Download Chapter 3: Determining Gross Income

Chapter 3
Determining
Gross Income
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What is Gross Income?
Code Section 61(a) defines gross
income as
“except as otherwise provided in this
subtitle, gross income means all income
from whatever source derived...”
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What is Income?


Gross income is realized income that is
not excluded
Taxable income is gross income less all
deductions
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Tax vs. Financial Accounting

The goals of financial accounting are not the
same as those for tax reporting
Financial accounting seeks to provide
information that decision makers find useful
Tax reporting seeks to collect revenue
equitably

Differences fall into two categories
Temporary or timing differences
Permanent differences
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Temporary Differences

Arise when income is taxed either before or
after it is accrued for accounting purposes
Example: prepaid rent generally is taxable
when received but it is included in financial
accounting income only as it is earned

Are accounted for as either a deferred tax
asset or deferred tax liability on financial
statements
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Permanent Differences

Income that is not taxed but is reported
for financial accounting purposes
Example: municipal bond interest
generally is not taxed but is recorded as
income in financial accounting records
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Return of Capital Principle


Basis = amount invested in an asset
Basis can be recovered tax-free
If the taxpayer’s return is more than basis, the
taxpayer has a gain
If taxpayer’s return is less than basis, the
taxpayer has a loss
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Investment Alternatives

Investments yielding appreciation
Tax deferred until gain is recognized
Gain is frequently taxed at lower capital gains
rates

Investments yielding annual income
Interest income is taxed annually at the
marginal tax rate for ordinary income;
dividends taxed annually but at lower capital
gains rates generally
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The Tax Year

Calendar year
Individuals
S corporations and partnerships have
restrictions on allowable tax years, so usually
use a calendar year

Fiscal year – 12-month period ending on
month other than December
52-to-53 week year (ends on same day)
Corporations freely select tax year
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Short Tax Year


A short-year tax return reports less than 12
months of operating results
Income must be annualized (adjusted to
reflect 12 months of operations to calculate
tax)
Required by businesses that change their tax
year
Not required in year entity begins or ends
business
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Accounting Methods

Taxpayers can use different methods for
financial accounting and tax
Cash method: receipt of cash or cash
equivalents determine income/expense
recognition
Accrual method: the all-events test determines
income/expense recognition
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Cash Method

Income is recognized when cash or cash
equivalents received
Cash equivalents broadly defined to include
property and services
Cash equivalents included at fair market value

A cash-basis taxpayer must recognize income
when an amount is
Credited to the taxpayer’s account
Set apart for the taxpayer, or
Made available in some other way to the taxpayer
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Constructive Receipt Doctrine


Constructive receipt is a modification that
prevents cash basis taxpayers from “turning
their backs” on income
Income is not constructively received if
The taxpayer is not entitled to the income
The payor has insufficient funds from which to
make payment
There are substantial limitations or restrictions
placed on actual receipt
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Limits on Cash Method



Businesses that carry inventory and sell
merchandise to customers generally must
use the accrual method to account for sales
and purchases
Hybrid method – accrual for sales of inventory
& cost of goods sold; cash method for other
income and expenses
Large corporations (gross receipts of more
than $5 million) cannot use cash method
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Accrual Method

Income is recognized when “all events test” is
met
All events have occurred that establish the
right to the income and
The income amount can be determined with
reasonable accuracy

If liability is in dispute, the all events test is
not satisfied until dispute is resolved
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Claim of Right Doctrine



Claim of right doctrine modifies the normal
recognition rules for accrual basis taxpayers
Applies whenever the taxpayer receives
income but there is a dispute regarding the
taxpayer’s right to keep some or all of the
income
Taxpayer must recognize income even
though some of the income may have to be
repaid later
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Prepaid Income


Prepaid Income is another exception to the
accrual method of accounting
Based on “wherewithal to pay concept”
income must be reported when received
Examples: rent, interest, and royalty
payments
Refundable deposits are not prepaid income
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Installment Method



Gain is recognized as proceeds from sale are
received
Use severely restricted – generally available
for casual sales only (excludes sales of
inventory and securities)
May not want to use if
Marginal tax rate is expected to increase
Unused losses are expiring
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Long-Term Contracts


Completed Contract Method—no income is
recognized and no deductions taken until
contract completion
Percentage-of-Completion Method—income
is recognized as contract progresses based
on an estimate of actual costs incurred to
total projected costs for contract
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Assignment of Income Doctrine


A taxpayer cannot assign earned income to a
third party to escape taxation
Earned income must be taxed to the taxpayer
rendering the services
Community property states (Arizona,
California, Idaho. Louisiana, Nevada, New
Mexico, Texas, Washington, Wisconsin)
allocate half of income to each spouse

Income from property is taxed to taxpayer
who owns the property
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Interest Income


Interest income from savings accounts,
certificates of deposit, corporate bonds, and
Treasury bills is included in gross income
Interest on state and local (municipal) bonds
is excluded from gross income
High income taxpayers may have a higher
after-tax return on municipal bonds than
taxable bonds offering a higher interest tax
Gain on the sale of tax-exempt securities must
be included gross income
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Original Issue Discount

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
Some debt instruments are issued at prices
below their maturity values
This original issue discount (OID) is
effectively interest paid at maturity rather than
periodically over the debt instrument’s life
Both cash and accrual basis taxpayers
recognize OID income as it accrues
Exception: Series EE bonds
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Market Discount

Bonds purchased after issue in the open or
secondary market at a price below maturity
value
Excess of redemption proceeds over cost is
recognized as ordinary income in year of
redemption
Electively, market discount can be accrued as
interest income over life of bond
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Below-Market-Rate Loans


Certain loans between related parties
(family members) may be made at low
interest rates (or even interest free)
On other loans, interest income that is not
actually received or accrued may be
imputed (treated as received or accrued and
taxed) at the applicable federal rate of
interest
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Gift Loan Exceptions


Any gift loan of $10,000 or less is exempt
from the imputed interest rules
For gift loans of $100,000 or less
Imputed interest cannot exceed the borrower’s
net investment income for the year
If borrower’s net investment income is no
more than $1,000, imputed interest is zero
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Other Loans


Loan to employee – imputed exchange of
cash is treated as taxable compensation
(income to employee and deduction for
employer)
Loan to shareholder – imputed exchange of
cash is treated as a dividend (taxable
income to shareholder, no deduction for
corporation)
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Dividend Income

Cash and FMV of other assets distributed by
a corporation from earnings and profits (E&P)
are treated as dividends includable in the
shareholder’s income
2003 Tax Act reduced tax rate to the 15% rate
applicable to long-term capital gains (5% rate
for individuals in 10% or 15% tax bracket)


Distributions in excess of E&P are nontaxable
return of capital (reducing stock basis)
Distributions in excess of stock basis are
taxed as capital gain (as if stock if sold)
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Mutual Fund Dividends


May pay dividends from gains they realize on
the sale of investment assets
These dividends are actually net long-term
capital gains and are called capital gains
distributions
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Dividend Reinvestment Plans


Treated as if the shareholder receives the
cash and then purchases additional shares of
stock with the dividend income. Value of
dividend included in income.
It is important for each shareholder to keep
track of basis for all shares
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Stock Dividends

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
Stock dividends are distributions of a
corporation’s own stock to its shareholder
(stock splits)
Usually stock dividends are not taxable to the
shareholder (unless shareholder has option
of receiving cash)
Shareholders simply own a greater number of
shares and the basis in their original holdings
is divided among all shares of stock now held
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Annuity Income

Usually consists of a taxable and nontaxable
amounts
 Nontaxable amount represents a return of capital
 Nontaxable amount of a payment is equal to the
Investment in annuity / expected return from
annuity x annuity payment received

If the amounts invested in the annuity were all
made by the employer (or by the employee
using pre-tax dollars), then the employee’s
investment is treated as zero
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Prizes and Awards


Prizes, awards, gambling winnings, and
treasure finds are taxable
The fair market value of goods or
services received is included in gross
income
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Government Transfer Payments


Need-based payments, such as welfare
payments, school lunches & food stamps, are
excluded from income
Unemployment compensation is taxable
because it is a substitute for wages that
would be taxable
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Social Security Benefits


Government devised a complex formula that
can result in the taxation of up to 85% of
social security benefits for taxpayers who
have significant other income while leaving
benefits completely tax free for those who
have little other income
MAGI = AGI before any social security
benefits + exempt interest income + ½ of
social security benefits
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Social Security Benefits



If MAGI is less than $25,000 for single
individuals or $32,000 for married couples,
then none of the social security benefits
received are taxable
Single taxpayers with MAGI above $34,000
and married taxpayers with income above
$44,000 can be taxed on up to 85% of their
benefits
Taxpayers between the above thresholds can
be taxed on up to 50% of their social security
benefits
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Damage Awards

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
Damages for physical injuries are not taxed
(under the return of capital doctrine)
Damages for all other awards are taxed
(because they are viewed as substitute for
what would otherwise be taxable income)
Punitive damages are taxable
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Divorce-Related Payments


A property settlement is simply a division of
assets (no income, no deduction)
Alimony is a legal shifting of income so it is
taxable income to the person receiving it and
deductible by the person who pays it
 First year’s alimony should not exceed average of
2nd and 3rd year payments by more than $15,000


Child support fulfills a legal obligation to
support a child (no income, no deduction)
Both parties may benefit by negotiating an
increase in payment if it qualifies as alimony
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Discharge of Debt

If a legal obligation is satisfied for less than
the outstanding debt, the amount of debt
forgiven represents an increase in the
taxpayer’s wealth and is subject to taxation
Exceptions are provided for debtors who are
bankrupt or insolvent
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Tax Benefit Rule


If a taxpayer deducted an expense or loss in one
year but recovers the amount deducted in a
subsequent year, all or a portion of the amount
recovered may have to be included in the gross
income in the year it is recovered
Amount included in income is limited to the
extent of tax benefit received by the tax
deduction
Example: bad debt recovery or refund of taxes
previously deducted
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Exclusions



Gifts
Inheritances
Life Insurance
Proceeds received are tax-free but any
interest income on proceeds is taxable
Inside buildup (increase in cash surrender
value) is not taxable income unless policy is
liquidated for more than premiums paid
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Accident & Health Insurance


Accident & health insurance proceeds from
are tax-free to extent they pay qualified
medical or dental expenses; excess benefits
taxable if employer provided policy
Disability insurance—substitute for lost pay
If premiums for disability insurance paid by
employer, then benefits received are taxable
If premiums paid by employee, exception
allows benefits to be tax free
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Scholarships

Qualified scholarships are excluded from
gross income
“Scholarship” includes only tuition, fees,
books, supplies, equipment, and related
expenses required for courses
Amounts designated or spent for room,
board, and laundry are included in income
and are taxable
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Scholarships

Any grant received in return for past,
present, or future services must be included
in gross income
Funds received by students in return for
teaching or research services are taxable

When taxable portion cannot be determined
until end of academic year, taxable income
can be deferred until the taxable year in
which the academic year ends
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Other Exclusions
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

Improvements made on leased property are
excluded from landlord’s income unless
improvements made in lieu of paying rent
Fringe benefits discussed in next chapter
Exclusion of gain on sale of home
$250,000 if single, $500,000 if married and
both spouses qualify
Must have owned and lived in home as
principal residence for at least 2 of previous 5
years
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International Issues

Source principal - countries tax income
earned within their borders but exclude
income from activities sourced in other
countries
Applies to foreign persons and foreign
corporations

Residency principle – countries tax worldwide
income
Applies to resident citizens and corporations
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Tax Treaty


An agreement between two countries that
explains how a taxpayer of one country is
taxed when conducting business in a second
country
Objective is to minimize double taxation
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International Taxation



A business is usually only taxed in country of
residence unless it maintains a permanent
establishment (e.g. office) in another country
Source country can tax income earned within
it’s borders when a permanent establishment
exists
Resident country allows taxpayer a foreign
tax credit up to tax paid in source country
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Taxpayers Subject to U.S. Tax


U.S. citizens, resident aliens, and U.S.
corporations are subject to U.S. tax on their
worldwide income
Resident alien – individual who is not a U.S.
citizen who has a legal residence in U.S.
established through
Green card or
Substantial presence test (183 days)

Nonresident alien – individual who is not U.S.
citizen and does not satisfy test to be resident
alien
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Nonresident Aliens and
Foreign Corporations



Effectively connected income – U.S. business
income subject to U.S. income tax
Non-U.S. business income – not subject to
U.S. income tax
U.S. investment income – taxed at flat 30%
(or treaty rate if lower)
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State and Local Taxation


Most states (and some local governments)
impose both corporate and individual income
taxes on both residents and nonresidents
Nonresidents can only be taxed on
Income derived from business activity within
that state and
Income from property in that state
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State Tax Issues


Nexis is the type and degree of connection
between a business and a state necessary for
the state to have the right to impose a tax
Multi-state businesses may be able to reduce
their overall tax cost by shifting income from a
high-tax state to a low-tax state
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Total Effective Tax Rate



For federal tax purposes, state income tax is
deductible in computing taxable income
Tax savings from this federal deduction
reduces the cost of the state income tax
When a taxpayer pays income tax at both the
federal and state levels, it increases the total
effective tax rate and decreases the after-tax
cash flow
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The End
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