Chapter 3: Gross Income: Inclusions Flashcards
Gross income
Defined by law as “except as otherwise noted…gross income means all income from whatever source derived”
Economist definition of income
The amount an individual could consume during a period and remain as well off at the end of the period as they were at the beginning
= Consumption + change in wealth (includes unrealized gains and adjustments for inflation)
Realization as per income for accounting purposes
Occurs when there is:
- a change in the form or substance of a taxpayer’s property (sale or purchase)
- a transaction with a second party
General condition for income to be taxable
- there must be economic benefit
- income must be realized
- income must be recognized (specific recognition rules may apply) (income may be exempt by statute)
Also determined by
- administrative convenience
- wherewithal to pay
Administrative convenience
There is a need for objectivity in taxation and using the economic concept of income has too much subjective valuation to be functional
Wherewithal to pay
Concept holds that a tax should be collected when the taxpayer is in the best position to pay the tax (when money has been collected from a sale rather then when property increases in value)
This is why prepaid (but unearned) income is taxed
Sources of income explicitly included in tax code
Income is not limited to only these items
- compensation for services (inc benefits, commissions)
- gross income from business
- gains from property deals
- interest
- rents
- royalties
- dividends
- annuities
- income from life insurance and endowment contracts
- pensions
- income from discharge of indebtedness
- distributive share of partnership gross income
- income in respect of a decedent
- income from an interest in an estate or trust
Why should taxpayers who are using the cash method of accounting be required to include in gross income the value or property or services received?
Because otherwise people would get paid in non taxable property or services instead of cash
Taxable income
All sources of income are presumed taxable unless specifically provided for by law
Burden to prove item is excluded from taxable income is on the taxpayer
Form of receipt of income
Income is not limited to cash received, can be income realized in any form “money, property, or services”
Valuing barter transactions
Generally cost basis of property received less cost basis of property given up = income
Indirect economic benefit
Excluded from gross income
Judicial rule: benefit is excludable if made primarily to serve business needs of employer and benefit to employees is secondary/incidental
Can income be assigned to another person?
No. An individual is taxed on the earnings from their personal service. Cannot assign to another to avoid taxation
Income from property is taxed to the owner of the property - to transfer tax property must be transfered
Common law property system
Income generally taxed to the individual who earns it via labor or capital
Generally only joint income is income from jointly owned properly
Law in most states
Community property system
Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, Wisconsin
Income may be separate or community
Community income belongs equally to the spouses. Income from personal efforts & income from community property considered community income
Normally each spouse is expected to report one half of community income
Separate property
All property owned before marriage and gifts and inheritance acquired after marriage
Whether income from separate property is separate or community depends on the state
Innocent spouse provisions
Spouse who had no knowledge or reason to know about a community income item protected from repercussions of failure to report income
Provision also permits it’s to include the entire amount in the income of the other spouse
Income of minor children
Taxes regardless of property law system earnings of a child from personal income or property are taxes to the child not the parents
Subject to kiddie tax law
Accounting methods for taxpayers
May choose between
- cash receipts and disbursements
- accrual
- hybrid
BUT whatever method must clearly reflect income as determined by the IRS and may be changed if it’s determines if method fails to clearly reflect income
Who must use accrual methid
Businesses with inventories
(Many exceptions exist for small business)
Who is allowed to use the cash method
- taxpayers (not tax shelters) whose average gross receipts for three years prior do not exceed $26 million
- businesses without inventories regardless of size
Cash receipts and disbursements method
Most common method of accounting
Income is taxed in the year the taxpayer actually or constructively received the income (not year income earned)
Promise to pay has no affect on taxable income
Issues with prepaid income and the cash method
Income is taxed when received but if prepaid the corresponding expenses may not be incurred till in income (which has already been taxed) is earned . May lead to a lack of funds
Constructive receipt
The income is made available to the taxpayer so that they may drawn in it at any time.
Cannot refuse to accept payment to avoid taxes
If taxpayer control of income has substantial limitations/restrictions, the payer lacks the funds to make payment, or the amount is otherwise unavailable then the taxpayer has not constructively received it.
Cash basis reporting exception: series E and EE U.S. savings bonds
Interest need not be reported until final maturity date, or even later if bonds exchanged within one year of maturity date for series HH Us savings bonds
Cash basis reporting exception: farmers and ranchers
- farmers may report crop insurance proceeds in year following receipt if crop would ordinarily have been sold that following year
- ranchers who sell livestock on account of extreme weather conditions may delay reporting if cab show livestock sale would otherwise have taken place in a later year
Cash basis reporting exception: small taxpayer inventory exception
Small taxpayers can deduct purchases of inventory in the year of purchase (vs the year of sale) IF
- the inventory purchases are paid for by the end of the year
- the inventory is actually sold in such year
accrual method reporting for taxable income
income is considered earned when all events have occured that fix the right to receive the income and when the amount of incme can be determined with resonable accuracy
per TCJA income can be reported no later than the year it is included on financial statements
treatment of prepaid income under accrual method
taxable in the year of receipt
some deferrments allowed:
- may defer advance payments for goods (inventory) IF taxpayer’s method of accounting for the sale is the same for tax and financial purposes
- may defer payments for future services to the year following the year in which the payment is received (even if payment is for multiple future years. if for current year reported in current year)
latter does not apply to: warranties included in the sale of a product, rent with no services included, insurance premiums, or interest
hybriid method of accounting for taxaable income
some income items reported cash method, some reported accrual method
often used by small businesses required to use acccrual method for inventorys (purchase and sale of goods) but use cash method for everything else for simplicity
compensation
payment for personal services
includes comissions, tips, bonuses, specialized compensation (various fees)
exclusions for some employer-provided fringe benefits (life insurance, health insurance, employee discounts, retirement contributions, education beneftis)
- limited exclusion to foreign earned income
Gross income
Gross income for tax purposes is comparable to gross profit for financial accounting purposes
(COGS as return of capitaland not subject to income tax, only profits subject to income tax)
gains realized from property transactions
included in gross incme unless a nonrecognition rule applies
(deduct cost of property from receipt from sale to get gain)
losses from dealings in property
not offset against gains in computing gross income - mostly entered as deductions FOR AGI
this is only business losses, losses from sale or disposition of asset held for personal use are not deductable
net capital loss deduction limitation
only $3,000 in net capital losses can be deducted from other income per year
interest
compensation for the use of money
mostly taxable
tax-exempt interest
interest on obligations of states, territories, and U.S. posessions as well as bonds issued by school districts and other special purpose government entities
section 501(c)(3) orgs can issue up to $225 million of tax exempt bonds
GAINS from the sale of these bonds are still taxable
interest on state and local tax refunds is taxabl
series EE savings bonds
may be purchased and redeemed tax free if the proceeds are used to pay certain colege expenses for holder, their spouse, or dependents
- must be purchased after 1989 by a person who was 24 or older at the time
- bond must be purchased by owner (not a gift)
- receiptss must be used for tuition and fees (which are first reduced by tax exemt scholarships, tax credits, veterans benefits)
- married couples living together must file a joint return
Amount of series EE saving bond interest excluded from tax
- total interest ONLY if combined amount of principle + interest received in the year doesn’t exceed the taxpayers (reduced) quallified educational expenses AND taxpayers gross income is not over $83,200 (single), exclusion phased out after this level, (fully phased out if AGI is over $98,200)
if net qualified educational expenses are less than total interest eclusion is equal to:
series EE interest x (net qualified educational expenses / (series EE interest + principal))
(this exclusion is also reduuced after AGI exceds $83,200 (singe)
computing reduction in series EE interest exclusion
if AGI over $83,200 (single) or $12,800 (married)
= otherwise excludable amount x (excess modified AGI / $15,000 single or $30,000 joint)
exclusion based on income year bonds redeemed, not the year they are purchased
Security deposits on rental units
not included in gross income as returnable to tenants at the expiration of the lease
(deposit included in goss income in year kept ONLY if not refunded)
tax on royalties
taxable as ordinary income
paying to amend a lease
amounts paid to lessor to cancel, amend, or moodifiy a lease are taxable
are improvements by lessees taxable
improvements mae by a lessee that increase the value of leased property are included in lessor’s income ony if improvements are made in leiu of rent or if they cause rent to be reduced
in such cases improvements are included in gross income at FMV when made
if not made in lieu of rent then no adjustment made to basis in te property and no recognition till property is disposed of
