EA1 Study Unit 2.1 - Gross Income I

Individual Income Tax Formula

• Gross Income less Section 62 Adjustments/Deductions results in Adjusted Gross Income (AGI).
• AGI less the greater of Itemized Deductions or Standard Deduction, and less Qualified Business Income Deduction results in Taxable Income.
• Taxable Income multiplied by the Tax Rate results in Gross Tax Liability.
• Gross Tax Liability less Credits results in Net Tax Liability or Refund Receivable.

Gross Income (IRC Definition)

• It is defined as all income from whatever source derived, unless specifically excluded.
• Section 61(a) lists types of income that constitute gross income, but it is not exhaustive.
• Includes compensation for services like fees, commissions, and fringe benefits.
• Includes gross income derived from business and gains derived from dealings in property.
• Also includes interest, rents, royalties, dividends, and annuities.
• It includes income from life insurance and endowment contracts, a broader application than the general exclusion for proceeds due to death.
• Pensions are included in gross income.
• Income from discharge of indebtedness is included.
• Distributive share of partnership gross income is included.
• Income earned but not received before death (in respect of a decedent) is included.
• Income from an interest in an estate or trust is included.
• Income derived from all sources is included whether or not a taxpayer receives Form W-2 or 1099.
• Report any errors on Form 1099-MISC to the payor; if uncorrected, attach an explanation with the correct amount.
• Alimony and separate maintenance payments are not included in gross income for divorces executed after 2018, or pre-2019 divorces modified after 2018 which expressly exclude it; however, payments under pre-2019 divorces may still be tested.

Domestic vs. Foreign Source Income Factors:

• Salaries, wages, and other compensation's source is where services were performed.
• Business income from personal services is sourced where services were performed.
• Business income from the sale of inventory-purchased is sourced where sold.
• Business income from the sale of inventory-produced is allocated.
• Interest income is sourced at the residence of the payor.
• Dividend income is sourced based on whether the corporation is a U.S. or foreign entity.
• Rental income is sourced at the property location.
• Royalties from natural resources are sourced at the location of the property.
• Royalties from patents or copyrights are sourced where the property is used.
• The sale of real property is sourced at the property location.
• The sale of personal property is sourced at the seller's tax home.
• Pension distributions connected to contributions are sourced where services that earned the pension were performed.
• Investment earnings on pension contributions are sourced at the location of the pension trust.
• The sale of natural resources is allocated based on the fair market value of the product at the export terminal.

Accounting Methods for Income

• The cash method includes income when constructively received.
• The accrual method reports income when all events have occurred fixing the right to receive the income and the amount can be determined with reasonable accuracy.
• The accrual method is required when there are inventories.
• The hybrid method allows a business to use the cash method for portions not needing the accrual method.
• Adjustments are made later for differences between estimated and actual amounts.

Constructive Receipt

• It occurs when income is credited to an account, set apart, or made available to the taxpayer, allowing them to draw upon it at any time.
• A check received in the mail is income on the date received, whether cashed or not.
• Trade date is used to determine receipt of income from securities trades, not the settlement date.
• Income is not constructively received if there are substantial limitations or restrictions on its receipt.
• Constructive receipt applies to the cash method; the accrual method reports income in the year earned.

Claim-of-Right Doctrine

• Taxpayers include payments received under a claim of right in income for the year received without use restrictions, even if the right to keep the payment isn't fixed or repayment may be required.
• Payment is not included in income if it is not received.

Compensation for Services

• All compensation for personal services is gross income, regardless of the form of payment.
• If paid in property, use the fair market value (FMV) at the time of receipt.
• The amount included in income becomes the basis in the property.
• If there was a prior agreement on price, that price is accepted as the FMV if no evidence suggests otherwise.
• The gross income of an employee includes amounts paid by an employer for liabilities or expenses, including taxes.
• Income from self-employment is included, with corporation directors considered self-employed and all fees included.
• Reported and unreported compensation, including tips, is gross income.
• Food service employers use 8% of food and drink sales to determine allocable tip income, calculated as (Food/drink sales × 8%) – All employee's reported tips.

Business Income from Electronic Payments

• Taxpayers receiving payments via payment cards or third-party networks will receive Form 1099-K.
• Third-party settlement organizations (TPSOs) must report payments for third-party network transactions exceeding $5,000 in 2024, $2,500 in 2025, and $600 thereafter.

Virtual Currency

• Virtual currency like Bitcoin operates like real currency in some environments but lacks legal tender status.
• Virtual currency is treated as property for U.S. federal tax purposes.
• Wages paid using virtual currency are taxable to the employee, reported on Form W-2, and subject to federal income tax withholding and payroll taxes.
• Virtual currency payments to independent contractors are taxable and subject to self-employment tax rules; payors typically issue Form 1099.
• Gain or loss on the sale or exchange of virtual currency depends on whether it's a capital asset.
• Payments made using virtual currency are subject to information reporting like other property payments.
• Taxpayers receiving virtual currency for goods/services must include its fair market value in U.S. dollars as of the receipt date in gross income.

Prepaid Income

• Generally, prepaid income is taxable in the year received, regardless of accounting method.
• Prepayments for merchandise inventory are not income until shipment.

Bartering

• Bartered services or goods are included in gross income at the fair market value of items received.

Assignment of Income

• Gross income includes income attributable to a person, even if received by others.
• It applies to those who earn income, produce the right to receive it, or control the property that is its source.
• This also applies to income earned by personal services or derived from property.
• Effective assignment requires complete transfer with no retained control over the property or income.

Royalties

• Royalties are payments to an owner for the use of their rights.
• They constitute ordinary gross income and are not a return of capital.

Personal Rental Income

• Cash or fair market value (FMV) of property/services from personal property use is taxable rental income.
• Schedule C is used if renting personal property as a business; not Schedule E (for real estate).
• Taxpayers are in the business of renting personal property if the main goal is income or profit, and there is continuity and regularity.
• If the rental of personal property is not a business, report any income and deductions on Form 1040 (Schedule 1).

Not-for-Profit Rental Income

• Taxpayers cannot deduct expenses if property is not rented to make a profit due to hobby loss rules.
• Report not-for-profit rental income on Form 1040 or 1040-NR.
• Casualty losses may be included on Schedule A if deductions are itemized.
• If rental income exceeds expenses for 3 of 5 consecutive years, there is a presumption of renting for profit.
• Taxpayers can elect to have the presumption made after 5 years with Form 5213, if starting a rental activity without 3 years of profit,
• File Form 5213 within 3 years after the return due date or 60 days after IRS notice proposing deduction disallowance.

Alimony

• For divorce decrees before 2019, alimony and separate maintenance payments are included in the recipient's gross income and deducted from the payor's gross income.
• Alimony is not deductible by the payor or included in the recipient's gross income if the divorce is finalized after 2018, or a pre-2019 divorce is modified after 2018 to expressly exclude it.
• Payments (even to third parties like a home mortgage) are considered alimony if paid in cash, pursuant to a written divorce or separation instrument, not designated as other than alimony, terminated at recipient's death, not paid to household members, and not paid to a spouse when filing jointly.

Child Support

• Child support is excluded from the recipient's gross income and is not deductible by the payor, not considered alimony.
• Partial payments go to child support until fully paid, then to alimony if specified for both.
• Reductions based on a child's contingency (age, marriage) are treated as child support.

Property Settlement

• Property settlements, or divisions of property, are not alimony.
• Property transferred incident to a divorce is treated as a gift and is excluded from gross income.
• "Incident to a divorce" means transfer within 1 year of the marriage ending or related to its cessation.
• This exclusion does not apply if either spouse is a nonresident alien.

Annuity Contracts

• Gross income includes a portion of amounts received under an annuity contract if a statute doesn't exclude it.
• Taxpayers can recover the annuity cost (price paid) tax-free.

401(k) Plans

• Employer contributions are generally not included in the participant's income.

Income from Life Insurance and Endowment Contracts

• Proceeds received due to death are generally excluded from gross income.
• Interest paid on policy proceeds over time is beneficiary income.
• The limit excluded from gross income for employer-owned life insurance is premiums and amounts paid by the policyholder.
• Income inclusion rule does not apply to family members, designated beneficiaries/trusts, or the insured's estate.
• Proceeds are taxable if the owner transfers the policy for consideration, however, payments are treated as a return of investment.

Debt Discharge

• The cancellation of debt can result in gross income when given for consideration.
• If a creditor cancels a debt in exchange for services, the debtor recognizes income equal to the compensation of services.
• Income from discharge of debt is reported similarly to other income like schedule C for sole prop.
• Corporations have gross income when satisfying a debt by transferring corporate stock.
• Gross income is the difference between debt principal and the value of stock transferred, plus other property value transferred.
• Gratuitous cancellation is treated as a gift with IRC exclusion.
• Exceptions are discharges that occur in bankruptcy or when the debtor is insolvent (not in bankruptcy).
• The amount excluded is lesser than the canceled debt or amount of insolvency.
• Exceptions exist for discharges that are related to qualified farm indebtedness or qualified real property business indebtedness.
• Also, discharges related to principal residence indebtedness are except (More information on this exception is provided below.)
• To exclude debt discharge, the taxpayer reduces specific tax attributes in the following order:
• NOLs, general business credit, minimum tax credit, capital loss carryovers, basis of the taxpayer's property, passive activity loss and credit carryovers, foreign tax credit carryovers.
• Election allows first decreasing the basis of depreciable property.
• Real property debt discharge involves two transactions.
• Property sold to the lender may issue Form 1099-A; a gain or loss may be reported.
• The Lender cancels the debt with Form 1099-C, income may have to be reported as discussed.
• The sale and cancellation need not occur in the same year; lenders issue only Form 1099-C if they occur in the same year.
• Nonbusiness debt (e.g., discount for early home mortgage payment) is reported as cancellation of debt under Other Income on Form 1040 (Schedule 1).
• Excludes debt discharges up to $750,000 secured by a principal residence used for acquiring, constructing, or improving the residence by Mortgage Forgiveness Debt Relief Act.
• Exclusion applies to discharges after December 31, 2020, and before January 1, 2026.
• The amount excluded reduces residence basis but not below zero, only applies if the taxpayer retains the residence.
• Principal residence follows Sec. 121 guidelines.
• Exclusion does not apply if the discharge is unconnected to the home's value decline or taxpayer's financial condition.

Student Loan Cancellation

• Federal, state, or local government student loan debt can be discharged and excluded from income until 2026. This excludes private loans or those from tax-exempt organizations.
• If the discharged student engages in specific employment tied directly to the lender, the discharge is payment for work.
• Discharges for death or permanent disability may also be excluded from income.

Social Security Benefits

• Generally not taxable unless additional income is received.
• Gross income inclusion depends on the relation of provisional income (PI) to base amount (BA) and adjusted base amount (ABA).
• PI is AGI plus tax-exempt interest, excluded foreign income, other exclusions/deductions, plus 50% of Social Security benefits.
• BA is $32,000 for MFJ, $0 for MFSLT, or $25,000 for all others.
• ABA is BA plus $12,000 (MFJ), $0 (MFSLT), or $9,000 (others).
• Social Security benefit inclusion:
  • If PI ≤ BA, inclusion = 0%
  • If BA < PI ≤ ABA, inclusion 50%
  • If PI > ABA, inclusion = 85%.

Railroad Retirement

• The Railroad Retirement Board provides retirement annuities at age 60 with 30+ years of service.
• Social Security beneficiaries are ineligible until 62.
• The Social Security Benefits Worksheet determines if any benefits are taxable.

Illegal Activities

• Income from illegal activities is gross income.

Scholarships

– Amounts for tuition, fees, books, supplies, or equipment for degree candidates at qualified educational institutions are excluded from gross income.

• Gross income includes amounts for services like teaching or research.
• Generally, undergraduate tuition reductions for employees of qualified educational organizations are not gross income. Subsistence payments administered by Veteran Affairs are excluded from gross income.

Prizes and Awards

• The amount of gross income for prizes and awards is their fair market value (FMV), unless in money form.

• Honorees can reject the prize or award, avoiding inclusion, and exclusions are available.

• Award recipients can exclude the FMV if the prize/award is:

• Recognition of religious, scientific, charitable, or similar meritorious achievement.

• Recipient is chosen without action.

• Receipt is not conditional on future service.

• Paid by the awarding group to a tax-exempt organization the recipient designates.

• Prizes/awards might meet requirements to be excluded and qualify as scholarships.

• Specific employee achievement awards can be excluded as a de minimis fringe benefit.

• Employee achievements are awards as part of a presentation for achievements in achievement or length of service that:

• Nonqualified plan awards cannot exceed $400 (employer cost).

• Qualified plan awards cannot exceed $1,600 (employer cost).

• Awards must be tangible personal property, not cash/equivalents.

• If employer costs exceed limitations, exclusions are preserved up to the limitation, this should be included as compensation to the extent it exceeds the limitation.

• Qualified plan awards are employee achievement awards under established nondiscriminatory written programs, not favoring the highly compensated.

Unemployment Benefits

• Unemployment benefits from federal/state programs and company-financed plans are gross income.
• Strike benefits from unions count as income.

Compensation for Injury or Sickness

• Gross income excludes specific benefits for disability pay, health/accident insurance, workers' compensation, and other "damages" for personal physical injury/sickness.

• Amounts are specifically excluded if received under worker's compensation acts or from an accident/health insurance policy.

• Excluded amounts can be received as reimbursement for medical care, for permanent injury/loss of bodily function.

• Damages are excluded regardless of lawsuit/agreement origins or whether they are lump sums or periodic if:

• Received for personal physical injury or physical sickness

• For emotional distress stemming from physical injury/sickness

• Compensation for slander to personal/professional/business reputation is gross income.

• Settlements or court awards for business lost profits count as gross income.

• Punitive damages count as gross income even if for physical injury/illness and the allocation needs to occur for both actual and punitive damages.

• Wrongful death damages can be excluded to the extent they were received because of personal injury/sickness.

• Damages solely for emotional distress count as gross income; this includes damages for claim such employment or age discrimination.

• Interest earned on awards for personal injuries counts as gross income.

Recovery of Medical Deductions

• Reimbursement in Year 2 is included in gross income to the extent of the previous Year 1 deduction if medical expenses were incurred in Year 1, deducted, and reimbursed in Year 2.

Accident and Health Plans

• Benefits paid to an employee from accident and health plans are excluded from their gross income if the employer either paid premiums or gave to an independent fund.
• The benefits must be payments for permanent injury/loss of bodily functions or reimbursement for medical expenses to the employee, spouse, or dependents.
  • Reimbursement beyond medical costs counts as income.
• The plan should not favor highly compensated executives, shareholders, or officers.
• Only to the amount that the taxpayer contirbuted to the plan, excess reimbursement beyond medical costs can be excluded (only up to the extent contributed by the taxpayer).

Disability Policies

• Tax-free if proceeds are paid for by the employee.
• If the employer contributes to the coverage (excluding the contributions from the employee's income), then the amount must be pro-rated.
• Payments from qualified trusts for self-employed persons count as employer contributions.
• Example: If 75% of premiums are paid by the employer, then 75% is included in income.

Employer-Provided Dependent Care

• Can exclude up to $5,000 if employer-provided dependent care is received either as amounts paid or fair market value for employer-provided daycare facility, pre-tax contributions under a flexible spending plan.

Employer-Provided Life Insurance

• Employees are allowed $50,000 of tax-free group-term life insurance.
• Employees include premiums for excess coverage (>$50,000) less any amounts paid by the employee.

Long-Term Care Coverage

• Employer contributions to employee long-term care coverage are nontaxable.

Pensions

• Rules are similar to annuity rules since most pensions are paid as annuities.
• Employees recover their cost tax-free.
• The investment in the contract is the amount the employee contributed in after-tax dollars.
• Early withdrawals are treated as a recovery for the employee and employer contributions.
• Additional withdrawals are included in gross income after contributions are recovered.
• Taxable disability payments as wages are reported for persons who retired because of disability before reaching the minimum retirement age for that plan.

Foreign Pension Distrubutions

• If a pension or annuity distribution is received from outside the US it meets the definition of a foreign pension or annunity.
• It is paid from a foreign employer, a trust, foreign government or agencies, foreign orgs, foriegn entities designated to pay the annuity.
• As with domestic pensions or annuities, taxes are applied after cost is accounted for of the investment into the contract.
• Income may be included even if the taxpayer did not receive form 1099 or similar foreign documentation.

Death Benefits

• All death benefits paid are included in gross income, except those from life insurance plans.
• Death benefits paid are those paid by the employer and not to to be confused with those from life insurance.

Rental Value of Parsonage

• Ministers can exclude rental value, exclusion is the smaller of:

1. Actual expenditures
2. Amount designated as allowance
3. Fair rental value plus utilities

• NOTE: The parsonage allowance is subject to self-employment taxes.

Combat Zone Compensation

• Military officers can exclude compensation equal to enlisted personnel, plus hostile fire/imminent danger pay.
• This exclusion applies only when serving in combat zones or if injuries are received.
• Exclusion available for officers and enlisted personnel.

Gifts or Inheritance

• Exclusion from gross income of the value of property gained by gift or inheritance.
• The transfer is less than full consideration and transfers must be voluntary and come from generosity.
• Gift transfer is the transfer of property without counter-payment of equal value.
• These include inter vivos and gifts by bequest.
• Transfers from employer to employee are presumed compensation, not gifts.

Treasure Trove

• Taxpayers have gross income to the extent of where it is undisputedly in the taxpayer's possession.

Gambling

• All winnings from sources in gambling must be reported on form W-2G.
• Gambling losses are deductable only to the extent of winnings and requires other itemization.
• Losses above winnings are not allowed for deduction in other years as carryover.

Recovery of Tax Benefit Item

• Taxpayers must include prior write off credits in gross in the present year.
• Exclusion from the exclusion is in section 111 and provides that amounts that did not reduce tax liability will reduce the exclusion.

Reimbursements for Moving Expenses

• Qualified reimbursements excluded for active duty military members. Include reimbursements which are not qualified or if the TP is not military in gross.

Adoption Assistance Programs

• Adopted expense of 3rd party paid to EE's are excludable from the EEs' gross.
• Requires a written plan that benefits those under the EE w/rules set up under the ER.
• < 5% must be paid to shareholders or owners in payments.
• Adequate notice is required as well as proper substantiation is included to EE's regarding the payment/ reimpursement.

Adoption Exclusion

• 2024: max exclusion is $16,180 and phases out from $252,150-$292,150 and is used to reduce the amount for what is used up in determining the credit.

• US Citizen or Resident: yr taken = payment year

• Foreign Country Adopt: year taken = when adaption became final

• NOT SUBJECT to inc Tax withholds: Subject to ss, medicare, fed unemployment tax

• Qualified exp: Reasonable and ness for adopt

• Non qualified includes: costs w/ surrogate, state/fed vio., adopter EE (same spouse)

Reimbursement of Living Expenses

• TP's receiving payments covered by damage/destroyed is excluded. In order to qualify for this exclusion the residence must be uninhabitable because of an un-damaged residence or as a result of a mandatory evacuation. -The exclusion is the actual living exp over normal living exp.

Reimbursed Employee Expenses

• If EE makes acct of exp in = amt to ER: The reimbursements get excluded from the EEs' gross inc, = Accountable PLan; ER may not deduct inc.
• This rule is also for expenses which ex expenses but if substantiation doesn't occur with ER, it is excluded (if not substantiated).

EE Housing at Edu. Institute

• Housing inc. academic and health centers have rent paid, the the EEs can exclude no more than 5% of FMV.

Fringe

• Inc does not = cost of any fringe benefit supplied by ER if qualified by the ER
• No addtl service cost.
• Qual EE discount
• Working cond fringe
• de minimis fringe
• Qual transport frnge
• Qual moving -active duty
• ER Provided edu Assistance
• ER paid LIfe Insurance.

No Additional Cost Service

• Value of no add cost fringe benefits have excluded inc, and the definition is something or product the ER gives the EE but ER has substantial svcs of that kind;
• Substantial cost to provide svcs
• EX: free TL service for TL company's EEs
• Fringe Benefits = available to EES with no discriminatory basis, this EXCLUDES: those to managers ONLY.

Ees Discount

• Can receive deductions at selling price for those at employers;
• Must offer S to EEs where that good/svc if used by the purchaser; Exempt up to =% Profit = customer or qual svcs 20% discount to customs. NOT allowed to discrim.

Working Condition Fringe

• FMV + Svss to ee by ER as work condition fringe = excluded by EE: To extent that ER can deduct + Ness bus exp
• IF the EE'S use prop for BUS
• The EE qualifies for Business Expense Ded.
• If the EE maintains reqs to be the BUS.

Maximum value of employer-provided vehicles for personal use is $62,000 if the cants per-mile valuation can be applied.

De Minimis Fringe

• Property used by EE has Excluded Inc because its value was so small to make acct too hard and the foll do apply! . Occasional use of company copy machines . Occasional company parties or picnics . Tickets to entertainment events, if only distributed occasionally . Occasional taxi fare or meal money due to overtime work . Coffee and snacks

.

Holiday gifts with a small FMV .

Tokens, vouchers, for cost/commute that = 315 a month as long as no cash benefit or credit card or cert; .

NO Sporting Ticc Season tickets that = commute more then 1 use or facility by Private Athletic club. -Eating Facility for the EE is min fringe if is located at ER bus with revenues => Oper costs And the ER exceed excess for the value of food of Employees Excluded.

Value of Facility as ath facility at EE Bus is EXCLUDED.

Transportation

• Month Ben 315: ER provider parking Transit EE from BUS = 1/2 EE ride share.

• may offer $ Ben w/o Lose = EE.

• EE uses cash= include GI

EE provided edu Assistance

• Upto $5,250 by EE: Does not mean TU reduce under sec for assist or research; Not include if NOT have $ Course or food Lodging.

• CARES act 5259 limit; Made from to EE for any QEL

Employer Provided LI

• 50,0000 has allow protect, Any over that Must Be recognised

Foreign EE inc exclude

• Us citizen can be in forign not exceed $126,500 inc and the statutory cost.

• 300 full days in forign if not 2555 for GI.

Forign EE Inc. - salary + comm + bonus+ fee+ Tips NOT Div + interest + CG + Gaming + Alimony