1. Chapter 3 Gross Income: Inclusions and Exclusions
“I like to pay taxes.  With them I buy civilization.” 
--Oliver Wendell Holmes, Jr.

2. LO #1 When and How to Record Income
Income Recognition for Tax Purposes
Similar to the recognition for accounting purposes
Income must be realized and earned
However, three additional conditions must be met in order to recognize income:
Transaction must have economic benefit
Transaction must have concluded
Income from the transaction must not be tax exempt income

3. LO #1 When and How to Record Income - Concept Check 3-1
1. An individual must recognize income on his or her tax return if the transaction meets three conditions.
Name the three conditions:________,________,
________
Economic benefit
Conclusion
Not tax exempt

4. LO #1 When and How to Record Income - Concept Check 3-1
2. An individual can exclude certain income from
taxation even though a transaction, which has
economic benefit, has occurred. True or False?
True

5. LO #2 Cash Method of Accounting
Cash Receipts and Disbursements Method
Used by almost all individuals to file their tax returns
Constructive receipt
Income is reported in the year the taxpayer receives the right to control the income rather than the year in which it’s earned
Receipt of property or services will trigger income recognition

6. LO #2 Cash Method of Accounting Concept Check 3-2
1. Income may be realized in any form, whether in
money, property, or services. True or False?
True
2. If you provide consulting services to your friend and in exchange, he fixes your car, you and your friend must report on both tax returns the fair market value of the services provided. True or False?

7. LO #3 Taxability of Components of Gross Income
Interest
Interest from financial institutions is reported on a 1099INT and is taxable
Interest earned on Series E, EE, and I U. S. Savings Bonds is taxable but can be reported gradually on annual basis or fully at maturity
Some interest received is tax exempt if the debt is issued by a U.S. state, possession, or political subdivision

8. LO #3 Taxability of Components of Gross Income
Other types of interest that must be reported
Payments received from seller-financed mortgages
Receipts from installment sale receivables
Imputed interest on loans made below market rate
Interest on bonds sold between interest dates
How to report interest
If the amount of interest is more than $1,500, use Schedule 1 for Form 1040A or Schedule B for Form 1040

9. LO #3 The Taxability of Components of Gross Income Concept Check 3-3
1. All interest received from state or local bonds
is not taxable. True or False?
False
2. A Schedule 1 (Form 1040A) or Schedule B (Form 1040) is required if an individual receives $1,500 of interest for the tax year. True or False?

10. LO #3 Taxability of Components of Gross Income
Dividends
Dividends are distribution to shareholders and is taxable
Dividends are taxed at capital gain rates if they are qualified dividends (from the earnings and profits of domestic or qualified foreign corporation)
Tax rate is 15 percent if the taxpayer’s marginal ordinary income tax rate is 25 percent or more
Tax rate is 5 percent if the taxpayer’s marginal ordinary income tax rate is less than 25 percent

11. LO #3 Taxability of Components of Gross Income
Other types of dividends
Stock dividends and stock splits are generally not taxable to shareholders
How to report dividends
If the amount of interest is more than $1,500, use Schedule 1 for Form 1040A or Schedule B for Form 1040

12. LO #3 Taxability of Components of Gross Income Concept Check 3-4
1. Qualified dividends arise from the earnings and profits of the payer corporation. True or False?
True
2. A corporation can pay only cash dividends to its shareholders. True or False?
False

13. LO #3 Taxability of Components of Gross Income
Refunds from State and Local Governments
Tax refunds are taxable if, in the prior year, the refund was deducted as an itemized deduction
The taxable amount is the smaller of
(a) the amount received, or (b) the amount deducted on Schedule A, or (c) the amount by which itemized deductions exceed the standard deduction

14. LO #3 Taxability of Components of Gross Income
Social Security Benefits
Part of the social security benefits may be taxable
Provisional income (also, called modified AGI) must be calculated and compared to the threshold amounts to determine taxability

15. LO #3 Taxability of Components of Gross Income
Provisional income defined
Adjusted gross income (before SS benefits) plus:
Interest on U.S. Savings Bonds excluded for educational purposes
Most tax exempt interest
Employer-provided adoption benefits
Excluded foreign income
Deducted interest on educational loans
Deducted tuition and fess
50% of social security benefits

16. LO #3 Taxability of Components of Gross Income
If provisional income exceeds certain thresholds, 50% of social security benefits are taxable
As provisional income increases, the taxable amount increases to as much as 85% of social security benefits

17. LO #3 Taxability of Components of Gross Income
Lower and upper threshold amounts for provisional income
Married Filing Jointly Single, Head of Household, or Qualifying Widow(er)
Lower and Upper Limits Lower and Upper Limits
$32, $25,000
$44, $34,000

18. LO #3 Taxability of Components of Gross Income
Example:
Karen files as a qualifying widow. She received $7,000 of social security benefits, $19,000 interest income, and $5,000 nontaxable municipal bond interest. Her provisional income is $27,500.
Karen reports taxable social security benefits equal to the lesser of 50 percent of social security benefits ($3,500) or 50 percent of the excess of provisional income over $25,000 ($1,250). Thus, her taxable benefits are $1,250

19. LO #3 Taxability of Components of Gross Income-Concept Check 3-5
1. Linda and Tom file a joint return. Their AGI before Social Security was $22,000, Social Security benefits received were $9,000, and tax-exempt interest was $1,250. What is the amount of their provisional income?
$27,750 ($22,000+$4,500+$1,250)

20. LO #3 Taxability of Components of Gross Income
Other types of taxable income
Unemployment compensation
Jury duty
Prizes and awards
Forgiveness of debt
Insurance proceeds in excess of the adjusted basis of the property

21. LO #3 Taxability of Components of Gross Income Concept Check 3-6
1. Name a type of income item that is listed on line 21 of Form 1040.____
Jury duty, gambling winnings, prizes and awards

22. LO #4 Items Excluded from Gross Income
Fringe benefits are excluded if they meet the nondiscrimination rules
Examples:
No additional cost services provided to an employee
Unsold hotel room or airline seats
Qualified transportation
Moving expenses

23. LO #4 Items Excluded from Gross Income
Fringe benefits (cont.)
Discounts provided to employees for products or services normally sold by the business
For products, the discount cannot exceed the gross profit percentage
For services, maximum discount is 20 percent of the normal selling price
De minimis benefits
Holiday turkeys, company picnics

24. LO #4 Items Excluded from Gross Income
Nontaxable fringe benefits with certain limitations
Life insurance
Premiums for coverage up to $50,000
Educational assistance
Up to $5,250 may be reimbursed to the employee
Dependent care assistance
Up to $5,000 of exclusion but cannot exceed earned income of the employee

25. LO #4 Items Excluded from Gross Income
Other nontaxable income:
Some have certain requirements or limitations:
Scholarships and fellowships
Qualified tuition program (QTP) withdrawals
Life insurance proceeds
Gifts and inheritances
Compensation for sickness or injury
Child support
Welfare
Employer-provided adoption assistance

26. LO #4 Items Excluded from Gross Income-Concept Check 3-7
1. Holiday turkeys given to employees are included in
gross income. True or False?
False
2. In general, scholarships are not taxable if the use of the money is to pay tuition, fees, books, supplies and equipment. True or False?
True

27. LO #5 Other Interest Income Items
Savings Bond Interest
Not taxable if used to pay qualified higher education expenses for the taxpayer, spouse or dependent children
Full exclusion allowed if the educational expenses paid exceed the redemption amount
Limitation applies if modified AGI exceeds $94,700 on a joint return or $63,100 on other returns

28. LO #5 Other Interest Income Items
Below-Market Interest Rate Loans
If the debt instrument was created with interest rates that materially vary from market rates at the time of issuance, then interest is required to be imputed.
Examples of when imputed interest does not apply:
Sales of property for $3,000 or less
Personal Residence

29. LO #5 Other Interest Income Items
Gift Loans
Imputed interest rules apply to gift loans over $11,000 where forgoing of interest is in the form of a gift
Original Issue Discount (OID)
Equal to the difference between the acquisition price and the maturity value
The holder must report part of the OID as interest income every year

30. LO #5 Other Interest Income Items
OID is not applicable to:
Tax exempt debt
U.S. Savings Bonds
Debt with a maturity of 1 year or less on the date of issue
Any obligation issued by a natural person before March 2, 1984
Non-business loans of $10,000 or less between natural persons

31. LO #5 Other Interest Income Items Concept Check 3-8
1. An individual is required to impute interest on a
deferred payment contract where no interest, or a low rate of interest, is stated. True or False?
True
2. If someone purchases a debt instrument (e.g., bond) from an issuer for an amount less than par value, the transaction creates original issue discount (OID). True or False?