Determining Gross Income

DeterminingGross Income Chapter3

What is Gross Income? Code Section 61(a) defines gross income as “except as otherwise provided in this subtitle, gross income means all income from whatever source derived...”

What is Income? • Gross income is realized income that is not excluded • Realization takes place when arm’s length transaction occurs (sale of goods) • Taxable income is gross income less all deductions

Tax vs. Financial Accounting • Objectives are not the same • Financial accounting seeks to provide information that decision makers find useful • Tax reporting seeks to collect revenue equitably • Differences fall into two categories • Temporary (timing) differences • Permanent differences

Temporary Differences • Arise when income is taxed either before or after it is accrued for accounting purposes • Example: prepaid rent generally is taxable when received but is only included in financial accounting income as it is earned • Create a deferred tax asset or deferred tax liability on financial statements

Permanent Differences • Income that is not taxed but is reported for financial accounting purposes • Example: municipal bond interest generally is not taxed but is recorded as income in financial accounting records

Return of Capital Principle • Basis = amount invested in an asset • Basis can be recovered tax-free • If the taxpayer’s return is more than basis, the taxpayer has a gain • If taxpayer’s return is less than basis, the taxpayer has a loss

Investment Alternatives • Investments yielding appreciation • Tax deferred until gain is recognized • Gain is frequently taxed at lower capital gains rates • Investments yielding annual income • Interest income is taxed annually at the marginal tax rate for ordinary income; dividends taxed annually but currently at lower capital gains rates

The Tax Year • Calendar year • Individuals • S corporations and partnerships have restrictions on allowable tax years, so usually use a calendar year • Fiscal year • 12-month period ending on month other than December • 52-to-53 week year (ends on same day) • Corporations freely select tax year

Short Tax Year • A short-year tax return reports less than 12 months of operating results • Income must be annualized (adjusted to reflect 12 months of operations) • Required by businesses that change their tax year • Not required in year entity begins or ends business

Accounting Methods • Taxpayers can use different methods for financial accounting and tax • Cash method: receipt of cash or cash equivalents determine income/expense recognition (subject to constructive receipt doctrine) • Accrual method: the all-events test determines income/expense recognition

Cash Method • Income is recognized when cash or cash equivalents received • Cash equivalents broadly defined to include property and services • Cash equivalents included at fair market value • A cash-basis taxpayer must recognize income when an amount is • Credited to the taxpayer’s account • Set apart for the taxpayer, or • Made available in some other way to the taxpayer

Constructive Receipt Doctrine • Constructive receipt is a modification that prevents cash basis taxpayers from “turning their backs” on income • Income is not constructively received if: • The taxpayer is not entitled to the income • The payor has insufficient funds from which to make payment, or • There are substantial limitations or restrictions placed on actual receipt

Limits on Cash Method • Businesses that carry inventory and sell merchandise to customers generally must use the accrual method to account for sales and purchases • Hybrid method – accrual for sales of inventory & cost of goods sold; cash method for other income and expenses • Large corporations (gross receipts of more than $5 million) cannot use cash method

Accrual Method • Income is recognized when “all events test” is met • All events have occurred that establish the right to the income and • The income amount can be determined with reasonable accuracy • If liability is in dispute, the all events test is not satisfied until dispute is resolved

Claim of Right Doctrine • Claim of right doctrine modifies the normal recognition rules for accrual basis taxpayers • Requires taxpayer to recognize income when payment is received, regardless of whether money may have to be repaid later • If taxpayer must return all or part of the income, deduction allowed in repayment year

Prepaid Income • Prepaid Income is another exception to the accrual method of accounting • Based on wherewithal to pay concept – taxpayer should be taxed when best able to pay the tax • Income must be reported when received • Examples: rent, interest, and royalty payments • Refundable deposits are not prepaid income

Assignment of Income Doctrine • A taxpayer cannot assign earned income to a third party to escape taxation • Earned income must be taxed to the taxpayer rendering the services • Community property states (Arizona, California, Idaho. Louisiana, Nevada, New Mexico, Texas, Washington, Wisconsin) • Allocate half of income to each spouse • Income from property is taxed to taxpayer who owns the property

Interest Income • Interest income from most sources is taxable, but interest on state and local (municipal) bonds is excluded from gross income • High income taxpayers may have a higher after-tax return on municipal bonds than taxable bonds offering a higher interest rate • Gain on the sale of tax-exempt securities must be included in gross income • Interest from private activity municipal bonds may be subject to AMT

Original Issue Discount • Some debt instruments are issued at prices below their maturity values • This original issue discount (OID) is effectively interest paid at maturity rather than periodically over the debt instrument’s life • Both cash and accrual basis taxpayers recognize OID income as it accrues • Exception: Series EE and Series I bonds

Market Discount • Bonds purchased after issue in the open or secondary market at a price below their stated maturity value • Excess of redemption proceeds over cost is recognized as ordinary income in year of redemption • Electively, market discount can be accrued as interest income over life of bond

Below-Market-Rate Loans • Interest-free or low interest rate loans are frequently made between related parties • Interest income that is not actually received or accrued may be imputed (treated as received or accrued and taxed) at the applicable federal rate of interest

Gift Loan Exceptions • Any gift loan of $10,000 or less is exempt from the imputed interest rules • For gift loans greater than $10,000 but less than $100,000 • Imputed interest cannot exceed the borrower’s net investment income for the year • If borrower’s net investment income is no more than $1,000, imputed interest is zero

Other Loans • Loan to employee – imputed exchange of cash is treated as taxable compensation (income to employee and deduction for employer) • Loan to shareholder – imputed exchange of cash is treated as a dividend (taxable income to shareholder, no deduction for corporation) • $10,000 exception if no tax avoidance motive

Dividend Income • Cash and FMV of other assets distributed by a corporation from earnings and profits (E&P) are treated as dividends includable in the shareholder’s income • Distributions in excess of E&P are nontaxable return of capital (reducing stock basis) • Distributions in excess of stock basis are taxed as capital gain (as if stock is sold)

Dividend Income • 15% rate applies to most dividends (zero rate for individuals in 10% or 15% tax bracket) in 2009 and 2010 • Qualified dividends are reported on two lines on an individual’s tax return • Line 9a “ordinary dividends” includes dividend income in adjusted gross income • Line 9b “qualified dividends” indicates that the dividend income qualifies for the special lower tax rate

Mutual Fund Dividends • May distribute dividends received on stock they hold to their mutual fund shareholders • May also pay dividends from gains they realize on the sale of investment assets • These dividends are actually net long-term capital gains and are called capital gains distributions

Dividend Reinvestment Plans • Treated as if the shareholder receives the cash and then purchases additional shares of stock with the dividend income (constructive receipt doctrine) • Value of dividend included in income • Amount included in income becomes the shareholder’s basis for these shares of stock

Stock Dividends • Stock dividends are distributions of a corporation’s own stock to its shareholders (treated the same as a stock split) • Usually stock dividends are not taxable to the shareholder • Shareholder owns a greater number of shares and the basis in the original shares is divided among all shares of stock now held • If shareholder has option of receiving cash or stock, then it is taxable

Annuity Income • Usually consists of a taxable and nontaxable amount • Nontaxable amount represents a return of capital • Nontaxable amount of a payment is equal to the Investment in annuity / expected return from annuity x annuity payment received • If the amounts invested in the annuity were all made by the employer (or by the employee using pre-tax dollars), then the employee’s investment is treated as zero

Prizes and Awards • Prizes, awards, gambling winnings, and treasure finds are taxable • The fair market value of goods or services received is included in gross income

Government Transfer Payments • Need-based payments, such as welfare payments, school lunches & food stamps, are excluded from income • Unemployment compensation is taxable because it is a substitute for wages that would be taxable • Exception: the first $2,400 of unemployment benefits received in 2009 were excluded (but this exception was not extended to 2010)

Social Security Benefits • Government devised a complex formula that can result in the taxation of up to 85% of social security benefits for taxpayers who have significant other income while leaving benefits completely tax free for those who have little other income • MAGI = AGI before any social security benefits + exempt interest income + ½ of social security benefits

Social Security Benefits • If MAGI is less than $25,000 for single individuals or $32,000 for married couples, then none of the social security benefits received are taxable • Single taxpayers with MAGI above $34,000 and married taxpayers with income above $44,000 can be taxed on up to 85% of their benefits • Taxpayers between the above thresholds can be taxed on up to 50% of their social security benefits

Damage Awards • Damages for physical injuries are not taxed (under the return of capital doctrine) • Damages for all other awards are taxed (viewed as substitute for income that would otherwise be taxable income) • Punitive damages are taxable

Divorce-Related Payments • A property settlement is simply a division of assets (no income, no deduction) • Alimony is a legal shifting of income – taxable income to recipient and deductible by payor • First year’s alimony should not exceed average of 2nd and 3rd year payments by more than $15,000 • Child support fulfills a legal obligation to support a child (no income, no deduction) • Both parties may benefit by negotiating an increase in payment if it qualifies as alimony

Discharge of Debt • If a legal obligation is satisfied for less than the outstanding debt, the amount of debt forgiven represents an increase in the taxpayer’s wealth and is subject to taxation • Exceptions are provided for debtors who are bankrupt or insolvent • Exceptions for the forgiveness of some student loans when the students work in certain professions

Discharge of Debt • Mortgage Forgiveness Debt Relief Act of 2007 provided relief for homeowners whose mortgage debt was forgiven • Forgiveness on up to $2 million of qualified debt on a principal residence from 2007 through 2009 was excluded from income • This provision was then extended through 2012 and applies to restructuring, short sales, and deeds-in-lieu of foreclosure • Basis of residence is reduced (but not below zero) for amount excluded

Tax Benefit Rule • If a taxpayer deducted an expense or loss in one year but recovers the amount deducted in a subsequent year, all or a portion of the amount recovered may have to be included in the gross income in the year it is recovered • Amount included in income is limited to the extent the taxpayer benefited from the tax deduction • Example: bad debt recovery or refund of taxes previously deducted

Exclusions • Gifts • Inheritances • Life Insurance • Proceeds received are tax-free but any interest income on proceeds is taxable • Inside buildup (increase in cash surrender value) is not taxable income unless policy is liquidated for more than premiums paid

Accident & Health Insurance • Accident & health insurance proceeds are tax-free to extent they pay qualified medical or dental expenses; excess benefits taxable if employer provided policy • Disability insurance is a substitute for lost pay is an employee cannot work • If premiums for disability insurance paid by employer, then benefits received are taxable • If premiums paid by employee, exception allows benefits to be received tax free

Scholarships • Qualified scholarships are excluded from gross income • “Scholarship” includes only tuition, fees, books, supplies, equipment, and related expenses required for courses • Amounts designated or spent for room, board, and laundry are included in taxable income

Scholarships • Any grant received in return for past, present, or future services must be included in gross income • Funds received by students in return for teaching or research services are taxable • When taxable portion cannot be determined until end of academic year, taxable income can be deferred until the taxable year in which the academic year ends

Other Exclusions • Improvements made on leased property are excluded from landlord’s income unless improvements made in lieu of paying rent • Fringe benefits (discussed in next chapter) • Exclusion of gain on sale of home • $250,000 if single, $500,000 if married and both spouses qualify • Must have owned and lived in home as principal residence for at least 2 of previous 5 years

International Issues • Source principal - countries tax income earned within their borders but exclude income from activities taking place (sourced) in other countries • Applies to foreign persons and foreign corporations • Residency principle – countries tax worldwide income • Applies to resident individuals and corporations

International Taxation • A business is usually only taxed in country of residence unless it maintains a permanent establishment (e.g. office) in another country • Source country can tax income earned within its borders when a permanent establishment exists • Double taxation can result when more than one jurisdiction has the right to tax the same income

Minimizing Double Taxation • Tax treaties and tax credits minimize the impact of this double taxation • A tax treaty is an agreement between two countries that explains how a taxpayer of one country is taxed when conducting business in another country • Foreign tax credits can offset domestic taxes on foreign source income

Taxpayers Subject to U.S. Tax • U.S. citizens, corporations, and resident aliens are subject to U.S. tax on their worldwide income • Resident alien – individual who is not a U.S. citizen but who has established legal residence in U.S.through • Green card or • Substantial presence test (183 days) • Individuals typically exempt from substantial presence test include diplomats, teachers, students, and certain professional athletes

Nonresident Aliens and Foreign Corporations • Nonresident alien – individual who is not U.S. citizen and does not satisfy test to be resident alien • Nonresident aliens and foreign corporations are subject to U.S. tax on • Effectively connected income – U.S. business income subject to U.S. income tax • U.S. investment income – taxed at flat 30% (or treaty rate if lower)

U.S. Corporations Doing Business in a Foreign Country • A U.S. corporation can operate in a foreign country through a branch or a subsidiary • A branch is viewed as an extension of the U.S. corporation • Branch’s income is combined with U.S. operations and subject to U.S. tax (no income deferral) • A controlled foreign corporation (CFC) is a corporation incorporated outside the U.S. that is owned more than 50% by U.S. shareholders

Determining Gross Income