Determining Gross Income

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DeterminingGross Income

• Chapter 3

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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...

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What is Income?

• Gross income is realized income that is not
  excluded
• Taxable income is gross income less all
  deductions

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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

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Tax vs. Financial Accounting

• Differences fall into two categories
• Temporary or timing differences (which usually
  even out over time)
• Permanent differences

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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

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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

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Return of Capital Principle

• Basis amount invested in an asset
• Basis is recovered tax-free
• If the taxpayers return is more than basis, the
  taxpayer has a gain
• If taxpayers return is less than basis, the
  taxpayer has a loss

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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

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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)

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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

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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

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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 taxpayers account
• Set apart for the taxpayer or
• Made available in some other way to the taxpayer

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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

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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

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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

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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 taxpayers 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

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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

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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

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Long-Term Contracts

• Completed Contract Methodno income is recognized
  and no deductions taken until completion
• Percentage-of-Completion Methodincome is
  recognized as contract progresses based on an
  estimate of actual costs incurred to total
  projected costs for contract

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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

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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

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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 instruments life
• Cash basis taxpayers recognize OID income as it
  accrues
• Exception Series EE bonds

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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

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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

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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 borrowers net
  investment income for the year
• If borrowers net investment income is no more
  than 1,000, imputed interest is zero

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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)

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Dividend Income

• Cash and FMV of other assets distributed by a
  corporation out of its earnings and profits (EP)
  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 EP are nontaxable
  return of capital (reducing stock basis)
• Distributions in excess of stock basis are taxed
  as capital gain (like a sale of stock)

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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 years alimony should not exceed average of
  2nd and 3rd 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

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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 taxpayers wealth
  and is subject to taxation
• Exceptions are provided for debtors who are
  bankrupt or insolvent

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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

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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

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Accident Health Insurance

• Accident health insurance proceeds tax-free to
  extent they pay qualified medical or dental
  expenses
• Disability insurancesubstitute 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

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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

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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

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Other Exclusions

• Improvements made on leased property are excluded
  from landlords 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

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The End