1. ©2009 South-Western, a part of Cengage Learning
Chapter 3
Income Sources
Kevin Murphy
Mark Higgins
©2009 South-Western, a part of Cengage Learning

2. 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

3. 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

4. Types of Income Earned Unearned Transfer Imputed
Capital Gains and Losses

5. 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

6. 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

7. 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

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

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

10. 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

11. 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

12. 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

13. 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

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

15. 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)

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

17. 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

18. 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

19. 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

20. 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

21. 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

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

23. Tier Two Calculation
The taxable portion of Social Security is equal to the lesser of:
1. 85% of Social Security received,
OR % 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

24. 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.

25. 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

26. 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

27. 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

28. 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

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

30. 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

31. 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.

32. 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 =

33. 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.

34. 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]

35. 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%

36. Capital Gains and Losses: Holding Period & Maximum Rate

37. 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

38. 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

39. 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

40. 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

41. 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.

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

43. 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.