1. 3 - 1 ©2004 Prentice Hall, Inc. Determining Gross Income Chapter 3

2. 3 - 2 ©2004 Prentice Hall, Inc. What is Gross Income? Code Section 61(a) defines gross income as: “except as otherwise provided in this subtitle, gross income means all income from whatever source derived...”

3. 3 - 3 ©2004 Prentice Hall, Inc. What is Income? Gross income is realized income that is not excluded Taxable income is gross income less all deductions

4. 3 - 4 ©2004 Prentice Hall, Inc. Tax vs. Financial Accounting The goals of financial accounting are not the same as those for tax reporting  Financial accounting seeks to provide information that decision makers find useful  Tax reporting seeks to collect revenue equitably

5. 3 - 5 ©2004 Prentice Hall, Inc. Tax vs. Financial Accounting Differences fall into two categories: 1.Temporary or timing differences (which usually even out over time) 2.Permanent differences

6. 3 - 6 ©2004 Prentice Hall, Inc. Temporary Differences Income that is taxed either before or after it is accrued for accounting purposes  Example: prepaid rent generally is taxable when received but it is included in financial accounting income only as it is earned Accounted for as deferred tax asset or deferred tax liability on financial statements

7. 3 - 7 ©2004 Prentice Hall, Inc. Permanent Differences Income that is not taxed but is reported for financial accounting purposes  Example: municipal bonds interest generally is not taxed but is recorded as income in financial accounting records

8. 3 - 8 ©2004 Prentice Hall, Inc. Return of Capital Principle Basis = amount invested in an asset Basis is recovered tax-free  If the taxpayer’s return is more than basis, the taxpayer has a gain  If taxpayer’s return is less than basis, the taxpayer has a loss

9. 3 - 9 ©2004 Prentice Hall, Inc. Investment Alternatives Investments yielding appreciation  Tax deferred until gain is recognized  Gain is frequently taxed at lower capital gains rates Investments yielding annual income  Income is taxed annually at ordinary marginal tax rate

10. 3 - 10 ©2004 Prentice Hall, Inc. The Tax Year Calendar year  Individuals  S corporations and partnerships have restrictions on year they can select, so usually use a calendar year Fiscal year – 12 month period ending on month other than December  52-to-53 week year (ends on same day)

11. 3 - 11 ©2004 Prentice Hall, Inc. Short Tax Year A short-year tax return reports less than 12 months of operating results Income must be annualized (adjusted to reflect 12 months of operations to calculate tax)  Required by businesses that change their tax year  Not required in year entity begins or ends business

12. 3 - 12 ©2004 Prentice Hall, Inc. Accounting Methods Taxpayers can use different methods for financial accounting and tax Cash method  Income broadly defined to include cash equivalents such as property and services  Cash equivalents are included at their fair market value

13. 3 - 13 ©2004 Prentice Hall, Inc. Constructive Receipt Doctrine Constructive receipt is a modification that prevents cash basis taxpayers from “turning their backs” on income A cash-basis taxpayer must recognize income when an amount is:  Credited to the taxpayer’s account  Set apart for the taxpayer or  Made available in some other way to the taxpayer

14. 3 - 14 ©2004 Prentice Hall, Inc. Constructive Receipt Doctrine Income is not constructively received if:  The taxpayer is not entitled to the income  The payor has insufficient funds from which to make payment  There are substantial limitations or restrictions placed on actual receipt

15. 3 - 15 ©2004 Prentice Hall, Inc. Limits on Cash Method Businesses that carry inventory and sell merchandise to customers generally must use the accrual method to account for sales and purchases Hybrid method – accrual for sales of inventory & cost of goods sold; cash method for other income and expenses Large corporations (gross receipts of more than $5 million) cannot use cash method

16. 3 - 16 ©2004 Prentice Hall, Inc. Accrual Method Income is recognized when “all events test” is met:  All events have occurred that establish the right to the income and  The income amount can be determined with reasonable accuracy If liability is in dispute, the all events test is not satisfied until dispute is resolved

17. 3 - 17 ©2004 Prentice Hall, Inc. Claim of Right Doctrine Claim of right doctrine is a modification to the normal rules for accrual basis taxpayers Applies whenever the taxpayer received income but there is a dispute regarding the taxpayer’s right to keep some or all of the income Taxpayer must recognize income even though some of the income may have to be repaid later

18. 3 - 18 ©2004 Prentice Hall, Inc. Prepaid Income Prepaid Income is another exception to the accrual method of accounting Based on “wherewithal to pay concept” income must be reported when received  Examples: rent, interest, and royalty payments  Refundable deposits are not prepaid income

19. 3 - 19 ©2004 Prentice Hall, Inc. Installment Method Gain is recognized as proceeds from sale are received Restriction on use – generally for casual sales (not for sale of inventory or securities) May not want to use if:  Marginal tax rate is expected to increase  Unused losses

20. 3 - 20 ©2004 Prentice Hall, Inc. Long-Term Contracts Completed Contract Method—no income is recognized and no deductions taken until completion Percentage-of-Completion Method—income is recognized as contract progresses based on an estimate of actual costs incurred to total projected costs for contract

21. 3 - 21 ©2004 Prentice Hall, Inc. Assignment of Income Doctrine A taxpayer cannot assign earned income to a third party to escape taxation Earned income must be taxed to the taxpayer rendering the services  Community property states (Arizona, California, Idaho. Louisiana, Nevada, New Mexico, Texas, Washington, Wisconsin) allocate income between spouses. Income from property is taxed to taxpayer who owns the property

22. 3 - 22 ©2004 Prentice Hall, Inc. Interest Income Interest income from savings accounts, certificates of deposit, corporate bonds, and Treasury bills is included in gross income Interest on state and local (municipal) bonds is excluded from gross income  For high income taxpayers, may provides higher after-tax return than taxable bonds offering a higher interest tax  Gain on the sale of tax-exempt securities is included gross income

23. 3 - 23 ©2004 Prentice Hall, Inc. Original Issue Discount Some debt instruments are issued at prices below their maturity values This original issue discount (OID) is interest paid at maturity rather than periodically over the debt instrument’s life Cash basis taxpayers recognize OID income as it accrues  Exception: Series EE bonds

24. 3 - 24 ©2004 Prentice Hall, Inc. Market Discount Bonds purchased after issue in the open or secondary market at a price below maturity value  Excess of redemption proceeds over cost is recognized as ordinary income in year of redemption  Can elect to accrue discount as interest income over life of bond

25. 3 - 25 ©2004 Prentice Hall, Inc. Below-Market-Rate Loans Loans between related parties (family members) may be made at low interest rates (or even interest free) Interest income that is not actually received or accrued may be imputed (treated as received or accrued and taxed) at the applicable federal rate of interest

26. 3 - 26 ©2004 Prentice Hall, Inc. Gift Loan Exceptions Any gift loan of $10,000 or less is exempt from the imputed interest rules For gift loans of $100,000 or less:  Imputed interest cannot exceed the borrower’s net investment income for the year  If borrower’s net investment income is no more than $1,000, imputed interest is zero

27. 3 - 27 ©2004 Prentice Hall, Inc. Other Loans Loan to employee – imputed exchange of cash is treated as taxable compensation (income to employee and deduction for employer) Loan to shareholder – imputed exchange of cash is treated as a dividend (taxable income to shareholder, no deduction for corporation)

28. 3 - 28 ©2004 Prentice Hall, Inc. Dividend Income Cash and FMV of other assets distributed by a corporation out of its earnings and profits (E&P) are treated as dividends includable as in income by the shareholder  Change made by 2003 Tax Act reduces tax rate to same 15% rate as capital gains (5% rate for individuals in 10% or 15% tax bracket) Distributions in excess of E&P are nontaxable return of capital (reducing stock basis) Distributions in excess of stock basis are taxed as capital gain (like a sale of stock)

29. 3 - 29 ©2004 Prentice Hall, Inc. Mutual Fund Dividends May pay dividends from gains they realize on the sale of investment assets These dividends are actually net long-term capital gains and called capital gains distributions

30. 3 - 30 ©2004 Prentice Hall, Inc. Dividend Reinvestment Plans Treated as if the shareholder received the cash, is taxed on the dividend income, and then purchases additional shares of stock with the dividend income It is important for each shareholder to keep track of basis for all shares

31. 3 - 31 ©2004 Prentice Hall, Inc. Stock Dividends Stock dividends are distributions of its own stock by a corporation to its shareholder (stock splits) Usually stock dividends are not taxable to the shareholder (unless shareholder has choice of receiving cash) Shareholders simply own a greater number of shares and the basis in their original holdings is divided among all shares of stock now held

32. 3 - 32 ©2004 Prentice Hall, Inc. Annuity Income Investment in annuity/Expected return from annuity x annuity payment received = nontaxable return of capital If investment was all made by employer (or by employee using pre-tax dollars) then investment is treated as zero

33. 3 - 33 ©2004 Prentice Hall, Inc. Prizes and Awards Prizes, awards, gambling winnings, and treasure finds are taxable The fair market value of goods or services received is included in gross income

34. 3 - 34 ©2004 Prentice Hall, Inc. Government Transfer Payments Need-based payment excluded (welfare payments, school lunches & food stamps) Unemployment compensation is taxable because it is a substitute for wages that would be taxable

35. 3 - 35 ©2004 Prentice Hall, Inc. Social Security Benefits Government devised a plan that taxes up to 85% of benefits of taxpayers who have significant other income while leaving benefits completely tax free for those who have little other income MAGI = AGI before any social security benefits + exempt interest income + ½ of social security benefits

36. 3 - 36 ©2004 Prentice Hall, Inc. Social Security Benefits If MAGI is less than $25,000 for single individuals or $32,000 for married couples, then none of the social security benefits received are taxable Single taxpayers with MAGI above $34,000 and married taxpayers with income above $44,000 will be taxed on 85% of their benefits Taxpayers between the above thresholds will be taxed on up to 50% of their social security benefits

37. 3 - 37 ©2004 Prentice Hall, Inc. Damage Awards Damages for physical injuries are not taxed (under the return of capital doctrine) Damages for all other awards are taxed (because they are viewed a substitute for what would otherwise be taxable income) Punitive damages are taxable

38. 3 - 38 ©2004 Prentice Hall, Inc. Divorce-Related Payments Property settlement is a division of assets (no income, no deduction) Alimony is a legal shifting of income so it is taxable income to the person receiving it and deductible by the person who pays it  First year’s alimony should not exceed average of 2 nd and 3 rd year payments by more than $15,000 Child support fulfills a legal obligation to support a child (no income, no deduction) Both parties may benefit by negotiating an increase in payment if it qualifies as alimony

39. 3 - 39 ©2004 Prentice Hall, Inc. Discharge of Debt If a legal obligation is satisfied for less than the outstanding debt, the amount of debt forgiven represents an increase in the taxpayer’s wealth and is subject to taxation  Exceptions are provided for debtors who are bankrupt or insolvent

40. 3 - 40 ©2004 Prentice Hall, Inc. Tax Benefit Rule If a taxpayer deducted an expense or loss in one year but recovers the amount deducted in a subsequent year, the amount recovered must be included in the gross income in the year it is recovered  Example: bad debt recovery or refund of taxes previously deducted Amount included in income is limited to the extent of tax benefit received by the tax deduction

41. 3 - 41 ©2004 Prentice Hall, Inc. Exclusions Gifts Inheritances Life Insurance  Proceeds tax-free but any interest income on proceeds is taxable  Inside buildup (increase in cash surrender value) is not taxable income unless policy is liquidated for more than premiums paid

42. 3 - 42 ©2004 Prentice Hall, Inc. Accident & Health Insurance Accident & health insurance proceeds tax- free to extent they pay qualified medical or dental expenses Disability insurance—substitute for lost pay  If premiums for disability insurance paid by employer, then benefits received are taxable  If premiums paid by employee, exception allows benefits to be tax free

43. 3 - 43 ©2004 Prentice Hall, Inc. Scholarships Qualified scholarships are excluded from gross income  “Scholarship” includes only tuition, fees, books, supplies, equipment, and related expenses required for courses  Value of room, board, and laundry are not excluded from income

44. 3 - 44 ©2004 Prentice Hall, Inc. Scholarships Any grant received in return for past, present, or future services must be included in gross income  Funds received by students in return for teaching or research services are taxable When taxable portion cannot be determined until end of academic year, taxable income can be deferred until the taxable year in which the academic year ends

45. 3 - 45 ©2004 Prentice Hall, Inc. Other Exclusions Improvements made on leased property are excluded from landlord’s income unless in lieu of rent income Fringe benefits discussed in next chapter Exclusion of gain on sale of home  $250,000 if single, $500,000 if married and both spouses qualify  Must have owned and lived in home as principal residence for at least 2 of previous 5 years

46. 3 - 46 ©2004 Prentice Hall, Inc. The End