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Chapter 3. Income Sources. Kevin Murphy Mark Higgins. ©2008 South-Western. What is Income?. All-inclusive Income Concept Defined by exception: “Except as otherwise provided…” § 61 Judicial findings Income is the gain derived from labor and capital

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chapter 3
Chapter 3

Income Sources

Kevin Murphy

Mark Higgins

©2008 South-Western

what is income
What is Income?
  • All-inclusive Income Concept
    • Defined by exception: “Except as otherwise provided…” § 61
  • Judicial findings
    • Income is the gain derived from labor and capital
    • Any increase in wealth that has been realized is income
what is income1
What is Income?
  • Current View
    • A change in the form and/or substance of the taxpayer’s property, and
    • The involvement of a second party in the income process
types of income
Types of Income
  • Earned
  • Unearned
  • Transfer
  • Imputed
  • Capital Gains and Losses
earned income definition
Earned Income: Definition
  • Two problems may arise when determining taxability of earned income
    • Cash-equivalent approach
    • Assignment of income

Compensation received for the provision of labor is earned income.

unearned income definition
Unearned Income: Definition
  • Examples of unearned income are:
    • Interest and Dividend Income
    • Rental and Royalty Income
    • Annuities

The earnings from investments and gains from the sale, exchange or disposition of investment assets is unearned income.

unearned income annuities
Unearned Income: Annuities
  • An annuity is a series of equal payments received at set time intervals for a determinable period
  • Capital Recovery Concept excludes the amount of original investment from taxable income
    • Must be spread over the time of receipt
annuity exclusions
Annuity Exclusions
  • If the payment term and amount are fixed:

Exclusion Ratio = Cost of the contract

Total expected return

annuity exclusions1
Annuity Exclusions
  • If the payment term depends on the life of the taxpayer
    • Must estimate the number of payments
    • Use the “simplified method”
annuity exclusions simplified method
Annuity ExclusionsSimplified Method
  • Annuity payments beginning after November 18, 1996
    • use Tables 3-1 or 3-2 to determine number of payments

Excluded portion = Contract Cost

Number of payments

annuity example
Annuity Example

George, age 64, purchased an annuity for $30,000. He begins receiving $300 per month in January. What amount is included in his gross income?

From Table 3-1, the number of payments to use is 260.

$30,000 / 260 = $115 monthly exclusion

$115 X 12 = $1,380 excluded per year

$300 X 12 = $3,600 amount received

$3,600 - $1,380 exclusion = $2,220 gross income

slide12

Unearned Income: Gains and Losses

Gains or losses may occur upon disposal

of investment property.

Proceeds from sale or disposition

less: Selling expenses

Amount realized from disposition

less: Adjusted basis of property

Gain or loss from disposition

unearned income income from conduit entities
Unearned Income:Income from Conduit Entities
  • Income from a conduit entity is reported by the owners and taxed on the owners’ returns
  • Distributions from conduit entities to the owners are treated as a recovery of capital
transfer income definition
Transfer Income: Definition

Some amounts of income are neither fully earned nor fully unearned.

  • Prizes and Awards
  • Unemployment Compensation
  • Social Security Benefits
  • Alimony Received
transfer income prizes and awards
Transfer Income: Prizes and Awards

Amounts received as prizes and awards are generally taxable.

  • Exceptions exist for:
    • Scientific and literary achievements
      • must be given by recipient to a qualified charity or government unit
    • Employee achievements
      • must be given to employee for length of service or safety
      • amount is limited to $400 per employee (or $1,600 if qualified plan)
transfer income unemployment compensation
Transfer Income:Unemployment Compensation

Amounts received from unemployment compensation plans are considered substitutes for earned income and are always taxable.

transfer income social security benefits
Transfer Income: Social Security Benefits

A portion of Social Security benefits received may be taxable if modified AGI exceeds certain limits.

Adjusted gross income

plus: 1/2 social security benefits

plus: tax exempt income

plus: foreign earned income exclusions

Modified AGI

modified agi example
Modified AGI Example

A single taxpayer received $3,000 from Social Security payments. Her AGI without the SS is $30,000.

Modified AGI = $30,000 + $1,500

= $31,500

transfer income social security benefits tier one
Transfer Income:Social Security Benefits - Tier One
  • Unmarried individuals with modified AGI between $25,000 and $34,000, and
  • MFJ individuals with modified AGI between $32,000 and $44,000
tier one calculation
Tier One Calculation

The taxable portion of Social Security is equal to the lesser of:

1. 1/2 Social Security received,

OR 2. 1/2 of the amount by which modified AGIexceeds the base amount.

where the base amounts are $25,000 for unmarried individuals, $32,000 for MFJ, and $0 for others

example continued
Example continued

With modified AGI= $31,500, the taxable portion of her $3,000 Social Security income is the lesser of:

1. $1,500, or

2. 1/2 ($31,500 - $25,000) = $3,250

Therefore, taxable SS is $1,500

slide22

Transfer Income:Social Security Benefits - Tier Two

  • For individuals whose income exceeds Tier One amounts . . .
tier two calculation
Tier Two Calculation

The taxable portion of Social Security is equal to the lesser of:

1. 85% of Social Security received,

OR 2. 85% of the amount by which modified AGI exceeds the base amount*,

PLUS the smaller of

a. the amount of SS benefits included under the 50% formula, or

b. $4,500 for unmarried individuals ($6,000 for MFJ)

*Where the base amounts are $34,000 for unmarried individuals, $44,000 for MFJ, and $0 for others

© 2004 South-Western College Publishing

example for tier two
Example for Tier Two

If our taxpayer receives Social Security of $12,000 and has AGI of $50,000 before SS:

Modified AGI= $50,000 + $6,000* = $56,000

Taxable SS is $10,200, which is the smaller of:

1. .85( $12,000) = $10,200, or

2. [.85 ($56,000 - $34,000)] + [(1/2 of $12,000 SS) or $4,500]

= $18,700 + $4,500

= $23,200.

transfer income alimony received
Transfer Income: Alimony Received

Amounts received for alimony payments are taxable income if:

  • the payments are made in cash
  • there is a written agreement
  • the payments are not disguised child support
  • the payments cannot be made to payee’s estate
  • the payer and payee do not live in the same household
imputed income personal consumption
Imputed Income: Personal Consumption
  • The value of the goods and services produced by individuals for personal consumption generally are not taxable
    • Realization concept
    • Administrative Convenience concept
imputed income below market rate loans
Imputed Income:Below Market-Rate Loans
  • Interest income and expense are imputed on below market-rate loans.
    • The relationship between the lender and the borrower determines the tax treatment
      • The lender has imputed interest income
      • The borrower has imputed interest expense
    • Administrative Convenience grants exceptions for
      • loans of $10,000 or less
      • gift loans of $100,000 or less
imputed income payment of expense by others
Imputed Income:Payment of Expense by Others
  • Payments made by family members may be considered nontaxable gifts
  • Payments made by employers are taxable income

A taxpayer whose expenses are paid by another has realized an increase in wealth.

imputed income bargain purchases
Imputed Income: Bargain Purchases

When a bargain purchase price does not result from an arms-length transaction, the bargain amount is taxable income.

capital gains and losses introduction
Capital Gains and Losses: Introduction

A capital asset is any asset other than inventory, receivables, and depreciable or real property used in a trade or business.

  • A sale or other disposition of capital assets results in a capital gain or loss
  • Capital gains and losses receive special tax treatment
capital gains and losses holding period
Capital Gains and Losses:Holding Period
  • The holding period for capital assets is how long the taxpayer owned the asset.
    • Short Term = held for < 12 months
    • Long Term = held for > 12 months
  • Determining holding period is the first step in determining tax treatment.
capital gains and losses netting procedures
Capital Gains and Losses:Netting Procedures

Long-term gains

netted against

Long-term losses

Net Long-term

Gain or Loss

=

Short-term gains

netted against

Short-term losses

Net Short-term

Gain or Loss

=

capital gains and losses netting procedures1
Capital Gains and Losses:Netting Procedures

Net Short-term Gain or Loss

netted against

Net Long-term Gain or Loss

Net Capital

Gain or Loss

=

If one is a loss and one is a gain, then:

If both are losses or both are gains, no further netting is done.

tax treatment for net gains
Tax Treatment for Net Gains
  • Net short-term capital gain is taxed as ordinary income
  • Adjusted net long-term capital gain is taxed at a maximum 15%
    • Adjusted NLTG = NLTG - [28% rate gain - Unrecaptured §1250 gain + Eligible dividends]
    • 28% rate gain = [Net collectibles gain + Small business stock gain - STCL - LTCL carryover]
tax treatment for net gains1
Tax Treatment for Net Gains
  • Net Collectibles gain and Small Business Stock gain is taxed at a maximum 28%
  • Unrecaptured §1250 gain is taxed at a maximum 25%
tax treatment for net losses by individuals
Tax Treatment for Net Losses by Individuals
  • Only $3,000 of net capital losses may be deducted in one year
    • Use short-term losses first
    • Carryover net loss > $3,000
  • Capital gains and losses of conduit entities flow-through to owners’ returns
when is income reported
When is Income Reported?

The Accounting Method chosen by a taxpayer dictates when income is reported.

  • Cash Method taxpayers report income when cash is actually or constructively received
  • Accrual Method taxpayers report income when it is earned
  • Hybrid Method taxpayers mix accrual and cash methods
accounting method cash
Accounting MethodCash

Cash method taxpayers must follow the Constructive Receipt Concept.

  • Exceptions to the cash method:
    • Taxpayers who sell inventory may not use the cash method for inventory
    • Taxpayers must use the accrual and the effective interest method with Original Issue Discount securities
    • Taxpayers who hold Series EE Bonds may elect to use the accrual method
accounting method accrual
Accounting MethodAccrual

Under tax law, income is accrued when

  • All events have occurred that fix the right to receive the income, and
  • The amount of income earned can be determined
accounting method accrual exceptions
Accounting MethodAccrual Exceptions
  • Exceptions to the accrual method:
    • The Wherewithal-to-Pay concept requires income be reported in the year pre-payment is received for rents, insurance, interest and royalties
    • One year deferral is allowed for some pre-payments
      • Report amount = Financial Accounting in first year
      • Remainder of amount in full in second year
    • Pre-payments for goods may be accrued if the payment is less than the Cost of Goods Sold.
accounting method hybrid
Accounting MethodHybrid

Taxpayers may mix the cash and accrual methods, using accrual for sales of inventories and cash for other revenues and expenses.

accounting method exceptions to all methods
Accounting MethodExceptions to All Methods

Installment Sales Method: Any time one payment is received after the year of sale, taxpayers must recognize income proportionately as the selling price is received unless they elect to report in the year of sale.

Long-term Construction Contracts: The percentage-of-completion method must be used for all long-term construction.