Chapter 4 - Gross Income: Concepts and Inclusions

Learning Objectives

Calculation of Gross Income: The Big Picture

• In 2020, Dr. Cliff Payne opened his dental practice as a sole proprietorship with a December 31 year-end.

• By the beginning of February, construction on his medical building was completed.

• He also leased an office building and entered into a contract to make improvements.

• He invested $12,000 in the stock of an unrelated corporation.

• Financial results of Dr. Payne’s first year of operation:

  • Revenues (amounts billed to patients for dental services): $385,000$

  • Accounts receivable:

    • January 1: $0$

    • December 31: $52,000$

• Sam Jones, a contractor who owed Dr. Payne $4,000$ for dental services, satisfied the account by installing solar panels on the roof of Dr. Payne’s new medical building.

• Based on his accounting records, Dr. Payne concludes that gross income for Federal income tax purposes is the $385,000$ he billed his patients for dental services rendered.

Gross Income

• Section 61(a) of the Internal Revenue Code defines gross income.

• Definition: Except as otherwise provided, gross income means all income from whatever source derived.

• The concept is interpreted broadly by the courts.

• Recovery of Capital Doctrine

  • Prevents income from being taxed more than once.

  • Capital is the accumulation of previously taxed income.

  • The Supreme Court has held that gross income is not synonymous with gross receipts.

  • A taxpayer does not have income until recovering any amount of capital that might have been invested in the item sold.

• Economic and Accounting Concepts of Income

  • Economists measure income as the sum of:

    • The value of goods and services consumed.

    • Change in the value of net assets from the beginning to the end.

  • 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.

• Income is recognized whether it is in the form of cash or "in-kind" cash equivalents (property or services).

• The amount of income from “in-kind” receipts is equal to the FMV of the property or services.

Recovery of Capital Doctrine: The Big Picture Example

• Dr. Payne sells common stock for $15,000$, which he purchased for $12,000$. Dr. Payne’s gross receipts are $15,000$.

  • This amount consists of a $12,000$ recovery of capital and $3,000$ of gross income.

Taxable Year

• The annual accounting period, or taxable year, is generally a 12-month period.

• The taxable year for most individual taxpayers is the calendar year.

• A fiscal year can be elected if the taxpayer maintains adequate books and records.

  • A fiscal year is a 12-month period ending on the last day of a month other than December (e.g., July 1 to June 30).

• Income must be recognized in the proper year because:

  • The taxpayer’s rate may vary across years.

    • The taxpayer’s marginal tax rate can change from year to year.

    • Congress may change the tax rates.

  • There may be a change in the taxpayer’s status (e.g., person may marry, or a business may be incorporated).

Accounting Methods

• Primary Methods

  • Cash receipts and disbursements method.

  • Accrual method.

• Other Methods

  • Hybrid method: A combination of cash and accrual methods.

  • Special accounting methods: Examples include the installment method, percentage of completion method, and completed contract method.

• Taxpayers can elect to use the installment method (a taxpayer may choose to spread the gain from an installment sale of eligible property).

• Certain contractors may elect to use either the percentage of completion method or the completed contract method.

• A change in the accounting method requires the advance consent of the IRS.

Cash Receipts Method

• 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 the taxpayer without substantial restrictions.

Constructive Receipt: The Big Picture

• On December 31, Dr. Payne has $10,000$ in patients' checks that have not been deposited.

  • One check for $3,000$ is from a patient who asked him not to deposit it until after January 4 because her account did not contain sufficient funds to pay the debt.

• Under the cash method, Dr. Payne must recognize $7,000$ income from the checks on hand because the checks are a cash equivalent that is actually received.

• The income from the $3,000$ check is neither actually nor constructively received because an insufficient account means the funds are not available.

• Dr. Payne sees a new patient on December 15 at a cost of $2,000$. Before services are performed, the patient agrees to a payment plan that requires payment to be made within 30 days after the services are performed.

  • The services are performed on December 28, and the patient pays on January 15.

• At year-end, Dr. Payne is not in constructive receipt of $2,000$ because, although he could have collected the fee before year-end, he was not yet entitled to the fee when he contracted to receive payments at a later date.

Exceptions to Cash Receipts Method

• Original issue discount (OID) interest is taxable when earned rather than when interest is received.

• OID rules do not apply to obligations with a maturity date of one year or less from the date of issue.

• Series E and EE bonds are not subject to the OID rules.

  • However, a cash basis taxpayer may elect to recognize the interest when earned.

Accrual Method

• 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 the taxpayer’s right to receive income, and

  • The amount can be determined with reasonable accuracy.

• The accrual method is required for determining purchases and sales when inventory is an income-producing factor.

• If rights to income have accrued but are subject to refund, the income is reported in the year of sale, and a deduction is allowed in the year when actual claims accrue.

• Claim of Right Doctrine

  • If the payment is received before the dispute is settled, this right requires the taxpayer to recognize the income in the year of receipt.

  • The taxpayer has the funds to pay tax; therefore, the government should be allowed to collect tax rather than wait until the uncertainty is resolved.

Claim of Right Doctrine: The Big Picture

• On completing construction improvements of the medical office building in 2020, the contractor submitted a bill.

• Dr. Payne refused to pay the bill, claiming the contractor had not met specifications, and the contractor did not reach a settlement with Dr. Payne until 2021.

  • No income accrues to the contractor until 2021.

  • However, if Dr. Payne had paid for the work and then filed suit, the contractor could not defer the income, and the income would be taxable in 2020.

Exceptions to Accrual Method

• A taxpayer can elect to defer recognition of income from advance payment for goods and services if the same method of accounting is used for tax and financial reporting purposes.

• This special method will result in differences in the timing of the reporting of revenue when financial reporting rules require it to be reported over 3 or more years.

• The special election is not available for unearned rent, interest, insurance premiums, and certain other advance payments, which are taxed in the year of receipt.

Hybrid Method

• A combination of cash and accrual methods.

• Generally, used when inventory is a material income-producing factor.

  • For example:

    • Use accrual method to account for the sale of goods and the cost of goods sold.

    • Use cash method for other income and expenses.

• Beginning in 2018, more types of businesses can use the cash method and not account for inventory.

  • The hybrid method is not likely to be commonly used.

Income Sources

• Income from personal services is taxable to the person who performs the services.

  • Fruit and tree metaphor.

  • Services performed by an employee for an employer’s customers are considered performed by the employer.

    • The employer is taxed on the income from the services provided to the customer, and the employee is taxed on any compensation received from the employer.

• Income from property is taxable to the owner of the property.

  • Assignment of income is not permitted.

• Interest income accrues daily.

  • If an interest-bearing instrument (e.g., bonds) is transferred, interest income must be allocated between transferor and transferee based on the number of days during the period that each owned the property.

Services of an Employee: The Big Picture

• Assume that instead of operating as a sole proprietorship, Dr. Payne incorporated his dental practice to limit his liability.

  • He entered into an employment contract with his corporation and was to receive a salary.

  • All patients contract to receive their services from the corporation.

  • Those services are provided by the corporation’s employee, Dr. Payne.

• Thus, the corporation earned the income from patients’ services and must include the patients’ fees in its gross income.

• Dr. Payne must include his salary in his gross income.

  • The corporation is allowed a deduction for the reasonable salary paid to Dr. Payne.

Dividends

• Unlike interest, dividends do not accrue on a daily basis.

• Dividends are generally taxed to the party who is entitled to receive them.

  • The shareholder of record as of the corporation’s record date.

• Dividends on stock transferred by gift after the declaration date but before the record date are generally taxed to the donor.

• Recent legislation has provided partial relief from the double taxation of corporate dividends.

  • Generally, dividends received are taxed at the same marginal rate that is applicable to a net capital gain.

  • Depending on the individual’s taxable income, capital gain tax rates of 0%, 15%, and 20% apply.

• The following dividends are not eligible for the reduced tax rates:

  • Dividends received by corporations.

    • Corporations are permitted a dividend received deduction ranging from 50% - 100% of dividends received from another domestic corporation.

  • 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 121-day period beginning 60 days before the ex-dividend date to qualify for the reduced tax rates.

Income Received by an Agent

• Income received by the taxpayer’s agent is considered to be received by the taxpayer.

  • A cash basis principal must recognize the income at the time it is received by the agent.

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 the partnership’s income and deductions.

  • Each partner reports their distributive share of the partnership’s income and deductions.

    • Reported in the year earned, even if not actually distributed.

    • Because a partner pays tax on income as the partnership earns it, distributions are treated as a tax-free recovery of capital.

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 corporation’s income and deductions for the year, even if not actually distributed.

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.

Income in Community Property States

• All property is deemed either to be separately owned by one spouse or to belong to the marital community.

  • Community income is allocable equally to each spouse.

  • Separate income is allocable to the owner-spouse in few states.

• Separate property may produce community income (examples: Idaho, Texas).

• Income from personal services is generally treated as if one-half is earned by each spouse.

• A spouse is taxed only on his or her actual earnings from personal services if the following conditions are satisfied:

  • The spouse lives apart for the entire year.

  • They do not file a joint return with each other.

  • No portion of the earned income is transferred between the individuals.

Alimony and Separate Maintenance Payments

• Alimony and separate maintenance payments made under an agreement entered into on or before December 31, 2018, are:

  • Deductible by the payor.

  • Includible in gross income of the recipient.

• For payments related to pre-2019 agreements, income is shifted from the income earner to the income beneficiary.

  • The recipient has a legal right to the income and is better able to pay the tax on the amount received.

• Payments may qualify as alimony if:

  • Payments are in cash.

  • The agreement or decree does not specify that the payments are not alimony.

  • The payor and payee are not members of the same household at the time the payments are made.

  • There is no liability to make the payments for any period after the death of the payee.

• Property settlements

  • Transfer of property to a former spouse.

    • The transferor is neither entitled to a deduction nor recognizes gain or loss.

    • There is no gross income and carryover of the transferor’s basis for the transferee.

• Front-loading of alimony payments

  • Alimony recapture (gross income) for the payor.

  • Deduction from gross income for the recipient.

• Child support payments

  • Payments made to satisfy a legal obligation to support the child of the taxpayer.

  • The money is used for the child’s benefit.

  • Nondeductible by the payor and not taxed to the recipient (or child).

• It may be difficult to determine whether an amount received is alimony or child support.

  • If the amount of the payment would be reduced due to some future event related to the child (e.g., the child reaches age 21), such payment is deemed child support.

Imputed Interest on Below-Market Loans

• Interest is imputed, using Federal government rates, when a loan does not carry a market rate of interest.

  • Imputed interest = the difference between the amount that would have been charged at the Federal rate and the amount actually charged.

• Applies to:

  • Gift loans.

  • Compensation-related loans.

  • Corporation-shareholder loans.

• Gift loans

  • Exemption for loans of $10,000$ or less between individuals.

    • If loan proceeds are used to purchase income-producing property, the exemption does not apply.

  • On loans of $100,000$ or less between individuals:

    • Imputed interest is limited to the borrower’s net investment income for the year.

    • No imputed interest if net investment income is $1,000$ or less.

    • This limitation for loans of $100,000$ or less does not apply if a principal purpose of a loan is tax avoidance.

• The $10,000$ exemption also applies to compensation-related and corporation-shareholder loans.

  • No exemption if the principal purpose of the loan is tax avoidance, which makes practically all loans of this type suspect.

• Interest expense imputed to the borrower may be deductible.

Income from Annuities

• The purchaser pays a fixed amount for the right to receive a future stream of payments.

  • Generally, early collections over the cost of the contract are included in gross income.

  • The increase in the cash value of the contract is not immediately taxable as it is subject to substantial restrictions.

• For collections on and after the annuity starting date:

  • The exclusion ratio is applied to annuity payments received under contract to determine the amount excludable.

$Exclusion Ratio = Investment in Contract / Expected Return$

• Once the investment is recovered, the remaining payments are taxable in full.

• If the annuitant dies before recovering the investment, the unrecovered cost is deductible in the year the payments cease.

• Examples

  • A taxpayer pays $10,000$ for an annuity that will pay $1,000$ a year for:

    • A: A term of 15 years.

    • B: Lifetime (life expectancy = 15 years).

    • Exclusion ratio for A & B = $10,000 / 15,000 = 0.667$

  • Example (continued)

    • A: 15 years of annuity payments.

      • Years 1-15: $333$ taxable and $667$ excludable.

    • B: Lifetime payments and the taxpayer lives 18 years.

      • Years 1-15: $333$ taxable and $667$ excludable.

      • Years 16-18: $1,000$ taxable each year.

    • B: Lifetime payments and taxpayer lives 10 years.

      • Years 1-10: $333$ taxable and $667$ excludable, and a $4,444$ deduction on the final return.

• The simplified method is required for allocating basis to the annuity payments received from a qualified retirement plan.

  • Exclusion amount is the employee’s investment in the contract divided by the number of anticipated monthly payments.

Prizes and Awards

• Gross income includes the FMV of any prizes and awards (other than exempted scholarships).

• Exceptions

  • The prize or award is received in recognition of religious, charitable, scientific, educational, artistic, literary, or civic achievement (e.g., Nobel Prize, Pulitzer Prize).

  • The recipient transfers the prize or award to a qualified governmental unit or nonprofit organization.

  • The recipient was selected without any action on their part to enter the contest or proceeding.

  • The recipient is not required to render substantial future services as a condition for receiving the prize.

  • Exclusion of employment achievement awards made in the form of tangible personal property but not cash or cash equivalents.

    • The award must be made in recognition of an employee’s length of service or safety achievement.

    • The ceiling on the excludable amount for an employee is $400$ per year.

    • The ceiling on the excludable amount for an employee is $1,600$ per year if the award is made as a part of a tax-qualified plan.

Unemployment Compensation

• Unemployment compensation is taxable in full.

• It is sponsored and operated by the states and Federal government.

• It provides a source of income for people who have been employed and are temporarily out of work.

Social Security Benefits

• Benefits included are based on two factors:

  • Taxpayer’s ability to pay.

  • The amount of benefits considered to be a recovery of the taxpayer’s contributions, or a recovery of capital.

• Up to 85% of benefits may be taxable.

• Taxability is based on the taxpayer’s modified adjusted gross income (MAGI).

  • MAGI = AGI (excluding Social Security) + foreign earned income exclusion + tax-exempt income.

  • If MAGI plus 50% of Social Security benefits (provisional income) does not exceed a threshold amount ($32,000$ for married filing jointly or $25,000$ for single taxpayers), the taxpayer need not include any Social Security benefits in gross income.

• If provisional income exceeds the threshold:

  • The amount included in gross income is equal to 50% of the amount by which the provisional income exceeds the threshold, limited to 50% of the benefits themselves.

  • If the taxpayer’s provisional income also exceeds a second threshold ($44,000$ or $34,000$), the amount included in gross income is equal to 85% of the amount that provisional income exceeds the higher threshold, plus the smaller of:

    • The amount determined in the first point above, or

    • 50% of the difference between the two threshold amounts ($6,000$ for married filing jointly or $4,500$ for a single taxpayer).

    • The threshold amounts for married taxpayers filing separately is zero.

• Examples of Social Security income

  • A: Married with AGI = $30,000$, tax-exempt interest income = $3,000$, Social Security benefits = $10,000$.

    • A portion of the Social Security benefit to be included in gross income = 50% of ($30,000 + 3,000 + 5,000 - 32,000$) i.e., $3,000$ limited to 50% of $10,000$ i.e., $5,000 = 3,000$.

  • B: Married with AGI = $40,000$, tax-exempt interest income = $6,000$, Social Security benefits = $10,000$.

    • A portion of the Social Security benefit to be included in gross income = 50% of ($40,000 + 6,000 + 5,000 - 32,000$) i.e., $9,500$ limited to 50% of $10,000$ i.e., $5,000 = 3,000$.

FBAR

• FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR).

  • Must be filed with the Treasury Department if the aggregate balance of all foreign bank, brokerage, and similar financial accounts exceeds $10,000$ at any time during the year.

  • Filed electronically.

  • Filed separately from Form 1040.

    • Schedule B of Form 1040 includes questions about foreign accounts.

  • Due by April 15 with an automatic extension to October 15.

  • There is a large penalty for non-filing, as much as 50 percent of the value of the foreign accounts.

Tax Planning

• Techniques for accomplishing the strategy:

  • Minimize income included in gross income.

  • Defer the recognition of income.

  • Shifting income to other taxpayers.

Accrual Method vs Cash Method: The Big Picture

• Accrual Method: Dr. Cliff Payne has correctly calculated the gross income of his sole proprietorship if using the accrual method.

  • He will report the $385,000$ amount on Schedule C of Form 1040.

• Cash Method: If Dr. Payne instead elects the cash method of accounting, he will only report the following:

  • Revenues: $385,000$

  • Plus: Accounts receivable (January 1): $0$

  • Less: Accounts receivable (December 31): ($52,000$)

  • Gross income: $333,000$