chapter 4 gross income: concepts and inclusions copyright ©2005 south-western/thomson learning...

Chapter 4Chapter 4

Gross Income:Concepts and Inclusions

Copyright ©2005 South-Western/Thomson LearningCopyright ©2005 South-Western/Thomson Learning

Eugene Willis, William H. Hoffman, Jr.,Eugene Willis, William H. Hoffman, Jr.,David M. Maloney, and William A. RaabeDavid M. Maloney, and William A. Raabe

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Gross Income (slide 1 of 3)Gross Income (slide 1 of 3)

• Definition: Gross income includes all (realized) income from whatever source derived, unless specifically excluded under the Code

• Concept is interpreted broadly by the courts

• Definition: Gross income includes all (realized) income from whatever source derived, unless specifically excluded under the Code

• Concept is interpreted broadly by the courts

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• Taxability of income follows the realization principle from accounting– Income is recognized (taxed) when realized

• Mere appreciation in wealth (economic income) is not considered realized income

Problem 26

• Taxability of income follows the realization principle from accounting– Income is recognized (taxed) when realized

• Mere appreciation in wealth (economic income) is not considered realized income

Problem 26

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• Income is recognized whether it is in the form of cash, or “in-kind” cash equivalents (i.e., property or services)– The amount of income from “in-kind” receipts

is equal to the FMV of the property or services

• Income does not include recovery of the taxpayer’s capital investment or liability

Problem 39

• Income is recognized whether it is in the form of cash, or “in-kind” cash equivalents (i.e., property or services)– The amount of income from “in-kind” receipts

is equal to the FMV of the property or services

• Income does not include recovery of the taxpayer’s capital investment or liability

Problem 39

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Accounting PeriodsAccounting Periods

• Taxable year is generally a 12-month period– Taxable year for most individual taxpayers is

the calendar year– Fiscal year can be elected if taxpayer maintains

adequate records• Fiscal year is a 12-month period ending on the last

day of a month other than December– Example: July 1 to June 30

• Taxable year is generally a 12-month period– Taxable year for most individual taxpayers is

the calendar year– Fiscal year can be elected if taxpayer maintains

adequate records• Fiscal year is a 12-month period ending on the last

day of a month other than December– Example: July 1 to June 30

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Accounting MethodsAccounting Methods

• There are 3 primary methods of accounting for tax purposes:– Cash receipts– Accrual– Hybrid

• There are 3 primary methods of accounting for tax purposes:– Cash receipts– Accrual– Hybrid

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Cash Receipts Method (slide 1 of 2)Cash Receipts Method (slide 1 of 2)

• Income is recognized in the year it is actually or constructively received in cash or cash equivalent

• An amount is constructively received when it is set aside and made available to taxpayer without substantial restrictions

Problem 38

• Income is recognized in the year it is actually or constructively received in cash or cash equivalent

• An amount is constructively received when it is set aside and made available to taxpayer without substantial restrictions

Problem 38

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Cash Receipts Method (slide 2 of 2)Cash Receipts Method (slide 2 of 2)

• Examples of constructive receipt– Interest on a savings account is taxable when

added to the account balance even though taxpayer does not withdraw the interest

– Dividends mailed on December 31, 2003 which arrive in taxpayer’s mail January 3, 2004 are taxable in 2004. The dividend was not available to the taxpayer until 2004.

• Examples of constructive receipt– Interest on a savings account is taxable when

added to the account balance even though taxpayer does not withdraw the interest

– Dividends mailed on December 31, 2003 which arrive in taxpayer’s mail January 3, 2004 are taxable in 2004. The dividend was not available to the taxpayer until 2004.

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Exceptions To Cash Receipts Method

Exceptions To Cash Receipts Method

• Original Issue Discount (OID) interest is taxable when earned rather than when interest is received

• Series E and EE bonds are not subject to the OID rules. However, a taxpayer may elect to recognize the interest when earned.

• Original Issue Discount (OID) interest is taxable when earned rather than when interest is received

• Series E and EE bonds are not subject to the OID rules. However, a taxpayer may elect to recognize the interest when earned.

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Accrual method (slide 1 of 2)Accrual method (slide 1 of 2)

• Income is recognized in the year that it is earned regardless of when it is collected

• Income is earned when:– All events have occurred that fix taxpayer’s

right to the income, and– The amount can be determined with reasonable

accuracy

• Income is recognized in the year that it is earned regardless of when it is collected

• Income is earned when:– All events have occurred that fix taxpayer’s

right to the income, and– The amount can be determined with reasonable

accuracy

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Accrual Method (slide 2 of 2)Accrual Method (slide 2 of 2)

• Claim of right doctrine – Requires amounts received to be included in

income even though the amount is in dispute and might be returned to the payor at a later date

– If payment has not been received, no income is recognized until the claim is settled

• Claim of right doctrine – Requires amounts received to be included in

income even though the amount is in dispute and might be returned to the payor at a later date

– If payment has not been received, no income is recognized until the claim is settled

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Exceptions to Accrual Method (slide 1 of 2)


• Taxpayer can elect to defer recognition of income from advance payment for goods if same method of accounting is used for tax and financial reporting purposes

Problem 37 a.

• Taxpayer can elect to defer recognition of income from advance payment for goods if same method of accounting is used for tax and financial reporting purposes

Problem 37 a.

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• Advanced payment for services to be performed after year-end is included in income in the year following receipt – The portion of the advanced payment that is

earned in the current year is included in income in the year of receipt (E-19, Problem 37 b & c)

• Prepaid rents or interest income are always recognized in the year received rather than when earned

• Advanced payment for services to be performed after year-end is included in income in the year following receipt – The portion of the advanced payment that is

earned in the current year is included in income in the year of receipt (E-19, Problem 37 b & c)

• Prepaid rents or interest income are always recognized in the year received rather than when earned

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Hybrid MethodHybrid Method

• A combination of cash and accrual methods

• Generally, used when inventory is a material income-producing factor– Use accrual method for determining sales and

cost of goods sold – Use cash method for other income and

expenses

• A combination of cash and accrual methods

• Generally, used when inventory is a material income-producing factor– Use accrual method for determining sales and

cost of goods sold – Use cash method for other income and

expenses

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Income Sources (slide 1 of 4)Income Sources (slide 1 of 4)

• Income from personal services is taxable to the person who performs the services– Fruit and tree metaphor Problem 13

• Income from property is taxable to the owner of the property– Assignment of income is not permitted

• Income from personal services is taxable to the person who performs the services– Fruit and tree metaphor Problem 13

• Income from property is taxable to the owner of the property– Assignment of income is not permitted

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• Interest income accrues daily– If interest bearing instrument (e.g., bonds) is

transferred, must allocate interest income between transferor and transferee

• Dividends are generally taxed to the party who is entitled to receive them– Dividends on stock transferred by gift after

declaration date but before record date is generally taxed to the donor

• Interest income accrues daily– If interest bearing instrument (e.g., bonds) is

transferred, must allocate interest income between transferor and transferee

• Dividends are generally taxed to the party who is entitled to receive them– Dividends on stock transferred by gift after

declaration date but before record date is generally taxed to the donor

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• Income from pass-through entities is taxable at the owner level rather than at the entity level

• Pass-through entities include:– Partnerships– S corporations– Estates and trustsProblem 42

• Income from pass-through entities is taxable at the owner level rather than at the entity level

• Pass-through entities include:– Partnerships– S corporations– Estates and trustsProblem 42

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• Community property issues– Community vs. separate property

• Community income is allocable equally to each spouse

• Separate income may be allocable to owner-spouse

– Separate property may produce community income (e.g., TX, LA)

– No allocation of community income for some spouses living apart for entire year and filing separately

• Community property issues– Community vs. separate property

• Community income is allocable equally to each spouse

• Separate income may be allocable to owner-spouse

– Separate property may produce community income (e.g., TX, LA)

– No allocation of community income for some spouses living apart for entire year and filing separately

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Dividends (slide 1 of 3)Dividends (slide 1 of 3)

• Tax Relief Reconciliation Act of 2003 provides partial relief from double taxation of corporate dividends – Generally, dividends received in taxable years

beginning after 2002 are taxed at the same marginal rate that is applicable to a net capital gain

• Thus, individuals otherwise subject to the 10% or 15% marginal tax rate pay 5% tax on qualified dividends received

• Individuals subject to the 25, 28, 33, or 35 percent marginal tax rate pay a 15% tax on qualified dividends

• Tax Relief Reconciliation Act of 2003 provides partial relief from double taxation of corporate dividends – Generally, dividends received in taxable years

beginning after 2002 are taxed at the same marginal rate that is applicable to a net capital gain

• Thus, individuals otherwise subject to the 10% or 15% marginal tax rate pay 5% tax on qualified dividends received

• Individuals subject to the 25, 28, 33, or 35 percent marginal tax rate pay a 15% tax on qualified dividends

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• The following dividends are not eligible for the reduced tax rates– Dividends from certain foreign corporations,– Dividends from tax-exempt entities, and– Dividends that do not satisfy the holding

period requirement• Stock on which the dividend is paid must have

been held for more than 60 days during the 120-day period beginning 60 days before the ex-dividend date

• The following dividends are not eligible for the reduced tax rates– Dividends from certain foreign corporations,– Dividends from tax-exempt entities, and– Dividends that do not satisfy the holding

period requirement• Stock on which the dividend is paid must have

been held for more than 60 days during the 120-day period beginning 60 days before the ex-dividend date

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• Dividends from foreign corporations are eligible for qualified dividend status only if:– The foreign corporation’s stock is traded

on an established U.S. securities market, or

– The foreign corporation is eligible for the benefits of a comprehensive income tax treaty between its country of incorporation and the United States (Problem 43)

• Dividends from foreign corporations are eligible for qualified dividend status only if:– The foreign corporation’s stock is traded

on an established U.S. securities market, or

– The foreign corporation is eligible for the benefits of a comprehensive income tax treaty between its country of incorporation and the United States (Problem 43)

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Alimony and Separate Maintenance Payments (slide 1 of 4)


• Alimony is:– Deductible by payor– Includible in gross income of recipient

• Alimony is:– Deductible by payor– Includible in gross income of recipient

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For post-1984 agreements and decrees, payments may qualify as alimony if:

1. The payments are in cash2. The agreement or decree does not specify

that the payments are not alimony3. The payor and payee are not members of

the same household at the time the payments are made

4. There is no liability to make the payments for any period after the death of the payee

For post-1984 agreements and decrees, payments may qualify as alimony if:

1. The payments are in cash2. The agreement or decree does not specify

that the payments are not alimony3. The payor and payee are not members of

the same household at the time the payments are made

4. There is no liability to make the payments for any period after the death of the payee

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• Property settlements– Transfer of property to former spouse– No deduction or recognized gain or loss for

payor– No gross income and carryover of payor’s

basis for recipient– Front-loading of alimony payments (E-34) p.22

• Alimony recapture (gross income) for payor• Deduction from gross income for recipient

• Property settlements– Transfer of property to former spouse– No deduction or recognized gain or loss for

payor– No gross income and carryover of payor’s

basis for recipient– Front-loading of alimony payments (E-34) p.22

• Alimony recapture (gross income) for payor• Deduction from gross income for recipient

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• Child support payments– Payments made to satisfy legal obligation to support

child of taxpayer– Nondeductible by payor and not taxed to recipient (or

child)

• If amount of payment would be reduced due to some future event related to the child (e.g., child reaches age 21), such reduction is deemed child support (E-36 on p.23)

Problem 45 & 46

• Child support payments– Payments made to satisfy legal obligation to support

child of taxpayer– Nondeductible by payor and not taxed to recipient (or

child)

• If amount of payment would be reduced due to some future event related to the child (e.g., child reaches age 21), such reduction is deemed child support (E-36 on p.23)

Problem 45 & 46

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Imputed Interest on Below-Market Loans (slide 1 of 3)


• Interest is imputed, using Federal government rates, when a loan does not carry a market rate of interest

• Applies to: • Gift loans

• Compensation-related loans

• Corporate-shareholder loans

• Tax avoidance loans

• Interest is imputed, using Federal government rates, when a loan does not carry a market rate of interest

• Applies to: • Gift loans

• Compensation-related loans

• Corporate-shareholder loans

• Tax avoidance loans

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• Gift loans– Exemption for loans of $10,000 or less– Limitation on imputed interest on loans of

$100,000 or less between individuals• Imputed interest is limited to borrower’s net

investment income for year

• No imputed interest if net investment income is $1,000 or less

• Gift loans– Exemption for loans of $10,000 or less– Limitation on imputed interest on loans of

$100,000 or less between individuals• Imputed interest is limited to borrower’s net

investment income for year

• No imputed interest if net investment income is $1,000 or less

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• $10,000 exemption also applies to compensation-related and corporation-shareholder loans– No exemption if principal purpose of loan is tax

avoidance

• Interest expense imputed to borrower may be deductible

• $10,000 exemption also applies to compensation-related and corporation-shareholder loans– No exemption if principal purpose of loan is tax

avoidance

• Interest expense imputed to borrower may be deductible

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Annuity Income (slide 1 of 6)


• Purchaser pays fixed amount for the right to receive a future stream of payments– Generally, early collections and loans against annuity

≤ increases in cash value are included in gross income

– Amounts > increases in cash value are treated as a recovery of capital until cost recovered; additional amounts are included in income

– Early distributions may also be subject to a 10% penalty

• Purchaser pays fixed amount for the right to receive a future stream of payments– Generally, early collections and loans against annuity

≤ increases in cash value are included in gross income

– Amounts > increases in cash value are treated as a recovery of capital until cost recovered; additional amounts are included in income

– Early distributions may also be subject to a 10% penalty

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• The exclusion ratio is applied to annuity payments received under contract to determine amount excludable:Exclusion ratio = Investment in contract

Expected return under contract

• Once investment is recovered, remaining payments are taxable in full

• The exclusion ratio is applied to annuity payments received under contract to determine amount excludable:Exclusion ratio = Investment in contract

Expected return under contract

• Once investment is recovered, remaining payments are taxable in full

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• Examples:– Taxpayer pays $10,000 for annuity that will

pay $1,000 a year• A: For a term of 15 years

• B: For lifetime (life expectancy = 15 years)

– Exclusion ratio for A & B =

$10,000 = .667

$15,000

• Examples:– Taxpayer pays $10,000 for annuity that will

pay $1,000 a year• A: For a term of 15 years

• B: For lifetime (life expectancy = 15 years)

– Exclusion ratio for A & B =

$10,000 = .667

$15,000

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• Example (cont’d)– A: 15 years of annuity payments

• Years 1-15: $333 taxable and $667 excludable

• Example (cont’d)– A: 15 years of annuity payments

• Years 1-15: $333 taxable and $667 excludable

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• Example (cont’d)– B: Lifetime payments and taxpayer lives 18

years• Years 1-15: $333 taxable and $667 excludable

• Years 16-18: $1,000 taxable

– B: Lifetime payments and taxpayer lives 10 years

• Years 1-10: $333 taxable and $667 excludable, and $3,330 deduction (FROM AGI) on final return

• Example (cont’d)– B: Lifetime payments and taxpayer lives 18

years• Years 1-15: $333 taxable and $667 excludable

• Years 16-18: $1,000 taxable

– B: Lifetime payments and taxpayer lives 10 years

• Years 1-10: $333 taxable and $667 excludable, and $3,330 deduction (FROM AGI) on final return

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• Simplified method for annuity distributions from qualified retirement plan available– Exclusion amount is investment in contract

divided by number of anticipated monthly payments (table amount based on age)

Problem 52

• Simplified method for annuity distributions from qualified retirement plan available– Exclusion amount is investment in contract

divided by number of anticipated monthly payments (table amount based on age)

Problem 52

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Prizes and AwardsPrizes and Awards

• General rule: FMV of item is included in income

• Exceptions:• Taxpayer designates qualified organization to

receive prize or award (subject to other requirements)

• Employee achievement awards of tangible personal property made in recognition of length of service or safety achievement

• General rule: FMV of item is included in income

• Exceptions:• Taxpayer designates qualified organization to

receive prize or award (subject to other requirements)

• Employee achievement awards of tangible personal property made in recognition of length of service or safety achievement

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Group Term Life InsuranceGroup Term Life Insurance

• Exclude premiums paid by employer on first $50,000 of coverage

• Premiums on excess coverage are included in gross income– Inclusion amount based on IRS provided tables

• Exclude premiums paid by employer on first $50,000 of coverage

• Premiums on excess coverage are included in gross income– Inclusion amount based on IRS provided tables

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Unemployment CompensationUnemployment Compensation

• Taxable in full• Taxable in full

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Social Security Benefits (slide 1 of 6)


• Up to 85% of benefits may be taxable

• Taxability based on taxpayer’s modified adjusted gross income (MAGI)– MAGI = AGI + foreign earned income

exclusion + tax exempt interest

• Two formulas for computing taxable benefits

• Up to 85% of benefits may be taxable

• Taxability based on taxpayer’s modified adjusted gross income (MAGI)– MAGI = AGI + foreign earned income

exclusion + tax exempt interest

• Two formulas for computing taxable benefits

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• Formula 1 (MAGI + .5SSB > 1st base amt)Include in income the lesser of:

.50 (Social Security Benefits), or

.50 [MAGI + .50 (SSB) – 1st base amount]

First Base amounts:– $32,000 MFJ,

– $0 MFS and not living apart,

– $25,000 for all other taxpayers

• Formula 1 (MAGI + .5SSB > 1st base amt)Include in income the lesser of:

.50 (Social Security Benefits), or

.50 [MAGI + .50 (SSB) – 1st base amount]

First Base amounts:– $32,000 MFJ,

– $0 MFS and not living apart,

– $25,000 for all other taxpayers

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• Formula 2 (MAGI + .5SSB > 2nd Base Amount)Include in income the lesser of:

• .85(Social Security benefits), or• Sum of: .85[MAGI .50(Social Security benefits)

second base amount], and the lesser of:– Amount included through application of the first

formula– $4,500 ($6,000 for married filing jointly).

• Base amounts:– $44,000 MFJ, – $0 MFS and not living apart– $34,000 for all other taxpayers

• Formula 2 (MAGI + .5SSB > 2nd Base Amount)Include in income the lesser of:

• .85(Social Security benefits), or• Sum of: .85[MAGI .50(Social Security benefits)

second base amount], and the lesser of:– Amount included through application of the first

formula– $4,500 ($6,000 for married filing jointly).

• Base amounts:– $44,000 MFJ, – $0 MFS and not living apart– $34,000 for all other taxpayers

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• Example of Social Security income:A: Married with AGI = $30,000; tax exempt

interest income = $3,000; Social Security benefits = $10,000

B: Married with AGI = $40,000; tax exempt interest income = $6,000; Social Security benefits = $10,000

• Example of Social Security income:A: Married with AGI = $30,000; tax exempt

interest income = $3,000; Social Security benefits = $10,000

B: Married with AGI = $40,000; tax exempt interest income = $6,000; Social Security benefits = $10,000

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• Example (cont’d)A: Formula 1: Lesser of:

.50 ($10,000) = $5,000, or

.50 [($30,000 + $3,000) + .50 ($10,000) - $32,000)] = $3,000

Therefore, $3,000 of Social Security benefits included in gross income

• Example (cont’d)A: Formula 1: Lesser of:

.50 ($10,000) = $5,000, or

.50 [($30,000 + $3,000) + .50 ($10,000) - $32,000)] = $3,000


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• Example (cont’d)– B: Formula 2: Lesser of:

• .85 ($10,000) = $8,500, or• Sum of

– .85[($40,000 + $6,000) + .50 ($10,000) - $44,000] = $5,950, and – Lesser of:– .50 ($10,000) = $5,000, or– $6,000


Problem 56

• Example (cont’d)– B: Formula 2: Lesser of:

• .85 ($10,000) = $8,500, or• Sum of

– .85[($40,000 + $6,000) + .50 ($10,000) - $44,000] = $5,950, and – Lesser of:– .50 ($10,000) = $5,000, or– $6,000


Problem 56

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If you have any comments or suggestions concerning this PowerPoint Presentation for West's Federal Taxation, please contact:

Dr. Donald R. Trippeer, CPA

[email protected]

chapter 4 gross income: concepts and inclusions copyright ©2005 south-western/thomson learning...

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