Determining Gross Income

1
DeterminingGross Income

• Chapter 3

2
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...

3
Gross Income

• There is a presumption that unless there is a
  specific exclusion for an item of income, then it
  must be included in Gross Income.
• See CIR v. Glenshaw Glass Co., 348 U.S. 426, 1955
  U.S. LEXIS 1508 (1954)

4
What is Income?

• Gross income is realized income that is not
  excluded
• Realization takes place when arms length
  transaction occurs (sale of goods)
• Taxable income is gross income less all deductions

5
Tax vs. Financial Accounting

• Goals are not the same
• Financial accounting seeks to provide information
  that decision makers find useful
• Tax reporting seeks to collect revenue equitably
• Differences fall into two categories
• Temporary or timing differences
• Permanent differences

6
Temporary Differences

• Arise when income is taxed either before or after
  it is accrued for accounting purposes
• Example prepaid rent generally is taxable when
  received but is only included in financial
  accounting income as it is earned
• Create a deferred tax asset or deferred tax
  liability on financial statements

7
Permanent Differences

• Income that is not taxed but is reported for
  financial accounting purposes
• Example municipal bond interest generally is not
  taxed but is recorded as income in financial
  accounting records

8
Form of Receipt

• Income is not limited to cash.
• The amount of income from in-kind receipts is
  equal to the FMV of the property or services

9

• The recovery of capital is not taxed.

10
Return of Capital Principle

• Basis amount invested in an asset
• Basis can be 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

11
Investment Alternatives

• Investments yielding appreciation
• Tax deferred until gain is recognized
• Gain is frequently taxed at lower capital gains
  rates
• Investments yielding annual income
• Interest income is taxed annually at the marginal
  tax rate for ordinary income dividends taxed
  annually but currently at lower capital gains
  rates

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The Tax Year

• Calendar year
• Individuals
• S corporations and partnerships have restrictions
  on allowable tax years, 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)
• Corporations freely select tax year

13
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)
• Required by businesses that change their tax year
• Not required in year entity begins or ends
  business

14
Accounting Methods

• Taxpayers can use different methods for financial
  accounting and tax
• Cash method receipt of cash or cash equivalents
  determine income/expense recognition (subject to
  constructive receipt doctrine)
• Accrual method the all-events test determines
  income/expense recognition

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Cash Method

• Income is recognized when cash or cash
  equivalents received
• Cash equivalents broadly defined to include
  property and services
• Cash equivalents included at fair market value
• 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

16
Constructive Receipt Doctrine

• Constructive receipt is a modification that
  prevents cash basis taxpayers from turning their
  backs on income
• Income is not constructively received if
• The taxpayer is not entitled to the income
• The payor has insufficient funds from which to
  make payment, or
• There are substantial limitations or restrictions
  placed on actual receipt

17
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

18
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

19
Claim of Right Doctrine

• Claim of right doctrine modifies the normal
  recognition rules for accrual basis taxpayers
• Requires taxpayer to recognize income when
  payment is received, regardless of whether money
  may have to be repaid later
• If taxpayer must return all or part of the
  income, deduction allowed in repayment year

20
Prepaid Income

• Prepaid Income is another exception to the
  accrual method of accounting
• Based on wherewithal to pay concept taxpayer
  should be taxed when best able to pay the tax
• Income must be reported when received
• Examples rent, interest, and royalty payments
• Refundable deposits are not prepaid income

21
Economic Benefit Doctrine

• See Old Colony Trust Co. v. Com., 279 U.S. 716,
  1929 U.S. LEXIS 66 (1929)

22
Who Owns the Income?

• Active Income
• See Lucas v. Earl, 281 U.S. 111, 1930 U.S. LEXIS
  738 (1930)
• Passive Income
• See Helvering v. Horst, 311 U.S. 112, 1940 U.S.
  LEXIS 1228 (1940)

23
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 half of income to each spouse
• Income from property is taxed to taxpayer who
  owns the property

24
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
• High income taxpayers may have a higher after-tax
  return on municipal bonds than taxable bonds
  offering a higher interest tax
• Gain on the sale of tax-exempt securities must be
  included gross income

25
Original Issue Discount

• Some debt instruments are issued at prices below
  their maturity values
• This original issue discount (OID) is effectively
  interest paid at maturity rather than
  periodically over the debt instruments life
• Both cash and accrual basis taxpayers recognize
  OID income as it accrues
• Exception Series EE bonds

26
Market Discount

• Bonds purchased after issue in the open or
  secondary market at a price below its stated
  maturity value
• Excess of redemption proceeds over cost is
  recognized as ordinary income in year of
  redemption
• Electively, market discount can be accrued as
  interest income over life of bond

27
Below-Market-Rate Loans

• Interest-free or low interest rate loans are
  frequently made between related parties
• 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

28
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

29
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 from earnings and profits (EP) are
  treated as dividends includable in the
  shareholders income
• 2003 Tax Act reduced tax rate to the 15 rate
  applicable to long-term 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 (as if stock is sold)

31
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 are called capital gains
  distributions

32
Dividend Reinvestment Plans

• Treated as if the shareholder receives the cash
  and then purchases additional shares of stock
  with the dividend income (constructive receipt
  doctrine)
• Value of dividend included in income
• It is important for each shareholder to keep
  track of basis for all shares

33
Stock Dividends

• Stock dividends are distributions of a
  corporations own stock to its shareholder (stock
  splits)
• Usually stock dividends are not taxable to the
  shareholder (unless shareholder has option 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

34
Annuity Income

• Purchaser pays fixed amount for the right to
  receive a future stream of payments

35
Annuity Income

• Usually consists of a taxable and nontaxable
  amounts
• Nontaxable amount represents a return of capital
• Nontaxable amount of a payment is equal to the
  Investment in annuity / expected return from
  annuity x annuity payment received
• If the amounts invested in the annuity were all
  made by the employer (or by the employee using
  pre-tax dollars), then the employees investment
  is treated as zero

36
Annuity Income

• The exclusion ratio is applied to annuity
  payments received under contract to determine
  amount excludable
• Exclusion ratio Investment in contract
• Expected return under contract
• Multiply the payment received by the exclusion
  ratio.
• Once investment is recovered, remaining payments
  are taxable in full

37
Annuity Income

• 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

• Example (contd)
• A 15 years of annuity payments
• Years 1-15 333 taxable and 667 excludable

39
Annuity Income

• Example (contd)
• 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

40
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

41
Prizes and Awards

• 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

42
Government Transfer Payments

• Need-based payments, such as welfare payments,
  school lunches food stamps, are excluded from
  income
• Unemployment compensation is taxable because it
  is a substitute for wages that would be taxable

43
Social Security Benefits

• Government devised a complex formula that can
  result in the taxation of up to 85 of social
  security benefits for 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

44
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 can
  be taxed on up to 85 of their benefits
• Taxpayers between the above thresholds can be
  taxed on up to 50 of their social security
  benefits

45
Social Security Benefits

• 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

46
Social Security Benefits

• Problem Husband wife file a joint return.
  They had the following income
• 15,000 taxable pension
• 6,000 interest from bank account
• 6,000 dividends
• 16,000 social security benefits
• Are any of their social security benefits
  included in their GI?

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Social Security Benefits

• Problem Husband wife file a joint return.
  They had the following income and deductions
• 16,000 taxable pension
• 2,000 interest from bank account
• 1,500 dividends
• 700 interest from municipal bonds
• 12,000 social security benefits
• 4,000 itemized deductions
• What is their GI?

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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 (viewed as
  substitute for income that would otherwise be
  taxable income)
• Punitive damages are taxable

49
Divorce-Related Payments

• A property settlement is simply a division of
  assets (no income, no deduction)
• Alimony is a legal shifting of income taxable
  income to recipient and deductible by payor
• 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

50
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

51
Tax Benefit Rule

• If a taxpayer deducted an expense or loss in one
  year but recovers the amount deducted in a
  subsequent year, all or a portion of the amount
  recovered may have to be included in the gross
  income in the year it is recovered
• Amount included in income is limited to the
  extent the taxpayer benefited from the tax
  deduction
• Example bad debt recovery or refund of taxes
  previously deducted

52
Exclusions

• Gifts
• Inheritances
• Life Insurance
• Proceeds received are 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

53
Gifts and Inheritances

• Gifts are nontaxable to donee if
• Transfer is voluntary without adequate
  consideration, and
• Made out of affection, respect, admiration,
  charity, or donative intent
• See Com. V. Duberstein, 363 U.S. 278, 1960 U.S.
  LEXIS 2030 (1960)

54
Gifts and Inheritances

• Inheritances are nontaxable to beneficiary
• Income earned on gifts or inheritances is taxable
  under normal rules
• Example Father gifts corporate bond to daughter.
  Gift is excluded from daughters gross income,
  but interest income earned after gift date is
  taxable to her.

55
Gifts and Inheritances

• Transfers by employers to employees do not
  qualify as excludible gifts
• May be excludible under other provisions, e.g.,
  employee achievement awards

56
Compensation for Injuries and Sickness

• Personal injury damages
• Compensatory damages received on account of
  physical personal injury or physical illness are
  excludible
• Includes amounts received for loss of income
  associated with the physical personal injury or
  physical sickness
• All other personal injury damages are taxable
• Compensatory damages for nonphysical injury
• All punitive damages

57
Compensation for Injuries and Sickness

• Workers compensation
• Although may be payment for loss of wages,
  workers compensation is specifically excluded
  from gross income

58
Compensation for Injuries and Sickness

• Accident and health insurance benefits
• Benefits received under policy purchased by
  taxpayer are excludible
• Even if benefits are substitute for income

59
Employer-Sponsored Accident and Health Plans
(Also called disability plans, sickness and
accident, salary continuance)

• Premiums paid by employer for insurance coverage
  of employee, spouse, and dependents are not
  taxable to employee
• Amounts received from insurance are not taxable
  when received for medical care or for permanent
  loss of body part or function
• Amounts received are included when based on the
  work time loss

60
Scholarships

• Qualified scholarships are excluded from gross
  income
• Scholarship includes only tuition, fees, books,
  supplies, equipment, and related expenses
  required for courses
• Amounts designated or spent for room, board, and
  laundry are included in taxable 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 improvements made
  in lieu of paying rent
• 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

63
International Issues

• Source principal - countries tax income earned
  within their borders but exclude income from
  activities taking place (sourced) in other
  countries
• Applies to foreign persons and foreign
  corporations
• Residency principle countries tax worldwide
  income
• Applies to resident individuals and corporations

64
Tax Treaty

• An agreement between two countries that explains
  how a taxpayer of one country is taxed when
  conducting business in a second country
• Objective is to minimize double taxation

65
International Taxation

• A business is usually only taxed in country of
  residence unless it maintains a permanent
  establishment (e.g. office) in another country
• Source country can tax income earned within its
  borders when a permanent establishment exists
• Resident country allows taxpayer a foreign tax
  credit up to tax paid in source country

66
Taxpayers Subject to U.S. Tax

• U.S. citizens, corporations, and resident aliens
  are subject to U.S. tax on their worldwide income
• Resident alien individual who is not a U.S.
  citizen but who has established legal residence
  in U.S. through
• Green card or
• Substantial presence test (183 days)
• Nonresident alien individual who is not U.S.
  citizen and does not satisfy test to be resident
  alien

67
Nonresident Aliens and Foreign Corporations

• Effectively connected income U.S. business
  income subject to U.S. income tax
• Non-U.S. business income not subject to U.S.
  income tax
• U.S. investment income taxed at flat 30 (or
  treaty rate if lower)

68
State and Local Taxation

• Most states (and some local governments) impose
  both corporate and individual income taxes on
  both residents and nonresidents
• Nonresidents can only be taxed on
• Income derived from business activity within that
  state and
• Income from property in that state

69
State Tax Issues

• Nexus is the type and degree of connection
  between a business and a state necessary for the
  state to have the right to impose a tax
• Multi-state businesses may be able to reduce
  their overall tax cost by shifting income from a
  high-tax state to a low-tax state

70
Total Effective Tax Rate

• For federal tax purposes, state income tax is
  deductible in computing taxable income
• Tax savings from this federal deduction reduce
  the cost of the state income tax
• When a taxpayer pays income tax at both the
  federal and state levels, it increases the total
  effective tax rate and decreases the after-tax
  cash flow

71
Installment Method

• Gain is recognized as proceeds from sale are
  received
• Use severely restricted generally available for
  casual sales only (excludes sales of inventory
  and securities)
• May not want to use if
• Marginal tax rate is expected to increase
• Unused losses are expiring

72
Long-Term Contracts

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

73

• See James v. U.S., 366 U.S.
• 213, 1961 U.S. LEXIS 2014
• (1961)

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The End