Transcript Chapter 4

Chapter 4
Gross Income:
Concepts and Inclusions
Individual Income Taxes
Copyright ©2006 South-Western/Thomson Learning
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
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Gross Income (slide 2 of 3)
• 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
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Gross Income (slide 3 of 3)
• 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
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Accounting 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
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Accounting Methods
• There are 3 primary methods of accounting
for tax purposes:
– Cash receipts and disbursements method
– Accrual method
– Hybrid method
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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
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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, 2004 which
arrive in taxpayer’s mail January 3, 2005 are
taxable in 2005. The dividend was not
available to the taxpayer until 2005.
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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.
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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
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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
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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
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Exceptions to Accrual Method
(slide 2 of 2)
• 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
• Prepaid rents or interest income are always
recognized in the year received rather than
when earned
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Hybrid 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
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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
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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
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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
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Dividends (slide 2 of 4)
• 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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Dividends (slide 3 of 4)
• 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 (slide 4 of 4)
• 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
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Income 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
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Income 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
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Income 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
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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
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Alimony and Separate
Maintenance Payments (slide 1 of 4)
• Alimony is:
– Deductible by payor
– Includible in gross income of recipient
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Alimony and Separate
Maintenance Payments (slide 2 of 4)
Payments may qualify as alimony if:
1. The payments are in cash
2. The agreement or decree does not specify that
the payments are not alimony
3. 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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Alimony and Separate
Maintenance Payments (slide 3 of 4)
• 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
• Alimony recapture (gross income) for payor
• Deduction from gross income for recipient
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Alimony and Separate
Maintenance Payments (slide 4 of 4)
• 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
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Imputed Interest on BelowMarket 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
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Imputed Interest on BelowMarket Loans (slide 2 of 3)
• 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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Imputed Interest on BelowMarket Loans (slide 3 of 3)
• $10,000 exemption also applies to
compensation-related and corporationshareholder 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
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Annuity Income
(slide 2 of 6)
• 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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Annuity Income
(slide 3 of 6)
• 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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Annuity Income
(slide 4 of 6)
• Example (cont’d)
– A: 15 years of annuity payments
• Years 1-15: $333 taxable and $667 excludable
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Annuity Income
(slide 5 of 6)
• 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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Annuity Income
(slide 6 of 6)
• 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)
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Prizes 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
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Group 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
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Unemployment Compensation
• 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
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Social Security Benefits
(slide 2 of 6)
• Formula 1
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
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Social Security Benefits
(slide 3 of 6)
• Formula 2
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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Social Security Benefits
(slide 4 of 6)
• 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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Social Security Benefits
(slide 5 of 6)
• 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
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Social Security Benefits
(slide 6 of 6)
• 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
Therefore, $8,500 of Social Security benefits included in gross
income
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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]
SUNY Oneonta
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