cch federal taxation basic principles chapter 4 gross income ©2003, cch incorporated 4025 w....

CCH Federal TaxationBasic Principles

Chapter 4 Gross Income

©2003, CCH INCORPORATED4025 W. Peterson Ave.Chicago, IL 60646-6085800 248 3248http://tax.cchgroup.com

CCH Federal Taxation Basic Principles 2 of 40

Chapter 4 Exhibits 1. Accounting Income 2. Economic Benefit Doctrine 3. Constructive Receipt Doctrine 4. Assignment of Income Doctrine 5. Compensation vs. Gift 6. Items Included in Gross Income 7. Prizes and Awards 8. Employee Achievement Awards 9. Scholarships and Fellowships10. Below-Market Interest Loans—Types of Loans11. Below-Market Interest Loans—Definitions12. Below-Market Interest Loans—Tax Effect

Chapter 4, Exhibit Contents A


13. Below-Market Interest Loans—Examples14. Rent and Royalty Income15. Tenant Improvements

16. Dividend Income

17. Pre-1985 Agreements

18. Post-1984 Agreements19. Alimony and Child Support (Post-1984 Divorces)20. Bankruptcy and Insolvency

21. Restricted Stock Plans

22. Incentive Stock Option Plans

23. Employee Stock Purchase Plans

24. Nonstatutory Stock Option Plans

Chapter 4 Exhibits

Chapter 4, Exhibit Contents B


Accounting Income

Income, from the accounting point of view, is the excess of revenues over the costs incurred in producing those revenues.

The emphasis for the accountant is on completed transactions.

All gains must be “realized” before they are includible in income.

Chapter 4, Exhibit 1a


Accounting Income

Accrual method—income is recognized when a transaction is consummated, even if cash or property has not yet been received.

Cash method—income is recognized only when cash or property is received.

Chapter 4, Exhibit 1b


Economic Benefit Doctrine

This doctrine answers the question “What is income?”

Any amount of compensation granted or paid to the individual for services rendered, be it cash, bonus, profit sharing, compensation in kind, or any ingenious method of payment, must be included in gross income.

Gross income is defined under the Code as “all income from whatever source derived.” Thus, taxable income may consist of cash, receivables, property, land, or any other form of economic benefit.

Chapter 4, Exhibit 2


Constructive Receipt Doctrine

This doctrine answers the question “When is it taxable income?”

Generally, any compensation granted to an individual to which the individual has an absolute right is regarded as constructively received income. Where the individual has only a conditional right, the courts hold that no present income was received.

Accrual basis taxpayers are not affected by this doctrine because they recognize income the moment it is “earned.”



Assignment of Income DoctrineThis doctrine answers the question “To whom is this income

taxable?”

If a person only has physical possession over the income of another person, he or she has no tax liability. Regardless of whether or not the person received it as an agent or creditor, it is taxed to the owner of the property. The rules that govern the assignment of income apply both to income from property as well as to income from services.

For example, a taxpayer has the employer forward a portion of the salary to one of the taxpayer’s creditors instead of to the taxpayer. The taxpayer would have to recognize this as income inasmuch as the taxpayer received benefit from the proceeds and had control of the income.



Compensation vs. Gift

Example

FACTS: Grandma offers 16-year-old Billy $10,000 if he quits smoking and playing pinball over the next five years. He does, and upon attaining the age of 21, she pays him $10,000.

QUESTION: Is the $10,000 received by Billy taxable income or a gift?

SOLUTION: The $10,000 is taxable income since there were strings attached.

The facts and circumstances dictate whether something received is taxable compensation or a tax-free gift (Code Sec. 102(a)). Compensation. Taxable income arises if the value of property received by a payee-taxpayer was intended by the payor as a return of some value. Gift. Generally, the value of property received by a taxpayer is a tax-free gift if it arises from a “detached and disinterested generosity.” (Duberstein, 60-2 USTC ¶ 9515.) Simply put, there must be no strings attached.



Items Included in Gross Income

Compensation for services, including fees, commissions, fringe benefits, and similar items

Gross income derived from business Gain derived from dealings in

property Interest Rents Royalties Dividends Alimony and separate maintenance

payments

Annuities Income from life insurance and

endowment contracts Pensions Income from discharge of

indebtedness Distributive share of partnership

gross income Income in respect of a decedent Income from an interest in an estate

or trust

Code Sec. 61(a) lists 15 items that generally must be included in gross income:


Special circumstances may result in the exclusion or deferral of any of these items.


Prizes and Awards

Example

FACTS: Mother Tanesha, a U.S. citizen, is awarded the Nobel Peace Prize, which includes a $500,000 cash award. The award was unsolicited and no future services were required of Mother Tanesha. Furthermore, she endorsed the check over to the Sisters of Charity, a qualified tax-exempt charity, rather than depositing it in her bank account.

QUESTION: Does Mother Tanesha have taxable income?

SOLUTION: YES! She constructively received the $500,000 when she endorsed the checkover to the charity. By endorsing the check, she exercised dominion and control over themoney, even though she did not deposit it. She could have avoided taxable income if she had directed the Nobel Committee to pay the Sisters of Charity directly.


Prizes and awards are generally taxed based on fair market value at time of receipt. However, if ALL of the following 4 conditions occur, then they are excludable : 1. Connected with the fields of science, charity, or the arts2. Involuntary selection process (i.e., through no effort of recipient)3. No future services required of recipient4. Assigned rather than constructively received


Employee Achievement Awards

the value of awards for length of service or safety achievement delivered at a “meaningful presentation” are excluded up to

1. $400 if the plan is non-qualified (i.e., discriminates in favor of highly paid employees), or

2. $1,600 if the plan is qualified (i.e., does not discriminate in favor of highly paid employees).

(If an employee receives both qualified and nonqualified awards, then the overall exclusion may not exceed $1,600.)

Example

FACTS: Ben received two qualified awards with a combined value of $1,500. He also received one nonqualified award valued at $250.

QUESTION: How much of the $1,750 income is excluded for tax purposes?

SOLUTION: $1,600, computed as follows:

1. Qualified Amount: $1,500 (limited to $1,600)

2. Nonqualified Amount: $ 250 (limited to $400)

Overall limitation: $1,600 ($1,500 + $250 = $1,750, but limited to the overall exclusion amount of $1,600 (i.e., $150 would be included in gross income).

Employee achievement awards are generally taxable, except that



Scholarships and Fellowships

The value of scholarships or fellowships are generally taxable, but may be excluded if they are:

1. To a degreed candidate attending an educational institution

2. For tuition and course related material (not room, board, or transportation)

3. As a result of academic achievement, and not in the connection of services performed (if from

an employer source, then taxable compensation)

Example 1: A “scholarship” received by a beauty queen for winning the Miss Georgia Peanut contest would actually be a taxable award for services rendered, even if she were a degreed candidate and the money was spent on tuition. It would really be compensation disguised as a scholarship.

Example 2: At State U., tuition is waived for all graduate teaching assistants. The tuition waived is intended as compensation for teaching assistant services and is therefore included in the graduate assistants’ gross income.



Below-Market Interest Loans—Types of Loans

What types of loans are subject to imputed interest calculations?

All of the following loans are subject to imputed interest:

Gift loans (made out of love, affection, or generosity). Note that the “gift” is NOT

the principal portion of the loan, rather, the amount of interest that is below market. Compensation-related loans (employer loans to employees) Corporation-shareholder loans (a corporation’s loans to ANY of its shareholders)

If all of the following apply: Interest charged is less than the applicable federal rate (AFR) Sum of all loans between lender and borrower exceeds $10,000 The loan was made after June 7, 1984



Below-Market Interest Loans—Definitions


What is imputed interest?

Imputed interest is the additional interest that would have been paid had a loan been granted at the current market rate rather than at an artificially low (or no) rate.

What is the applicable Federal rate (“AFR”)?

The AFR is adjusted monthly and is published by the IRS (Code Sec. 7872(b)(2) and (f)(2)). Actually, there are three federal rates:

1. Short-term ( 3 years and demand loans)

2. Mid-term (> 3 years and 9 years)

3. Long-term (> 9 years).


Below-Market Interest Loans—Tax Effect


What is the tax effect of below-market interest loans?

Principal, per se, creates no tax exposure to lender or borrower as long as it is collectible. However, the imputed interest does have a tax effect on lender and borrower as summarized below:

Type of Loan Step Lender Borrower

Gift Loan Step 1:

Step 2:

Nondeductible gift, possibly subject to gift tax.Interest income.

Tax-free gift received.

Interest expense.

Compensation-related Loan

Step 1:

Step 2:

Compensation expense.

Interest income.

Compensation income.

Interest expense.

Corporation to Shareholder Loan

Step 1:

Step 2:

Nondeductible dividend deemed paid.

Interest income.

Dividend income.

Interest expense.


Below-Market Interest Loans—Tax EffectThe two steps for each of the three below-market interest loans are not easy to conceptualize. See if this makes sense:

Step 1: “Pretend” that the lender has returned the imputed interest back to the borrower as either a gift, compensation, or a dividend. “Pretend” that the imputed interest amount has been paid even though it has not actually been paid. For example, in the case of a gift loan, the lender is treated as having “gifted” the imputed interest back to the borrower, even though no gift had actually been made. If the “pretend gift” of imputed interest exceeds the $11,000 gift tax exclusion (not to be confused with the $10,000 loan limit for imputed interest), then the lender/donor may have gift tax exposure.

Step 2: “Pretend” that the borrower has returned the imputed interest back to the lender as an interest payment.



Below-Market Interest Loans— Examples

Example 1

FACTS: On January 1, Lennie loans $10,000 to his friend Barry. The loan is

payable on demand at zero interest. To impute interest, Lennie

and Barry elect to use the blended annual federal rate of 6% rather

than the monthly short-term AFR tables.

QUESTION: What is the tax effect on lender and borrower?

SOLUTION: None since the loan is $10,000, but see following Examples 2

and 3.


CCH Federal Taxation Basic Principles 19 of 40Chapter 4, Exhibit 13b


Example 2

FACTS and QUESTION: Same as Example 1, except the loan amount is $10,001.

SOLUTION:Lennie (lender/donor): Step 1: Imputed interest income is $609.03 Step 2: Nondeductible gift is $609.03, subject to the $11,000 annual exclusionBarry (borrower/donee): Step 1: Tax-free gift received in the amount of $609.03 Step 2: Imputed interest expense is $609.03, deductible as a miscellaneous itemized deduction subject to 2% AGI

Type of Loan Step Lender Borrower

Gift Loan 1: Nondeductible gift Tax-free gift received

2: Interest income Interest expense

CCH Federal Taxation Basic Principles 20 of 40Chapter 4, Exhibit 13c


Example 2

COMPUTATIONS:

(a) (b) = ½ x AFR (c) = (a) x (b) (d) = int. payment (e) = (a)+[( c) – (d)]

Period Beginning loan balance, adjusted

for unpaid imputed interest

AFR rate Minimum Interest

Required

Actual Interest Paid

Ending loan balance, adjusted for unpaid

imputed interest

1/1 - 6/30 10,001.00 3.0%(1/2 x 6%)

300.03 0 10,301.03

7/1 - 12/31 10,301.03 3.0%(1/2 x 6%)

309.03 0 10,610.06

609.03

Special rule for loans under $100,000: Under Code Sec. 7872(d)(1)(A), imputed interest is capped at the BORROWERS net investment income amount (NII). However, under Code Sec. 7872(d)(1)(E)(ii), if BORROWER’S NII is $1,000, then imputed interest is deemed to be zero.


Example 3

FACTS and QUESTION: Same as Example 2, except that Barry’s net investment income is $1,000.

SOLUTION: There would be zero imputed interest since Barry’s (i.e., Borrower’s) NII $1,000.


Chapter 4, Exhibit 13d


Rent and Royalty Income

Tax Effect on Landlord: ALL rent received, including future years’ rent received in advance, is taxable income.

Tax Effect on Tenant with a Business Lease: ONLY rent that is paid AND due in the tax year is deductible.

Example

FACTS: Tenant pays Landlord $10,000, covering the first and last year’s rent.

QUESTION: What is the tax effect on Landlord and Tenant?

SOLUTION: $10,000 taxable income to Landlord; $5,000 deduction to Tenant.



Tenant Improvements


When are tenant improvements taxable to cash-basis landlords?

1. If in lieu of rent: Taxable when the lease terminates (Helvering v. Bruun, 40-1

USTC ¶ 9337)

2. If NOT in lieu of rent: When the property is sold (assuming that they add value

which results in a higher sales price) (Code Sec. 1019)


Dividend Income

The term “dividend” means any distribution of property made by a corporation to its shareholders out of its earnings and profits.

There are two common types of dividends:CashStock (dividends and rights)



Dividend Income

Cash dividend Mutual funds Life insurance and annuity contracts Stock dividends Stock rights



Alimony—Pre-1985 AgreementsIf the following four conditions exist, then the recipient must include the alimony payments in gross income and the person making the payments is entitled to a tax deduction for adjusted gross income:

Payments are required under the terms of the decree of divorce or separate maintenance or a written separation agreement or a decree of support

Payments must be to discharge the legal obligation of support

Payments must be periodic Payments must not be for child support



Alimony—Post-1984 Agreements

Payments under instruments executed after December 31, 1984, that meet the following requirements are deductible as alimony:

Payments must be made in cash Payments must be made under a divorce or separation

instrument Parties must live in separate households after a

divorce or separation decree is entered Alimony must end at the payee’s death Parties involved may not file a joint return



Alimony and Child Support (Post-1984 Divorces)


What distinguishes alimony from child support?

The following conditions must be met to qualify for an alimony deduction:

Death: Payments terminate no later than the death of the payee spouse. Instrument: Payments must be made under a divorce or separation instrument. Cash: Payments must be made in cash. (Checks are cash; cars and houses are not.) Households : Parties must live in separate households after the decree is entered. Returns : Parties may not file a joint return.

What is the tax treatment for alimony and child support?

Alimony Child Support

Taxable to Payee? Yes No

Deductible to Payor? Yes (“for” AGI) No


What about partial payments?

If an ex-spouse is obligated to pay alimony and child support, partial payments insufficient to meet both obligations are deemed to be child support until the child support obligation has been satisfied. Once the child support obligation has been satisfied, remaining payments are treated as alimony.

Example

Hugh is required to pay $5,000 alimony and $5,000 child support each year. Hugh has made annual payments of $3,000 in years 1 and 2, and designated each payment as “in satisfaction of alimony obligation.” Despite this designation, each of the payments will be deemed as child support since child support obligations had not been satisfied in either year. In order to get alimony treatment in year 3, Hugh must catch up on all child support obligations for the current and preceding years. Thus, in year 3, the first $9,000 of any payments would be treated as child support (i.e., $2,000 child support shortfall in years 1 and 2, plus $5,000 child support obligation in year 3.) Any payments above $9,000 would be deemed to be alimony (limited to $15,000, the aggregate alimony obligation for years 1, 2, and 3).

Alimony and Child Support (Post-1984 Divorces)


Bankruptcy and Insolvency

Forgiveness of debt is generally includable in gross income. There are 2

exceptions in which taxes on a forgiveness of debt are deferred: 1. The debt is discharged in a Chapter 11 bankruptcy filing.

2. The borrower is insolvent outside of bankruptcy (i.e., Liabilities > FMV of assets immediately prior to discharge) so forgiveness of debt income is postponed to the extent of insolvency.




Limits on ordinary income deferral. Code Sec. 1017(b)(2)

provides that the deferral must not exceed (i)—(ii), where:

(i) = Aggregate of the bases of property immediately after the

discharge

(ii) = Aggregate of liabilities immediately after the discharge.

Therefore, a borrower cannot defer that portion of ordinary

income from debt forgiveness that is equal to his or her book

equity after debt forgiveness.

CCH Federal Taxation Basic Principles 32 of 40Chapter 4, Exhibit 20c

Offsetting reduction of tax attributes. As a price for the deferral, Code Sec. 108(b)(2) requires that the amount deferred be applied to reduce seven tax attributes in the order listed below:

1. Net operating losses and loss carryovers 2. General business credits under Code Sec. 38 3. Minimum tax credits under Code Sec. 53 4. Net capital loss and loss carryovers 5. Basis of depreciable assets or nondepreciable real assets held as inventory (Code Sec. 1017(b)(3)(E)). (This would include house lots held as inventory.) 6. Passive activity losses 7. Foreign tax credit carryovers under Code Sec. 27




Code Sec. 108(b)(5) election to first reduce basis of assets. Code Sec. 108(b)(5) offers a special election to first reduce the tax basis of depreciable property or real property held as inventory.

Chapter 4, Exhibit 20d


Bankruptcy and Insolvency Recapture of ordinary income. Under Code Sec. 1017(d), the amount

deferred from gross income under Code Sec. 108(a), which applied in reduction of basis under Code Sec. 108(b)(2) or (b)(5), would be recaptured as if it were a Code Sec. 1245 asset.

Chapter 4, Exhibit 20e

Example

If a borrower were, $650,000 insolvent and his lender “forgave” $650,000 of the borrower’s indebtedness, the borrower’s $650,000 debt forgiveness would generally be tax-deferred rather than taxed immediately. If the amount of tax-deferred debt forgiveness, $650,000, had been used to reduce the basis of house lots, then, as future lots were closed, the reduced lot bases would result in additional ordinary income (i.e., a lower cost of sales carries a higher gross margin resulting in higher ordinary income). Eventually, the entire $650,000 would be recaptured as ordinary income, unless the market values estimated at the point of forgiveness were overstated.


Deferred Compensation—Restricted Stock Plans

As a general rule, the value of any property transferred in connection with services rendered is taxable as compensation, whether the property is goods, common stock, a partnership interest, or any other property.

Stock or other property is taxable whenever the right to it is “substantially vested” which means that it is either transferable or not subject to a substantial risk of forfeiture.




Compensation results if property is transferred “in connection with” services rendered. Thus, it does not matter whether:

Services are rendered as an employee or independent contractor.

The property was transferred by the employer or another person, such as a shareholder.

The property was transferred to the compensated person or to anyone else, (e.g., a beneficiary, a trust, a corporation, or other agent). Any income received, (e.g., dividends) before the property is substantially vested is also treated as compensation.




If property transferred in connection with services rendered is not “substantially vested,” an election may nevertheless be made to include the current fair market value of the property in gross income.

There are two advantages of making the election:Any future appreciation will qualify as a capital gain,

historically taxed at rates lower than ordinary income.The appreciation between the date of transfer and the date

of substantial vesting is not taxed until the eventual disposition of the property in a taxable sale or exchange.

Chapter 4, Exhibit 21c


Deferred Compensation—Incentive Stock Option Plans

For options to qualify as ISOs, the following conditions must be met: The term of the option may not exceed 10 years. The option price must be no less than the fair market value of the stock on

the date of issuance. The option must be transferable by inheritance only. The option plan must specify the aggregate number of shares that may be

issued and the employees eligible to receive the option. The option must be granted within 10 years of the earlier of the date of

adoption of the plan or the date it was approved by the shareholders. If the employee owns more than 10% of the company, the option price

must be at least 110% of the market value and its term may not exceed 5 years.



Deferred Compensation—Employee Stock Purchase Plans

An employee stock option plan is, generally, one permitting employees to buy stock in the employer corporation at a discount.

No income is recognized under such a plan at the time the option is granted; the recognition is deferred until stock acquired under the plan is disposed of.



Deferred Compensation—Nonstatutory Stock Option Plans

Nonstatutory stock options are options that do not qualify for the favorable tax treatment accorded to options that are covered by a specific Code provision as are qualified stock options, incentive stock options, employee stock purchase plans, restricted stock plans.

While statutory options are generally not taxed until the taxpayer disposes of the options and any gains on the dispositions are taxed at capital gains rates, nonstatutory stock options usually are taxed at ordinary compensation income rates at the time they are granted, the options being considered compensation for services rendered by the employee.


cch federal taxation basic principles chapter 4 gross income ©2003, cch incorporated 4025 w....

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