ACCT 351: Federal Tax Law Ch5: Gross Income and Exclusions PDF

C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H ACCT 351: Federal Tax Law Ch5: Gross Income and Exclusions Federal Tax Law by Professor Lee...

C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H ACCT 351: Federal Tax Law Ch5: Gross Income and Exclusions Federal Tax Law by Professor Lee 1  C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H Chapter 5: Gross Income and Exclusions 1. Realization and Recognition of Income 2. Types of Income 3. Exclusions Federal Tax Law by Professor Lee 2 What is Included in Gross Income C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H 1) Definition of gross income for tax purposes a) §61(a) – Except as otherwise provided in this subtitle, gross income means all income from whatever source derived. b) Reg. §1.61-(a) – Gross income includes income realized in any form, whether in money, property, or services. 2) Taxpayers recognize gross income when a) They receive an economic benefit (Economic benefit) i. Ex) compensation for services, income from investments (e.g., interest, dividends, rents, etc.) ii. Borrowed money represents a liability, not gross income b) They realize the income (Realization principle) i. Taxpayer engages in a transaction with another party ii. Transaction results in a measurable change in property right. c) No specific exclusion or deferral (Recognition) i. Excluded income is never taxed ii. Deferred income is taxed when recognized in a subsequent year Federal Tax Law by Professor Lee 3 Other Income Concepts C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H 1) Form of receipt: Cash, property, or services a) Taxpayers have the legal and ethical responsibility to report realized income no matter the form of its receipt or whether the IRS knows the taxpayer received the income. 2) Return of capital principle: a) In general, the cost of an asset is its tax basis b) Return of capital means the tax basis is excluded when calculating realized income i. Because return of capital does not represent an economic benefit c) Thus, gains from the sale or disposition of an asset is included in realized income 3) Recovery of amounts previously deducted: a) Individuals typically claim deductions in the year paid b) Deductions may sometimes be reimbursed or refunded by the government in a subsequent year c) 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 Federal Tax Law by Professor Lee 4  C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H Federal Tax Law by Professor Lee 5 Example 5-1 C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H In April, Gram used part of the life insurance proceeds she received from Gramps’s death to purchase 50 shares in Acme Corporation for $30 per share. From April to the end of December, the value of the shares fluctuated between $40 and $25, but on December 31, the shares were worth $35. If Gram does not sell the shares, how much income from her stockholdings in Acme Corporation does she realize for the year? Answer: $0. $0 Gram does not sell !. Unless Gram sells the stock, she does not enter into a transaction resulting in a measurable change of property rights with a second party. Thus, she does not realize income even though she experienced an economic benefit from the appreciation of the stock from $30 per share to $35 per share. Federal Tax Law by Professor Lee 6 Example 5-2 C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H What if: Suppose during March, Gram paid no rent to her neighbor (also her landlord). Although the neighbor typically charges $750 per month for rent, he allowed Gram to live rent-free in exchange for babysitting his infant son. What income would Gram and Gram’s neighbor realize and recognize on this exchange? Answer: $750. $750 Gram and the neighbor each would recognize $750 of income for March. The neighbor recognizes $750 of rental receipts because this is the value of the babysitting services the neighbor received in lieu of a cash payment for rent from Gram (an economic benefit the neighbor realized through the exchange). Gram recognizes $750 of babysitting income, because this is the value of the services provided to her neighbor (an economic benefit was realized because Gram was not required to pay rent). Federal Tax Law by Professor Lee 7 When to Recognize Income C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H 1) Individual taxpayers file tax returns for a calendar-year period a) Corporations often use a fiscal year-end b) The method of accounting generally determines the calendar year in which realized income is recognized and included in gross income. a) They're financial reporting 1 2) Accounting methods b) tax method vs accrual method a) Corporations: accrual method of accounting -. So individual Often 2 use cash method. b) Individuals: cash method so when for expense you pay meaning you 3) Receipt of income can deduct but, you receive income that's When Accrual a) Actual receipt you recognize income. b) Constructive receipt Methodisusedfor taxreturnfor corp a i. Income is unconditionally available to taxpayer ~. If it's 3 not in hand , you're still ii. Taxpayer is aware of the income’s availability your receiving. income iii.No restriction on the taxpayer’s control over the income Federal Tax Law by Professor Lee 8 Example 5-4 C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H Courtney is a cash-method taxpayer. Based on her outstanding performance, Courtney earned a $4,800 year-end bonus. On December 28, Courtney’s supervisor told her that her bonus was issued as a separate check and that Courtney could pick up the check in the accounting office anytime. Courtney did not pick up the check until January 2 of the next year, and she did not cash it until late January. When does Courtney realize and recognize the $4,800 income? on Dec 28. Answer: On December 28 of the tax year in question. Courtney constructively received the check that year because it was unconditionally available to her on December 28, she was aware of the check’s availability, and there were no restrictions on her control over the check. Courtney must include the $4,800 bonus in gross income for that year, even though she did not actually receive the funds until late January of the next year. Note: Courtney’s employer would include her bonus in Courtney’s W-2 for the year in which it issued the check. Federal Tax Law by Professor Lee 9 Types of Income C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H. Business income is ordinary. income 1) Income from services (earned income) 1 2 : interest income a) Wages, salaries, tips, etc.; attach W-2 , by investing in bonds or you Put your money into money market or savings b) Business (self-employed) income; attach Schedule C account , not ordinary income. 2) Income from property (unearned income) 1099-INT reported form a) Interest b) Dividends c) Gains or losses from sale of property d) Rents, royalties e) Annuities 3) Income from other sources a) Alimony i. For any divorce or separation agreement executed before January 1, 2019 b) Income from flow-through entities c) Prizes, awards and gambling winnings d) Social security benefits e) Discharge of indebtedness Federal Tax Law by Professor Lee 10 Types of Income (2) C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H 1) Income from services a) Income from labor most common source of gross income b) Generated by the efforts of taxpayer c) Wages, salaries, tips, etc.– attach W-2 d) Business (self-employed) income - attach Schedule C i. We will discuss more in detail in Chapter 9 2) Income from property a) Interest i. Reported on Form 1099-INT ii. Amount recognized in GI = full amount of interest received iii. Tax exempt interest a. Interest received from state and local government bonds is NOT taxed Federal Tax Law by Professor Lee 11 Example 5-7 C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H EWD pays Courtney a salary of $158,000. In addition, Courtney earned and received $19,500 in fees from consulting work she did on weekends independent of her employment with EWD. She incurred $1,500 in miscellaneous expenses for supplies and transportation while doing the consulting work. What is Courtney’s total income from services (earned income), from her employment and from her self-employment activities? + 500 $177 500 (1 500) = 000 158 19 = $) 000 , , , , , Answer: $176,000 $158,000 salary + $19,500 business income - $1,500 of expenses related to her business. Note that business deductions are for AGI deductions that taxpayers subtract from their gross business income to derive net business income or loss reported on Schedule 1 (line 3) of Form 1040. We discuss for AGI deductions in greater detail in Ch 6. Individual Deductions Federal Tax Law by Professor Lee 12 Example 5-9 C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H Gram purchased a $100,000, three-year certificate of deposit (CD) with a portion of the life insurance proceeds she received on Gramps’s death. At year-end, her CD account is credited with $4,100 of interest, and her savings account is credited with $650 of interest. Courtney had a total of $271 of interest credited to her savings account and $50 credited to her checking account during the year. How much interest must Gram and Courtney include in their gross income for the year? Gram Courtney Answer: M Gram must recognize $4,750 (= $4,100 + $650) $4 100 , 271 #s Courtney must recognize $321(= $271 + $50) $4 , 750 e Federal Tax Law by Professor Lee 13 Types of Income (3) C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H b) Dividend i. Distributions made to shareholders from a corporation’s after-tax earnings a. Normally reported on Form 1099-DIV · if you purchase stocks then you will , receive dividends from the ii. Amount recognized in GI = full amount of dividend received - company dividend income Not is Capital gain iii. Types of dividends · - · if you have qualified income then you a. Cash and property dividends , will be subject to double taxation. for qualified 1. Exception: Stock dividends (excluded from gross income) long period time income, you have to invest in iv. Tax rates on dividends - -dividend comes from their net income a. Ordinary dividends taxed at taxpayer’s marginal tax rate -Stock dividends NOT taxable is b. Qualified dividends EX YOU are MFF have $)look a receive : ordinary income , an qualified dividend of a 1. Dividends are qualified if: $5K so gross income $105K , due is. 15 % 1) They are received from a domestic, taxable entity or qualified foreign entity and toincome the ordinary will be 2) Taxpayer holds stock for more than 60 days during the 121-day period beginning multiplied by $5K 60 days before ex-dividend date 2. At preferential tax rates depending on the taxpayer’s filing status and amount of taxable income Federal Tax Law by Professor Lee 14 Types of Income (3) C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H Federal Tax Law by Professor Lee 15 Example 5-8 C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H Courtney owns 1,000 shares of Home Depot stock that she registered in a dividend reinvestment plan. Under this plan, all dividends are automatically used to purchase more shares of the stock. This year, Home Depot declared and paid $700 in dividends on Courtney’s stock. Must Courtney include the dividend in her gross income for the year? Answer: Yes. Courtney includes the $700 of dividends (unearned income) in her gross income. The fact that Courtney chose to reinvest the dividends does not affect their taxability because she received an economic benefit and change in property rights associated with the dividend. Federal Tax Law by Professor Lee 16  Types of Income (4) C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H c) Gains or losses from sale of property i. Realize a gain or loss when disposing of an asset ii. Gain/(Loss) realized (not necessarily recognized) = Sales proceeds – selling expenses – tax basis in property iii. Amount recognized in GI = gain/loss NOT subject to exclusion or deferral provisions iv. We will learn more in detail in Chapter 11 d) Rental income – attach Schedule E i. Rental property or partially personal/rental property ii. Amount recognized in AGI = Rental income received – operating expenses – depreciation a. Recognize ALL rental income received in GI b. Offset rental income with rental-related expenses, including depreciation as deductions for AGI 1. Mortgage interest, property taxes, HOA dues, repairs and maintenance, utilities, etc. for depends the type of property you sale * if lived about 10 years it will be Ordinary * Depreciation deduction is huge thing in rental - · on a if it's business Property ; EX : Warehouse then · selling expense : you pay your real Estate agent , it investments , you get all of tax benefits by deducting the becomes an ordinary income depreciation in rental property Ex : sales proceeds - D , 000 $900 which equals the expense - (10 , 000) ordinary tax rate Selling Tax basis D500 - 000 , Capital Gain - $390 000 , Federal Tax Law by Professor Lee 17 Example 5-12 C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H On December 31, Gram sold her 50 shares of Acme Corporation stock for $40 per share. Gram also paid $150 in broker’s commissions on the sale. Gram originally purchased the shares in April of this year for $30 per share. How much gross income does Gram recognize from the stock sale? Answer: Gram recognizes $350 gross income on the sale, computed as follows: Sales (50 x $40) = $2 , 000 expense (150) (50X$30) So Tax Basis Federal Tax Law by Professor Lee 18 Example 5-10 C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H Courtney owns a condo in town that she rents to tenants. This year, the condo generated $14,000 of rental revenue. Courtney incurred $4,000 in real estate taxes, $2,500 in utility expenses, $500 in advertising expenses, and $2,000 of depreciation and other expenses associated with the rental. What effect does the rental have on Courtney’s gross income? What effect does the rental have on Courtney’s taxable income? Answer: The rent increases Courtney’s gross income by $14,000. Courtney will deduct her allowable deductions for the rental (i.e., $4,000 +2,500 + 500 +2,000 = $9,000). Courtney will report only $5,000 of taxable income from rental activities. Federal Tax Law by Professor Lee 19 Types of Income (5) C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H e) Annuity i. An investment that pays a stream of equal payments over time a. Fixed payment to insurance company in return for periodic payments over time b. Insurance company invests proceeds to fund future annuity payments ii. Formula: Prorate payment between return of capital (nontaxable) and gross income (taxable) a. Expected Value of Annuity (EVA) 1. For a fixed term annuity, EVA = annual payment amount * number of payments 2. For a life annuity, use IRS tables to determine the expected value b. How much should you include in gross income? 1. Amount recognized in GI = (1- annuity exclusion ratio) * annuity payments during the year Federal Tax Law by Professor Lee 20 if you purchase annvity from an interest company they will give , you a stream of money when you are at a certain aged beyond - you will first have to pay them to get that -Annuity They will get your investment account. Ex : You purchased $100k,this interest company will invest that $100K into money generating investment & they will generate that gain on investment a that's how they fund that annuity - to you. · EX : original investment ; $100K &10 years later You will get $10 , 000 per year for 20 years , so your expected value of annuity will be $200K So the exclusion , ratio will be L 50 % & You only need to pay taxes on the $5 , 000 /gross income) which is a portion on annuity.  * Will Example 5-11 be Exam C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H In January of this year, Gram purchased an annuity from UBET Insurance Co. that will pay her $10,000 per year for the next 15 years. Gram received the first $10,000 payment in December. Gram paid $99,000 for the annuity and will receive $150,000 over the life of the annuity (15 years × $10,000 per year). How much of the $10,000 payment received by Gram in December should she include in her gross income? -$99 , 000 = $150 , 000 = 66 % /0 66. Investment annuity = Return expected Capital/ value of of Exclusion Ratio Original = = Answer: $3,400 Expected value of annual Payment annuity = # of Payments amout x 1) Exclusion ratio= $99,000/$150,000 = 0.66 = 66% Amount Recognized 6I =(1-anniston ratio) XannityPaymena in Y 2) Inclusion amount = (1 - 0.66)*$10,000 = $3,400 (1 66) -0. x $10 , 000 = $3 400, What if: The annuity pays Gram $1,000 per month for the next 15 years, and she received her first $1,000 payment in December of this year. How much should Gram include in her gross income? 1) Exclusion ratio= $99,000/$180,000 (=$1,000*12*15) = 0.55 = 55% 2) Inclusion amount = (1 - 0.55)*$1,000 = $450 Federal Tax Law by Professor Lee 21 Types of Income (6) C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H 3) Income from other sources a) Alimony payment received i. For tax purposes alimony is defined as: a. A transfer of cash made under a written separation agreement or divorce decree 1. The separation or divorce decree does not designate the payment as something other than alimony 2. The spouses do not live together when the payment is made 3. The payments cannot continue after the death of the recipient b. Property divisions and child support payments do not qualify as alimony ii. Amount recognized in GI = full amount of alimony received a. Note: Spouse paying alimony can deduct payments made as deduction for AGI iii. Alimony payments are NOT included in the gross income for a person receiving alimony and are NOT deductible by a person paying alimony for any divorce or separation agreement executed after December 31, 2018. Federal Tax Law by Professor Lee 22 Example 5-14 & 5-15 C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H In addition to paying child support, under the divorce decree executed in 2023 Al is required to pay Courtney $20,000 cash each year until she dies. The decree does not designate this amount as a payment for something other than alimony, and Al and Courtney do not live together. Does this payment qualify as alimony? Answer: Yes, because 1) the payment is made in cash, 2) the payments are not designated as something other than alimony, 3) Al and Courtney do not live together, and 4) the payments cease on Courtney’s death. In the current year, Al made a $20,000 alimony payment to Courtney. Because their divorce agreement was executed in 2023, Courtney does not include the $20,000 in her gross income, and Al does not treat the payment as a deduction for AGI Suppose that Courtney and Al’s divorce agreement was executed in 2018. What amount of the $20,000 payment would Courtney include in her gross income and would Al deduct? Answer: $20,000. Because the divorce agreement was executed before January 1, 2019, Courtney would include the $20,000 payment in gross income, and Al would treat the payment as a deduction for AGI. As required by the divorce decree, Al made $10,000 in child support payments during the year to Courtney to help her support Deron. Al is required to make child support payments until Deron is 18 years old. Is the current-year payment considered alimony? Answer: No, because the divorce decree specifies that the payments are for child support. Thus, Courtney does not include these payments in her gross income, and Al does not deduct them. Federal Tax Law by Professor Lee 23 Types of Income (7) C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H b) Flow-through/pass-through income – attach Schedule E part 2 i. Partnerships/S-corporations a. Flow-through entities as they do not pay income tax at the entity level ii. Income and deductions of the entity “flow through” to the owners of the entity (partners/shareholders) a. Amount recognized in GI = (taxpayer’s ownership percentage) * (total partnership income – total partnership deductions) 1. Include earnings in proportion to his or her ownership percentage, as gross income 2. Normally reported on Schedule K-1 from partnership/S-corporation tax return b. Owners of flow-through entities are taxed on their share of the entity’s income whether or not cash is distributed to them. 1. When owners receive cash distributions from the entity, the distributions are generally treated as a return of capital to the extent of their investment in the entity. Federal Tax Law by Professor Lee 24 Imme through/pass through of flow : · you own a Taco business a set up a LLC/partner- Ship - I invest $90 , 000 a my partner invest $10k so I get 90 % of ownership & my Partner gets 101 -from calculating of the (Rev -deductions = Profit) * 90% ,. profit will go to me & 10 % to my Partner AND we each pay our own percentages of the taxes. EX : 90% /$200 , 000 - 100 , 000) = , 000 90 & my own tax 10% /$200 000 100 , 000) marginal 000 rate - = , 10 , & my partner's own this will be marginal tax rate - ordinary income. -will receive a k-1 -you don't pay tax on return of Capital. If you receive cash , you are receiving your investment back , So you don't include it in your gross income Example 5-13 C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H Suppose that Courtney is a 40 percent partner in KJZ partnership. KJZ reported $20,000 of business income and $3,000 of interest income for the year. KJZ also distributed $1,000 of cash to Courtney. What amount of gross income from her ownership in KJZ partnership would Courtney report for the current year assuming her tax basis in KJZ is $15,000 before considering the distribution? Answer: $9,200 40%*($20,000 + 3,000) = $9,200 $1,000 are not included in her gross income because it is considered as a return of her investment. Federal Tax Law by Professor Lee 25  Types of Income (7) C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H income taxable ; have to include in gross c) Prizes, awards, and gambling winnings - i. Amount recognized in GI = fair market value of prize or award ii. Excluded only if made a) For scientific, literary, or charitable achievement such as Nobel Prize * if you receive an a) Only if (1) the recipient was selected without any action on his part (2) the recipient is not achievement bonus , then You can exclude it in GI required to render substantial future services as a condition to receive the prize or award, and UNLESS it's a gift card etc. , (3) the payer of the prize or award transfers the prize or award to a federal, state, or local governmental unit or qualified charity b) For employee length of service or safety achievement ($400 limit per employee per year) a) Exception: cash, cash equivalents, gift cards, gift coupons or gift certificates, or vacations, meals, lodging, tickets to theater or sporting events, stocks, bonds, other securities, and other * If you win money when similar items have to gambling , you report taxes on the c) To Team USA athletes from U.S. Olympic Committee on account of their competition in winning for GI BUT , you. Olympic and Paralympic games (AGI limit applies - $1mil for MFJ) can deduct the loss as itemized iii. Gambling winnings deduction. a) Taxpayer is allowed to deduct their gambling losses up to their gambling winnings, but the losses are usually deductible as miscellaneous itemized deductions Federal Tax Law by Professor Lee 26 Example 5-17 C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H After devoting much of her free time during the year to filling out sweepstakes entries, Gram hit the jackpot. She won a WaveRunner worth $9,500 in a sweepstakes sponsored by Reader’s Digest. How much of the prize, if any, must Gram include in her gross income? Answer: Gram must include the full $9,500 value of the WaveRunner in her gross income. $9 , 500 Federal Tax Law by Professor Lee 27 Types of Income (8) C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H d) Social security benefits i. Amount recognized in GI: depends on modified AGI (MAGI) and filing status a. MAGI = AGI excluding social security benefits, adding tax-exempt interest and foreign earned income, if any ii. Three possibilities a. IF MAGI + ½ Social security benefits NO amount recognized b. IF $25,000 ($32,000 for MFJ) < MAGI + ½ Social security benefits for MFJ) THEN recognize LESSER of 50% SSB or 50% (MAGI + ½ SSB – $25,000 ($32,000 for MFJ)) c. IF $34,000 ($44,000 for MFJ) < MAGI + ½ Social security benefits THEN recognize LESSER of: 85% (MAGI + ½ SSB– $34,000 ($44,000 for MFJ)) + 85% SSB or LESSER of ½ SSB or $4,500 ($6,000 for MFJ) d. MFS: lesser of 85% SSB or 85% (MAGI + ½ SSB) Federal Tax Law by Professor Lee 28 Example 5-18 3 C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H Gram received $7,200 of Social Security benefits this year. Suppose that Gram’s modified AGI is $16,000. What amount of the Social Security benefits must Gram include in her gross income? * Not MFJ Answer: $0 What if: Assume that Gram received $7,200 of Social Security benefits this year and that her modified AGI is $26,400. What amount of benefits must Gram include in her gross income? Answer: $2,500 Federal Tax Law by Professor Lee 29  Types of Income (10) C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H from getting benefits your employer · e) Imputed Income - certain employee discounts/loans i. Certain employee discounts or low interest loans generate income via indirect benefits ii. Amount recognized in GI a. For bargain purchases, EX: If you're working for a clothing company 1. Exclude from GI amount of discount on employer-provided goods as long as the a you're getting employee discount does not exceed the employer’s gross profit percentage on all property offered an from discount , excludes it the for sale to customers and of amount as long as discount is les than 2. Exclude up to 20% employer-provided discounts on services they're margin 3. Discounts in excess of these amounts are taxable (i.e., included in GI) as compensation * if youget b. For below-market loans, the amount of imputed income (included in GI) is the difference loans , You have to pay to between the amount of interest using the applicable federal interest rate and the amount of interest your employer If the market 5 a interest the taxpayer actually pays. is % you're getting %,then 1. 2 Do not apply to aggregate loans of $10,000 or less between the lender and borrower the difference which is the 3% will be included in your 6I. UNLESS it's below , 000 then you $10 can ignore the benefits you're getting from your employer Federal Tax Law by Professor Lee 30 Example 5-19 C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H To create more space for Gram, Courtney received EWD architectural design services as part of her compensation package and at a substantial discount. EWD’s services were valued at $35,000, but Courtney was charged only $22,000. How much of the discount must Courtney include in gross income? Answer: $6,000 Federal Tax Law by Professor Lee 31 Example 5-20 C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H At the beginning of January, EWD provides Courtney with a $100,000 zero-interest loan. Assume that the applicable federal interest rate (compounded semiannually) is 4 percent. Courtney used the loan proceeds to acquire several personal-use assets (an automobile and other items). What amount is Courtney required to include in gross income in the current year? Answer: $4,000 What if: Assume the same facts except that EWD had loaned Courtney $10,000 at a zero-interest rate. How much imputed interest income would Courtney be required to include in her gross income for the year? Answer: $0 Federal Tax Law by Professor Lee 32 Types of Income (11) moneeB YoThe C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H f) Discharge of indebtedness - You lender borroways ender you The -n - it will be given to realized Income. meaning you have to include you Forgiven debt it in is pay your gross income BUT the exception is taxpayer i. A taxpayer’s debt is forgiven by a lender. ~ is insolvent meaning if you sell all your assets , and can NOT pay back All your liabilities you ii. Amount Recognized in GI = Amount of debt relief don't have to pay taxes on , your debt forgiveness iii. Exceptions: Debtor does not recognize income IF a. Taxpayer is insolvent before AND after discharge of debt b. But if the discharge makes the taxpayer solvent, the taxpayer recognizes taxable income to the extent of his solvency 1. For example, if a taxpayer is discharged of $30,000 of debt and this causes him to be solvent by $10,000 (after the debt relief, the taxpayer’s assets exceed his liabilities by $10,000), the taxpayer must include $10,000 in gross income c. Most discharges of student loans (loans for post-secondary educational expenses) after 2020 and before 2026 Federal Tax Law by Professor Lee 33 Example 5-21 C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H In the previous example, Courtney borrowed $100,000 from EWD. Because EWD wants to keep Courtney as an employee, it agreed to forgive $10,000 of loan principal at the end of each year that Courtney stays on board. On December 31 of this year, EWD formally cancels $10,000 of Courtney’s indebtedness. How much of this debt relief is Courtney required to include in gross income? Answer: $ 10,000 Federal Tax Law by Professor Lee 34 Exclusion Provisions C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H 1) To encourage particular activities a) Municipal interest income b) Gains on the sale of personal residence (§121) up to 250K (500K for MFJ) c) Certain fringe Benefits (e.g., health insurance and life insurance premium, meals on site, etc.) d) Education-related exclusions (e.g., scholarships or grants used for Tuition and fees, books, etc.) 2) To mitigate double taxation a) Gifts and inheritances b) Life insurance proceeds c) Foreign earned income 3) To support social policy a) Worker’s compensation b) Compensation for personal injury c) Health Care Reimbursement for medical expenses d) Disability Insurance Federal Tax Law by Professor Lee 35  getting benefits * that are Exclusion Provisions not included in gross income C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H 1) Congress allows certain types of income to be excluded or deferred to subsidize or encourage particular activities receive benefits from state/local gov Then get exclude your. you to it if you a) Municipal Interest T ~ * i. Bonds issued by state and local governments located in the United States a. This exclusion subsidizes the financing of state and local governments b) Gains on the sale of personal residence (§121) i. Taxpayers may exclude up to $250,000 ($500,000 if MFJ) of gain on the sale of their principal residence * if a. Must satisfy ownership and use tests renting a house you own , order in 1. A taxpayer must have owned the residence (house, condominium, trailer or to avoid paying taxes have to live your in houseboat) AND used the property as her principal residence for a total of two or , you own renting home for years ! more years during the five-year period on the date of the sale two 2. For MFJ, either spouse meets the ownership test and both spouses meet the use test. * After excluding You still have b. The tax law limits each taxpayer to one exclusion every two years a , gain which long term capital c. Any excess gain generally qualifies as long-term capital gain is a gain if lived more than a year Federal Tax Law by Professor Lee 36 Example 5-22 C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H Courtney holds a $10,000 City of Cincinnati municipal bond. The bond pays 5 percent interest annually. Courtney acquired the bond a few years ago. The city used the proceeds from the bond issuance to help pay for renovations on a major league baseball stadium. In late December, Courtney received $500 of interest income from the bond for the year. How much of the $500 interest from the municipal bond may Courtney exclude from her gross income? Answer: All $500 because the interest is from a municipal bond Federal Tax Law by Professor Lee 37 Example 5-23 C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H What if: Assume that in October of this year, Courtney sold her prior home in Cincinnati. Courtney and her ex-husband purchased the home four years ago for $400,000, and Courtney received the house in the divorce. Courtney lived in the home until she moved to Kansas City in January. Courtney sold the home for $550,000. How much taxable gain does she recognize on the sale of the home? Answer: $0. What if: Assume the same facts except Courtney sold the home for $700,000. How much taxable gain does she recognize on the sale of the home? Answer: $50,000 Federal Tax Law by Professor Lee 38 Exclusion Provisions (2) C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H these benefits they - If employers give you , c) Fringe Benefits don'tdeduct can pay their on for employees taxes on it good taxes. It is but both ways , we i. In general, employer provided benefits are included in employee’s gross income as compensation for services. a. Automobile for personal purposes, gym membership, etc. ii. Certain fringe benefits are EXCLUDED from gross income. a. Medical and dental health insurance coverage [§106] (exception: purchased through the exchange) b. Life insurance coverage [§79]: Limit up to $50,000 of group-term life insurance c. Meals provided to employees [§119]: Furnished by employer, on employer’s business premises and for the convenience of employer d. De minimis (small) benefits [§132(a)(4)] e. Employee educational assistance programs [§127]: up to $5,250 of employer-provided educational assistance benefits covering tuition, books, and fees f. Qualified employee discounts [§132(a)(3)] – see imputed income g. Etc. see exhibit 5-3 for a detailed list Federal Tax Law by Professor Lee 39 Example 5-24 & 25 C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H EWD paid $6,000 this year for Courtney’s health insurance premiums and $150 in premiums for her $40,000 group-term life insurance policy. How much of the $6,150 in benefits can Courtney exclude from her gross income? Answer: Courtney can exclude all $6,150 in benefits from her gross income. In December, Courtney mailed a newsletter to several dozen friends and relatives with a recent picture of her son, daughter, and mother. Courtney printed both the newsletter and the photos on printers at work (with permission of EWD). Courtney would have paid $55 for the duplicate newsletters and photos at a nearby copy center. How much of this $55 benefit that Courtney received from EWD may Courtney exclude from her gross income? Answer: All $55 is excluded. The $55 benefit is considered a nontaxable de minimis fringe benefit because it is small in amount and infrequent Federal Tax Law by Professor Lee 40 Exclusion Provisions (3) C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H you don't use it if those for d) Education-related exclusions purposes - then you must recognize , gross incomeit in your i. Congress excludes certain types of income if the funds are used for higher education. The purpose is to aid individual in studies or research and candidate for a degree at the educational institution. ii. Scholarships (including Pell grants) a. Recipient does NOT recognize income upon receipt IF: 1. Recipient is a candidate for a degree at an educational institution 2. The fund is used to pay for A. Tuition, fees, books, supplies and equipment required for courses at the institution b. Recipient MUST recognize income IF: 1. The fund is used for room and board, travel, and optional equipment. 2. The fund is received as payments for teaching, research, or other services required as a condition for receiving the scholarship. Federal Tax Law by Professor Lee 41 Example 5-26 C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H Ellen, Courtney’s daughter, received a $5,700 scholarship from the University of Missouri–Kansas City that pays $5,400 of her tuition and provides $300 cash for books. Ellen spent $350 on books. How much of the scholarship may she exclude from gross income? Answer: All $5,700 is excluded. What if: How much is Ellen allowed to exclude if she spent only $250 on books? Answer: $5,650 Federal Tax Law by Professor Lee 42 Exclusion Provisions (4) C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H 2) Congress allows certain types of income to be excluded to mitigate double taxation / a) Gifts and inheritances income get taxed - one you twice i. Gift and inheritances is subject to a federal transfer tax (gift tax & estate tax) i. As a general rule, for 2024, the federal gift tax does not apply to relatively small gift ($18,000 or less per person per year), and the federal estate tax only applies to transfers from larger estates (over $13,610,000). - * if you receive gift that is below $18K then the federal a , gift tax it's Life insurance proceeds does not applyIf then that person transfer tax million b) do a needs to a i. Recipient/beneficiary may exclude life insurance proceeds c) Foreign earned income if you make money - # foreign country & pay in a taxes to that foreign country you , Must report it again where you live a pay taxes AGAIN , but can be excluded from i. U.S. Citizens taxed on worldwide income regardless of where earned BUT foreign country $126 300 also taxes that income. , United States is the only * country that has worldwide income tax system ii. Taxpayer exclude foreign income IF: a. Bona-fide resident of foreign country for at least a calendar year OR b. Present in foreign country at least 330 days during any 12 consecutive months iii. Maximum exclusion is $126,500 based on 365 days a. Pro-rate exclusion IF in foreign country less than 365 days Federal Tax Law by Professor Lee 43 Exclusion Provisions (4) C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H 3) Congress allows certain types of income to be excluded due to social policy (sickness and injury-related exclusions) * if you've sick,you get benefits tax a) Worker’s compensation i. Worker’s compensation (state-sponsored) is fully excluded from GI ii. What is worker’s compensation? a. Employee is injured on the job - from excluded 6F excluded b. Medical treatment to recover from work related injuries and wage replacement while recovering iii. Note that unemployment compensation is fully included in GI - if you're looking ACTIVELY for a job b) Compensation for personal injury , can get paid you i. Compensatory damages for physical injury or physical sickness are excluded from GI. - You're riving a. Damages taxpayers receive for emotional distress related to a physical injury are excluded from GI. that money to b. Note that punitive damages are included in GI because they are intended to punish the wrong-doing recover of a person rather than to compensate the injured party. you Sue - Whoever caused the accident to c) Health Care Reimbursement for medical expenses punish him/her for the wrong doing. If the d) Disability Insurance (wage replacement insurance) judge says that person has to pay you this certain THEN taxes amount , you must pay i. If employer pays the premiums as a nontaxable fringe benefit, then taxpayer must include any disability benefits he/she receives in GI ii. If taxpayer pays the premiums, then he/she can exclude any benefits received from GI Federal Tax Law by Professor Lee 44 Example 5-30 C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H In February, Courtney’s cousin, Kelsey, was struck and injured by a bus while walking in a crosswalk. Because the bus driver was negligent, the bus company settled Kelsey’s claim by paying her $11,500 for medical expenses and $23,500 for emotional distress associated with the accident. How much of the $35,000 Kelsey received from the bus company may she exclude from her gross income? Answer: All $35,000. What if: Assume Kelsey sued the bus company and was awarded $50,000 in punitive damages. How much of the $50,000 would Kelsey be able to exclude from her gross income? Answer: $0. Federal Tax Law by Professor Lee 45 Example 5-31 C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H Courtney purchased disability insurance last year. In late April of this year, she broke her wrist in a mountain biking accident and could not work for two weeks. Courtney’s doctor bills totaled $2,000, of which $1,600 was reimbursed by her health insurance purchased by EWD. How much of the $1,600 health insurance reimbursement for medical expenses is Courtney allowed to exclude from her gross income? Answer: All $1,600 is excluded. All medical expense reimbursements from health insurance are excluded from a taxpayer’s gross income. Federal Tax Law by Professor Lee 46 Example 5-31(continued) C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H Courtney also received $6,000 for lost wages due to the accident from her disability insurance policy. How much of the $6,000 is Courtney allowed to exclude from her gross income? Answer: All $6,000 is excluded. Courtney can exclude the entire amount because she paid the premiums on the policy. What if: How much of the $6,000 payment for lost wages from the disability insurance policy would Courtney exclude if EWD paid the disability insurance premium on her behalf as a nontaxable fringe benefit? Answer: $0. What if: How much of the $6,000 payment for lost wages from the disability insurance policy would Courtney exclude if she paid half the cost of the policy personally and EWD paid the other half as a taxable fringe benefit? Answer: $6000. Federal Tax Law by Professor Lee 47 Courtney’s Income Summary C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H Federal Tax Law by Professor Lee 48 Form 1040 & Schedule 1 C A L I F O R N I A S T AT E U N I V E R S I T Y L O N G B E A C H Federal Tax Law by Professor Lee 49