Gross Income PDF

Gross Income Introduction The purpose of an examination is to determine the taxpayer’s substantially correct tax liability. The starting point in the examination is gross income. It is the revenue agent’s responsibility to establish that all items of gross income were correctly reported on the ind...

Gross Income Introduction The purpose of an examination is to determine the taxpayer’s substantially correct tax liability. The starting point in the examination is gross income. It is the revenue agent’s responsibility to establish that all items of gross income were correctly reported on the individual income tax return under examination. Gross Income Defined IRC § 61(a) defines gross income as “all income from whatever source derived” unless specifically excluded. Gross income may include: Money Property Services Benefits Sources of gross income, other than money, are included at fair market value (FMV). In certain cases, such as determining gross income from a trade or business, gross income is not the same as gross receipts which refers to revenue from sale of products or services rendered. Sources of Gross Income A Revenue Agent may encounter various sources of gross income in the examination of Form 1040 returns, including: Compensation for services, Payments other than cash, Bargain purchases, Gross income derived from businesses, Gains from dispositions of assets, Interest, Dividends, Income in respect of a decedent, Retirement income, and Bartering. Continued on next page RA Basic 1040 – C1 – PG Income: Gross and Adjusted Gross Income 31282-102 3-4 July 2020 Gross Income, Continued Compensation for Services IRC § 61(a) (1) includes compensation for services in gross income. Form W-2, Wage and Tax Statement, reports salaries and wages paid by an employer to an employee. Form W-2 includes the gross amount paid to the employee, the amounts withheld for Federal, state, and local income taxes, as well as Social Security and Medicare taxes. Income from services is not always reported on Form W-2. Form 1099-MISC, Miscellaneous Income, reports payments to self-employed persons such as outside salespersons or independent contractors. An information return (W-2, 1099, and 1098) is not a tax return but used for reporting purposes only. Sometimes, cash payments for services are made “under the table” or “off the books” and are not reported on information returns. These payments must be included in gross income. Gross income may also include certain fringe benefits provided to employees such as bonuses, meals, lodging and employer provided vehicles. Payments Other than Cash Treas. Reg. § 1.61-2(d)(1) states if services are paid for in property or other services, the fair market value of such property or other services taken in payment, must be included in income as compensation. Gross income also includes the fair rental value (FRV) of property used personally in lieu of compensation. Example 1: Beige, an attorney, performs legal services for Alder Auto Sales. As payment for her services, Alder transfers title of a car to Beige. Alder sold similar models to customers at an average price of $32,000. Beige includes $32,000 in her gross income. Continued on next page Income: Gross and Adjusted Gross Income RA Basic 1040 – C1 – PG July 2020 3-5 31282-102 Gross Income, Continued Payments Other Than Cash (continued) Example 2: Blue is a salesclerk for Fir Feed Co., owned by Fir. Blue receives an annual salary of $45,000. Fir also allows Blue and his family to spend three weeks a year in his Florida condominium. Fir normally rents the condominium to vacationers for $1,000 per week. Blue must report gross income of $48,000 – his salary ($45,000) plus the FRV ($3,000) of the condominium. Exercise 1 Red is a private duty nurse. Her patient, Birch, gives her a cruise to the Bahamas as partial payment for services provided. Birch had purchased the cruise for $1,500. Birch gives Red the remaining daily charges of $1,300 in cash. What amount is includable in Red’s gross income? Why? Answer: Continued on next page RA Basic 1040 – C1 – PG Income: Gross and Adjusted Gross Income 31282-102 3-6 July 2020 Gross Income, Continued Bargain Purchase IRC § 83 and Treas. Reg. § 1.61-2(d)(2) state that when a service provider, be it an employee or an independent contractor, receives property as compensation at less than fair market value, the difference between the fair market value of the property received and the amount paid for such property must be included in gross income. These transactions are known as “bargain purchases” because the amount paid is less than the fair market value. Example 3: Gold is the top performing sales agent for Elm Real Estate Development Co. In recognition of her outstanding performance, Elm sells Gold a home in one of its new subdivisions for $150,000. Similar models sold to customers for $225,000. Gold’s gross income must include the $75,000 difference. Gross Income Derived from Business Gross income means the total sales, less the cost of goods sold, plus any income from investments and from incidental or outside operations or sources. Example 4: White is in the retail jewelry business. In the current tax year, her total sales are $300,000. White purchased the jewelry for $200,000. Operating expenses include store rent of $25,000 and sales commissions of $60,000. The business accounts receivable earned $3,000 in interest. White’s gross income is $103,000. Sales $300,000 Interest income $3,000 Cost of goods sold ($200,000) Gross income $103,000 Continued on next page Income: Gross and Adjusted Gross Income RA Basic 1040 – C1 – PG July 2020 3-7 31282-102 Gross Income, Continued Gains From Sales of Property IRC § 61(a)(3) includes gains derived from sales or exchanges of property in gross income. Example 5: Orange sells common stock for $15,000. He purchased the stock for $12,000. Orange includes the gain of $3,000 in gross income. Continued on next page RA Basic 1040 – C1 – PG Income: Gross and Adjusted Gross Income 31282-102 3-8 July 2020 Gross Income, Continued Exercise 2 Purple operates a car wash. He received gross receipts of $500,000. He paid $400,000 operating expenses. He also received $3,000 for the car dealership’s advertisement on the side of his car wash. Purple sells his boat for $25,000. He originally purchased it for $20,000. Calculate Purple’s gross income. Answer: Continued on next page Income: Gross and Adjusted Gross Income RA Basic 1040 – C1 – PG July 2020 3-9 31282-102 Gross Income, Continued Interest IRC § 61(a)(4) specifically includes interest in gross income. Interest is not defined in the Code or regulations. The Tax Court, in numerous cases, has accepted the definition of interest in Black’s Law Dictionary as “the compensation allowed by law or fixed by parties for the use, forbearance, or detention of money”. A distribution of earnings from a savings and loan association or credit union often is called a dividend. For tax purposes, this payment is interest and must be reported as interest on the tax return. Interest earned on loans between individuals is includible in gross income. For example, the seller of a personal residence holds the mortgage for the purchaser and receives monthly payments of principal and interest directly from the purchaser. The interest portion of the payments must be included in gross income. Most interest is reported to the recipient on Form 1099-INT, Interest Income. Dividends IRC § 61(a)(7) requires the inclusion of dividends in gross income. A dividend is a distribution (cash or property) from the earnings and profits of a corporation to a shareholder (IRC § 316(a)). Sometimes closely held or family-owned corporations pay personal expenses of a shareholder or provide other noncash benefits such as use of corporate property. If the corporation has sufficient earnings and profits, these payments or benefits are constructive dividends and are includible in the gross income of the shareholder. The amount of the distribution equals the fair market value of the distributed property on the date of distribution (IRC § 301(b)(3)). Note: The corporation is not allowed to take a deduction for these amounts. Example 6: Elm is the sole shareholder and president of Elm Enterprises, Inc. In addition to his salary, the corporation pays the $1,000 monthly mortgage payment on Elm’s residence. Elm also personally uses a corporate-owned auto with a lease value of $300 per month. Elm includes $15,600 ($1,300 per month) dividend income in gross income. Continued on next page RA Basic 1040 – C1 – PG Income: Gross and Adjusted Gross Income 31282-102 3-10 July 2020 Gross Income, Continued Reinvested Dividends Instead of receiving a dividend check, a stockholder may reinvest their cash dividends by having the corporation use the dividends to purchase additional shares of the corporation’s stock. Reinvesting is very common for shareholders of mutual funds. The dividend is taxable to the individual regardless of any reinvestment. The transaction is treated as if the shareholder received the cash and then used it to purchase additional shares. Example 7: Brown owns 100 shares of Hickory, Inc. stock. Hickory paid a cash dividend of $20 per share when Hickory stock was selling for $100 per share. Brown has Hickory reinvest her $2,000 in 20 additional shares of Hickory stock. Brown has a basis of $2,000 in the 20 new shares of stock and must include $2,000 in gross income. Stock Dividends A corporation may issue additional shares of stock to a shareholder as a dividend in lieu of cash. Under IRC § 305(a), this “stock” dividend is not included in income. The basis (cost) of all shares of stock is determined by dividing the adjusted basis of the old stock by the total number of shares of old and new stock (IRC § 307). The adjusted basis affects the gain or loss on the later sale of the stock. See Publication 550, Investment Income and Expenses, for additional information. A non-taxable stock dividend, or stock split, differs from a reinvested dividend because the shareholder does not have the option of receiving cash. Example 8: Tan bought 200 shares of Pine Corp. stock for $10 per share for a total cost of $2,000. Pine declares a 25 percent stock dividend and issues 50 additional shares. Tan does not include the value of the 50 shares in gross income. However, she now allocates her $2,000 original cost to 250 shares resulting in an adjusted basis of $8 per share. Continued on next page Income: Gross and Adjusted Gross Income RA Basic 1040 – C1 – PG July 2020 3-11 31282-102 Gross Income, Continued Exercise 3 Green owns 100 shares of Cedar Copy Center, Inc. which paid cash dividends of $5 per share. She reinvested the $500 and purchased more shares. She also owns 200 shares of Cypress Copy Center, Inc. she bought for $2,000. Cypress Copy Center, Inc. declared a 50 percent stock dividend. What amount is Green’s gross income? Answer: Income in Respect of a Decedent Taxable income due an individual that is paid after his or her death is income in respect of a decedent. Income received in respect of a decedent generally is included in the gross income of the estate and reported on a fiduciary tax return, Form 1041, U.S. Income Tax Return for Estates and Trusts. The taxpayer’s estate may distribute the right to receive the income to a beneficiary, or the right to the income may be bequeathed to a beneficiary. The beneficiary then reports the income in the year of receipt on his or her tax return. Continued on next page RA Basic 1040 – C1 – PG Income: Gross and Adjusted Gross Income 31282-102 3-12 July 2020 Gross Income, Continued Retirement Income Retirement Income includes: Social security benefits Pensions Annuities For taxpayers described in IRC § 86(b), up to 50 percent of social security benefits may be includible in gross income (IRC § 86(a)(1)). However, up to 85 percent may be includible in income when the “adjusted base amount” is exceeded (IRC § 86(a)(2)). Pensions are generally a series of definitely determinable payments made after an individual retires from employment. The payments are made on a regular basis and are dependent on such factors as years of service with the employer or an employee’s prior compensation. A pension is a form of annuity and is includible in income under IRC § 72(a). An annuity is a specified amount payable at stated intervals over a period of more than one year. Annuities may be purchased for a lump-sum payment or through installment payments. There are two methods of computing the taxable portion of annuity payments: 1. The simplified method, or 2. The general rule. Other Sources of Income Other sources of income that are includible in gross income include: Unemployment compensation Found property Illegal income Gambling winnings Bartering income Cancellation of debt Continued on next page Income: Gross and Adjusted Gross Income RA Basic 1040 – C1 – PG July 2020 3-13 31282-102 Gross Income, Continued Unemployment Compensation IRC § 85 specifically includes in gross income any amount received under a law of the United States or of a state that is in the nature of unemployment compensation. Amounts paid through private non-governmental unemployment plans are also includible in gross income. These amounts include payments made directly by employers and through union plans. However, where an employee contributes directly to a private unemployment compensation plan, only the amounts received in excess of the employee's contributions are includible in gross income. Found Property Treas. Reg. § 1.61-14(a) states that money or property found by a taxpayer (treasure trove) is includible in gross income at its FMV when it becomes the taxpayer’s property. Example 9: Black’s hobby is metal detecting. He finds an old container with $8,800 in currency inside. Black must include the $8,800 in gross income. Illegal Income The U.S. Supreme Court has ruled that gross income includes gains from illegal activities, such as embezzlement, bookmaking, theft, narcotics transactions, and prostitution (James v. United States, 366 U.S. 213 (1961). Note: Though a marijuana business is illegal under federal law, it remains obligated to pay federal income tax on its taxable income. Technical issues continue to evolve in the areas of IRC § 280E, Income Recognition, and other unique issues in the marijuana industry. Reference the Knowledge Management Portal for the most recent developments: Form 1040 Knowledge Base Home, Expenses and Deductions. Continued on next page RA Basic 1040 – C1 – PG Income: Gross and Adjusted Gross Income 31282-102 3-14 July 2020 Gross Income, Continued Gambling Winnings Gross income includes winnings from all forms of gambling activities (legal and illegal) including racing, games, lotteries, sweepstakes, and raffles (Rev. Proc. 77-29, 1977-2, C.B. 538). Gambling losses do not offset winnings in computing gross income, but may be deductible as an itemized deduction, unless the taxpayer is involved in “the trade or business” of gambling (Merkin v. Commissioner, T.C. Memo. 2008-146). Gambling winnings generally are reported on Form W-2G, Certain Gambling Winnings. If a taxpayer is engaged in the trade or business of gambling, his/her losses from gambling, up to the amount of his/her gains from such transactions, would be deductible in arriving at his/her adjusted gross income. [IRC §§ 62 and 165(d)]. To be engaged in a trade or business within the meaning of IRC § 162(a), an individual taxpayer must be involved in the activity with continuity, regularity, and with the primary purpose of deriving a profit. Example 10: Red spends two days gambling in Las Vegas. On the first day, she spends $800 of her own funds and wins $1,000 at the blackjack table. The following day, she spends her $1,000 winnings on the roulette wheel and wins $250. Red includes $1,250 gambling winnings in gross income. Bartering Income Bartering transactions involve the “non-cash” exchange of goods and services between individuals or businesses. The barter can be accomplished directly between the exchanging parties or through barter clubs. The FMV of the property or services received in the barter transaction is includible in gross income (Treas. Reg. § 1.61- 2(d)(1); Whitehead v. Commissioner, T.C. Memo. 2001-317). In some cases, individuals provide services or property through a barter club in exchange for trade units or credits. The units or credits are redeemable at a later time for services or property of equal value. The value of the units or credits is includible in gross income when credited to the individual’s account. Transactions through barter clubs are reported to members on Form 1099-B, Proceeds From Broker and Barter Exchange Transactions. Continued on next page Income: Gross and Adjusted Gross Income RA Basic 1040 – C1 – PG July 2020 3-15 31282-102 Gross Income, Continued Bartering Income (continued) Example 11: Bronze sells swimming pools. Bronze trades a pool worth $13,200 to Silver for a car that Silver usually sells to customers of his auto dealership for $15,000. Bronze includes $15,000 in gross income, FMV of the car she receives in the transaction. Silver includes $13,200 in gross income, the FMV of the pool he receives. Exercise 4 Gray received $1,000 in winnings from an illegal street race. He also won $5,000 playing blackjack on his vacation to Atlantic City. Gray lost $6,000 gambling that same weekend in Atlantic City. Gray does carpentry work and built Ash a new deck priced at $13,000. In exchange, Ash gave Gray an old truck with a FMV of $15,000. What is Gray’s gross income? Answer: Continued on next page RA Basic 1040 – C1 – PG Income: Gross and Adjusted Gross Income 31282-102 3-16 July 2020 Gross Income, Continued Cancellation of Debt Treas. Reg. § 1.61-12(a) provides that the discharge (cancellation) of indebtedness may result in the realization of income. Cancellation of debt is an economic benefit equivalent to receiving cash. Cancellation of debt is treated as if the taxpayer received cash and then paid the debt with the funds. If the payment of the debt would result in a deduction to the taxpayer, then cancellation of the debt is not includible in income (IRC § 108(e)(2)). An individual may not have taxable cancellation of debt income in the following situations: Bankruptcy Insolvency Certain farm debts Non-recourse loans Employee Business Expense Reimbursement Per IRC § 61, reimbursements of employee business expenses under a non- accountable plan must be included in gross income. The reimbursement must be included in the Form W-2 wage amount and reflected in gross income on the return. Per Treas. Reg. § 1.63-2(c)(4), reimbursements of employee business expenses under an accountable plan are not required to be reported as gross income on Form 1040, U.S. Individual Income Tax Return. NOTE: Prior to January 1, 2018, employee reimbursements were subject to different criteria. If you encounter this situation, you should consult your manager and do further research. Continued on next page Income: Gross and Adjusted Gross Income RA Basic 1040 – C1 – PG July 2020 3-17 31282-102 Gross Income, Continued Items Not Considered Gross Income Income received by a taxpayer that is the return of the taxpayer’s own investment is a “return of capital” and is not includible in gross income. Examples of return of capital include: Repayment of loans Life insurance dividends Reimbursements Determining Fair Market Value (FMV) Treas. Reg. § 1.1001-1(a) states that FMV is a question of fact and depends on the circumstances in each case. There is no general formula that is applicable to all valuation issues. The revenue agent should maintain a reasonable attitude, recognizing that valuation is not an exact science. In order to establish FMV, the revenue agent may use various sources including third parties such as realtors, vendors, appraisers, and county tax assessors. Disclosure rules prevent disclosing the taxpayer is under audit. Contacting third parties and the related disclosure rules are discussed later in training. Fair Market/Rental Value Treas. Reg. § 1.170A-1(c)(2) defines fair market value (FMV) as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts”. The FMV is the price of the property in the market in which it is customarily sold. Fair rental value (FRV) applies to the use of property. FRV is the amount at which an arm’s length willing lessor would rent property to an arm’s length willing lessee. Continued on next page RA Basic 1040 – C1 – PG Income: Gross and Adjusted Gross Income 31282-102 3-18 July 2020 Gross Income, Continued Arm’s Length Transaction Fair Market Value (FMV) and Fair Rental Value (FRV) also requires that the transaction be at “arm’s-length”. No other factors, such as family relationship, may affect the price. Example 12: Beige’s brother, Blue, purchases a grand piano. Blue has his old piano appraised by a reputable dealer at $3,500. Rather than advertise the piano for sale, Blue sells it to Beige for $1,500. The FMV of the piano is $3,500. The actual sales price of $1,500 does not represent FMV because the sale is between related parties. It is not an “arm’s-length” transaction. Tax Attributes the Taxpayer Must Reduce Income from the discharge of indebtedness is includible in gross income unless it is excludable under IRC § 108 or other applicable legislative provision. Five types of exclusions are provided. When an amount is excluded from gross income as the result of a discharge of indebtedness in a Title 11 case, a discharge of indebtedness during insolvency, or a discharge of qualified farm indebtedness, a taxpayer is required to reduce its tax attributes. Per IRC § 108(b)(2), the taxpayer must reduce the following tax attributes in the order listed: Net operating loss General business credit Minimum tax credit Capital loss carryover Basis of property Passive activity loss and credit carryover Foreign tax credit carryover The taxpayer can elect to apply any portion of the reduction against the basis of depreciable property before reducing any of the other tax attributes (IRC § 108(b)(5)). Income: Gross and Adjusted Gross Income RA Basic 1040 – C1 – PG July 2020 3-19 31282-102 Constructive Receipt and Prepaid Income Introduction Actual receipt of income occurs when possession is physically transferred. Constructive receipt of income can occur before actual receipt. Income is constructively received when credited to an account or otherwise made available so that the recipient chooses the time of actual receipt. Under the cash method of accounting, income is taxed when it is constructively received. Constructive Receipt Regulation Treas. Reg. § 1.451-2(a) stipulates that the taxpayer has received income when three conditions are met: 1. The taxpayer has control over the entire amount without substantial limitations and restrictions. 2. The amount has been credited or set aside for the taxpayer. 3. The funds are available for payment by the payer. Example 13: On December 9, 2019, Red sells truck parts for $200,000, agreeing to a payment date of February 9, 2020. Constructive receipt does not occur in 2019. Under the terms of the sale, funds are not available to Red until 2020. Example 14: Gold agrees to wait to cash a customer’s check until he deposits funds into his account. Income is not constructively received because the payer does not have sufficient funds in the bank to cover the check (Johnston v. Commissioner, T.C. Memo 1964-323). Example 15: Balsam Corporation employs White as a major league baseball player. Balsam Corporation contracts to pay White $700,000 in 2019 and $200,000 annually for the next three years. White has not constructively received the deferred payments of $600,000 in 2019 because he has no legally enforceable right to demand the payment in 2019. Continued on next page RA Basic 1040 – C1 – PG Income: Gross and Adjusted Gross Income 31282-102 3-20 July 2020 Constructive Receipt and Prepaid Income, Continued Substantial Limitations Constructive receipt cannot occur if there are substantial limitations or restrictions on the taxpayer’s right to income (Treas. Reg. § 1.451-2(a)). Constructively Received Income A revenue agent may examine income tax returns that require analyzing the constructive receipt of income for: Savings accounts U.S. savings bonds (series E, EE, I, H, and HH) Payments by mail Payments by check Payments in escrow Payments to third parties Continued on next page Income: Gross and Adjusted Gross Income RA Basic 1040 – C1 – PG July 2020 3-21 31282-102 Constructive Receipt and Prepaid Income, Continued Exercise 5 Orange, an architect, completes plans for a building in December 2019. After inspecting the plans, the customer offers full payment of $20,000. Orange accepts $15,000 in December 2019 and asks the customer to delay the payment of the balance until January 2020. What amount is includable in gross income in 2019. Why? Answer: Continued on next page RA Basic 1040 – C1 – PG Income: Gross and Adjusted Gross Income 31282-102 3-22 July 2020 Constructive Receipt and Prepaid Income, Continued Savings Accounts Interest earned on savings accounts is constructively received when the taxpayer has the right of withdrawal; this is usually when the interest is credited to the account. Income is not received when there are substantial restrictions on withdrawal. Interest Income Sometimes there are restrictions on the withdrawal of interest earned on a savings account, such as: Withdrawals must be in multiples of even amounts. Withdrawals decrease the earnings by a non-substantial amount. Withdrawals of earnings may be made only upon withdrawal of all or part of the amount deposited. Notice must be given in advance of the withdrawal. These restrictions are not substantial and will not prevent the interest from being includible in income when interest is credited to the account (Treas. Reg. §§ 1.451-2(a) (1) through (4)). U.S. Savings Bonds An exception to the constructive receipt rules applies to interest earned on series E, EE, and I U.S. savings bonds. A cash-basis taxpayer holding series E, EE, or I bonds may either: Postpone reporting the interest until the earlier of the year the taxpayer cashes the bonds or the year in which they finally mature or, Elect under IRC § 454(a) to report the annual increase in redemption value as interest income each year. In the year the election is made, the taxpayer includes the current year increase in value of all bonds held. The taxpayer also must include the unreported prior year increases in value. For series H and HH U.S. savings bonds, the interest is paid at stated intervals by interest checks or coupons and must be reported in the year received. Continued on next page Income: Gross and Adjusted Gross Income RA Basic 1040 – C1 – PG July 2020 3-23 31282-102 Constructive Receipt and Prepaid Income, Continued Payments by Mail Payments sent by mail are includible in income when delivered to the recipient. If the payment is available, but the taxpayer requests the mailing to be postponed, the payment is constructively received when made available. Example 16: Purple, a cash-basis taxpayer, provided computer services for Oak, Inc. in Dayton, OH on December 12, 2019. Purple traveled to Atlanta for another contract, so Oak, Inc. mailed Purple’s payment to his home in Minneapolis. The check arrived at Purple’s home on December 19, 2019. Purple returned home on January 5, 2020, and deposited the check the following day. Even though Purple deposited the check in 2020, he constructively received the funds on December 19, 2019. Example 17: A corporation declares dividends on December 18, 2019. The dividends are paid with checks dated December 30 and mailed on December 31. The shareholder receives the check on January 3, 2020 and reports the dividend income on his 2020 return. Payments by Check Constructive receipt of income occurs when a check is made available to a taxpayer. Actual receipt of income occurs when a check is delivered to a taxpayer, even if: The taxpayer holds the check for a number of days before cashing it. The banks are closed at the time of delivery or availability of the check (Kahler v. Commissioner, 18 T.C. 31 (1952)). However, if the check is not honored by the bank when presented, receipt of income did not occur at the time of delivery or availability. Continued on next page RA Basic 1040 – C1 – PG Income: Gross and Adjusted Gross Income 31282-102 3-24 July 2020 Constructive Receipt and Prepaid Income, Continued Exercise 6 Tan receives five checks totaling $25,000 on December 30 and 31, 2019. All are deposited on January 4, 2020. On January 7, the bank returns two checks (totaling $10,000) due to insufficient funds. Later in 2020, Tan collects the $10,000. What amount of income would Tan report in 2019? Why? Answer: Review Deposits During an examination, the revenue agent should investigate and review records regarding amounts deposited into bank accounts within the first month of the following year. If the taxpayer received the income before the end of the year, it is taxable in that year even if it was not deposited to the bank account until the next year. Payments in Escrow Income placed in escrow at the request or demand of the taxpayer is constructively received at the time the taxpayer has the right to control the income (Prosser v. Commissioner, 7 B.T.A., 734 (1927)). Continued on next page Income: Gross and Adjusted Gross Income RA Basic 1040 – C1 – PG July 2020 3-25 31282-102 Constructive Receipt and Prepaid Income, Continued Payments to Third Parties If a taxpayer is entitled to a payment made to a third party or agent of the taxpayer, the payment is constructively received by the taxpayer when the payment is made to the third party or agent (Rev. Rul. 60-31, 1960-1 C.B. 174). Example 18: Brown negotiates the sale of a rental property through an agent. The agent receives $150,000 at the closing on November 15, 2019, and remits the money to Brown on January 20, 2020, when Brown returns from Europe. Brown includes $150,000 in income in 2019. Prepaid Income Advance payments are includible in income when received if there are no restrictions on the taxpayer’s use of the money. These payments include prepaid interest, prepaid rent, prepaid service fees, bonuses, and advance royalties received on the execution of a lease or other agreement (South Dade Farms, Inc. v. Commissioner, 138 F.2d. 818 (5th Cir. 1943)). Example 19: Green, who uses the cash method of accounting, operates a dance studio and sells contracts for dance lessons. The contracts can extend into the next tax year. She requires full payment at the time the contract is executed. Green must report the income in the year she receives payment. The restriction on use of the money must be substantial and out of the taxpayer’s control. If a state regulatory body requires the taxpayer to put the advance payments in an escrow account, he would legally not have access to the funds until after it was released. The taxpayer would not be required to include the amount in income until he had unrestricted access. Continued on next page RA Basic 1040 – C1 – PG Income: Gross and Adjusted Gross Income 31282-102 3-26 July 2020 Constructive Receipt and Prepaid Income, Continued Prepaid Income (continued) Security deposits are examples of advance payments that are not includable in income upon receipt. Instead, only after the payer has forfeited the right for refund, does the taxpayer include the amount in income. Many court cases have addressed whether payments received by the taxpayer are security deposits (non-taxable) or prepaid income (taxable). The facts and circumstances of each taxpayer should be considered and evaluated to determine whether a security deposit is nontaxable or prepaid income in disguise. One of the main factors to consider is if the receiver has the right to keep the money or if it is dependent on the payer. Commissioner v Indianapolis Power & Light Co., 493 U.S. 203 (1990) The restrictions to retaining the funds should not be in the taxpayer’s control. The revenue agent will need to consider the following: Why is the taxpayer requiring these payments? Will the payer’s actions decide if the amount is refunded either full or in part? What has to occur for the payments to be kept by the taxpayer and the payer have no legal right to it? The most common example of security deposits are for rental real estate property. Other examples include utility deposits paid by customers with poor credit, and deposits for equipment to be returned on termination of a service. In all three examples, the security deposit is to ensure the contractual performance of the payee and not the taxpayer. The taxpayer cannot control whether the funds are retained or paid back to the payee. Continued on next page Income: Gross and Adjusted Gross Income RA Basic 1040 – C1 – PG July 2020 3-27 31282-102 Constructive Receipt and Prepaid Income, Continued Revenue Procedure 2004-34 Under Rev. Proc. 2004-34, 2004-1 C.B. 991, the IRS allows accrual basis taxpayers to defer the reporting of advance payments until the next tax year, to the extent that performance occurs after the year of receipt. Rev. Proc. 2004-34 applies if: The advance payment could be included in gross income for tax purposes immediately, and It is reported as revenue in whole or in part in a subsequent tax year on the taxpayer’s financial statements. Accrual basis taxpayers may defer the reporting of advance payments if they meet the requirements of Revenue Procedure 2004-34. Rev. Proc. 2004-34 applies to: Revenue from services Sale of goods in most instances Use of intellectual property Occupancy of property where there are substantial services Sale, lease, or license of computer software Subscriptions (most) Memberships (most) The taxpayer’s reporting of advance payments is a method of accounting. If he or she has reported advance payments in full in the year of receipt (full inclusion method), the taxpayer must file Form 3115, Application for Change in Accounting Method, to change to the deferral method described in Rev. Proc. 2004-34. Continued on next page RA Basic 1040 – C1 – PG Income: Gross and Adjusted Gross Income 31282-102 3-28 July 2020 Constructive Receipt and Prepaid Income, Continued Exercise 7 Black rents an apartment from Blue. When she moves in on December 1, 2019, she pays Blue $1,200 for December and January rent. She also pays a $600 security deposit. Blue places the security deposit in a separate account to be returned to Black at the termination of the lease. Blue uses the cash method of accounting. How much is includable in Blue’s 2019 gross income? Why? Answer: Income: Gross and Adjusted Gross Income RA Basic 1040 – C1 – PG July 2020 3-29 31282-102 Adjusted Gross Income Introduction The Internal Revenue Code allows certain deductions from gross income to determine adjusted gross income (AGI). When making examination adjustments that change AGI, you must adjust those income and deduction items that are affected by AGI. These items are reported on Form 1040, Schedule 1, Additional Income and Adjustments to Income. AGI Definition IRC § 62(a) defines AGI as gross income minus the deductions defined in IRC §§ 62(a)(1) through 62(a)(21). IRC § 62(a) lists deductions to determine AGI, including: Those deductions that are embedded in specific items in the income section of Form 1040, U.S. Individual Income Tax Return (business income, rental income, farm income, and other income), and All of the items in the Adjustments to Income section of Form 1040, Schedule 1. Deductions from Gross Income IRC § 62(a) does not allow any specific deduction. It lists items allowed by other Code sections that are deductible from gross income to compute AGI. This list includes: Certain expenses of elementary and secondary school teachers. Jury duty pay remitted to employer. Tuition and related expenses (post-secondary). Contributions to Health Savings Accounts. Attorney fees relating to awards to Whistleblowers. Self-employed health insurance. Reservists travel expenses when more than 100 miles away from home. Interest on education loans (see Publication 970, Tax Benefits for Education). Trade or business deductions. Deductions attributable to rents and royalties. Qualified moving expenses for members of the Armed Forces. Continued on next page RA Basic 1040 – C1 – PG Income: Gross and Adjusted Gross Income 31282-102 3-30 July 2020 Adjusted Gross Income, Continued Placement of Deductions Adjustments to gross income is a separate line item on Form 1040, Individual Income Tax Return, and are detailed on Schedule 1. Deductions from gross income to determine AGI, such as Schedule C expenses, are called “above the line” deductions. Deductions from AGI to determine taxable income include itemized deductions or the standard deduction. These items are called “below the line” deductions. Example 20: Bronze has the following income and deductions: Wages $45,000 Interest Income $4,000 Schedule C business income $5,000 One-half of self-employment tax ($353) Penalty on early withdrawal from savings account ($500) Contributions to a medical savings account (MSA) ($700) Bronze’s AGI $52,447 Standard Deduction ($12,200) Bronze’s Taxable Income $40,247 Adjustments The items in the Income section of Form 1040 are shown net of deductions from gross income. For example, an amount for Schedule C business income is the amount the taxpayer received as business income minus cost of goods sold and the expenses incurred to produce that income. The expenses are considered deductions from gross income. If income or expenses for any of the items in the Income section are changed during an examination, AGI also changes. For example, medical deductions on Schedule A, Itemized Deductions, are subject to a limitation and only expenses greater than 7.5 percent of AGI are deductible. Any changes affecting AGI will change this limitation on the medical expenses allowed. Continued on next page Income: Gross and Adjusted Gross Income RA Basic 1040 – C1 – PG July 2020 3-31 31282-102 Adjusted Gross Income, Continued Adjustments (continued) Example 21: Bronze’s per return AGI of $52,447 includes the following Schedule C business income: Income $20,000 Advertising ($5,000) Automobile ($6,000) Professional fees ($2,500) Supplies ($500) Net Schedule C income $6,000 Bronze would need more than $3,934 in medical expenses ($52,447 AGI × 7.5 percent) in order to deduct them on his Schedule A. An examiner audits Bronze’s Schedule C business expenses and adjusts disallow $4,500 in advertising, $1,000 in professional fees, and $1,000 of the automobile expenses. Bronze’s net Schedule C income is increased by $6,500. These adjustments affect his AGI: AGI before audit $52,447 Schedule C adjustments $6,500 Subtotal $58,947 One-half of SE tax on adj. ($459) AGI after audit $58,488 As a result of the audit changes, Bronze would need more than $4,387 in medical expenses ($58,488 AGI × 7.5 percent) in order to deduct them on his Schedule A. Continued on next page RA Basic 1040 – C1 – PG Income: Gross and Adjusted Gross Income 31282-102 3-32 July 2020 Adjusted Gross Income, Continued Trade or Business Expenses Some trade or business expenses are deductible from gross income to determine AGI, and some are deductible from AGI. Self Employed Deductions – Above the Line IRC § 62(a) defines “adjusted gross income” as gross income minus deductions listed in IRC §§ 62(a)(1) through 62(a)(21). IRC § 62(a)(1) states that all business expenses of self-employed persons are deductible from gross income to determine AGI. Accordingly, operating expenses are deducted above the line in arriving at Schedule C business income for Form 1040. Some items listed in IRC § 62(a) are deducted “above the line” in the Adjusted Gross Income section of Form 1040, Schedule 1. For example, trade or business deductions under IRC § 62(a)(1) include the deductions for self-employed health insurance and one-half of the self-employment tax. According to IRC § 62(a)(2), employee business expenses deductible from gross income to compute AGI are limited to expenses of: Employees reimbursed under an accountable plan. Qualified performing artists (QPAs) as defined in IRC § 62(a)(2)(B). Officials paid on a fee basis as defined in IRC § 62(a)(2)(C). School teachers, up to $250, as defined in IRC § 62(a)(2)(D). National Guard and military reserve members as defined in IRC § 62(a)(2)(E). Additional resources on AGI can be found on the Knowledge Management site under Expenses and Deductions. Continued on next page Income: Gross and Adjusted Gross Income RA Basic 1040 – C1 – PG July 2020 3-33 31282-102 Adjusted Gross Income, Continued AGI Calculation Note: Handicapped individuals can report their expenses as an itemized deduction on Schedule A (IRC § 67(b)(6)). Example 22: Silver and Gold file a joint return. Silver is a self-employed electrician. During the tax year, he earns $50,000 and incurs $10,000 in expenses. One-half of his self-employment tax is $2,826. Gold is a purchaser for a major department store. Her salary is $45,000 and she incurs $5,000 in expenses, for which she is not reimbursed. Silver and Gold’s AGI is $82,174: Silver’s earnings (self-employed) $50,000 Silver’s expenses ($10,000) One-half self-employment tax ($2,826) Gold’s salary $45,000 AGI $82,174 Continued on next page RA Basic 1040 – C1 – PG Income: Gross and Adjusted Gross Income 31282-102 3-34 July 2020 Adjusted Gross Income, Continued Exercise 8 Gray owns his own tree service business. He also works as an employee at a construction company. Gray has the following income and expenses: Wages: $32,000 Dividends: $500 Employee business expenses: $1,200 Gross receipts from business: $75,000 Operating expenses from $45,000 business: Sweepstakes Winnings: $15,000 What is Gray’s adjusted gross income? Why? (Ignore the S.E. Tax calculation.) Answer: Income: Gross and Adjusted Gross Income RA Basic 1040 – C1 – PG July 2020 3-35 31282-102  Page intentionally left blank RA Basic 1040 – C1 – PG Income: Gross and Adjusted Gross Income 31282-102 3-36 July 2020 Summary Main Points 1. Gross income is defined in IRC § 61(a) as all income from whatever source derived unless specifically excluded. Gross income may include money, property, services, and benefits. Gross income includes forms of income, other than money, at Fair Market Value (FMV). 2. Income is constructively received when credited to an account or otherwise made available to the recipient, so that the recipient chooses the time of actual receipt. Under the cash method of accounting, income is taxed when it is constructively received. 3. Interest earned on savings is constructively received when credited to the account, unless there are substantial restrictions on withdrawal. 4. Advance payments are includible in income when received if there are no restrictions on the taxpayer’s use of the money. These payments include prepaid interest, prepaid rent, bonuses, and advance royalties received on the execution of a lease or other agreement. 5. The IRS allows accrual basis taxpayers to defer the reporting of advance payments until the succeeding tax year if the advance payment could be included in gross income for tax purposes immediately and it is reported as revenue on a later tax year on the taxpayer’s financial statements. 6. Adjustments to gross income is a separate line item on Form 1040, U.S. Individual Income Tax Return. Deductions from gross income, such as Schedule C expenses, to determine AGI are called “above the line” deductions. Deductions from AGI, such as itemized deductions or the standard deduction, to determine taxable income are called “below the line” deductions. 7. All business expenses of self-employed persons are deductible from gross income to determine AGI. Accordingly, operating expenses are deducted “above the line” in determining Schedule C business income for Form 1040. Income: Gross and Adjusted Gross Income RA Basic 1040 – C1 – PG July 2020 3-37 31282-102 Answers to Exercises Exercise 1 Red is a private duty nurse. Her patient, Birch, gives her a cruise to the Bahamas as partial payment for services provided. Birch had purchased the cruise for $1,500. Birch gives Red the remaining daily charges of $1,300 in cash. What amount is includable in Red’s gross income? Why? Answer: $2,800 Cruise $1,500 Cash Payment $1,300 Total $2,800 Red is required to include all payments received for her services. She is required to include the FMV of the cruise and the cash payments in her gross income. Exercise 2 Purple operates a car wash. He received gross receipts of $500,000. He paid $400,000 operating expenses. He also received $3,000 for the car dealership’s advertisement on the side of his car wash. Purple sells his boat for $25,000. He originally purchased it for $20,000. Calculate Purple’s gross income. Answer: $508,000 Gross Receipts $500,000 Less Cost of Goods Sold 0 Plus Advertising Income $3,000 $503,000 Sale of Boat $25,000 Less Cost of Boat ($20,000) $5,000 Gross Income $508,000 Gross income includes Schedule C total income received less cost of goods sold. Note: Schedule C operating expenses are not included in gross income. Cost of goods sold is the only Schedule C deduction allowed to calculate gross income. Gross income includes the gain from sales of property. Continued on next page RA Basic 1040 – C1 – PG Income: Gross and Adjusted Gross Income 31282-102 3-38 July 2020 Answers to Exercises, Continued Exercise 3 Green owns 100 shares of Cedar Copy Center, Inc. which paid cash dividends of $5 per share. She reinvested the $500 and purchased more shares. She also owns 200 shares of Cypress Copy Center, Inc. she bought for $2,000. Cypress Copy Center, Inc. declared a 50 percent stock dividend. What amount is Green’s gross income? Answer: $500 The taxpayer is required to include cash dividends in gross income. It was the taxpayer’s choice to reinvest the dividends. Stock dividends (dividends received in the form of stock) are not included in gross income. The taxpayer did not have the option of receiving cash in lieu of the stock dividend. Exercise 4 Gray received $1,000 in winnings from an illegal street race. He also won $5,000 playing blackjack on his vacation to Atlantic City. Gray lost $6,000 gambling that same weekend in Atlantic City. Gray does carpentry work and built Ash a new deck priced at $13,000. In exchange, Ash gave Gray an old truck with a FMV of $15,000. What is Gray’s gross income? Answer: $21,000 Street Race Winnings $1,000 Blackjack Winnings $5,000 Deck Receipts $15,000 Gross Income $21,000 Gray is required to include all gambling and illegal activities in gross income. The $6,000 gambling loss may be allowed as an itemized deduction on Schedule A. It would not affect gross income. The taxpayer is required to report all income from business operations. The FMV of the truck would be used to determine Gray’s income received relating to the deck. Continued on next page Income: Gross and Adjusted Gross Income RA Basic 1040 – C1 – PG July 2020 3-39 31282-102 Answers to Exercises, Continued Exercise 5 Orange, an architect, completes plans for a building in December 2019. After inspecting the plans, the customer offers full payment of $20,000. Orange accepts $15,000 in December 2019 and asks the customer to delay the payment of the balance until January 2020. What amount is includable in gross income in 2019. Why? Answer: $20,000 The entire payment of $20,000 was available to Orange in 2019. She chose to delay the payment of $5,000. The $20,000 was constructively received in 2019. Exercise 6 Tan receives five checks totaling $25,000 on December 30 and 31, 2019. All are deposited on January 4, 2020. On January 7, the bank returns two checks (totaling $10,000) due to insufficient funds. Later in 2020, Tan collects the $10,000. What amount of income would Tan report in 2019? Why? Answer: $15,000 5 Checks $25,000 Insufficient Funds $10,000 2019 Gross Income $15,000 Tan received the five checks in 2019. In general, the check payments are includable in the year received. However, if the funds are not available to honor the check, the amount is not includable in gross income. Continued on next page RA Basic 1040 – C1 – PG Income: Gross and Adjusted Gross Income 31282-102 3-40 July 2020 Answers to Exercises, Continued Exercise 7 Black rents an apartment from Blue. When she moves in on December 1, 2019, she pays Blue $1,200 for December and January rent. She also pays a $600 security deposit. Blue places the security deposit in a separate account to be returned to Black at the termination of the lease. Blue uses the cash method of accounting. How much is includable in Blue’s 2019 gross income? Why? Answer: $1,200 Blue is required to include the two months’ rent of $1,200. She is not required to include the security deposit of $600. For cash method taxpayers, advance payments are includible in income when received if there are no restrictions on the taxpayer’s use of the money. Prepaid income does not include security deposits when the taxpayer does not have unrestricted use of the funds. Security deposits with restrictive use are not includable in gross income. Continued on next page Income: Gross and Adjusted Gross Income RA Basic 1040 – C1 – PG July 2020 3-41 31282-102 Answers to Exercises, Continued Exercise 8 Gray owns his own tree service business. He also works as an employee at a construction company. Gray has the following income and expenses: Wages: $32,000 Dividends: $500 Employee business expenses: $1,200 Gross receipts from business: $75,000 Operating expenses from business: $45,000 Sweepstakes Winnings: $15,000 What is Gray’s adjusted gross income? Why? (Ignore the S.E. Tax calculation.) Answer: $77,500 Wages: $32,000 Dividends: $500 Gross receipts from business: $75,000 Sweepstakes Winnings: $15,000 Gross Income $122,500 Less Business Operating Expenses ($45,000) Adjusted Gross Income $77,500 The employee business expenses do not affect the calculation of adjusted gross income. The remaining items are all included in the calculation of adjusted gross income. (Schedule C business operating expenses are included in AGI but not gross income.) RA Basic 1040 – C1 – PG Income: Gross and Adjusted Gross Income 31282-102 3-42 July 2020 Class Exercises Class Exercise 1 Blue provides his preparer with the following information: Wages $35,000 Employee business expenses $2,000 Interest $500 Gambling winnings $600 Gambling losses $2,000 Schedule C Business Receipts $60,000 Schedule C Cost of Goods Sold $15,000 Schedule C Operating Expenses $20,000 Cash Dividend $300 Calculate Blue’s adjusted gross income. Answer: Continued on next page Income: Gross and Adjusted Gross Income RA Basic 1040 – C1 – PG July 2020 3-43 31282-102 Class Exercises, Continued Class Exercise 2 Gold contracted to design a website for White. The contract stated $10,000 would be due before Gold began work on the website and the remaining $40,000 would be due upon completion. White paid the $10,000 in March 2019. Gold completed the website December 2019. White stated he could pay $25,000 in December 2019 but did not have the remaining $15,000. White planned to have the money in January 2020. Gold told White she would accept $20,000 in December 2019 and the remaining $20,000 in January 2020. White paid Gold $20,000 in December 2019. What amount should Gold include in her income for 2019? Answer: Class Exercise 3 Green received a dividend check in the mail on November 11, 2019. She deposited it on January 25, 2020. On December 10, 2019, Green’s previous employer called to tell her the last paycheck was ready to be picked up. Green did not pick up the check until February 20, 2020. When should Green include the income from the dividend check and paycheck in her gross income? Why? Answer: Continued on next page RA Basic 1040 – C1 – PG Income: Gross and Adjusted Gross Income 31282-102 3-44 July 2020 Class Exercises, Continued Class Exercise 4 Black hires a lawyer to oversee the selling of his ranch in Wyoming. Black is in New Zealand when the ranch sells on June 6, 2019. He asks the lawyer to keep the money until he returns on September 10, 2019. The lawyer receives the money on June 6, 2019. Black has the money transferred to his personal account on September 10, 2019. What date does Black constructively receive the money? Answer: Continued on next page Income: Gross and Adjusted Gross Income RA Basic 1040 – C1 – PG July 2020 3-45 31282-102 Class Exercises, Continued Class Exercise 5 Determine whether the following items are included in: a. Gross income b. Adjusted gross income but not gross income c. Neither (Choices can be used more than once.) Answer Item 1. Self-employed health insurance deduction 2. Interest Income 3. Sale of property 4. Stock dividend 5. Pre-paid income 6. Schedule C operating expenses 7. Schedule C gross receipts 8. Schedule C cost of goods sold 9. Contributions to health savings plan 10. Employee business expenses 11. Gambling winnings 12. Gambling losses RA Basic 1040 – C1 – PG Income: Gross and Adjusted Gross Income 31282-102 3-46 July 2020 Exclusion vs. Deduction Definitions Exclusions do not appear on a tax return, except for some that have limitations or require a computation. Deductions must appear somewhere on a return to reduce income. Deductions are apparent on a return while exclusions will not be readily seen. Therefore, interviewing the taxpayer and inspecting the books and records are important in order to locate any income that was improperly excluded. If a revenue agent detects excluded income during an examination, the taxpayer must provide documentation to verify that the income falls within an exclusion provision (Rule 142(a), Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 430 (1955). Code References Most exclusions appear in Chapter 1, Subchapter B, and Part III of the Code as Items Specifically Excluded From Gross Income. Subchapter B, Part II, Items Specifically Included in Gross Income, also offers exceptions to taxability. These sections state that an item is taxable unless certain conditions are met. This lesson introduces the most commonly encountered exclusions from income. However, the general rule is “gross income means all income from whatever source derived, unless excluded by law” (Treas. Reg. § 1.61-1(a)). Continued on next page Income Exclusions RA Basic 1040 – C1 – PG July 2020 4-3 31282-102 Alimony and Child Support Non-Taxable Section 11051 of the Tax Cuts and Jobs Act repeals the requirement under Code Sections 61(8) and 71 that alimony income be included in the payee’s income. The repeal applies to any divorce or separation instrument (as defined by Section 71(b)(2) prior to its repeal), executed after December 31, 2018. Divorce and separation agreements executed on or before December 31, 2018, will be grandfathered. Grandfathered agreements modified after the December 31, 2018, effective date will also be grandfathered unless the modification expressly provides that the modified agreement be governed by the new law. Payments made under post-1984 instruments that fix an amount or a portion of the payment as child support qualify as child support for tax purposes and are not deductible by the payor and are not includible in gross income by the payee receiving the payment (Commissioner v. Lester, 366 U.S. 299, 303 (1961); Lawton v. Commissioner, T.C. Memo. 1999-243; Treas. Reg. § 1.71-1T(c), Q&A-16, 49 Fed. Reg. 34456 (Aug. 31, 1984)). If any amount specified in the divorce or separation instrument is to be reduced (1) upon the occurrence of a contingency specified in that instrument relating to a child (attaining a specified age, marrying, dying, leaving school, or a similar contingency) or (2) at a time that can clearly be associated with that kind of contingency – the amount of the specified reduction is treated as child support from the outset (Ambrose v. Commissioner, T.C. Memo. 1996-128; Treas. Reg. § 1.71-1T, Q&A-16 through 18, 49 Fed. Reg. 34456-34457 (Aug. 31, 1984)). A divorce or separation agreement must be made in writing (Herring v. Commissioner, 66 T.C. 308, 311 (1976); Leventhal v. Commissioner, T.C. Memo. 2000-92; Ellis v. Commissioner, T.C. Memo. 1990-456). A payment made pursuant to an oral agreement is not a payment made pursuant to a divorce or separation instrument unless there is some type of written instrument memorializing the agreement (Herring v. Commissioner, 66 T.C. 308, 311 (1976); Osterbauer v. Commissioner, T.C. Memo. 1982-266). Example: A post-1984 divorce instrument provides that alimony payments will be reduced by $500 per month when a child reached age 18. Under these circumstances, $500 of each payment is treated as child support. Note: Amounts will not be treated as child support unless specifically designated as such in the governing divorce document (Berry v. Commissioner, T.C. Memo. 2005-91; Lawton v. Commissioner, T.C. Memo. 1999-243; Raymond v. Commissioner, T.C. Memo. 1997-219). RA Basic 1040 – C1 – PG Income Exclusions 31282-102 4-6 July 2020 Life Insurance Proceeds General Rule Read IRC § 101(a)(1) and Treas. Reg. § 1.101-1(a). Insurance proceeds paid by reason of death of the insured are excludable from income. This provision of the law also includes death benefits having the characteristics of life insurance payable by reason of death such as worker’s compensation or payments under accident and health insurance contracts. Includible There are some instances where a portion of the payments based on life insurance policies might be includable in income: The policy is transferred for valuable consideration (IRC § 101(a)(2)). There is interest paid on the insurance proceeds (IRC § 101(c)). The beneficiary opts to have the proceeds payable in installment payments (IRC § 101(d)). As the policy principal is retained by the insurance company, the payments also include interest earned on the policy. In the case of these exceptions, there are additional payments that are not “by reason of death of the insured”, i.e., payments that are more than the basis or larger than the lump sum. This is the rationale behind their inclusion in income. Accelerated Death Benefits An insured person who is terminally or chronically ill can sell his or her life insurance contract to a viatical settlement provider and exclude the benefits from income (IRC § 101(g)). A viatical settlement provider, as defined in IRC § 101(g)(2)(B)(i), is one who meets certain industry requirements and is in the business of purchasing assignments of life insurance contracts on the lives of terminally or chronically ill taxpayers. If terminally ill, the death benefits of a life insurance contract, paid in advance of death, are treated as paid after death, and are excludable from income. Continued on next page Income Exclusions RA Basic 1040 – C1 – PG July 2020 4-7 31282-102 Life Insurance Proceeds, Continued Accelerated Death Benefits (continued) Accelerated death benefits for the chronically ill are excludable from income if the amount received is for long-term care costs that are not covered by Medicare (IRC § 101(g)(3)) or the payments are on a per diem or another periodic basis (IRC § 101(g)(3)(C) and (D)). For 2019 the amount cannot exceed $370 per day (Rev. Proc. 2018-57 ) under IRC § 7702B(d)(4). Long-Term Care and Accelerated Death Benefits are reported on Form 1099-LTC. RA Basic 1040 – C1 – PG Income Exclusions 31282-102 4-8 July 2020 Gifts and Inheritances Definitions A gift or inheritance is excludable from income. Read IRC § 102(a). A gift is a voluntary transfer of cash or property from one individual (the donor) to another individual (the donee). There must be no consideration or compensation for the gift. An inheritance, devise, or bequest is a transfer of cash or property from a decedent (deceased person) to an heir and involves no valuable consideration. The statutory phrase in IRC § 102(a), “…acquired by…bequest, devise, or inheritance” also applies when a person receives property in settlement of a suit contesting a will. The property acquired in settlement is excludable as an inheritance. Exclusion Limited Read IRC § 102(b)(1) and (2). The exclusion of IRC § 102(a) applies only to the corpus (principal sum) of the gift or inheritance. Income earned by the corpus is taxable. If a gift or bequest consists only of the right to receive income from property, that income does not qualify for exclusion and is taxable. Example 1: John inherited stock worth $10,000 from his late father. This stock earned $500 in dividend income after John received it. The initial $10,000 is excludable from John’s income because that is what he inherited. The $500 dividend income earned after the transfer is taxable to John. Example 2: Under the terms of her uncle’s will, Linda is to receive income for the next 5 years from property held by his estate. This income is taxable to Linda. She did not receive the property the decedent owned that is generating this income. She is receiving only the income. Continued on next page Income Exclusions RA Basic 1040 – C1 – PG July 2020 4-9 31282-102 Gifts and Inheritances, Continued Estate and Gift Tax This discussion is limited to the basic treatment of gifts and inheritances for income tax purposes. Transfers by gift are subject to a separate gift tax imposed on the donor under IRC § 2501. In addition, a decedent’s estate is subject to a separate estate tax imposed under IRC § 2001. A donor has an annual exclusion for individual gifts. For 2019, the exclusion is $15,000. No gift tax return is required for gifts under this amount. The gift exclusion applies to each donee. Therefore, an individual may make gifts to numerous donees during the year as long as the combined gift amount to any one individual does not exceed $15,000. If a gift exceeds the exclusion amount, a Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, is required to be filed. However, the Code provides a unified credit against estate and gift taxes to be used during one’s lifetime. For 2019, the Unified Credit is $11,400,000. Refer to Publication 559, Survivors, Executors, and Administrators, and OJT 2, Estate Gift and Excise Taxes Workshop. IRS Area offices generally have at least one group of Estate and Gift Tax Attorneys to deal with this area of tax law. Continued on next page RA Basic 1040 – C1 – PG Income Exclusions 31282-102 4-10 July 2020 Gifts and Inheritances, Continued Exercise 1 While reviewing/analyzing bank accounts during an examination of Anne’s 2019 return, a revenue agent determines Anne has more funds than she reports on her return. When the revenue agent asks her about the source of the funds, Anne provides documentation for the items below. When her mother died on December 31, 2018, Anne received stock worth $5,000. This stock earned dividends in 2019 of $600. Anne also received cash from her mother’s estate of $40,000. She deposited the cash into her savings account where it earned $2,500 in interest income. Her mother’s estate holds rental property worth $100,000. This property will be sold when the real estate market improves. The property produces net rental income which totaled $3,500 in 2019. Anne was also the beneficiary of her mother’s life insurance policy for $50,000. Anne chooses to receive this sum ratably over 10 years. She received $6,000 in 2019 and will receive $6,000 each year. Which amounts are excludable? Which amounts are taxable? Why? Answer: Income Exclusions RA Basic 1040 – C1 – PG July 2020 4-11 31282-102 Tax Exempt Interest Generally Excludable Read IRC § 103. Interest earned on state and municipal bonds is generally excludable. Interest and earned original-issue-discount (OID) interest on state and municipal bonds issued prior to June 9, 1980, and received prior to the maturity date, is interest that is excludable from gross income (Rev. Rul. 72-587, 1972-2 C.B. 74). However, unearned OID on state and municipal bonds issued after June 8, 1980, is not interest income excludable from gross income under IRC § 103(a); rather, it represents a gain from the sale or exchange of a capital asset (Rev. Rul. 80-143, 1980-1 C.B. 19). Interest on bonds issued to finance essential operations of state or local government units is exempt. However, the exclusion does not apply to interest on state or municipal instruments that are arbitrage bonds or private business activity bonds that are not exempt as qualified bonds. IRC § 141(a) defines qualified tax-exempt private business activity bonds. Although the interest income is exempt, any gain on the disposition of the obligation is taxable as a gain on the sale or exchange of a capital asset. Likewise, a loss on the disposition of a municipal bond is deductible as a capital loss. Capital gains and losses are discussed in another lesson. Expenses Expenses incurred in earning tax-exempt income are not deductible (IRC § 265). When interest income on government obligations is properly excluded on a tax return, expenses related to that excluded income should not appear on the individual’s Form 1040, U.S. Individual Income Tax Return. If there is excluded income, the return must be inspected to ensure that expenses related to that income were not included anywhere in the return. Continued on next page RA Basic 1040 – C1 – PG Income Exclusions 31282-102 4-12 July 2020 Tax Exempt Interest, Continued Exercise 2 While inspecting Irene’s bank deposits, a revenue agent finds a payment from Cedar City for $100,000. Irene submits evidence that $10,000 of this amount is tax-exempt interest. The face value of the bonds redeemed is $90,000. What additional information should the revenue agent request about the bond redemption? Answer: Income Exclusions RA Basic 1040 – C1 – PG July 2020 4-13 31282-102 Personal Injury or Sickness Exclusions from Income Read IRC §§ 104(a)(1) and (2) and Treas. Reg. 1.104-1(c). IRC § 104(a)(1) excludes worker’s compensation for personal injuries or sickness from income. IRC § 104(a)(2) excludes amounts received, whether by suit or agreement, for damages (other than punitive) due to personal physical injury or physical sickness. However, any payments received to reimburse medical expenses that were deducted in a previous year are includible in income when received. Example 3: In March 2019, a taxpayer received $10,000 of compensatory damages for a 2018 physical injury. None of the payment was worker’s compensation. The taxpayer deducted $1,000 of medical expenses related to the injury on his 2018 return. The payment would be treated as follows: Total amount received $10,000 Less: Medical expenses previously deducted (this must be included in income) ($1,000) Excludable from income $9,000 Definitions Compensatory damages are awards equal to the actual value of the injury or damage sustained by the victim. Punitive damages are awards to an injured party over and above compensation for the injury. Punitive damages are awarded to punish the party who caused the injury. Punitive damages are also called exemplary damages. Personal injury is defined as physical injury or sickness. Continued on next page RA Basic 1040 – C1 – PG Income Exclusions 31282-102 4-14 July 2020 Personal Injury or Sickness, Continued Punitive Damages The Small Business Job Protection Act of 1996 amended IRC § 104(a)(2) to include punitive damages as income except for damages received under a binding agreement issued on or before September 13, 1995. In order to qualify for income exclusion under section 104(a)(2), taxpayers must satisfy a two-prong test: (1) The underlying cause of action giving rise to the settlement award must be based upon tort or tort type rights, and (2) the damages must be received on account of personal physical injuries or physical sickness (Sec. 104(a)(2); Commissioner v. Schleier, 515 U.S. 336-337 (1995); sec. 1.104-1(c), Income Tax Regs.). Only compensatory damages on account of physical injury or sickness are excludable. Emotional distress is not considered a physical injury or sickness unless the payments are received for medical care (Sec. 104(a) (flush language); Sanford v. Commissioner, T.C. Memo. 2008-158; Polone v. Commissioner, T.C. Memo. 2004-339, affd. 505 F.3d 966 (9th Cir. 2007); Venable v. Commissioner, T.C. Memo. 2004-240, affd. 110 Fed. Appx. 421 (5th Cir. 2004)). “Any amounts paid in such circumstances for physical symptoms of emotional distress are similarly includable in income.” (Wells v. Commissioner, T.C. Memo. 2010-5, 2010 Tax Ct. Memo LEXIS 4, at *9; see also McGowen v. Commissioner, 2011-186; Moulton v. Commissioner, T.C. Memo. 2009-38, 2009 Tax Ct. Memo LEXIS 40, at *18; Lindsey v. Commissioner, T.C. Memo. 2004-113, 2004 Tax Ct. Memo LEXIS 113, at *14, aff’d, 422 F.3d 684 (8th Cir. 2005)). Compensatory damages for non-physical injury, such as employment discrimination, breach of contract, etc. are not excludable from income (Rev. Rul. 96-65, 1996-2 C.B. 6; United States v. Burke, 504 U.S. 229, 233 (1992); Robinson v. Commissioner, 102 T.C. 116,126 (1994), affd. in part, revd. in part on another issue 70 F.3d 34 (5th Cir. 1995) and cases cited therein; Stocks v. Commissioner, 98 T.C. 1, 9 (1992)). Note: The revenue agent should thoroughly inspect the judgment to discern whether only compensatory damages were received and if additional award was received for punitive damages. Income Exclusions RA Basic 1040 – C1 – PG July 2020 4-15 31282-102 Prizes and Awards Overview IRC § 74(a) states that prizes and awards are includable in income with two limited exceptions. While items such as door prizes, game show prizes, and lottery winnings are taxable, some achievement awards are excludable from income. Awards made by a sole proprietorship to the sole proprietor are not an award made to an employee and therefore are not excludable. Achievement Awards Read IRC §§ 74(a) and (b). A prize or award is excludable from income when it is in recognition of religious, charitable, scientific, educational, artistic, literary, or civic achievement, and the recipient does not receive it because of action on their part or as compensation. The payor must transfer the award to a charitable organization or government unit. Employee Achievement Awards Read IRC §§ 74(c) and 274(j). IRC § 74(c)(1) states that gross income shall not include the value of an employee achievement award as defined by IRC § 274(j) unless it exceeds the deduction limit for the employer. Any excess amount will be considered taxable income to the employee (IRC § 74(c)(2)). An achievement award, as defined in § 274(j)(3)(A)(i), is limited to tangible personal property only. The TCJA clarifies that tangible personal property doesn’t include cash, cash equivalents, gift cards, gift coupons, certain gift certificates, tickets to theater or sporting events, vacations, meals, lodging, stocks, bonds, securities, and other similar items. The deduction limits are $400 for a nonqualified plan and $1,600 for a qualified plan award. A qualified plan is part of an established written plan that does not discriminate in favor of highly compensated employees. Continued on next page RA Basic 1040 – C1 – PG Income Exclusions 31282-102 4-16 July 2020 Prizes and Awards, Continued Example 4: Barbara received a silver watch as a length of service award from her employer. This was the first and only award Barbara ever received from her employer. The cost of the watch to the company was $375, and the fair market value was $415. The full fair market value of $415 is excludable from Barbara’s gross income for income tax purposes under IRC § 74(c) and IRC § 274(j)(2). Productivity Awards The exclusion applies only to safety achievement awards and length of service achievement awards. The same limitations for employee achievement awards discussed above also apply to safety achievement and length of service achievement awards. Other special rules for length of service and safety achievement awards can be found in IRC § 274(j)(4). Productivity awards are fully taxable to the employee. [IRC § 274(j)(4)(c)]. Exercise 3 A revenue agent is reviewing medical expenses on Adam’s return and notices a receipt from a hospital in Hawaii. Adam explains that he won an all-expense-paid trip to Hawaii for being his firm’s leading salesperson. He said he did not include the value of the trip in gross income because it was not on his Form W-2. Adam also said the trip was of no benefit to him because he was sick in the hospital while he was there. Is the cost of the trip excludable from gross income? Why or why not? Answer: Income Exclusions RA Basic 1040 – C1 – PG July 2020 4-17 31282-102 Scholarships General Rule A qualified scholarship is excludable from income. Read IRC § 117(a) through (c). Conditions of Exclusions An amount can be excluded from income as a scholarship if all the following conditions are met. 1. The individual receiving the scholarship must be a degree candidate. A degree candidate is a full or part-time student studying for an academic or professional degree at the graduate or under-graduate level. Someone taking courses who is not in pursuit of a degree cannot claim an exclusion. 2. The degree candidate must study at a qualified educational organization. IRC § 170(b)(1)(A)(ii) defines a qualified educational organization as an accredited college or university or certain accredited professional or technical schools. 3. The amount received as a scholarship must be used for qualified expenses. Any amount not used is includable in income. Qualified expenses include tuition and related fees, books, supplies, and equipment needed for the courses taken. Scholarship funds used for room and board and incidentals are includable as income. Not Excludible An amount received as a scholarship is not excludable from income if the payment is for teaching, research, or other services required as a condition of receiving the grant or scholarship. The amount received is payment for services. Continued on next page RA Basic 1040 – C1 – PG Income Exclusions 31282-102 4-18 July 2020 Scholarships, Continued Qualified Scholarships Pell Grants, Supplemental Educational Opportunity Grants, and Grants to States for State Student Incentives are scholarships. They are tax-exempt to the extent they are used for qualifying tuition and course-related expenses during the grant period. Qualified scholarships can also include amounts characterized as fellowships or grants. Example 5: Mary earned $1,000 teaching college accounting classes while working on her doctoral degree. In the same year, she received a fellowship grant of $2,500. She incurred the following expenses: room and board of $1,500, tuition and required fees of $1,750, and books costing $250. The amount Mary must include in taxable income is: Grant received $2,500 Less: Qualifying expenses: Tuition and fees ($1,750) Books ($250) Taxable portion of grant $500 Income from teaching $1,000 Includible in gross income $1,500 Income Exclusions RA Basic 1040 – C1 – PG July 2020 4-19 31282-102 Education Savings Bond Program Interest Exclusion Read IRC § 135(a). A taxpayer can exclude from gross income the interest earned on U.S. savings bonds (i.e., Series EE or I) issued after December 31, 1989, if the proceeds are used to pay qualified higher education expenses for the taxpayer, the taxpayer’s spouse, or the taxpayer’s dependents (if qualified for dependency exemption under IRC § 151). The bond purchaser must be age 24 or older at the date of purchase, and the bond cannot be issued in the name of a child under age 24. Qualified higher education expenses are limited to tuition and fees required for enrollment or attendance. This is different from the definition of “qualified educational expenses” under IRC § 117, which also allows for other fees, books, supplies and equipment. Room and board are not qualified expenses. The total amount of qualified expenses for a student are reduced by any scholarships, fellowships, grants, or tuition reductions received and cannot include any expenses used to claim education credits or a distribution from an education IRA that was excluded from income. Example 6: In February 2019, Mark and Joan, a married couple, cashed a qualified series EE U.S. savings bond they bought in April 2002. They received proceeds of $7,816 representing principal of $5,000 and interest of $2,816. In 2019, their daughter received a tax-free educational assistance allowance of $500, and a scholarship of $2,000, both of which were used to pay mandatory tuition of $12,500. Mark and Joan’s adjusted gross income is below the phaseout amount. They are claiming an education credit of which $1,000 of expenses was used to calculate the credit. They can exclude the entire amount of interest received from the bond redemption because the total amount of qualified higher education expenses ($12,500), reduced by the tax-free educational assistance allowance ($500), the scholarship ($2,000), and the expenses used to compute the education credit ($1,000), yields adjusted qualified higher education expenses of $9,000. This amount exceeds the total proceeds of the redemption ($7,816). Continued on next page RA Basic 1040 – C1 – PG Income Exclusions 31282-102 4-20 July 2020 Education Savings Bond Program, Continued Interest Allocation If the proceeds from the bonds redeemed exceed qualified educational expenses, the taxpayer must make an allocation because part of the interest earned is taxable (IRC § 135(b)(1)). The formula to allocate interest is defined by IRC § 135(b)(1)(B): Total Qualified Higher Education Expenses (from all sources) ÷ Total Bond Proceeds × Interest Received = Interest Excludible from Income Example 7: In February 2019, John and Mary, a married couple, cashed in a qualified series EE bond and received proceeds of $6,500, representing principal of $5,000 and interest of $1,500. In 2019 they used the proceeds from this bond to pay their son’s qualified college tuition of $6,000. They did not claim any education credit and do not have an education IRA. As the amount of the bond proceeds is greater than the qualified tuition, John and Mary must allocate the interest. John and Mary can exclude $1,385 of interest income from the bond. The amount is computed as follows: $6,000/$6,500 × $1,500 = $1,385 John and Mary must include $115 ($1,500 – $1,385) in interest income from the bond on their 2017 tax return. Continued on next page Income Exclusions RA Basic 1040 – C1 – PG July 2020 4-21 31282-102 Education Savings Bond Program, Continued Income Limitation The exclusion under IRC § 135 is phased out for taxpayers with adjusted gross income (computed without regard to this exclusion and after certain modifications; the “modified adjusted gross income”) over $81,100 (single or head of household) or $121,600 (married filing jointly or qualifying widow(er) with dependent child) for 2019. If the taxpayer’s modified adjusted gross income exceeds $96,100 (single or head of household) or $151,600 (married filing jointly or qualifying widow(er)), this exclusion is not available for 2019. The exclusion under IRC § 135 is not available for married taxpayers filing separate returns. Modified AGI is defined by IRC § 135(c)(4). Computation Taxpayers use Form 8815, Exclusion of Interest From Series EE and I U.S. Savings Bonds Issued After 1989, to compute the allowable exclusion. RA Basic 1040 – C1 – PG Income Exclusions 31282-102 4-22 July 2020 Examination Techniques A minimum income probe is required in each examination per IRM 4.10.4.3, Minimum Requirements for Examination of Income. IRP documents may be included with the case file or may be retrieved from the Integrated Data Retrieval System (IDRS). It is important to learn what income is excludable from gross income and not reflected on the tax return. The initial interview is critical in determining what income is excluded and why. Be sure to include probing, open-ended, and close-ended questions. Review bank and brokerage accounts for large, unusual, or questionable (LUQ) deposits. Question the taxpayer regarding the source of the deposits. Request additional information if the taxpayer’s explanation is insufficient. Scan all accounts to locate assets acquired during the year and consider what sources of funds are available to the taxpayer. The type of information used to verify exclusion depends on the type of exclusion claimed. Statements from insurance companies or copies of gift or inheritance tax returns may need to be inspected. In addition, consider requesting a copy of the will or a statement from the executor of an estate. Trustees of estates can provide information regarding trusts and income earned from a trust by beneficiaries. A taxpayer should be able to tell you why a state bond was issued, i.e., sewage plant, electrical plant, municipal building, etc. If a return has tax-exempt interest income listed, look for improperly deducted expenses relating to this tax-exempt interest. IRC § 265(a)(1) and (2) specifically deny deductibility of expenses or interest paid on tax-exempt bonds. The Audit Techniques Guide (ATG) titled Lawsuit Awards and Settlements can be accessed at the IRS’ website: http://www.irs.gov/pub/irs- utl/lawsuitesawardssettlements.pdf If the taxpayer claims a scholarship exclusion, both the source of the funds and the expenses incurred need to be reviewed. Continued on next page Income Exclusions RA Basic 1040 – C1 – PG July 2020 4-23 31282-102 Examination Techniques, Continued Insurance companies settle many lawsuits before they go to court. Lawsuits are entered into public record in the court of jurisdiction. Court awards may or may not be disclosed. The RA may need to request information from the taxpayer, insurance companies, and attorneys to determine the type of award. Settlements prepared between parties should be read thoroughly to determine the breakdown of the award into types, i.e., punitive, compensatory, etc. If the taxpayer claims an award was based on achievement or employee achievement, documentation should be requested from the awarding organization or the employer. If the taxpayer kept all or a portion of an achievement award, then a taxable event has occurred. Consider obtaining records from administrators of scholarships for the gross amounts and the purpose of payments, and from educational organizations for the expenses. Ask the taxpayer questions such as:  What expenses did you pay with the scholarship?  What kind of educational facility did you attend?  How did you pay for room and board?  Did you provide services or research related to the scholarship? Consider matching redeemed U.S. savings bond proceeds and interest with qualified educational costs, look for the 1099-T, Tuition Statement. Verify attendance of the taxpayer, taxpayer’s spouse, or dependent(s) at a qualified educational institution by requesting grade reports. Ensure the exclusion of the scholarship is not taken in conjunction with education credits or exclusion of an Individual Retirement Account (IRA) distribution. RA Basic 1040 – C1 – PG Income Exclusions 31282-102 4-24 July 2020 Summary Main Points 0B 1. Exclusions, unlike deductions, do not appear on a tax return. 2. Gross income does not include: Life insurance proceeds. Property acquired by gift or inheritance. Interest on state and municipal bonds. Certain damages. Certain achievements awards, or awards for length of service or safety achievement. Scholarships and fellowship grants (with limitations). Education savings bond interest (for qualified expenses). Certain accelerated death benefits on life insurance policies. 3. Gross income does include: Interest earned on life insurance proceeds held by the insurance company. Income earned on property received by gift or inheritance, and rights to future income so acquired. FMV or prizes and awards, unless the recipient meets specific requirements. Amounts received as scholarship or fellowship grants which represent compensation for services (past, present, or future) or for studies or research performed for the benefit of the grantor. Objectives 1B At the end of this lesson you will be able to: 4-1 Determine if a particular benefit qualifies for exclusion from gross income. 4-2 Distinguish between exclusions and deductions. Income Exclusions RA Basic 1040 – C1 – PG July 2020 4-25 31282-102 Answers to Exercises Exercise 1 2B While reviewing/analyzing bank accounts during an examination of Anne’s 2019 return, a revenue agent determines Anne has more funds than she reports on her return. When the revenue agent asks her about the source of the funds, Anne provides documentation for the items below. When her mother died on December 31, 2018, Anne received stock worth $5,000. This stock earned dividends in 2019 of $600. Anne also received cash from her mother’s estate of $40,000. She deposited the cash into her savings account where it earned $2,500 in interest income. Her mother’s estate holds rental property worth $100,000. This property will be sold when the real estate market improves. The property produces net rental income which totaled $3,500 in 2019. Anne was also the beneficiary of her mother’s life insurance policy for $50,000.