©2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 2 Gross Income & Exclusions Income Tax Fundamentals 2007 edition Gerald E. Whittenburg & Martha Altus-Buller

©2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Income Classifications  All sources of income are included unless specifically excluded Non-cash items included at fair market value  Three income classifications Active salary, wages and self employed Portfolio dividends and interest Passive rental real estate and limited partnership  Can only take passive losses against passive gains  Can carry forward unused losses to future years

©2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Interest Income  If total interest income >$1,500 must report on Schedule B (1040) or Schedule 1 (1040A) Fair market value of gifts/services a taxpayer receives for making long term deposits or opening an account is taxable interest  Taxpayer may exclude interest on state and local government obligations  After-tax return rate for tax-free municipal bond calculated as follows After-tax return = Tax-free interest rate / [1 – taxpayer’s tax rate]

©2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Dividend Income  3 kinds of dividends Ordinary dividends  Return of net income to shareholders  Schedule B (1040) when total dividend income > $1,500 Nontaxable distributions  Return of original investment - not paid from net income  Therefore not included in taxpayer’s income  Reduces basis in stock Capital gain distributions (CGD)  When stock reaches zero basis, further distributions are CGD  Report on page 1 of 1040 or Schedule D

©2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Alimony  Alimony is deductible to payer and taxable to payee  Alimony payments must meet requirements as follows if subject to divorce agreements after Must be in cash and received by ex-spouse 2. Must be made in connection with written instrument 3. Can’t continue after death of ex-spouse 4. Can’t be designated as anything other than alimony 5. Parties may not be members of the same household

©2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Annuities/Pensions  Taxpayer buys a contract (usually in retirement) in return for periodic payments for the remainder of his/her life  Taxable portion of these periodic payments, called annuities, are calculated based on mortality tables provided by IRS and the annuity purchase price  General Rule for exclusion - Payments received are both taxable (interest) and nontaxable (return of capital) Must calculate amount to exclude from income 1. To calculate exclusion ratio Investment in Contract / (Annual payment x life expectancy) 2. Exclusion amount = Exclusion Ratio x Amount Received

©2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Life Insurance Proceeds  Life insurance proceeds are excluded from gross income If proceeds paid to beneficiary by reason of death of the insured Interest on proceeds paid over several years is generally taxable income  Viatical settlements are excludable from gross income in certain situations Chronically or terminally ill taxpayer collects early payout from insurance company or sells/assigns policy to a viatical settlement provider  If policy is transferred for value, then all or part of the proceeds may be taxable to recipient Taxable amount = Proceeds from death of insured - Cash surrender value (at time of transfer) + Premiums paid by beneficiary

©2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Gifts and Inheritances and Scholarships  Inheritances are excluded from income Income received from property after transfer is taxable Estate may incur taxes  Gifts received are excluded from income Gifts in business settings usually considered taxable income If recipient renders services for the gift, amount is taxable  Scholarships received for fees, books, tuition, course- required supplies or equipment are excluded from income Must include scholarship amounts in income if  Any amounts apply to room and board  Any amounts received are compensation for required work

©2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Social Security  All or part of Social Security benefits may be excluded from income  Based on taxpayer’s Modified AGI (MAGI) MAGI = AGI + tax-exempt interest*  If [MAGI + (50%)(SS benefits)] < base amount** then benefits are not taxed If this number exceeds base amount, must compute taxable portion *Plus, on rare occasions, other items **See next screen

©2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Calculating Taxable Amount of SS Benefits at 50% Level If [MAGI + (50%)(SS benefits)] is between lower base and upper base amounts… Lower Upper Filing Status $32,000 $44,000 MFJ $ 0 $ 0 MFS $25,000 $34,000 All others …then, the taxable amount is lesser of: (a) 50% (SS benefits) or (b) 50% [MAGI + (50% x SS Benefits) - Lower Base]

©2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Calculating Taxable Amount of SS Benefits at 85% Level If [MAGI + (50%)(SS benefits)] is greater than upper base, the formula changes; then the taxable amount is lesser of: 1. 85% (SS benefits) or 2. 85% [MAGI + (50% x SS Benefits) - Upper Base] plus lesser of: ( i) result from formula on prior screen or (ii) $4,500 ($6,000 for MFJ)