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Chapter 3

Chapter 3. Gross Income: Inclusions and Exclusions “I like to pay taxes.  With them I buy civilization.”  --Oliver Wendell Holmes, Jr. LO #1 When and How to Record Income. Income Recognition for Tax Purposes Similar to the recognition for accounting purposes

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Chapter 3

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  1. Chapter 3 Gross Income: Inclusions and Exclusions “I like to pay taxes.  With them I buy civilization.”  --Oliver Wendell Holmes, Jr.

  2. LO #1 When and How to Record Income • Income Recognition for Tax Purposes • Similar to the recognition for accounting purposes • Income must be realized and earned • However, three additional conditions must be met in order to recognize income: • Transaction must have economic benefit • Transaction must have concluded • Income from the transaction must not be tax exempt income

  3. LO #1 When and How to Record Income - Concept Check 3-1 1. An individual must recognize income on his or her tax return if the transaction meets three conditions. Name the three conditions:________,________, ________ Economic benefit Conclusion Not tax exempt

  4. LO #1 When and How to Record Income - Concept Check 3-1 2. An individual can exclude certain income from taxation even though a transaction, which has economic benefit, has occurred. True or False? True

  5. LO #2 Cash Method of Accounting • Cash Receipts and Disbursements Method • Used by almost all individuals to file their tax returns • Constructive receipt • Income is reported in the year the taxpayer receives the right to control the income rather than the year in which it’s earned • Receipt of property or services will trigger income recognition

  6. LO #2 Cash Method of Accounting Concept Check 3-2 1. Income may be realized in any form, whether in money, property, or services. True or False? True 2. If you provide consulting services to your friend and in exchange, he fixes your car, you and your friend must report on both tax returns the fair market value of the services provided. True or False? True

  7. LO #3 Taxability of Components of Gross Income • Interest • Interest from financial institutions is reported on a 1099INT and is taxable • Interest earned on Series E, EE, and I U. S. Savings Bonds is taxable but can be reported gradually on annual basis or fully at maturity • Some interest received is tax exempt if the debt is issued by a U.S. state, possession, or political subdivision

  8. LO #3 Taxability of Components of Gross Income • Other types of interest that must be reported • Payments received from seller-financed mortgages • Receipts from installment sale receivables • Imputed interest on loans made below market rate • Interest on bonds sold between interest dates • How to report interest • If the amount of interest is more than $1,500, use Schedule 1 for Form 1040A or Schedule B for Form 1040

  9. LO #3 The Taxability of Components of Gross Income Concept Check 3-3 1. All interest received from state or local bonds is not taxable. True or False? False 2. A Schedule 1 (Form 1040A) or Schedule B (Form 1040) is required if an individual receives $1,500 of interest for the tax year. True or False? False

  10. LO #3 Taxability of Components of Gross Income • Dividends • Dividends are distribution to shareholders and is taxable • Dividends are taxed at capital gain rates if they are qualified dividends (from the earnings and profits of domestic or qualified foreign corporation) • Tax rate is 15 percent if the taxpayer’s marginal ordinary income tax rate is 25 percent or more • Tax rate is 5 percent if the taxpayer’s marginal ordinary income tax rate is less than 25 percent

  11. LO #3 Taxability of Components of Gross Income • Other types of dividends • Stock dividends and stock splits are generally not taxable to shareholders • How to report dividends • If the amount of interest is more than $1,500, use Schedule 1 for Form 1040A or Schedule B for Form 1040

  12. LO #3 Taxability of Components of Gross Income Concept Check 3-4 1. Qualified dividends arise from the earnings and profits of the payer corporation. True or False? True 2. A corporation can pay only cash dividends to its shareholders. True or False? False

  13. LO #3 Taxability of Components of Gross Income • Refunds from State and Local Governments • Tax refunds are taxable if, in the prior year, the refund was deducted as an itemized deduction • The taxable amount is the smaller of • (a) the amount received, or (b) the amount deducted on Schedule A, or (c) the amount by which itemized deductions exceed the standard deduction

  14. LO #3 Taxability of Components of Gross Income • Social Security Benefits • Part of the social security benefits may be taxable • Provisional income (also, called modified AGI) must be calculated and compared to the threshold amounts to determine taxability

  15. LO #3 Taxability of Components of Gross Income • Provisional income defined • Adjusted gross income (before SS benefits) plus: • Interest on U.S. Savings Bonds excluded for educational purposes • Most tax exempt interest • Employer-provided adoption benefits • Excluded foreign income • Deducted interest on educational loans • Deducted tuition and fess • 50% of social security benefits

  16. LO #3 Taxability of Components of Gross Income • If provisional income exceeds certain thresholds, 50% of social security benefits are taxable • As provisional income increases, the taxable amount increases to as much as 85% of social security benefits

  17. LO #3 Taxability of Components of Gross Income • Lower and upper threshold amounts for provisional income Married Filing Jointly Single, Head of Household, or Qualifying Widow(er) Lower and Upper Limits Lower and Upper Limits $32,000 $25,000 $44,000 $34,000

  18. LO #3 Taxability of Components of Gross Income • Example: • Karen files as a qualifying widow. She received $7,000 of social security benefits, $19,000 interest income, and $5,000 nontaxable municipal bond interest. Her provisional income is $27,500. • Karen reports taxable social security benefits equal to the lesser of 50 percent of social security benefits ($3,500) or 50 percent of the excess of provisional income over $25,000 ($1,250). Thus, her taxable benefits are $1,250

  19. LO #3 Taxability of Components of Gross Income-Concept Check 3-5 1. Linda and Tom file a joint return. Their AGI before Social Security was $22,000, Social Security benefits received were $9,000, and tax-exempt interest was $1,250. What is the amount of their provisional income? $27,750 ($22,000+$4,500+$1,250)

  20. LO #3 Taxability of Components of Gross Income • Other types of taxable income • Unemployment compensation • Jury duty • Prizes and awards • Forgiveness of debt • Insurance proceeds in excess of the adjusted basis of the property

  21. LO #3 Taxability of Components of Gross Income Concept Check 3-6 1. Name a type of income item that is listed on line 21 of Form 1040.____ Jury duty, gambling winnings, prizes and awards

  22. LO #4 Items Excluded from Gross Income • Fringe benefits are excluded if they meet the nondiscrimination rules • Examples: • No additional cost services provided to an employee • Unsold hotel room or airline seats • Qualified transportation • Moving expenses

  23. LO #4 Items Excluded from Gross Income • Fringe benefits (cont.) • Discounts provided to employees for products or services normally sold by the business • For products, the discount cannot exceed the gross profit percentage • For services, maximum discount is 20 percent of the normal selling price • De minimis benefits • Holiday turkeys, company picnics

  24. LO #4 Items Excluded from Gross Income • Nontaxable fringe benefits with certain limitations • Life insurance • Premiums for coverage up to $50,000 • Educational assistance • Up to $5,250 may be reimbursed to the employee • Dependent care assistance • Up to $5,000 of exclusion but cannot exceed earned income of the employee

  25. LO #4 Items Excluded from Gross Income • Other nontaxable income: • Some have certain requirements or limitations: • Scholarships and fellowships • Qualified tuition program (QTP) withdrawals • Life insurance proceeds • Gifts and inheritances • Compensation for sickness or injury • Child support • Welfare • Employer-provided adoption assistance

  26. LO #4 Items Excluded from Gross Income-Concept Check 3-7 1. Holiday turkeys given to employees are included in gross income. True or False? False 2. In general, scholarships are not taxable if the use of the money is to pay tuition, fees, books, supplies and equipment. True or False? True

  27. LO #5 Other Interest Income Items • Savings Bond Interest • Not taxable if used to pay qualified higher education expenses for the taxpayer, spouse or dependent children • Full exclusion allowed if the educational expenses paid exceed the redemption amount • Limitation applies if modified AGI exceeds $94,700 on a joint return or $63,100 on other returns

  28. LO #5 Other Interest Income Items • Below-Market Interest Rate Loans • If the debt instrument was created with interest rates that materially vary from market rates at the time of issuance, then interest is required to be imputed. • Examples of when imputed interest does not apply: • Sales of property for $3,000 or less • Personal Residence

  29. LO #5 Other Interest Income Items • Gift Loans • Imputed interest rules apply to gift loans over $11,000 where forgoing of interest is in the form of a gift • Original Issue Discount (OID) • Equal to the difference between the acquisition price and the maturity value • The holder must report part of the OID as interest income every year

  30. LO #5 Other Interest Income Items • OID is not applicable to: • Tax exempt debt • U.S. Savings Bonds • Debt with a maturity of 1 year or less on the date of issue • Any obligation issued by a natural person before March 2, 1984 • Non-business loans of $10,000 or less between natural persons

  31. LO #5 Other Interest Income ItemsConcept Check 3-8 1. An individual is required to impute interest on a deferred payment contract where no interest, or a low rate of interest, is stated. True or False? True 2. If someone purchases a debt instrument (e.g., bond) from an issuer for an amount less than par value, the transaction creates original issue discount (OID). True or False? True

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