benefits), or Sum of:.85[MAGI +.50(Social Security benefits) - second base amount], and the lesser of: –Amount included through application of the first formula –$4,500 ($6,000 for married filing jointly). Base amounts : –$44,000 MFJ, – $0 MFS and not living apart – $34,000 for all other taxpayers Formula 2 - If MAGI plus ½ of Social Security benefits exceeds the base amounts below Include in income the lesser of :.85(Social Security benefits), or Sum of:.85[MAGI +.50(Social Security benefits) - second base amount], and the lesser of: –Amount included through application of the first formula –$4,500 ($6,000 for married filing jointly). Base amounts : –$44,000 MFJ, – $0 MFS and not living apart – $34,000 for all other taxpayers

Individual Income Taxes C4-47 Social Security Benefits (slide 4 of 6) Example of Social Security income: A: Married with AGI = $30,000; tax exempt interest income = $3,000; Social Security benefits = $10,000 B: Married with AGI = $40,000; tax exempt interest income = $6,000; Social Security benefits = $10,000 Example of Social Security income: A: Married with AGI = $30,000; tax exempt interest income = $3,000; Social Security benefits = $10,000 B: Married with AGI = $40,000; tax exempt interest income = $6,000; Social Security benefits = $10,000

Individual Income Taxes C4-48 Social Security Benefits (slide 5 of 6) Example (cont’d) A: Formula 1: Lesser of:.50 ($10,000) = $5,000, or.50 [($30,000 + $3,000) +.50 ($10,000) - $32,000)] = $3,000 Therefore, $3,000 of Social Security benefits included in gross income Example (cont’d) A: Formula 1: Lesser of:.50 ($10,000) = $5,000, or.50 [($30,000 + $3,000) +.50 ($10,000) - $32,000)] = $3,000 Therefore, $3,000 of Social Security benefits included in gross income

Individual Income Taxes C4-49 Social Security Benefits (slide 6 of 6) Example (cont’d) –B: Formula 2: Lesser of:.85 ($10,000) = $8,500, or Sum of –.85[($40,000 + $6,000) +.50 ($10,000) - $44,000] = $5,950, and –Lesser of: –.50 ($10,000) = $5,000, or –$6,000 Therefore, $8,500 of Social Security benefits included in gross income Example (cont’d) –B: Formula 2: Lesser of:.85 ($10,000) = $8,500, or Sum of –.85[($40,000 + $6,000) +.50 ($10,000) - $44,000] = $5,950, and –Lesser of: –.50 ($10,000) = $5,000, or –$6,000 Therefore, $8,500 of Social Security benefits included in gross income

Individual Income Taxes C4-50 If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA SUNY Oneonta If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA SUNY Oneonta