Gross Income and Exclusions - Chapter 5 Notes

Realization and Recognition of Income

  • Gross Income: Taxpayers report realized and recognized income on their tax returns for the year.
  • Income that is excluded or deferred is not included in gross income.
  • Excluded income is never taxed.
  • Deferred income is taxed when recognized in a subsequent year.

What Is Included in Gross Income?

  • Definition of gross income for tax purposes:
    • §61(a): “gross income means all income from whatever source derived”
    • Reg. §1.61-(a): “includes income realized in any form, whether in money, property, or services”
  • Taxpayers recognize gross income when:
    • They receive an economic benefit.
    • They realize the income.
    • The tax law does not provide for exclusion or deferral.
  • Economic Benefit:
    • Borrowed funds represent a liability, not gross income.
  • Realization Principle:
    • Taxpayer engages in a transaction with another party.
    • Transaction results in a measurable change in property rights.
  • Recognition:
    • Realized income is assumed to be recognized absent a deferral or exclusion provision.

Other Income Concepts

  • Form of receipt—does it matter?

  • Return of capital principle:

    • The cost of an asset is called tax basis.
    • Return of capital means the tax basis is excluded when calculating realized income.
    • Return of capital does not represent an economic benefit.
    • Gain from the sale or disposition of an asset is included in realized income.

  • Recovery of amounts previously deducted:

    • Individuals typically claim deductions in the year paid.

    • Deductions may sometimes be reimbursed or refunded in a subsequent year.

    • Tax benefit rule: Refunds of expenditures deducted in a prior year are included in gross income to the extent that the refund reduced taxes in year of the deduction.

    • Example: Jorge received a refund of property taxes that he deducted on his tax return last year. Under the tax benefit rule, the refund is included in gross income to the extent that the prior deduction produced a tax benefit.

When to Recognize Income

  • Individual taxpayers file tax returns for a calendar-year period.
  • Corporations often use a fiscal year-end.
  • The method of accounting generally determines the year in which realized income is recognized and included in gross income.
  • Accounting Methods:
    • Corporations: accrual method of accounting.
    • Individuals: cash method.
  • Constructive Receipt:
    • Taxpayer must realize and recognize income when it is actually or constructively received.
    • Deemed to occur when the income is credited to the taxpayer’s account.
  • Claim of Right:
    • Income recognized when there are no restrictions on use of income (e.g., no obligation to repay).

Who Recognizes the Income?

  • In addition to determining when taxpayers realize and recognize income, it is important to consider who (which taxpayer) recognizes the income.
  • This question arises when an income-shifting strategy is involved.
  • The assignment of income doctrine holds that the taxpayer who earns income from services must recognize the income.
  • Income from property, such as dividends and interest, is taxable to the person who actually owns the income-producing property.
  • To shift income from property to another person, a taxpayer must also transfer the ownership in the property to the other person.

Problem 5-39

  • Asia owns stock that is listed on the New York Stock Exchange, and this year the stock increased in value by 20,000. Economic income of 20,000 is present, but there is no realization for tax purposes. Without realization, there can be no recognition; hence, this will not be included in the gross income.

  • Ben sold stock for 10,000 and paid a sales commission of 250. Ben purchased the stock several years ago for 4,000. Economic income of 10,000 less the 250 in sales commission is present and has been realized through the sale. Return of capital limits the addition to gross income to the net gain on the sale, 5,750.

  • Bessie's share of rental income (2,700) is included in gross income, and her share of municipal interest (750) is excluded from her gross income.

Problem 5-41

  • XYZ declared a 1 per share dividend on August 15. The date of record for the dividend was September 1. Ellis is a cash-method taxpayer.
    • Ellis bought 100 shares of XYZ stock on August 1 for 21 per share. Ellis received a 100 dividend on September 10. Ellis still owns the shares at year-end. Yes, Ellis must include the 100 dividend in gross income.
    • Ellis bought 100 shares of XYZ stock on August 1 for 21 per share. Ellis sold his XYZ shares on September 5 for 23 per share. Ellis received the 100 dividend on September 10. Yes, Ellis owns the XYZ shares on the record date and received the 100 dividend. Hence, Ellis must include the 100 dividend in gross income. Ellis also has 200 of income from the stock sale (2,300 − $2,100) that is included in gross income.
    • Ellis bought 100 shares of XYZ stock for 22 per share on August 20. Ellis received the 100 dividend on September 10. Ellis still owns the shares at year-end. Yes, Ellis owns the XYZ shares on the record date and received the 100 dividend. Hence, Ellis must include the 100 dividend in gross income.

Problem 5-43

  • Hank is an excellent handyman and often works part-time on small projects. Mike offered to pay Hank 500 for minor repairs to his house. Hank completed the repairs in December. Hank uses the cash method of accounting.
    • Mike paid Hank 200 in cash in December and promised to pay the remaining 300 with interest in three months. Gross income will include 200.
    • Mike gave Hank tickets in December to the big game in January. The tickets have a face value of 50, but Hank could sell them for 400. Hank went to the game with his son. 400 this year. The value of the tickets was 400 when Hank received them.
    • Mike bought Hank a new set of snow tires and gave them to Hank in December. The tires typically sell for 500, but Mike bought them on sale for 450. 450. This is the fair market value of the tires at the time Mike transferred them to Hank.

Problem 5-44

  • Jim joined the Austin Barter Club. This year, Jim provided lawn-mowing services to other club members.
    • Jim received 275 of car repair services from another member of the club. Jim should include 275 in his gross income.
    • Jim received a 550 credit that gave him the option of receiving a season pass at a local ski resort from another member of the club. However, he forgot to request the pass and his credit expired. Jim should recognize income of 550 under constructive receipt.
    • Jim received a 450 credit that can only be applied for goods or services from club members next year. The 450 credit would be included in his gross income next year when it can be redeemed.

Problem 5-46

  • Louis files as a single taxpayer. In April, he received a 900 refund of state income taxes that he paid last year. Assume the standard deduction last year was 12,950.
    • Last year Louis claimed itemized deductions of 13,200. Louis's itemized deductions include state income taxes paid of 1,750 and no other state or local taxes. Louis must include 250 of the 900 refund in gross income.
    • Last year Louis had itemized deductions of 10,800 and he chose to claim the standard deduction. Louis's itemized deductions included state income taxes paid of 1,750 and no other state or local taxes. None of the refund is included in his gross income.
    • Last year Louis claimed itemized deductions of 14,390. Louis's itemized deductions included state income taxes paid of 2,750 and no other state or local taxes. Louis must include the entire 900 refund in gross income.

Problem 5-47

  • L. A. and Paula file as married taxpayers. In August, they received a 5,200 refund of state income taxes that they paid last year. Assume the standard deduction last year was 27,700.
    • Last year L. A. and Paula had itemized deductions of 19,200, and they chose to claim the standard deduction. None of the refund is included in gross income.
    • Last year L. A. and Paula claimed itemized deductions of 30,200. Their itemized deductions included state income taxes paid of 10,500, which were limited to 10,000 due to the cap on state and local tax deductions. They must include 2,500 of the 5,200 refund in gross income.

Problem 5-49

  • Elmer was an extremely diligent employee this year, and his employer gave him three additional days off with pay (Elmer's gross pay for the three days totaled 1,200, but his net pay was only 948). Elmer should include in gross income the 1,200 gross pay.
  • Amax purchased new office furniture and allowed each employee to take home old office furniture valued at 250. Amax employees should include the value of the furniture (250) in gross income.

Types of Income

  • Income from services (earned income):
    • Income from labor is the most common source of gross income.
    • Generated by the efforts of the taxpayer.
  • Income from property (unearned income):
    • Includes gains or losses from the sale of property, dividends, interests, rents, royalties, and annuities.
    • Depends on the type of income and type of transaction generating income.
    • For example: § 305(a) states that dividends paid in stock are generally not included in gross income. If, however, the taxpayer has the option to receive the dividend in cash (instead of stock), the dividend is included in gross income.

Annuities

  • An investment that pays a stream of equal payments over time.
  • A portion of each annuity payment is a nontaxable return of capital, and the remainder is gross income.
  • Taxpayers use the annuity exclusion ratio to determine the return of capital (nontaxable) portion of each payment.
  • Annuity exclusion ratio = original investment/expected value of the annuity
  • For annuities with a fixed term, the expected value is the number of payments times the payment amount.
  • Example: Gram purchased an annuity for 99,000. The annuity pays her 10,000 per year for the next 15 years. She should include 3,400 in her gross income because the exclusion ratio is 99,000/150,000, or 66 percent.
  • For annuities over a life, taxpayers must use IRS tables to determine the expected value based on the taxpayer’s life expectancy.

Property Dispositions

  • Taxpayers usually realize a gain or loss when disposing of an asset.
  • Taxpayers are allowed to recover their investment in property (tax basis) before they realize any gain—recovery of capital.

Other Sources of Gross Income

  • Income other than wages or business and property.
  • Income from Flow-Through Entities:
    • Individuals may invest in various business entities.
    • The legal form of the business affects how the income generated by the business is taxed.
    • If the entity is a flow-through entity such as a partnership or S corporation, the income and deductions of the entity “flow through” to the owners of the entity (partners or shareholders).

Alimony

  • For tax purposes, alimony is defined as:
    • A transfer of cash made under a written separation agreement or divorce decree.
    • The separation or divorce decree does not designate the payment as nonalimony.
    • In the case of legally separated (or divorced) taxpayers under a separation or divorce decree, the spouses do not live together when the payment is made.
    • The payments cannot continue after the death of the recipient.
  • Types of payment that do not qualify as alimony:
    • Property divisions.
    • Child support payments fixed by the divorce or separation agreement.
  • For divorce or separation agreements executed before January 1, 2019, alimony is included in the recipient’s gross income and deductible for AGI by the payor.
  • For divorce or separation agreements executed after December 31, 2018, alimony is not taxable to the recipient or deductible by the payor.

Prizes, Awards, and Gambling Winnings

  • Excluded only if made:
    • For scientific, literary, or charitable achievement under certain conditions.
    • For employee length of service or safety achievement (400 tangible property limit per employee per year).

Social Security Benefits

  • Taxable up to 85 percent of Social Security benefits in gross income, depending on the taxpayer’s filing status, Social Security benefits, and modified AGI.
  • Modified AGI is regular AGI (excluding 50 percent of Social Security benefits) plus tax-exempt interest income, excluded foreign income, and certain other deductions for AGI.

Imputed Income

  • Certain employee discounts or low-interest loans generate income via indirect benefits.
  • For low-interest loans, the amount of imputed income is the difference between the amount of interest using the applicable federal interest rate and the amount of interest the taxpayer pays.
  • The borrower is deemed to pay imputed interest (interest expense to borrower, interest income to lender), and then the lender is deemed to have returned the imputed amount (the tax consequences depend on the relationship between borrower and lender).
  • Imputed interest rules do not apply to aggregate loans of 10,000 or less between the lender and borrower.

Discharge of Indebtedness

  • When a taxpayer’s debt is forgiven by a lender, the taxpayer must usually include the amount of debt relief in gross income.
  • Exceptions exist for certain types of loans.
  • To provide tax relief for insolvent taxpayers—taxpayers with liabilities, including tax liabilities, exceeding their assets—a discharge of indebtedness is not taxable.
  • If the discharge of indebtedness makes the taxpayer solvent, the taxpayer recognizes taxable income to the extent of his solvency.
  • Taxpayers, regardless of solvency, are also allowed to exclude from gross income most discharges of student loans after 2020 and before 2026.

Exclusion Provisions

  • Congress allows certain types of income to be excluded or deferred.
    • To subsidize or encourage particular activities.
    • To mitigate inequity.
  • Municipal Bond Interest:
    • Bonds issued by state and local governments located in the United States.
    • This exclusion is generally recognized as a subsidy to state and local governments.
  • Gains on the Sale of Personal Residence:
    • Taxpayers may exclude up to 250,000 (500,000 if married filing jointly) of gain on the sale of their principal residence.
    • Must satisfy ownership and use tests.
    • Any excess gain generally qualifies as long-term capital gain.

Fringe Benefits

  • The value of these benefits is included in the employee’s gross income as compensation for services.
  • Certain fringe benefits, called “qualified” fringe benefits, are excluded from gross income.
  • Common qualifying fringe benefits are medical and dental health insurance coverage, life insurance coverage, de minimis (small) benefits.
  • Common Qualifying Fringe Benefits (excluded from employee’s gross income):
    • Medical and dental health insurance coverage (§106): An employee may exclude from income the cost of medical and insurance coverage and dental health insurance premiums the employer pays on an employee’s behalf.
    • Life insurance coverage (§79): Employees may exclude from income the value of life insurance premiums the employer pays on an employee’s behalf for up to 50,000 of group-term life insurance.
    • De minimis (small) benefits §132(a)(4): Congress allows employees to exclude from income relatively small and infrequent benefits employees receive at work (such as limited use of business copy machine).

Education-Related Exclusions

  • As an incentive for taxpayers to participate in higher education, Congress excludes certain types of income if the funds are used for higher education.
  • Scholarships:
    • Students seeking a college degree can exclude scholarships that pay for required tuition, fees, books, and supplies.
    • Exclusion applies only if the recipient is not required to perform services in exchange for receiving the scholarship (limited exception for tuition waivers for student employees and teaching and research assistants).
  • Other Educational Subsidies:
    • Taxpayers can exclude from gross income earnings on investments in qualified education plans such as 529 plans and Coverdell education savings accounts as long as they use the earnings to pay for qualifying educational expenditures.
    • Taxpayers can exclude interest earned on Series EE savings bonds when the redemption proceeds are used to pay qualified higher-education expenses.
    • The exclusion of interest on Series EE savings bonds is restricted to taxpayers with modified AGI below specific limits.

Exclusions That Mitigate Double Taxation

  • Congress provides certain exclusions to eliminate the potential double tax that may arise for:
    • Gifts and Inheritances:
      • Individuals may receive property as gifts or from a decedent’s estate (an inheritance).
      • While the receipt of property is most certainly real income to the recipient, the value of gifts and inheritances is excluded from gross income because these transfers are subject to a federal gift and estate tax.
    • Life Insurance Proceeds:
      • Amounts received due to the death of the insured are excluded from the income of the recipient.
      • Similar to inheritances, life insurance proceeds are typically subject to the federal estate tax.
      • If the proceeds are paid over a period of time rather than in a lump sum, a portion of the payments represents interest and must be included in gross income.
      • Exclusion generally does not apply when:
        • Life insurance policy is transferred to another party for valuable consideration.
        • Taxpayer cancels life insurance contract and receives proceeds over previous premiums paid.
      • Exclusion available for accelerated death benefits in certain circumstances.

Sickness and Injury-Related Exclusions

  • Several exclusion provisions apply to taxpayers who are sick or injured to reflect their inability to pay the tax and facilitate recovery.
  • Workers’ Compensation:
    • Payments from workers’ compensation plans are excluded from gross income.
  • Payments Associated with Personal Injury:
    • Awards that relate to physical injury or sickness or are payments for the medical costs of treating emotional distress are excluded from gross income.
    • Other payments, including punitive damages, are fully taxable.
  • Health Care Reimbursement:
    • Reimbursements by health and accident insurance policies for medical expenses paid by the taxpayer are excluded from gross income.
  • Disability Insurance:
    • Pays the insured individual for wages lost when the individual misses work due to injury or disability.
    • If an individual purchases disability insurance directly, any disability benefits are excluded from gross income.
    • If the individual’s employer purchases the disability insurance and the premiums are taxable compensation to the employee, any disability benefits received are excluded from gross income.
    • If the disability policy premiums paid for by the employer are considered a nontaxable fringe benefit to the employee, the employee must include disability benefits received in gross income.

Deferral Provisions

  • Allow taxpayers to defer (but not permanently exclude) the recognition of certain types of realized income.
  • Transactions generating deferred income include:
    • Installment sales
    • Like-kind exchanges
    • Involuntary conversions, and
    • Contributions to non-Roth qualified retirement accounts

Problem 67

  • Terry received 4,500 in sick pay from a disability insurance policy.
    • Terry has disability insurance provided by his employer as a nontaxable fringe benefit. Terry's employer paid 2,800 in disability premiums for Terry this year. 4,500 is included in Terry's gross income.
    • Terry paid 2,800 in premiums for his disability insurance this year. 0 is included in Terry's gross income.
    • Terry's employer paid the 2,800 in premiums for Terry, but Terry elected to have his employer include the 2,800 as compensation on Terry's W-2. 0 is included in Terry's gross income.
    • Terry and his employer share the cost of the disability insurance. Terry's employer paid 1,800 in disability premiums for Terry this year as a nontaxable fringe benefit, and Terry paid the remaining 1,000 of premiums from his after-tax salary. 2,893 is included in Terry's gross income.

Problem 72

  • Dontae's employer has offered him the following employment package:
    • Salary 400,000
    • Health insurance 10,000
    • Dental insurance 1,500
    • Membership to Heflin Country Club 20,000
    • Season tickets to Atlanta Braves games 5,000
    • Tuition reimbursement for graduate courses 4,000
    • Housing allowance 40,000
  • Dontae's gross income from his employment is 465,000. The health and dental insurance is excludable benefits, and the tuition reimbursement is excludable.