EA1 Study Unit 3.1-3.3 Gross Income II: Interest, Securities, and Decedent

Interest Income

• Represents the value received or accrued for the use of money
• Taxpayers must report interest when their account is credited, under the "constructive receipt" doctrine
• Accrued interest that cannot be withdrawn by year-end due to an institution's financial issues is not included until the year it becomes accessible
• All interest is considered gross income for tax purposes unless an exclusion applies

Taxable Interest Examples

• Merchandise premium, like a toaster, offered when opening an interest-bearing account
• Noncash gifts are tax-free if their value is less than $10 for deposits under $5,000, or less than $20 for deposits of $5,000 or more
• Imputed interest on below-market term loans

Imputed Interest on Below-Market Loans (BMLs)

• Below-market interest rates can be economically equivalent to receiving income, so interest is imputed
• BMLs are either demand loans or term loans
• Demand loans are payable in full on demand or have indefinite maturity dates
• Term loans are any loans that are not demand loans

Below-Market Demand Loan Definition

• Interest is payable at a rate lower than the applicable federal rate, the excess interest is treated as imputed interest
• Imputed interest is considered transferred from borrower to lender on the last day of each year, with potential deductibility for the borrower
• The interest is deemed retransferred by the lender, characterized as a gift, compensation, or dividend

Below-Market Term Loan Definition

• The amount lent exceeds the present value of all due payments
• During a gift term loan, the lender transfers the excess of the loan amount over the present value of payments at the start
• Retransfers are calculated at year-end
• Non-gift term loans are treated as original issue discount, resulting in interest income for the lender and expense for the borrower

BML Imputed Interest Rules Apply To

• Gift loans
• Loans between corporations and shareholders
• Compensation-related loans between employers/employees or between independent contractors and those they provide services for
• Loans with tax avoidance as a primary purpose

BML Exceptions

• No interest is imputed if total loans between borrower and lender are below certain minimums
• For gift loans between individuals of $10,000 or less, interest is not imputed unless the loan is used to acquire income-producing assets
• If gift loans between individuals total less than $100,000, the deemed transfer is limited to the borrower's net investment income, treated as $0 if it doesn't exceed $1,000
• This allows family gift loans without penalizing the lender
• If a BML between a corporation and its shareholder is $10,000 or less, interest isn't imputed unless the loan's main purpose is tax avoidance
• Certain loans lacking a significant tax effect are excluded from BML rules

Original Issue Discount (OID)

• OID is the excess of a bond's stated redemption price at maturity over its issue price
• It is included in income based on the effective interest rate method of amortization
• If OID is at least $10 for the calendar year, and the obligation term exceeds 1 year, the interest income must be reported on Form 1099-OID

Educational Expense U.S. Savings Bond Redemptions

• Taxpayers paying for qualified higher education expenses may exclude some or all interest from Series EE or I U.S. Savings Bonds
• Qualifications require the taxpayer, their spouse, or a dependent to incur tuition and fees at an eligible educational institution
• Taxpayer's modified adjusted gross income must be within a limit, with phaseouts at certain income levels
• Married couples have a 2024 phaseout range of $145,200-$175,200
• Single or head of household filers have a 2024 exclusion phaseout range of $96,800-$111,800
• The bond purchaser must be the sole owner or joint owner with their spouse
• The bond issue date must follow the owner’s 24th birthday
• Married taxpayers must file jointly
• If qualified expenses are less than the principal and interest redeemed, the excludable amount is determined using the exclusion rate

State & Local Government Obligations

• Payments to holders of debt obligations by a state or local government (municipal bonds) are generally exempt from federal income tax
• Exclusion of interest is allowed, even for obligations not evidenced by a bond, such as installment purchase agreements or ordinary commercial debt
• These obligations must be in registered form
• The exclusion applies to states, the District of Columbia, U.S. possessions, and their political subdivisions

Tax-Exempt Interest Restrictions

• Interest on non-qualified private activity bonds and arbitrage bonds is included in gross income
• Private activity bonds: proceeds for private business use, principal/interest secured by private business property, or proceeds used for private loans (subject to percentage and dollar limits)
• Exclusion remains for qualified private activity bonds funding residential rental housing, public facilities, qualified mortgages/VA bonds, small issue bonds, student loan bonds, redevelopment bonds and tax-exempt organization bonds
• Interest from state, local, and federal tax refunds is included in income
• Tax-exempt interest is reported on the federal income tax return

IRS Form 1099-INT Reporting

• IRS Form 1099-INT reports interest income
• Nominee distributions occur when multiple taxpayers are entitled to interest from an account in only one name
• The recipient taxpayer with the Form 1099-INT has additional reporting duties when interest is allocated to others
• Schedule B of Form 1040 must list all interest on the 1099-INT, regardless of rightful ownership
• The taxpayer can then subtract interest belonging to other owners to calculate their allocable interest
• For each other interest recipient, the taxpayer files two copies of Form 1099-INT, one for the IRS and one for the recipient, along with Form 1096 to the IRS as the "filer"

Income from Securities: Dividends

• Amounts received as dividends are ordinary gross income

Qualified Dividends

• Taxed at 0%, 15%, or 20% based on filing status and income
• Capital gains rates apply
• Securities must be held for over 60 days (90 days for preferred stock)

Taxable Dividend Definition

• A distribution of money or property by a corporation to shareholders, related to their stock, out of earnings and profits
• Distributions exceeding earnings and profits are considered capital recovery, are not taxable, but reduce basis
• Once basis is zero, additional distributions are capital gains and are taxed accordingly
• Dividends paid by credit unions or savings and loans are not qualified dividends

Mutual Fund Distributions

• Depend on the character of the income source
• Distributions from funds investing in tax-exempt securities are tax-exempt interest
• Capital gain distributions are treated as long-term, regardless of the investment holding period
• If capital gain remains undistributed, the taxpayer must report the amount as gross income
• Long-term capital gains tax rates: 0%, 15%, 20%, 25%, and 28%
• Mutual funds and REITs can retain long-term capital gains and pay tax, instead of distribution
• Taxpayers must treat their share of these long-term capital gains as a distribution, even without actual receipt

Dividend Reinvestment Plans (DRIPs)

• Allow shareholders to use dividends to buy more company stock instead of getting cash
• Stock basis from DRIPs is the fair market value, even if purchased at a discount
• DRIP members buying stock at fair market value must report dividends as income
• Members buying stock below fair market value report the fair market value of the additional stock as income on the dividend payment date
• If DRIPs allow investing more cash to buy shares below fair market value, report the difference between the cash invested and the stock's fair market value as income
• Fair market value is determined on the dividend payment date
• Service charges subtracted from cash dividends before additional stock purchase are considered dividend income
• Reinvested dividends are taxable in the year paid
• Reinvested dividends are added to the stock or mutual fund's basis
• Reinvested dividends are treated as ordinary dividends

Stock Dividends

• Shareholders generally exclude the value of a stock dividend from gross income, unless one of five exceptions applies
• Exception 1: Stock dividends are not excluded if any shareholder can elect to receive cash or other property; cash for fractional shares is included in gross income
• Exception 2: If some shareholders get cash or property, and others get stock, which increases the proportionate interest in earnings
• Exception 3: If common stock shareholders receive preferred stock while other common stock shareholders get common stock
• Exception 4: The distribution is on preferred stock, unless solely to adjust conversion ratios from a stock split or dividend
• Exception 5: If a shareholder receives common stock and cash for a fractional share portion, only cash received for the fractional portion is included in gross income

Constructive Dividends

• Payments of personal expenses by a corporation can be taxable constructive dividends

Stock Options

• "Nonstatutory stock options" - Options not qualifying for favorable tax treatment under a specific code provision; i.e., qualified, incentive, employee stock purchase, and restricted stock options
• Nonstatutory stock options are taxed at ordinary income rates at the time they are granted
• The options are considered compensation for services
• If acquired under a nonstatutory program, the employee may be taxed when the option is granted, exercised, sold, or when restrictions on disposition lapse

Stock Options with Readily Ascertainable Fair Market Value

• If a stock option has a readily ascertainable fair market value at the time it's granted in connection with the performance of services, the person who performed the services realizes compensation when (1) the rights of the option become transferable or (2) when the rights are not subject to a substantial risk of forfeiture
• If the option does not have an ascertainable fair market value at the time it is granted, taxation occurs when the right to receive the stock is unconditional
• The compensation taxed is the difference between the option cost and the fair market value of the stock when the optionee can receive it

Incentive Stock Options (ISOs)

• Employees may not recognize income when an incentive stock option is granted or exercised depending upon certain restrictions
• The employee recognizes long-term capital gain if the stock is sold 2 or more years after the option was granted and 1 year or more after the option was exercised
• The employer is not allowed a deduction
• Otherwise, the excess of the stock’s FMV on the date of exercise over the option price is ordinary income to the employee when the stock is sold
• The employer may deduct amount
• The gain realized is short-term or long-term capital gain
• Nonqualified stock options have two methods of reporting
• Employee stock options are not qualified if it does not meet certain requirements to be an incentive stock option
• If the option's FMV is ascertainable on the grant date:
• The employee has gross income equal to the FMV of the option
• The employer is allowed a deduction
• There are no tax consequences when the option is exercised
• Capital gain or loss is reported when the stock is sold
• If the option's FMV is not ascertainable on the grant date:
• The excess of FMV over the option price is gross income to the employee when the option is exercised
• The employer is allowed a corresponding compensation deduction
• The employee's basis in the stock is the exercise price plus the amount taken into ordinary income

Employee Stock Purchase Plans (ESPPs)

• ESPPs are employee stock option plans, generally permitting employees to buy stock in the employer corporation at a discount
• Options under ESPPs qualify for special tax treatment
• No income is recognized when the option is granted; recognition is deferred until the stock is disposed of
• If stock is disposed of after being held for the required period, the employee will realize ordinary income to the extent of the excess of the fair market value of the stock at the time the option was granted over the option price; any further gain is a capital gain
• If the stock is disposed of a value less than the value at the time the option was granted, amount of income is limited to excess of current value over the option price
• An ESPP must provide that only employees may be granted options and must be approved by the stockholders of the granting corporation within 12 months before or after the date the plan is adopted
• The option price may not be less than the smaller of:
• 85% of the fair market value of the stock when the option is granted
• 85% of the fair market value at exercise
• The option must be exercisable within 5 years from the date of grant, where the option price is not less than 85% of the fair market value of the stock at exercise
• If the option price is stated in any other terms, the option must not be exercisable after 27 months from the date of the grant
• No options may be granted to owners of 5% or more of the value or voting power of all classes of stock of the employer or its parent or subsidiary
• No employee may be able to purchase more than $25,000 of stock in any 1 calendar year
• The option may not be transferable (other than by will or laws of inheritance) and may be exercisable only by the employee to whom it is granted
• If the exercise price was less than the value of the stock upon grant and the option was exercised, the employee may have compensation income (with an offsetting deduction by the employer) upon disposition, including a transfer at death
• The compensation equals the lesser of fair market value at grant or at exercise, less the exercise price, and is added to the stock basis
• There is no offsetting deduction by the employer

Income in Respect of a Decedent (IRD)

• The filer of a decedent's income tax and estate tax returns is required to make the appropriate allocation of income related to the decedent during the year of death
• IRD is all amounts to which a decedent was entitled as gross income but that were not includible in computing taxable income on the final return
• The person had a right to receive it prior to death

IRD Exclusions

• Amounts not received by a cash-method (CM) taxpayer are excluded from the final income tax return
• Amounts not properly accrued by an accrual-method (AM) taxpayer are excluded from the final income tax return

IRD vs Not IRD

• IRD:
• Salary earned before death (cash-method)
• Collection after death of A/R (cash-method)
• Gain on sale of property received NOT before death (cash-method)
• Rent accrued but not received before death (cash-method)
• Interest on installment debt accrued before death (cash-method)
• Installment income recognized after death on contract entered into before death
• Not IRD:
• Salary earned and accrued (accrual method)
• Collection of A/R (accrual method)
• Gain on sale of property received before death
• Rent received before death
• Interest on installment debt accrued after death (accrual method)
• Installment contract income recognized before death
• The cash method applies to income once designated IRD
• IRD is reported as if the recipient were the decedent
• IRD received by a trust or estate is fiduciary income
• A right to receive IRD has a transferred basis
• The basis is not stepped up to FMV on the date of death, as is generally the case for property acquired from a decedent
• IRD has the same character and tax status it would have had in the hands of the decedent
• IRD is taxable as income to the recipient and is includible in the gross estate; double tax is mitigated by deductions

IRD Deductions

• Deductions in respect of a decedent
• Expenses accrued before death, which were not deductible because the decedent used the cash method, are deductible when paid if otherwise deductible
  • They are deductible on the return of the taxpayer reporting the IRD (Form 1041)
  • They are also deductible on the estate tax return (Form 706)
• Deduction for estate tax: Estate taxes attributable to IRD included in the gross estate are deductible on the recipient's income tax return
  • Administrative expenses and debts of a decedent are deductible on the estate tax return [Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return]
  • Some may also be deductible on the estate's income tax return (Form 1041, U.S. Income Tax Return for Estates and Trusts)
  • Double deductions are disallowed
  • The right to deduct the expenses on Form 706 must be waived in order to claim them on Form 1041
• A deduction (on Form 1041) is allowed for any excess of the federal estate tax over the amount of the federal estate tax if the IRD had been excluded from the gross estate

Tax Returns that Report IRD

• The decedent's estate (Form 1041), if the estate receives a right to the income
• The beneficiary's Form 1040, if the right to income out of the decedent’s death is passed directly to the beneficiary, and is never acquired by the decedent's estate
• The Form 1040 of any person to whom the decedent's estate properly distributes the income
• The decedent's final Form 1040 would not include IRD