1. Chapter 3 Income Sources ©2006 South-Western Kevin Murphy Mark Higgins Kevin Murphy Mark Higgins

2. Transparency 3-2 © 2006 South-Western What is Income? vAll-inclusive Income Concept FDefined by exception: “Except as otherwise provided…” § 61 vJudicial findings FIncome is the gain derived from labor and capital FAny increase in wealth that has been realized is income

3. Transparency 3-3 © 2006 South-Western What is Income? vCurrent View FA change in the form and/or substance of the taxpayer’s property, and FThe involvement of a second party in the income process

4. Transparency 3-4 © 2006 South-Western Types of Income vEarned vUnearned vTransfer vImputed vCapital Gains and Losses

5. Transparency 3-5 © 2006 South-Western Earned Income: Definition vTwo problems may arise when determining taxability of earned income FCash-equivalent approach FAssignment of income Compensation received for the provision of labor is earned income.

6. Transparency 3-6 © 2006 South-Western Unearned Income: Definition vExamples of unearned income are: FInterest and Dividend Income FRental and Royalty Income FAnnuities The earnings from investments and gains from the sale, exchange or disposition of investment assets is unearned income.

7. Transparency 3-7 © 2006 South-Western Unearned Income: Annuities vAn annuity is a series of equal payments received at set time intervals for a determinable period vCapital Recovery Concept excludes the amount of original investment from taxable income FMust be spread over the time of receipt

8. Transparency 3-8 © 2006 South-Western Annuity Exclusions vIf the payment term and amount are fixed: Exclusion Ratio = Cost of the contract Total expected return

9. Transparency 3-9 © 2006 South-Western Annuity Exclusions vIf the payment term depends on the life of the taxpayer FMust estimate the number of payments FUse the “simplified method”

10. Transparency 3-10 © 2006 South-Western Annuity Exclusions Simplified Method vAnnuity payments beginning after November 18, 1996 Fuse Tables 3-1 or 3-2 to determine number of payments Excluded portion = Contract Cost Number of payments

11. Transparency 3-11 © 2006 South-Western 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. Transparency 3-12 © 2006 South-Western Unearned Income: Gains and Losses Proceeds from sale or disposition less:Selling expenses Amount realized from disposition less:Adjusted basis of property Gain or loss from disposition Gains or losses may occur upon disposal of investment property.

13. Transparency 3-13 © 2006 South-Western Unearned Income: Income from Conduit Entities vIncome from a conduit entity is reported by the owners and taxed on the owners’ returns vDistributions from conduit entities to the owners are treated as a recovery of capital

14. Transparency 3-14 © 2006 South-Western Transfer Income: Definition Some amounts of income are neither fully earned nor fully unearned. FPrizes and Awards FUnemployment Compensation FSocial Security Benefits FAlimony Received

15. Transparency 3-15 © 2006 South-Western Transfer Income: Prizes and Awards Amounts received as prizes and awards are generally taxable. FExceptions exist for: VScientific and literary achievements èmust be given by recipient to a qualified charity or government unit VEmployee achievements èmust be given to employee for length of service or safety èamount is limited to $400 per employee (or $1,600 if qualified plan)

16. Transparency 3-16 © 2006 South-Western Transfer Income: Unemployment Compensation Amounts received from unemployment compensation plans are considered substitutes for earned income and are always taxable.

17. Transparency 3-17 © 2006 South-Western 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. Transparency 3-18 © 2006 South-Western 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. Transparency 3-19 © 2006 South-Western Transfer Income: Social Security Benefits - Tier One vUnmarried individuals with modified AGI between $25,000 and $34,000, and vMFJ individuals with modified AGI between $32,000 and $44,000

20. Transparency 3-20 © 2006 South-Western Tier One Calculation The taxable portion of Social Security is equal to the lesser of: 1. 1/2 Social Security received, OR2. 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. Transparency 3-21 © 2006 South-Western 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. Transparency 3-22 © 2006 South-Western 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, OR2. 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

24. Transparency 3-24 © 2006 South-Western 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. Transparency 3-25 © 2006 South-Western Transfer Income: Alimony Received Amounts received for alimony payments are taxable income if: Fthe payments are made in cash Fthere is a written agreement Fthe payments are not disguised child support Fthe payments cannot be made to payee’s estate Fthe payer and payee do not live in the same household

26. Transparency 3-26 © 2006 South-Western Imputed Income: Personal Consumption vThe value of the goods and services produced by individuals for personal consumption generally are not taxable FRealization concept FAdministrative Convenience concept

27. Transparency 3-27 © 2006 South-Western Imputed Income: Below Market-Rate Loans vInterest income and expense are imputed on below market-rate loans. FThe relationship between the lender and the borrower determines the tax treatment VThe lender has imputed interest income VThe borrower has imputed interest expense FAdministrative Convenience grants exceptions for Vloans of $10,000 or less Vgift loans of $100,000 or less

28. Transparency 3-28 © 2006 South-Western Imputed Income: Payment of Expense by Others vPayments made by family members may be considered nontaxable gifts vPayments made by employers are taxable income A taxpayer whose expenses are paid by another has realized an increase in wealth.

29. Transparency 3-29 © 2006 South-Western Imputed Income: Bargain Purchases When a bargain purchase price does not result from an arms-length transaction, the bargain amount is taxable income.

30. Transparency 3-30 © 2006 South-Western Capital Gains and Losses: Introduction vA sale or other disposition of capital assets results in a capital gain or loss vCapital gains and losses receive special tax treatment A capital asset is any asset other than inventory, receivables, and depreciable or real property used in a trade or business.

31. Transparency 3-31 © 2006 South-Western Capital Gains and Losses: Holding Period vThe holding period for capital assets is how long the taxpayer owned the asset. FShort Term = held for < 12 months FLong Term = held for > 12 months vDetermining holding period is the first step in determining tax treatment.

32. Transparency 3-32 © 2006 South-Western 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. Transparency 3-33 © 2006 South-Western Capital Gains and Losses: Netting Procedures Net Short-term Gain or Loss netted against Net Long-term Gain or Loss Net Capital Gain or Loss = If one is a loss and one is a gain, then: If both are losses or both are gains, no further netting is done.

34. Transparency 3-34 © 2006 South-Western Tax Treatment for Net Gains vNet short-term capital gain is taxed as ordinary income vAdjusted net long-term capital gain is taxed at a maximum 15% FAdjusted NLTG = NLTG - [28% rate gain - Unrecaptured §1250 gain + Eligible dividends] F28% rate gain = [Net collectibles gain + Small business stock gain - STCL - LTCL carryover]

35. Transparency 3-35 © 2006 South-Western vNet Collectibles gain and Small Business Stock gain is taxed at a maximum 28% vUnrecaptured §1250 gain is taxed at a maximum 25% Tax Treatment for Net Gains

36. Transparency 3-36 © 2006 South-Western Capital Gains and Losses: Holding Period & Maximum Rate

37. Transparency 3-37 © 2006 South-Western Tax Treatment for Net Losses by Individuals vOnly $3,000 of net capital losses may be deducted in one year FUse short-term losses first FCarryover net loss > $3,000 vCapital gains and losses of conduit entities flow-through to owners’ returns

38. Transparency 3-38 © 2006 South-Western When is Income Reported? The Accounting Method chosen by a taxpayer dictates when income is reported. FCash Method taxpayers report income when cash is actually or constructively received FAccrual Method taxpayers report income when it is earned FHybrid Method taxpayers mix accrual and cash methods

39. Transparency 3-39 © 2006 South-Western Accounting Method Cash Cash method taxpayers must follow the Constructive Receipt Concept. FExceptions to the cash method: VTaxpayers who sell inventory may not use the cash method for inventory VTaxpayers must use the accrual and the effective interest method with Original Issue Discount securities VTaxpayers who hold Series EE Bonds may elect to use the accrual method

40. Transparency 3-40 © 2006 South-Western Accounting Method Accrual Under tax law, income is accrued when vAll events have occurred that fix the right to receive the income, and vThe amount of income earned can be determined

41. Transparency 3-41 © 2006 South-Western Accounting Method Accrual Exceptions vExceptions to the accrual method: FThe Wherewithal-to-Pay concept requires income be reported in the year pre-payment is received for rents, insurance, interest and royalties FOne year deferral is allowed for some pre- payments VReport amount = Financial Accounting in first year VRemainder of amount in full in second year FPre-payments for goods may be accrued if the payment is less than the Cost of Goods Sold.

42. Transparency 3-42 © 2006 South-Western 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. Transparency 3-43 © 2006 South-Western 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.

44. Transparency 3-44 © 2006 South-Western End of Chapter 3