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Chapter 4 Gross Income: Concepts and Inclusions Copyright ©2005 South-Western/Thomson Learning Eugene Willis, William H. Hoffman, Jr., David M. Maloney,

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Presentation on theme: "Chapter 4 Gross Income: Concepts and Inclusions Copyright ©2005 South-Western/Thomson Learning Eugene Willis, William H. Hoffman, Jr., David M. Maloney,"— Presentation transcript:

1 Chapter 4 Gross Income: Concepts and Inclusions Copyright ©2005 South-Western/Thomson Learning Eugene Willis, William H. Hoffman, Jr., David M. Maloney, and William A. Raabe

2 C4 - 2 Gross Income (slide 1 of 3) Definition: Gross income includes all (realized) income from whatever source derived, unless specifically excluded under the Code Concept is interpreted broadly by the courts Definition: Gross income includes all (realized) income from whatever source derived, unless specifically excluded under the Code Concept is interpreted broadly by the courts

3 C4 - 3 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  Problem 26 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  Problem 26

4 C4 - 4 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 or liability  Problem 39 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 or liability  Problem 39

5 C4 - 5 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 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

6 C4 - 6 Accounting Methods There are 3 primary methods of accounting for tax purposes: –Cash receipts –Accrual –Hybrid There are 3 primary methods of accounting for tax purposes: –Cash receipts –Accrual –Hybrid

7 C4 - 7 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  Problem 38 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  Problem 38

8 C4 - 8 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, 2003 which arrive in taxpayer’s mail January 3, 2004 are taxable in The dividend was not available to the taxpayer until 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, 2003 which arrive in taxpayer’s mail January 3, 2004 are taxable in The dividend was not available to the taxpayer until 2004.

9 C4 - 9 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. 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.

10 C 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 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

11 C 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

12 C 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  Problem 37 a. 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  Problem 37 a.

13 C 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 (E-19, Problem 37 b & c) Prepaid rents or interest income are always recognized in the year received rather than when earned 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 (E-19, Problem 37 b & c) Prepaid rents or interest income are always recognized in the year received rather than when earned

14 C 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 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

15 C Income Sources (slide 1 of 4) Income from personal services is taxable to the person who performs the services –Fruit and tree metaphor  Problem 13 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  Problem 13 Income from property is taxable to the owner of the property –Assignment of income is not permitted

16 C Income Sources (slide 2 of 4) Interest income accrues daily –If interest bearing instrument (e.g., bonds) is transferred, must allocate interest income between transferor and transferee 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 Interest income accrues daily –If interest bearing instrument (e.g., bonds) is transferred, must allocate interest income between transferor and transferee 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

17 C Income Sources (slide 3 of 4) Income from pass-through entities is taxable at the owner level rather than at the entity level Pass-through entities include: –Partnerships –S corporations –Estates and trusts  Problem 42 Income from pass-through entities is taxable at the owner level rather than at the entity level Pass-through entities include: –Partnerships –S corporations –Estates and trusts  Problem 42

18 C Income Sources (slide 4 of 4) Community property issues –Community vs. separate property 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 Community property issues –Community vs. separate property 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

19 C Dividends (slide 1 of 3) 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 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

20 C Dividends (slide 2 of 3) 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 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

21 C Dividends (slide 3 of 3) 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 (Problem 43) 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 (Problem 43)

22 C 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

23 C Alimony and Separate Maintenance Payments (slide 2 of 4) For post-1984 agreements and decrees, 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 For post-1984 agreements and decrees, 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

24 C 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 (E-34) p.22 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 payor –No gross income and carryover of payor’s basis for recipient –Front-loading of alimony payments (E-34) p.22 Alimony recapture (gross income) for payor Deduction from gross income for recipient

25 C 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 (E-36 on p.23)  Problem 45 & 46 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 (E-36 on p.23)  Problem 45 & 46

26 C Imputed Interest on Below- Market 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 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

27 C Imputed Interest on Below- Market 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 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

28 C Imputed Interest on Below- Market Loans (slide 3 of 3) $10,000 exemption also applies to compensation-related and corporation- shareholder loans –No exemption if principal purpose of loan is tax avoidance 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 Interest expense imputed to borrower may be deductible

29 C 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

30 C 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 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

31 C 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 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

32 C Annuity Income (slide 4 of 6) 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

33 C 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 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

34 C Annuity Income (slide 6 of 6) Simplified method for annuity distributions from qualified retirement plan available –Exclusion amount is investment in contract divided by number of anticipated monthly payments (table amount based on age)  Problem 52 Simplified method for annuity distributions from qualified retirement plan available –Exclusion amount is investment in contract divided by number of anticipated monthly payments (table amount based on age)  Problem 52

35 C 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 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

36 C 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 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

37 C Unemployment Compensation Taxable in full

38 C 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 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

39 C Social Security Benefits (slide 2 of 6) Formula 1 (MAGI +.5SSB > 1st base amt) Include in income the lesser of:.50 (Social Security Benefits), or.50 [MAGI +.50 (SSB) – 1 st base amount] First Base amounts: – $32,000 MFJ, – $0 MFS and not living apart, – $25,000 for all other taxpayers Formula 1 (MAGI +.5SSB > 1st base amt) Include in income the lesser of:.50 (Social Security Benefits), or.50 [MAGI +.50 (SSB) – 1 st base amount] First Base amounts: – $32,000 MFJ, – $0 MFS and not living apart, – $25,000 for all other taxpayers

40 C Social Security Benefits (slide 3 of 6) Formula 2 (MAGI +.5SSB > 2 nd Base Amount) 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 Formula 2 (MAGI +.5SSB > 2 nd Base Amount) 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

41 C 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 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

42 C 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 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

43 C 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  Problem 56 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  Problem 56

44 C If you have any comments or suggestions concerning this PowerPoint Presentation for West's Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA


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