Chapter 5: Gross Income and Exclusions PDF

**Chapter 5: Gross Income and Exclusions** **LO 5-1: Realization and Recognition of Income** **LO 5-2: Types of Income** **LO 5-3: Exclusion Provisions** **LO 5-1: Realization and Recognition of Income** Chapter 5 begins to answer a question...What is included in gross income? What does the IR...

**Chapter 5: Gross Income and Exclusions** **LO 5-1: Realization and Recognition of Income** **LO 5-2: Types of Income** **LO 5-3: Exclusion Provisions** **LO 5-1: Realization and Recognition of Income** Chapter 5 begins to answer a question...What is included in gross income? What does the IRC say about gross income? \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ **61(a)[General Definition]{.smallcaps}.---** Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items: **61(a)(1) **Compensation for services, including fees, commissions, fringe benefits, and similar items; **61(a)(2) **Gross income derived from business; **61(a)(3) **Gains derived from dealings in property; **61(a)(4) **Interest; **61(a)(5) **Rents; **61(a)(6) **Royalties; **61(a)(7) **Dividends; **\[61(a)(8) **Alimony and separate maintenance payments;\] -- Prior to TCJA 2017 **61(a)(8) **Annuities; **61(a)(9) **Income from life insurance and endowment contracts; **61(a)(10) **Pensions; **61(a)(11) **Income from discharge of indebtedness; **61(a)(12) **Distributive share of partnership gross income; **61(a)(13) **Income in respect of a decedent; and **61(a)(14) **Income from an interest in an estate or trust. \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ Any additional insight provided by the Treasury Regulations? \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ **Regulation,§1.61-1. Gross income** **(a)*General definition*.---** Gross income means all income from whatever source derived, unless excluded by law. Gross income includes income realized in any form, whether in money, property, or services. Income may be realized, therefore, in the form of services, meals, accommodations, stock, or other property, as well as in cash. Section 61 lists the more common items of gross income for purposes of illustration. For purposes of further illustration, § 1.61-14 mentions several miscellaneous items of gross income not listed specifically in section 61. Gross income, however, is not limited to the items so enumerated. Always remember our baseline assumption the ALL INCLUSIVE INCOME CONCEPT - ALL income is gross income, unless the IRC specifically says otherwise - See Ch. 5 Discussion Q and A \#s 1-6 - Also know: economic benefit, realization principle, wherewithal to pay A few other concepts we should discuss... - **Return of Capital Principle**: when a TP sells property, the TP is allowed to recover the cost of the property tax-free - Cost or initial investment in property is known as [tax basis] - Example: TP purchased land in 20X0 for \$100,000 and sold it in 20X5 for \$150,000...what is included in gross income? \$50,000 in 20X5 - **Tax Benefit Rule**: if a portion of an expenditure that was deducted in a prior tax year is refunded, the refund is included in gross income in the year of receipt - Example: Business deducts \$1,000 for the purchase of supplies on its 20X0 tax return, but receives a \$250 rebate on the supplies in 20X1. - **Assignment of Income Doctrine**: prevents TPs from transferring taxation of their income to other TPs - Example: Erin earned \$10,000 in 20X0 by renting her beach house. She gave all of the money earned to her daughter, Bonnie. Who reports the income? - **Accounting Method**: all TPs must choose an accounting method - Accrual: recognize income when earned, deduct expenses when incurred - Cash: recognize income when it is received, deduct expenses when paid - **Constructive Receipt Doctrine**: Cash basis TPs realize and recognize income when it is actually or constructively received - Income is unconditionally available to the TP and the TP is aware - Example: John, a CEO, received a year-end bonus check in the mail on December 28, 20X0. He decided to wait until after January 1, 20X1 to deposit the check, hoping to delay recognition of the income. - **Claim of Right Doctrine**: income is realized if a TP receives the income and there are no restrictions on the TP's use of the funds - Potential need or no need to pay back claim of right income - Example: Employee receives a \$10,000 bonus in early-20X1 because the company met an important earnings target in 20X0. The bonus does not have restrictions, but does have a "claw-back" provision -- if 20X0 earnings are restated, Employee might be required to repay the bonus. See Form 1040: - The first 9 lines of Form 1040 are dedicated to items of gross income - Line 8 of Form 1040 references Schedule 1...additional form for other types of income. **LO 5-2: Types of Income** We will split gross income into 3 categories: 1. Income from Services 2. Income from Property 3. Other Sources of Income Income from **services** (AKA earned income): income generated by the efforts of a TP - Salaries, wages, tips, etc. - Reported *to* individual TP on Form W-2 (source form) - Reported *by* individual TP on Form 1040, Page 1 (T/R form) - Fees earned through self-employment, including income from illegal activities - Possibly reported *to* individual TP on Form 1099-NEC (source) - prior to 2020 on Form 1099-MISC - Reported *by* individual TP on Schedule C (T/R) - Unemployment compensation (must INCLUDE in gross income) - Reported to individual TP on Form 1099-G (source) - Reported by individual TP on Schedule 1 (T/R) Income from **property** (AKA unearned income): earnings from investments and gains/losses - Interest income (bank accounts, bonds, etc.) and dividend income (stocks) - Reported *to* individual TP on Form 1099-INT / Form 1099-DIV (source) - Reported *by* individual TP on Schedule B to Form 1040 (T/R), if required - Income from rental and royalty-producing activities - Rental of residential and nonresidential buildings, land, machinery, etc. - Royalties produced through oil wells, mining operations, etc. - Reported *by* individual TP on Schedule E, Part 1 (T/R) - Income from annuities (more later) and other retirement-related sources - Reported *to* individual TP on Form 1099-R (source) - Reported *by* individual TP on Form 1040, Page 1 (T/R) - Gains and losses from disposing of property generating unearned income (addressed in Ch. 7) **Other sources** of income: - Income from flow-through entities (more later) - Reported *to* individual TP on Schedule K-1 (source) - Reported *by* individual TP on Schedule E (T/R) - Alimony (more later) - Reported *by* individual TP on Schedule 1 (T/R) - Prizes, awards, and gambling winnings - Reported *by* individual TP on Schedule 1 (T/R) - Social Security benefits (more later) - Amount included in gross income ranges from 0 -- 85% (never more than 85%) - At least 15% of benefits will be EXCLUDED from income - Reported *to* individual TP on Form SSA-1099 (source) - Reported *by* individual TP on Form 1040, Page 1 (T/R) - Imputed income -- can read pg. 5-19 about bargain purchase & below market loans - Discharge of indebtedness -- can read pgs. 5-20 to 5-21 More on **annuities**: **Annuity**: investment that pays a stream of equal payments over time - Return of capital principle allows TP to recover amount invested tax-free - Some of each payment is return of capital and some is to be included in gross income - If TP dies before recovering full investment, remaining investment is deducted on final T/R - Timing of payments: - Can be paid over a fixed period of time \ [\$\$Annuity\\ Exclusion\\ Ratio = \\ \\frac{\\text{Original\\ Investment}}{\\text{Expected\\ Value\\ of\\ Annuity}} = Return\\ of\\ Capital\\ Percentage\$\$]{.math.display}\ Expected value of annuity = number of payments expected \* payment amount Payment amount \* return of capital percentage = amount NOT included in gross income - Can be paid over a person's lifetime - Still use the annuity exclusion ratio, but... - Expected value of annuity is based on life expectancies - If TP receives payments **after** investment is fully recovered, subsequent payments are fully taxable - Only covering the case of a single-life annuity (not responsible for joint-life) Example: Emily purchased an annuity from a life insurance company several years ago. The annuity promised to pay her \$25,000 per year for 15 years. Emily paid \$300,000 for the annuity, and she is schedule to receive the first payment during the current tax year. How much of the first payment must Emily include in gross income? What if Emily dies after receiving 5 payments from the insurance company? What if the facts are the same, except that Emily will receive \$25,000 per year for life when she reaches age 70? What if Emily lives long enough to receive a 17^th^ payment of \$25,000 from the life insurance company? More on **Social Security benefits**: - **0% to 85%** of Social Security benefits received must be INCLUDED in income - The amount included depends on: - Filing status - "**Modified AGI**" = AGI + tax-exempt interest + foreign income excluded + a few other (less-common) adjustments - The amount of Social Security benefits received - Single (see textbook for MFJ and MFS): - SS benefits are NOT included IF **Modified AGI + 50% of SS benefits** is **\$25,000 or less** - For **Modified AGI + 50% of SS benefits** from **\$25,001 to \$34,000**, include lesser of: - 50% of SS benefits received, OR - 50% of (modified AGI + 50% of SS benefits -- \$25,000) - IF **Modified AGI + 50% of SS benefits** **\> \$34,000**, include lesser of: - 85% of SS benefits received, OR - 85% of (modified AGI + 50% of SS benefits - \$34,000), plus lesser of: - \$4,500, OR - 50% of SS benefits **Example**: David (single) received \$13,500 in Social Security benefits this year. What amount of these SS benefits must David include in current year income under the following scenarios? - David also received \$8,200 in wages, \$500 in interest on corporate bonds, and \$250 in interest on municipal bonds - **Modified AGI + 50% of SS benefits** = \$8,200 + \$500 + \$250 + (50% \* \$13,500) = \$15,700 - Amount included = \$0 - David also received \$23,000 in wages, \$500 in interest on corporate bonds, and \$250 in interest on municipal bonds - **Modified AGI + 50% of SS benefits** = \$23,000 + \$500 + \$250 + (50% \* \$13,500) = \$30,500 - Amount included is lesser of: - 50% \* \$13,500 = \$6,750 - 50% \* (\$30,500 - \$25,000) = \$2,750 included - David also received \$51,000 in wages, \$500 in interest on corporate bonds, and \$250 in interest on municipal bonds - **Modified AGI + 50% of SS benefits** = \$51,000 + \$500 + \$250 + (50% \* \$13,500) = \$58,500 - Amount included is lesser of: - 85% \* \$13,500 = \$11,475 included - 85% \* (\$58,500 - \$34,000) + \$4,500 = \$25,325 - From above: Lesser of: \$4,500, OR - 50% \* \$13,500 = \$6,750 More on **income from flow-through entities**: - Flow-through entity: legal entity such as a partnership, limited liability company, or S corporation, which does NOT pay federal income tax - Entity reports income, deductions, and other items on an INFORMATION return - Income and deductions flow through to entity's owners (partners, shareholders) - Owners report share of entity's income and deductions on individual income tax returns More on **alimony**: - **Alimony:** a support payment of cash made to a former (or soon-to-be former) spouse - If divorce was settled before January 1, 2019: - Alimony received is included in gross income - Alimony paid is deductible for AGI - If divorce was settled after December 31, 2018: - Alimony received is EXCLUDED from gross income - Alimony paid is NOT DEDUCTIBLE - Other non-alimony payments are NOT income if received, NOT deductible if paid - Property divisions (splitting assets or funds from selling assets like home, vehicles, etc.) - Child support payments specifically fixed by divorce agreement - Portions of alimony payments scheduled to end at specific moments in the future Sally and Bob are married and have four children together. They divorced in 2017. Sally pays Bob alimony of \$10,000 per month, which will be reduced to \$8,000 per month when the youngest child reaches age 18. What are the tax consequences? For Sally? For Bob? What if the divorce settled in 2020? **LO 5-3: Exclusion Provisions** All Inclusive Income Concept said everything is income unless the IRC provides a specific exclusion IRC Sections 101 through 140 cover these specific exclusions Congress has created these provisions for **two main reasons**: 1. To subsidize and encourage certain activities 2. To be fair to taxpayers (mitigate double taxation, help sick and injured) 3 common exclusions: 1. **Exclusion of interest on municipal bonds** (those issued by state and local governments in U.S) a. Interest on bonds issued by U.S. government is INCLUDED in income b. Why the exclusion? Allows states and municipalities to pay lower interest rates 2. **Exclusion of gain on the sale of a personal residence** c. Exclude up to \$250,000 (\$500,000 if MFJ) gain on sale of home d. Subject to several limitations -- ownership test, use test, and tax law limits each TP to one exclusion every two years. 3. **Fringe Benefits** e. Noncash benefits provided to an employee as additional compensation f. "Qualified" fringe benefits are excluded from gross income (See Exhibit 5-3 for common examples) -- more in Chapter 12 g. Employee expense reimbursements -- if the employer's reimbursement plan qualifies as an **accountable plan**, employees exclude expense reimbursements from gross income (p. 5-23) Other exclusions: - **Education-related exclusions** - Scholarships may be **EXCLUDED IF**: - Used for tuition, fees, books, supplies, other equipment REQUIRED for courses - Scholarships for room and board (meals, dorm) NOT excluded - Scholarship amounts in excess of tuition and fees NOT excluded - Recipient is NOT required to perform services in exchange for the scholarship - "Scholarships" that represent compensation NOT excluded - However, tuition waivers or reductions for student employees, teaching or research assistants NOT TAXABLE - Any compensation for name, image, and likeness (NIL) is taxable - Other educational subsidies -- may exclude earnings from following investments as long as the earnings are used to pay for qualifying educational expenditures: - 529 plans - Coverdell education savings accounts - **Exclusions that mitigate double taxation** - Gifts and Inheritances: generally subject to a transfer tax (gift or estate tax), but NOT subject to income taxation - Gift: property transferred to recipient before transferor's death - Inheritance: property transferred to recipient after transferor's death - Life Insurance Proceeds: generally excluded from income, but... - If paid in installments, some of each payment is included in income as interest - If life insurance is sold to 3^rd^ party for consideration, the 3^rd^ party must INCLUDE the death benefit received in excess of the amount invested in gross income - Foreign Earned Income - TPs earning income abroad choose from two options: - Exclude income from U.S. income taxation, up to a limit - Include income in U.S. income taxation, claim itemized deduction OR Foreign Tax Credit - **Sickness and injury-related exclusions** - Workers' compensation payments: always EXCLUDED - Payments associated with personal injury - EXCLUDE compensatory damage payments tied to a physical injury/sickness - INCLUDE compensatory damage payments NOT tied to physical injury/sickness - Always INCLUDE punitive damage payments - Health care reimbursement: always EXCLUDED if for medical expenses - Disability insurance - IF TP purchases private plan (not through employer) or has premiums paid by employer included in taxable compensation, benefits are EXCLUDED - IF TP receives coverage through employer as a nontaxable fringe benefit, benefits are INCLUDED Knowing the forms and schedules associated with filing tax returns is important...you'll be expected to know the purpose of each of the following: Tax Forms: - Form 1040 - Schedule 1 - Schedule B - Schedule C - Schedule E - Form 1065 (includes Schedules K-1) - Form 1120-S (includes Schedules K-1) Source Documents: - Form W-2 - Form 1099-INT - Form 1099-DIV - Form 1099-R - Form SSA-1099 - Form 1099-MISC and Form 1099-NEC - Form 1099-G - Schedule K-1