Gross Income and Exclusions
Chapter 5 Gross Income and Exclusions
Realization and Recognition of Income
Gross income is income that taxpayers realize, recognize, and report on their tax returns for the year.
- Unless a tax provision says otherwise, gross income includes all income (broadly defined – all inclusive)
A taxpayer recognizes income and reports the income on his or her tax return when the following are met:
- Taxpayer receives an economic benefit
- Taxpayer receives an item of value (salary, proceeds from property sale, investment income)
- Loan proceeds do not meet this criterion as the economic benefit is completely offset by the new liability
- Taxpayer realizes income
- Income is realized when a taxpayer engages in a transaction with another party; there is a sale or exchange
- Stock appreciation is not realized as income until a sale or exchange occurs
- Often times, the transaction provides the taxpayer the wherewithal to pay his/her tax liability resulting from the transaction
- No tax provision allows the taxpayer to exclude or defer the income from gross income
- Generally, taxpayers must recognize all realized income by reporting it as gross income
- Some exclusions and deferral opportunities exist
- In these circumstances, it is important to distinguish between realized and recognized income; realized gain does not always equal recognized gain
Other Income Concepts
- Taxpayer must not receive cash to realize and recognize income
- Taxpayers have the legal and ethical responsibility to report realized income no matter the form of its receipt or whether the IRS knows the taxpayer received the income
- Return of Capital Principle
- When receiving a payment for property, taxpayers are allowed to recover the cost of the property (basis) tax free
- Recovery of Amounts Previously Deducted
- Refunds are not typically included in gross income, unless the tax benefit rule applies
- Tax benefit rule: If the refund is made for an expenditure deducted in a previous year (resulting in tax savings in the previous year), then the tax benefit rule mandates that the refund is included in gross income to the extent the prior deduction produced a tax benefit
When do Taxpayers Recognize Income?
Dependent upon whether the taxpayer uses the accrual or cash method of accounting
- Income recognized when earned and expenses deducted in the period when liabilities are incurred
- Income recognized when cash is received and expenses are deducted when cash is paid
Things to consider:
- Constructive receipt – we’ve already discussed this concept
- Income must be recognized when it is unconditionally available to the taxpayer, the taxpayer is aware of the income’s availability, and there are no restrictions on the taxpayer’s control over the income
- Claim of right doctrine
- Income has been realized if a taxpayer receives income and there are no restrictions on the taxpayer’s use of the income (the taxpayer does not have an obligation to repay the amount)
Who recognizes the Income?
Things to consider:
- Assignment of income doctrine – we’ve already discussed this concept
- Community Property Systems
- Nine states implement community property systems (none in the northeast)
- Applies to married couples
- Property that a spouse brings into a marriage is treated as that spouse’s separate property
- The income earned from services is treated as if earned equally by both spouses
- Property acquired after marriage is usually treated as owned equally by both spouses (exception is property received via gift or inheritance)
- Common Law Systems
- All of the income earned from the services of one spouse is included in the gross income of the spouse who earned it
- For property owned separately, all of the income from the separately owned property is included in that spouse’s gross income
- For property owned jointly, each co-owner is taxed on the income attributable to his or her share of the property.
- Why does this matter?
- It doesn’t if the couple says married and files a joint return
- It matters if the couple files separate tax returns, or divorces during the year
Types of Income Subject to Taxation
- Income from services
- Often referred to as earned income
- If the taxpayer is an employee, she will receive a W-2
- If the taxpayer is self-employed, he will receive 1099s, and complete Schedule C
- Rarely exempt from taxation
- Includes unemployment compensation, reported on 1099-G
- Income from property
- Often referred to as unearned income
- Gains/losses from the sale of property, dividends, interest, rents, royalties and annuities
- Income typically reported on some form of 1099
- Reduce gross rents by allowable deductions
- Tax treatment depends on character
- Tax-exempt, ordinary, qualified dividend, capital gain
- An investment that pays a stream of equal payments over time
- For tax, we must determine how much of each annuity payment represents gross income (ordinary income) and how much represents a nontaxable return of capital (return of investment).
- Ratio to determine nontaxable portion: Original Investment/Expected Value of Investment
- Property Dispositions
- Taxpayers are allowed to recover their investment in property (tax basis) before they realize any gain and recognize the gain on their tax returns.
- The tax law must allow for a deduction if a loss is realized – a loss will only reduce the taxpayer’s taxable income if the loss is deductible
- Recall the rules for capital gains and losses
- Any selling expenses reduce the amount realized on the sale/exchange
-Selling expenses = brokerage fees, realtor fees
Know capital loss rules
Other Sources of Gross Income
- Income from Flow-through Entities
- Partnerships, LLCs and S Corporations – ( s-corps do not pay tax)
- The owners of these types of entities report income or deductions, generally in proportion to his/her ownership percentage, on his or her individual tax return
- They must report income even if they receive no cash
- Cash distributions are generally not taxable income
- Income and deductions retain their character when reported by the owners
-Ordinary income = business income (taxable income even if no cash)
-Interest, dividend, capital gains/losses (all have separate line on 1040) (taxable income even if no cash)
- What is alimony?
- A transfer of cash made under a written separation agreement or divorce decree
- The decree does not designate the payment as something other than alimony
- The spouses do not live together when the payment is made
- Payments cannot continue after the death of the recipient
- The paying spouse gets an above-the-line deduction – shifting income
- Certain restrictions – cannot front load
- Child support is not alimony. Property divisions are not alimony. For these payments, the recipient does not report taxable income and the payer receives no tax deduction.
- Payments that cease once a child reaches the age of 18 would be treated as child support
- Prizes and Awards
- In general, the value of these types of payments are included as taxable income
- If the taxpayer receives property, the FMV of the property is included as taxable income
- Awards for scientific, literary or charitable achievement (Nobel Prize) are excluded but only if the recipient was selected without any action on his or her part to enter the contest, the recipient is not required to render substantial future services as a condition to receive the award, and the payer of the prize or award transfers the prize or award to a government or a qualified charity designated by the taxpayer
- Awards for length of service or safety achievement, but are limited to $400 of tangible property other than cash per employee per year
- Gambling Winnings
- Gross gambling winnings must be included in gross income
- Taxpayers are allowed to deduct their gambling losses to the extent of their gambling winnings, but only as miscellaneous itemized deductions
- Ex: if win 10,000 and lose 12,000 itemized deductions would be 10,000 not 12,000 because 10,000 is the amount that you won
- Social Security Benefits
- Taxpayers may be required to include up to 85% of their social security benefits in gross income depending on the taxpayer’s filing status and modified AGI.
- Modified AGI is regular AGI plus tax-exempt interest income, excluded foreign income, and certain other for AGI deductions
- See page 5-18 of your textbook
- Imputed Income
- Indirect economic benefits
- Bargain purchases, below-market loans
- Discharge of Indebtedness
- When a taxpayer’s debt is forgiven by a lender, the taxpayer must include the amount of debt relief in gross income
- Discharge of indebtedness is not taxable if the taxpayer is insolvent before and after the debt forgiveness
- If the discharge of the indebtedness makes the taxpayer solvent, the taxpayer recognizes gross income to the extent of his solvency
Exclusion Provisions – Income not subject to taxation
- Some specific types of income that taxpayers realize are allowed to be permanently excluded from gross income (exclusions) or temporarily deferred until a subsequent period (deferrals)
- State and municipal bond interest – we’ve already discussed this concept
- Gains on the Sale of Personal Residence
- Taxpayers meeting certain home ownership and use requirements can permanently exclude up to $250,000 ($500,000 if MFJ) of realized gain on the sale of their principal residence
- Gain in excess of the exclusion generally qualifies as long-term capital gain
- Ownership test
- Taxpayer must have owned the residence for a total of two or more years during the five-year period ending on the date of the sale
- Use test
- The taxpayer must have used the property as her principal residence for a total of two or more years (can be noncontiguous) during the five-year period ending on the date of the sale
- Each taxpayer is only eligible for this exclusion once every two years
- Married couples filing joint returns are eligible for the full $500,000 exclusion if either spouse meets the ownership test and both spouses meet the principal use test.
- If either spouse is ineligible for the exclusion because of the once in two years rule, the couple’s available exclusion is reduced to $250,000
- Fringe Benefits – noncash compensation
- In general, all compensation is taxable
- However, qualifying fringe benefits are excluded from gross income; see page 5-24
- Medical and dental health insurance coverage
- Life insurance coverage up to $50,000
- De minimis small benefits
- Dependent care benefits
- Contributions to qualifying retirement accounts are not currently included in the employee’s gross income, but are deferred until the employee withdraws the contribution + earnings from the plan
- Education-Related Exclusions
- Scholarships that pay for tuition, fees, books, supplies and other equipment required for the student’s coursework are excluded from taxable income
- Excess scholarship money is fully taxable
- The scholarship exclusion applies only if the recipient is not required to perform services in exchange for receiving the scholarship
- Tuition waivers or reductions provided for student employees and grad students are not taxable
- Athletic scholarships that cover room and board can be excluded from gross income if they are not cancelled if the student cannot participate in the sport
- Other Educational Subsidies
- Taxpayers can exclude from gross income earnings on investments in qualified education plans (529 plans) if earnings are used to pay for qualifying educational expenses
- Series EE bonds receive similar treatment
- These benefits are phased out based on AGI
Exclusions that Mitigate Double Taxation
- Gifts and Inheritances
- Taxes are imposed on the transfer of the property
- Life Insurance Proceeds
- Included in the decedent’s taxable estate
- Interest must be included in income if not paid out as a lump sum
- If you sell your policy, the purchaser must include proceeds as taxable income (less amount paid for policy + premium payments)
- If a policy holder cashes in (cash surrender value), the amount received less premiums paid is included as gross income
- Accelerated death benefits are not taxable if used to pay for the taxpayer’s long-term care
- Only if taxpayer is terminally ill (Illness expected to result in death within 24 months)
- Foreign-Earned Income
- Congress allows taxpayers to exclude foreign-earned income up to an annual maximum amount
- 2014 exclusion is $99,200 (salary paid by US government does not qualify for exclusion)
- This may not be the most beneficial option as a taxpayer can also deduct foreign taxes paid as an itemized deduction or claim the foreign tax credit
- To qualify for the exclusion, the taxpayer must live in the foreign country for 330 days in a consecutive 12-month period
- Exclusion is computed on a daily basis so taxpayers may have to reduce the annual exclusion amount by a pro rata amount for each day the taxpayer is not considered to be a resident of the foreign country
- Special rules for employer provided housing – taxpayers may also exclude from income reasonable housing costs
Sickness and Injury-Related Exclusions:
- Workers’ Compensation
- Any payments a taxpayer receives from a state-sponsored workers’ compensation plan are excluded from the taxpayer’s income
- Recall that unemployment compensation is fully taxable
- Payments Associated with Personal Injury
- All payments associated with compensating a taxpayer for physical injury are excluded from gross income (legal settlements)
- Compensatory damages on account of physical injury or physical sickness
- Punitive damages are fully taxable
- Health Care Reimbursement
- Any reimbursement a taxpayer receives from a health and accident insurance policy are excluded from gross income
- Tax Benefit Rule! If a taxpayer previously deducted medical expenses, reimbursements become taxable income to the extent the taxpayer previously received a tax benefit
- Disability Insurance
- If an individual purchases disability insurance directly, the cost of the policy is not deductible, but any disability benefits are excluded from gross income
- If an employer provides the disability insurance plan, the employee may have the option to treat the benefit as taxable compensation, or as a tax free fringe benefit
- If the premiums paid are taxable compensation, the policy is considered to have been purchased by the employee and benefits are nontaxable
- If the premiums are treated as a tax free fringe benefit, the benefits resulting from the policy are taxable income
- A. and Paula file as married taxpayers. In August of this year they received a $5,200 refund of state income taxes that they paid last year. How much of the refund, if any, must L. A. and Paula include in gross income under the following independent scenarios? Assume the standard deduction last year was $12,200.
- Last year L. A. and Paula had itemized deductions of $10,200, and they chose to claim the standard deduction.
- Last year L. A. and Paula claimed itemized deductions of $23,000. Their itemized deductions included state income taxes paid of $7,500.
- Last year L. A. and Paula claimed itemized deductions of $15,000. Their itemized deductions included state income taxes paid of $10,500.
George and Weezy received $30,200 of Social Security benefits this year ($12,000 for George; $18,200 for Weezy). They also received $5,000 of interest from jointly owned City of Ranburne Bonds and dividend income. What amount of the Social Security benefits must George and Weezy include in their gross income under the following independent situations?
- George and Weezy file married joint and receive $8,000 of dividend income from stocks owned by George.
8000 dividend income
8000+5000 + 15,100 = 28,100 < 32,000 so NO benefits are taxable
- George and Weezy file married separate and receive $8,000 of dividend income from stocks owned by George.
8000 dividend income – stock owned by George
85% (modified agi + 50% of social security)
85% (25,000 + 8,000)+ (50% of 12,000)
85% *16,500 = 14,025
85% of 18,200 = 15,470
85% (2500 + 9100) = 9.860
- George and Weezy file married joint and receive $30,000 of dividend income from stocks owned by George.
<32,000 ALWAYS non-taxable)
If 32,000 – 44,000 è middle calulcation
If > 44,000, generally 85% is taxable. (bottom calculation)
Modified AGI + 50% of social security benefits
(5,000 + 30,000) + 50% (30,200)
(35,000 + 15,100) = 50,100
Less of 85% social security = 25,670
Or less of 85% (modified agi + ½ social security – 44,000)
85% (35,000 + 15,100 – 44,000) = 5185
6000 + 5185 = 11,185 = taxable income from total of 30,200
- George and Weezy file married joint and receive $15,000 of dividend income from stocks owned by George.
Jimmy has fallen on hard times recently. Last year he borrowed $250,000 and added an additional $50,000 of his own funds to purchase $300,000 of undeveloped real estate. This year the value of the real estate dropped dramatically and Jimmy’s lender agreed to reduce the loan amount to $230,000. For each of the following independent situations, indicate the amount Jimmy must include in gross income and explain your answer:
- The real estate is worth $175,000 and Jimmy has no other assets or liabilities.
- The real estate is worth $235,000 and Jimmy has no other assets or liabilities.
- The real estate is worth $200,000 and Jimmy has $45,000 in other assets but no other liabilities.
Fred currently earns $9,000 per month. Fred has been offered the chance to transfer for three to five years to an overseas affiliate. His employer is willing to pay Fred $10,000 per month if he accepts the assignment. Assume that the maximum foreign earned income exclusion for next year is $99,200.
- How much U.S. gross income will Fred report if he accepts the assignment abroad on January 1 of next year and works overseas for the entire year? If Fred’s employer also provides him free housing abroad (cost of $18,000), how much of the $18,000 is excludible from Fred’s income?
- Suppose that Fred’s employer has only offered Fred a six-month overseas assignment beginning on January 1 of next year. How much U.S. gross income will Fred report next year if he accepts the six-month assignment abroad and returns home on July 1 of next year?
- Suppose that Fred’s employer offers Fred a permanent overseas assignment beginning on March 1 of next year. How much U.S. gross income will Fred report next year if he accepts the permanent assignment abroad? Assume that Fred will be abroad for 305 days out of 365 days next year. If Fred’s employer also provides him free housing abroad (cost of $16,000 for next year), how much of the $16,000 is excludible from Fred’s income?
Irene is disabled and receives payments from a number of sources (see below). The interest payments are from bonds that Irene purchased over past years and a disability insurance policy that Irene purchased herself. Calculate Irene’s gross income.
Interest, bonds issued by City of Austin, Texas $ 2,000
Social Security benefits 8,200
Interest, U.S. Treasury bills 1,300
Interest, bonds issued by Ford Motor Company 1,500
Interest, bonds issued by City of Quebec, Canada 750
Disability insurance benefits 19,500
Distributions from qualified pension plan 5,400
Ken is 63 years old and unmarried. He retired at age 55 when he sold his business, Understock.com. Though Ken is retired, he is still very active. Ken reported the following financial information this year. Assume Ken files as a single taxpayer. Determine Ken’s gross income.
- Ken won $1,200 in an illegal game of poker (the game was played in Utah, where gambling is illegal).
- Ken sold 1,000 shares of stock for $32 a share. He inherited the stock two years ago. His tax basis (or investment) in the stock was $31 per share.
- Ken received $25,000 from an annuity he purchased eight years ago. He purchased the annuity, to be paid annually for 20 years, for $210,000.
- Ken received $13,000 in disability benefits for the year. He purchased the disability insurance policy last year.
- Ken decided to go back to school to learn about European history. He received a $500 cash scholarship to attend. He used $300 to pay for his books and tuition, and he applied the rest toward his new car payment.
- Ken’s son, Mike, instructed his employer to make half of his final paycheck of the year payable to Ken. Ken received the check on December 30 in the amount of $1,100.
- Ken received a $610 refund of the $3,600 in state income taxes his employer withheld from his pay last year. Ken claimed $6,150 in itemized deductions last year (the standard deduction for a single filer was 6,100).
- Ken received $30,000 of interest from corporate bonds and money market accounts.