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Chapter 3
Income Sources
Kevin Murphy
Mark Higgins
©2008 South-Western
What is Income?
All-inclusive Income Concept
Defined by exception: “Except as
otherwise provided…” § 61
Judicial findings
Income is the gain derived from labor and
capital
Any increase in wealth that has been
realized is income
© 2008 South-Western
Transparency 3-2
What is Income?
Current View
A change in the form and/or substance of
the taxpayer’s property, and
The involvement of a second party in the
income process
© 2008 South-Western
Transparency 3-3
Types of Income
Earned
Unearned
Transfer
Imputed
Capital Gains and Losses
© 2008 South-Western
Transparency 3-4
Earned Income: Definition
Compensation received for the
provision of labor is earned income.
Two problems may arise when
determining taxability of earned income
Cash-equivalent approach
Assignment of income
© 2008 South-Western
Transparency 3-5
Unearned Income: Definition
The earnings from investments and
gains from the sale, exchange or
disposition of investment assets is
unearned income.
Examples of unearned income are:
Interest and Dividend Income
Rental and Royalty Income
Annuities
© 2008 South-Western
Transparency 3-6
Unearned Income: Annuities
An annuity is a series of equal
payments received at set time intervals
for a determinable period
Capital Recovery Concept excludes the
amount of original investment from
taxable income
Must be spread over the time of receipt
© 2008 South-Western
Transparency 3-7
Annuity Exclusions
If the payment term and amount are
fixed:
Exclusion Ratio =
© 2008 South-Western
Cost of the contract
Total expected return
Transparency 3-8
Annuity Exclusions
If the payment term depends on the life
of the taxpayer
Must estimate the number of payments
Use the “simplified method”
© 2008 South-Western
Transparency 3-9
Annuity Exclusions
Simplified Method
Annuity payments beginning after
November 18, 1996
use Tables 3-1 or 3-2 to determine number
of payments
Excluded portion =
Contract Cost
Number of payments
© 2008 South-Western
Transparency 3-10
Annuity Example
George, age 64, purchased an annuity for $30,000. He
begins receiving $300 per month in January. What
amount is included in his gross income?
From Table 3-1, the number of payments to use is 260.
$30,000 / 260 = $115 monthly exclusion
$115 X 12 = $1,380 excluded per year
$300 X 12 = $3,600 amount received
$3,600 - $1,380 exclusion = $2,220 gross income
© 2008 South-Western
Transparency 3-11
Unearned Income: Gains and Losses
Gains or losses may occur upon disposal
of investment property.
Proceeds from sale or disposition
less: Selling expenses
Amount realized from disposition
less: Adjusted basis of property
Gain or loss from disposition
© 2008 South-Western
Transparency 3-12
Unearned Income:
Income from Conduit Entities
Income from a conduit entity is reported
by the owners and taxed on the owners’
returns
Distributions from conduit entities to the
owners are treated as a recovery of
capital
© 2008 South-Western
Transparency 3-13
Transfer Income: Definition
Some amounts of income are neither
fully earned nor fully unearned.
Prizes and Awards
Unemployment Compensation
Social Security Benefits
Alimony Received
© 2008 South-Western
Transparency 3-14
Transfer Income: Prizes and Awards
Amounts received as prizes and awards
are generally taxable.
Exceptions exist for:
Scientific and literary achievements
must be given by recipient to a qualified charity or
government unit
Employee achievements
must be given to employee for length of service or
safety
amount is limited to $400 per employee (or $1,600 if
qualified plan)
© 2008 South-Western
Transparency 3-15
Transfer Income:
Unemployment Compensation
Amounts received from unemployment
compensation plans are considered
substitutes for earned income and are
always taxable.
© 2008 South-Western
Transparency 3-16
Transfer Income:
Social Security Benefits
A portion of Social Security benefits
received may be taxable if modified AGI
exceeds certain limits.
Adjusted gross income
plus: 1/2 social security benefits
plus: tax exempt income
plus: foreign earned income exclusions
Modified AGI
© 2008 South-Western
Transparency 3-17
Modified AGI Example
A single taxpayer received $3,000 from Social
Security payments. Her AGI without the SS is
$30,000.
Modified AGI = $30,000 + $1,500
= $31,500
© 2008 South-Western
Transparency 3-18
Transfer Income:
Social Security Benefits - Tier One
Unmarried individuals with modified AGI
between $25,000 and $34,000, and
MFJ individuals with modified AGI
between $32,000 and $44,000
© 2008 South-Western
Transparency 3-19
Tier One Calculation
The taxable portion of Social Security is equal to
the lesser of:
OR
1. 1/2 Social Security received,
2. 1/2 of the amount by which
modified AGI exceeds the base amount.
where the base amounts are $25,000 for unmarried
individuals, $32,000 for MFJ, and $0 for others
© 2008 South-Western
Transparency 3-20
Example continued
With modified AGI = $31,500, the taxable portion of
her $3,000 Social Security income is the lesser of:
1.
$1,500, or
2.
1/2 ($31,500 - $25,000) = $3,250
Therefore, taxable SS is $1,500
© 2008 South-Western
Transparency 3-21
Transfer Income:
Social Security Benefits - Tier Two
• For individuals whose income exceeds
Tier One amounts . . .
© 2008 South-Western
Transparency 3-22
Tier Two Calculation
The taxable portion of Social Security is equal to the lesser
of:
1. 85% of Social Security received,
OR 2. 85% of the amount by which
modified AGI exceeds the base amount*,
PLUS the smaller of
a. the amount of SS benefits included under
the 50% formula, or
b. $4,500 for unmarried individuals ($6,000 for
MFJ)
*Where the base amounts are $34,000 for unmarried
individuals, $44,000 for MFJ, and $0 for others
© 2004 South-Western College Publishing
Example for Tier Two
If our taxpayer receives Social Security of $12,000
and has AGI of $50,000 before SS:
Modified AGI = $50,000 + $6,000* = $56,000
Taxable SS is $10,200, which is the smaller of:
1. .85( $12,000) = $10,200, or
2. [.85 ($56,000 - $34,000)] + [(1/2 of $12,000 SS) or $4,500]
= $18,700 + $4,500
= $23,200.
© 2008 South-Western
Transparency 3-24
Transfer Income: Alimony Received
Amounts received for alimony payments are
taxable income if:
the payments are made in cash
there is a written agreement
the payments are not disguised child support
the payments cannot be made to payee’s estate
the payer and payee do not live in the same
household
© 2008 South-Western
Transparency 3-25
Imputed Income:
Personal Consumption
The value of the goods and services
produced by individuals for personal
consumption generally are not taxable
Realization concept
Administrative Convenience concept
© 2008 South-Western
Transparency 3-26
Imputed Income:
Below Market-Rate Loans
Interest income and expense are
imputed on below market-rate loans.
The relationship between the lender and
the borrower determines the tax treatment
The lender has imputed interest income
The borrower has imputed interest expense
Administrative Convenience grants
exceptions for
loans of $10,000 or less
gift loans of $100,000 or less
© 2008 South-Western
Transparency 3-27
Imputed Income:
Payment of Expense by Others
A taxpayer whose expenses are paid by
another has realized an increase in
wealth.
Payments made by family members
may be considered nontaxable gifts
Payments made by employers are
taxable income
© 2008 South-Western
Transparency 3-28
Imputed Income: Bargain Purchases
When a bargain purchase price does
not result from an arms-length
transaction, the bargain amount is
taxable income.
© 2008 South-Western
Transparency 3-29
Capital Gains and Losses:
Introduction
A capital asset is any asset other than
inventory, receivables, and depreciable
or real property used in a trade or
business.
 A sale or other disposition of capital assets
results in a capital gain or loss
 Capital gains and losses receive special tax
treatment
© 2008 South-Western
Transparency 3-30
Capital Gains and Losses:
Holding Period
The holding period for capital assets is
how long the taxpayer owned the asset.
Short Term = held for < 12 months
Long Term = held for > 12 months
Determining holding period is the first
step in determining tax treatment.
© 2008 South-Western
Transparency 3-31
Capital Gains and Losses:
Netting Procedures
Long-term gains
netted against
Long-term losses
Short-term gains
netted against
Short-term losses
© 2008 South-Western
=
Net Long-term
Gain or Loss
=
Net Short-term
Gain or Loss
Transparency 3-32
Capital Gains and Losses:
Netting Procedures
If one is a loss and one is a gain, then:
Net Short-term Gain or Loss
netted against
Net Long-term Gain or Loss
=
Net Capital
Gain or Loss
If both are losses or both are gains, no further netting is
done.
© 2008 South-Western
Transparency 3-33
Tax Treatment for Net Gains
Net short-term capital gain is taxed as
ordinary income
Adjusted net long-term capital gain is
taxed at a maximum 15%
Adjusted NLTG = NLTG - [28% rate gain Unrecaptured §1250 gain + Eligible
dividends]
28% rate gain = [Net collectibles gain +
Small business stock gain - STCL - LTCL
carryover]
© 2008 South-Western
Transparency 3-34
Tax Treatment for Net Gains
Net Collectibles gain and Small
Business Stock gain is taxed at a
maximum 28%
Unrecaptured §1250 gain is taxed at a
maximum 25%
© 2008 South-Western
Transparency 3-35
Capital Gains and Losses:
Holding Period & Maximum Rate
Holding
Period
Category 15% MTR > 15% MTR
< 12 months
Short-term
MTR
MTR
> 12 months
Long-term
5%
15%
> 12 months
Collectibles
15%
(& excess
small
business
gain)
Unrecaptured 15%
Sec. 1250
gain
> 12 months
© 2008 South-Western
28%
25%
Transparency 3-36
Tax Treatment for Net Losses by
Individuals
Only $3,000 of net capital losses may
be deducted in one year
Use short-term losses first
Carryover net loss > $3,000
Capital gains and losses of conduit
entities flow-through to owners’ returns
© 2008 South-Western
Transparency 3-37
When is Income Reported?
The Accounting Method chosen by a
taxpayer dictates when income is
reported.
Cash Method taxpayers report income
when cash is actually or constructively
received
Accrual Method taxpayers report income
when it is earned
Hybrid Method taxpayers mix accrual and
cash methods
© 2008 South-Western
Transparency 3-38
Accounting Method
Cash
Cash method taxpayers must follow the
Constructive Receipt Concept.
Exceptions to the cash method:
Taxpayers who sell inventory may not use the
cash method for inventory
Taxpayers must use the accrual and the
effective interest method with Original Issue
Discount securities
Taxpayers who hold Series EE Bonds may
elect to use the accrual method
© 2008 South-Western
Transparency 3-39
Accounting Method
Accrual
Under tax law, income is accrued when
All events have occurred that fix the
right to receive the income, and
The amount of income earned can be
determined
© 2008 South-Western
Transparency 3-40
Accounting Method
Accrual Exceptions
Exceptions to the accrual method:
The Wherewithal-to-Pay concept requires
income be reported in the year pre-payment is
received for rents, insurance, interest and
royalties
One year deferral is allowed for some prepayments
Report amount = Financial Accounting in first year
Remainder of amount in full in second year
Pre-payments for goods may be accrued if the
payment is less than the Cost of Goods Sold.
© 2008 South-Western
Transparency 3-41
Accounting Method
Hybrid
Taxpayers may mix the cash and
accrual methods, using accrual for sales
of inventories and cash for other
revenues and expenses.
© 2008 South-Western
Transparency 3-42
Accounting Method
Exceptions to All Methods
Installment Sales Method: Any time one
payment is received after the year of sale,
taxpayers must recognize income
proportionately as the selling price is received
unless they elect to report in the year of sale.
Long-term Construction Contracts: The
percentage-of-completion method must be
used for all long-term construction.
© 2008 South-Western
Transparency 3-43