comprehensive volume c4-1 chapter 4 gross income: concepts and inclusions gross income: concepts and...

C4-C4-11Comprehensive VolumeComprehensive Volume

Chapter 4Chapter 4

Gross Income:Concepts and Inclusions

Gross Income:Concepts and Inclusions

Copyright ©2010 Cengage Learning

Comprehensive Volume


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

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

• Concept is interpreted broadly by the courts

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

• Concept is interpreted broadly by the courts



• 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

• 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



• 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

• 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


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


Accounting Methods (slide 1 of 2)Accounting Methods (slide 1 of 2)

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

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


Accounting Methods (slide 2 of 2)Accounting Methods (slide 2 of 2)

• In addition to overall accounting methods, taxpayers may choose (elect) tax treatment for various transactions, for example – Taxpayers can elect to use the installment

method – Certain contractors may elect to use either the

percentage of completion method or the completed contract method

• In addition to overall accounting methods, taxpayers may choose (elect) tax treatment for various transactions, for example – Taxpayers can elect to use the installment

method – Certain contractors may elect to use either the

percentage of completion method or the completed contract method


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

• 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


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

• Example - Constructive receipt – An employer issued a bonus check to an employee on

December 31st but asked her to hold it for a few days until the company could make deposits to cover the check.

• The income was not constructively received on December 31 since the issuer did not have sufficient funds in its account to pay the debt.

• Example - Constructive receipt – An employer issued a bonus check to an employee on

December 31st but asked her to hold it for a few days until the company could make deposits to cover the check.

• The income was not constructively received on December 31 since the issuer did not have sufficient funds in its account to pay the debt.


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 cash basis 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 cash basis taxpayer may elect to

recognize the interest when earned


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

• The accrual method is required for determining purchases and sales when inventory is an income-producing factor

• 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

• The accrual method is required for determining purchases and sales when inventory is an income-producing factor


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


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

• 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




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

earned in the current year is included in income in the year of receipt

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

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

earned in the current year is included in income in the year of receipt

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


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


Income Sources (slide 1 of 2)Income Sources (slide 1 of 2)

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

• 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

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


Income Sources (slide 2 of 2)Income Sources (slide 2 of 2)

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

transferred, must allocate interest income between transferor and transferee based on the number of days during the period that each owned the property

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

transferred, must allocate interest income between transferor and transferee based on the number of days during the period that each owned the property


Dividends (slide 1 of 4)Dividends (slide 1 of 4)

• 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

• 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



• Recent legislation has provided 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 in 2009 pay 0% 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

• Recent legislation has provided 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 in 2009 pay 0% 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



• 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 121-day period beginning 60 days before the ex-dividend date to qualify for the reduced tax rates

• 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 121-day period beginning 60 days before the ex-dividend date to qualify for the reduced tax rates



• 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

• 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


Income Received By An AgentIncome Received By An Agent

• Income received by the taxpayer’s agent is considered to be received by the taxpayer– A cash basis principal must recognize the

income at the time it is received by the agent

• Income received by the taxpayer’s agent is considered to be received by the taxpayer– A cash basis principal must recognize the

income at the time it is received by the agent


Income From PartnershipsIncome From Partnerships

• A partnership is not a separate taxable entity– Files an information return (Form 1065)

• Provides data necessary for determining each partner’s distributive share of partnership’s income and deductions

• Each partner reports distributive share of partnership income and deductions

– Reported in year earned, even if not actually distributed

• Because a partner pays tax on income as the partnership earns it, distributions are treated under the recovery of capital rules

• A partnership is not a separate taxable entity– Files an information return (Form 1065)

• Provides data necessary for determining each partner’s distributive share of partnership’s income and deductions

• Each partner reports distributive share of partnership income and deductions

– Reported in year earned, even if not actually distributed

• Because a partner pays tax on income as the partnership earns it, distributions are treated under the recovery of capital rules


Income From S CorporationsIncome From S Corporations

• A small business corporation may elect to be taxed similarly to a partnership– Referred to as an S corporation

• The shareholders, rather than the corporation, pay the tax on the corporation’s income

• Generally, shareholders report their share of the corp’s income and deductions for the year, even if not actually distributed

• A small business corporation may elect to be taxed similarly to a partnership– Referred to as an S corporation

• The shareholders, rather than the corporation, pay the tax on the corporation’s income

• Generally, shareholders report their share of the corp’s income and deductions for the year, even if not actually distributed


Income From Estates And TrustsIncome From Estates And Trusts

• Beneficiaries of estates and trusts – Generally, taxed on the income earned by the

estates or trusts that is actually distributed or required to be distributed to them

– Any income not taxed to the beneficiaries is taxable to the estate or trust

• Beneficiaries of estates and trusts – Generally, taxed on the income earned by the

estates or trusts that is actually distributed or required to be distributed to them

– Any income not taxed to the beneficiaries is taxable to the estate or trust


Income In Community Property States

Income In Community Property States

• All property is deemed either to be separately owned by the spouse or to belong to the marital community– 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

• All property is deemed either to be separately owned by the spouse or to belong to the marital community– 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


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




Payments may qualify as alimony if:1. Payments are in cash2. Agreement or decree does not specify that the

payments are not alimony3. Payor and payee are not members of the same

household at the time the payments are made4. There is no liability to make the payments for

any period after the death of the payee

Payments may qualify as alimony if:1. Payments are in cash2. Agreement or decree does not specify that the

payments are not alimony3. Payor and payee are not members of the same

household at the time the payments are made4. There is no liability to make the payments for

any period after the death of the payee




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

transferor– No gross income and carryover of transferor’s

basis for transferee– Front-loading of alimony payments

• 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

transferor– No gross income and carryover of transferor’s

basis for transferee– Front-loading of alimony payments

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




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

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

child)

• May be difficult to determine whether an amount received is alimony or child support– 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

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

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

child)

• May be difficult to determine whether an amount received is alimony or child support– 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


Imputed Interest on Below-Market Loans (slide 1 of 4)


• Interest is imputed, using Federal government rates, when a loan does not carry a market rate of interest– Imputed interest = the difference between the amount

that would have been charged at the Federal rate and the amount actually charged

• 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– Imputed interest = the difference between the amount

that would have been charged at the Federal rate and the amount actually charged

• Applies to: • Gift loans• Compensation-related loans• Corporate-shareholder loans• Tax avoidance loans




• Gift loans– Exemption for loans of ≤ $10,000 between individuals

• If loan proceeds are used to purchase income-producing property, the following limitation applies

– 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 between individuals

• If loan proceeds are used to purchase income-producing property, the following limitation applies

– 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




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

avoidance• Makes practically all loans of this type suspect

• 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• Makes practically all loans of this type suspect

• Interest expense imputed to borrower may be deductible


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




• 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




• 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




• 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




• 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 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 on final return




• The simplified method is required for annuity distributions from a qualified retirement plan – Exclusion amount is investment in contract

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

• The simplified method is required for annuity distributions from a qualified retirement plan – Exclusion amount is investment in contract

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


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 (limits apply)

• 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 (limits apply)


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

• If plan discriminates in favor of key employees (e.g., officers), key employees are not eligible for exclusion– In such a case, the key employees must include in

gross income the greater of:• The actual premiums paid by the employer, or • The amount calculated from the Uniform Premiums table

• 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

• If plan discriminates in favor of key employees (e.g., officers), key employees are not eligible for exclusion– In such a case, the key employees must include in

gross income the greater of:• The actual premiums paid by the employer, or • The amount calculated from the Uniform Premiums table


Unemployment CompensationUnemployment Compensation

• Prior to 2009, unemployment compensation was taxable in full

• Under ARRTA of 2009 the first $2,400 of unemployment compensation is excluded from gross income– This relief from taxation is limited to 2009

• Prior to 2009, unemployment compensation was taxable in full

• Under ARRTA of 2009 the first $2,400 of unemployment compensation is excluded from gross income– This relief from taxation is limited to 2009


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 (excluding Social Security) +

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 (excluding Social Security) +

foreign earned income exclusion + tax exempt interest

• Two formulas for computing taxable benefits




• Formula 1 - If MAGI plus ½ of Social Security benefits exceeds the base amounts below, but not the second set of base amounts,Include in income the lesser of:

.50 (Social Security Benefits), or

.50 [MAGI + .50 (SSB) - base amount]

Base amounts:– $32,000 MFJ,– $0 MFS and not living apart,– $25,000 for all other taxpayers

• Formula 1 - If MAGI plus ½ of Social Security benefits exceeds the base amounts below, but not the second set of base amounts,Include in income the lesser of:

.50 (Social Security Benefits), or

.50 [MAGI + .50 (SSB) - base amount]

Base amounts:– $32,000 MFJ,– $0 MFS and not living apart,– $25,000 for all other taxpayers




• Formula 2 - If MAGI plus ½ of Social Security benefits exceeds the base amounts belowInclude 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 - If MAGI plus ½ of Social Security benefits exceeds the base amounts belowInclude 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




• 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




• 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





• 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


• 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



If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact:

Dr. Donald R. Trippeer, CPA [email protected]

SUNY Oneonta

If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact:

Dr. Donald R. Trippeer, CPA [email protected]

SUNY Oneonta

comprehensive volume c4-1 chapter 4 gross income: concepts and inclusions gross income: concepts and...

Documents