CH. 5 - Gross Income & Exclusions

Question 1

Gross Income

Answer 1

Income that taxpayers realize, recognize, and report on their tax returns for the year.

More officially, it is realized income minus excluded and deferred income.

Official definition: all income from whatever source derived, unless excluded by law. Gross income includes income from any form, whether in money, property, or service.

Unless a tax provision clearly states otherwise, gross income includes all income.

Question 2

What are the three requirements for a taxpayer to recognize gross income?

Answer 2

1. they receive an economic benefit
2. they realize the income (AKA they actually have the cash in hand) and
3. no taxpayer provision allows them to exclude or defer the income from gross income for that year.

Question 3

Explain what economic benefit is as it relates to gross income

Answer 3

Taxpayers must receive an economic benefit (aka receive an item of value) to have gross income. Common examples include:
-compensation for services (in the form of cash, other property, or even services received)
-proceeds from sale of property (typically cash, property, or debt relief)
-income from investments or business activities (such as business income, rents, interest, and dividends)

Question 4

When a taxpayer borrows money, is the economic benefit criterion met for gross income?

Answer 4

No, because when a taxpayer borrows money, the funds received are offset by the liability (the debt plus interest).

Question 5

What is the realization principle as it relates to gross income?

Answer 5

the proposition that income only exists when there is a transaction with another party resulting in a measurable change in property rights.

Aka assets or services are exchanged for cash, claims to cash, or other assets with determinable value.

Question 6

What are the two major advantages for adopting the realization principle when it comes to gross income?

Answer 6

Parties to the transaction must agree to the value of the exchanged property rights, so the transaction allows the income to be measured objectively.

Secondly, the transaction often provides the taxpayer with the wherewithal to pay taxes. Aka, the transaction itself provides the taxpayer with the funds to pay the taxes generated by the transaction.

Question 7

Wherewithal to pay

Answer 7

the ability or resources to pay taxes due from a particular transaction.

Question 8

What is the recognition principle as it pertains to gross income?

Answer 8

Taxpayers who realize an economic benefit must include the benefit in gross income unless a specific provision of the tax code says otherwise.

Question 9

What is the difference between realized income and recognized income income?

Answer 9

Realized income is that which is earned. If a company ships out goods worth $10,000 and includes an invoice for those goods with 30-day terms, the company doesn’t recognize the $10,000 in income until it has a check in hand for that amount. AKA CASH.

Recognized income, by contrast, is recorded but not necessarily received. If a company ships out $10,000 in goods and sends out an invoice with 30-day terms, it might record that $10,000 as recognized income before it gets paid. AKA CAN BE NON-CASH

Question 10

Tax basis

Answer 10

If you invest in a company by buying common stock, that amount is considered your tax basis.

Question 11

Return of capital

Answer 11

the tax basis (ie the amount you originally paid for your shares is excluded from calculating realized income) is excluded when calculating realized income.

Question 12

Tax benefit rule

Answer 12

Refunds of expenditures deducted in a prior year (usually state income taxes filed with your 1040) are include in gross income to the extent that the refund reduced taxes in the year of the deduction.

Question 13

accrual method

Answer 13

a method of accounting that generally recognizes income in the period earned and recognizes deductions in the period that liabilities are incurred.

Question 14

cash method

Answer 14

the method of accounting that recognizes income in the period in which cash, property, or services are received and recognizes deductions in the period paid.

Question 15

Constructive Receipt Doctrine

Answer 15

the judicial doctrine that provides that a taxpayer must recognize income when it is actually or constructively received. Constructive receipt is deemed to have occurred if the income has been credited to the taxpayer’s account or if the income is unconditionally available to the taxpayer, the taxpayer is aware of the income’s availability, and there are no restrictions on the taxpayer’s control over the income.

Aka, you shouldn’t delay cashing checks, etc to work in your favor tax wise.

Question 16

Claim of right doctrine

Answer 16

Informal: when there are no restrictions on the use of income–aka you are the one that is responsible and the one the money is meant to go to (aka no obligation to repay). Aka you can’t pass it off as someone else’s income when it’s really your own.

Formal: judicial doctrine that states that income has been realized if a taxpayer receives income and there are no restrictions on the taxpayer’s use of the income (for example, the taxpayer does not have an obligation to repay the amount).

Question 17

What is assignment of income?

Answer 17

-The assignment of income doctrine holds that the taxpayer who earns the income from services must recognize the income
-Income from property such as dividends and interest is taxable to the person who actually owns the income producing property.
-To shift income from property to another person, a taxpayer must also transfer the ownership in the property to the other person.

Question 18

What are community property systems, and in what states are they recognized?

Answer 18

*Recognized in 9 states: (AZ, CA, ID, LA, NV, NM, TX, WA, and WI)

Income earned from services by one spouse is treated as though it were earned equally by both spouses. Also, property acquired by either spouse during the marriage is usually community property and is treated as though it was owned equally by both spouses. Property that a spouse brings into a marriage is treated as the spouse’s separate property.

Question 19

Define earned income

Answer 19

compensation and other forms of income received for providing goods or services in the ordinary course of business.

Aka income from services (so called because it is generated by the efforts of the taxpayer).

Question 20

Unearned income

Answer 20

income from property that accrues as time passes without effort on the part of the owner of the property.

Aka income from property, such as gains or losses from the sale of property, dividends, interest, rents, royalties, and annuities.

The tax treatment of unearned income depends on the type of income and, in some circumstances, the type of transaction generating the income.

Question 21

What is an annuity?

Answer 21

an investment that pays a stream of equal payments over time.

The tax law deems a portion of each annuity payment as a nontaxable return of capital and the remainder as gross income. Taxpayers use the annuity exclusion ratio to determine the portion of each payment that is a nontaxable return of capital.

Annuity exclusion ratio = original investment/expected value of annuity = return of capital percentage.

For fixed annuities, the expected value is the number of payments x the amount of the payment. However, for annuities paid over a persons life, taxpayers must use IRS tables to determine the expected value based upon the taxpayers life expectancy at the start of the annuity.

Question 22

What are the key facts in regards to the return of capital principle?

Answer 22

-Taxpayers are allowed to recover the capital invested in property tax-free
-Payments from purchased annuities are part income and part return of capital
-When property is sold or disposed of, the realized gain or loss equals the sale proceeds reduced by the tax basis of the property.

Question 23

Flow-through entities

Answer 23

legal entities, like partnerships, limited liability companies, and S corporations, that do not pay income tax. Income and losses from flow-through entities are allocated to their owners.

That is, the owners of the business report income or deductions as though they operated a portion of the business personally.

Question 24

Alimony

Answer 24

a support payment of cash made to a former spouse. The ­payment must be made under a written separation agreement or divorce decree that does not designate the payment as something other than alimony, the payment must be made when the spouses do not live together, and the payments must cease no later than when the recipient dies.

Question 25

True or false: if a transfer of property does not meet the definition of alimony, the receipient of the transfer excludes the value of the transfer from income, and the person transferring the property is not allowed to deduct the value of the property transferred, regardless of the date of the divorce agreement.

Answer 25

True!

Question 26

What are the three exceptions to when prizes, awards, and gambling winnings are not included in gross income?

Answer 26

1. Awards for scientific, literary, or charitable achievement such as the Nobel Peace Prize (but exceptions to this)
2. Awards to employees for length of service or safety achievements
3. The value of any awards (medals) and prize money received by Team USA athletes from the Olympics

Question 27

Are social security benefits included in gross income?

Answer 27

It depends (complicated). Taxpayers may be requried to include up to 85% of the benefits in gross income depending on the taxpayers filing status, the amount of the social security benefits, and modified AGI.

Question 28

What is modified AGI?

Answer 28

regular AGI (excluding Social Security benefits) plus tax-exempt interest income, excluded foreign income, and certain other deductions for AGI.

Question 29

Imputed income

Answer 29

income from an economic benefit the taxpayer receives indirectly rather than directly. The amount of the income is based on comparable alternatives.

Bargain purchases (goods sold to employees by an employer at a discount and below-market loans (such as a loan from an employer to an employee at a zero or unusually low interest rate) are two common examples.

Question 30

Discharge of indebtedness

Answer 30

Debt forgiveness

In general, when a taxpayers debt is forgiven by a lender (the debt is discharged), the taxpayer must include the amount of debt relief in gross income.

However, a discharge of indebtedness is not taxable if the taxpayer is insolvent before and after the debt forgiveness. If the discharge of indebtedness makes the taxpayer solvent, the taxpayer recognizes gross income to the extent of their solvency.

Question 31

What are the key facts regarding other sources of income?

Answer 31

-For divorce or separation agreements executed before 2019, alimony is taxable to the receipent when it is paid in cash, it is pursuant to a writtant agreement or decree, the spouses do not live together, and the payment is contingent upon the life of the receipient. For divorce or separation after 2018, alimony is not taxable to the receipient.
-Awards are excluded in gross income unless they meet one of three narrowly defined exceptions.
-A maximum of 85% of social security benefits is included in gross income depending on level of AGI.
-Discharge of debt is included in gross income unless the taxpayer is insolvent before and after forgiveness.

Question 32

Nonrecognition provisions

Answer 32

tax laws that allow taxpayers to permanently exclude income from taxation or to defer recognizing realized income until a subsequent period.

Question 33

(In general), what are the two reasons that Congress allows most exclusions and deferrals?

Answer 33

1. To subsidize or encourage certain behaviors
2. To be fair to taxpayers (such as mitigating the inequality of double taxation).

Question 34

What are three common exclusions?

Answer 34

1. The exclusion of municipal bond interest
2. Gain on the sale of a personal residence
3. Fringe benefits

Question 35

Municipal Bonds

Answer 35

the common name for state and local government debt. Aka bonds issued by state and local governments. Their exclusion is generally recognized as a subsidy to state and local governments (the exclusion allows state and local governments to offer bonds at a lower before-tax interest rate).

Question 36

True or false: Taxpayers meeting certain home ownership and use requirements can permanently exclude up to $500,000 of realized gain on the sale of their principal residence.

Answer 36

False. It is $250,000–only $500,000 if married filing jointly.

Question 37

Fringe benefits

Answer 37

noncash benefits provided to an employee as a form of compensation. As a general rule, fringe benefits are taxable. However, certain fringe benefits are excluded from gross income.

Example: cars, paying for a gym membership, paying for moving expenses, etc.

In general, the value of these benefits is included in the employees gross income as compensation for services. However, certain fringe benefits, known as “qualified fringe benefits,” are excluded from gross income.

Question 38

What are the key facts regarding education exclusions?

Answer 38

-Students seeking a college degree can exclude scholarships that pay for required tuition, fees, books, and supplies
-Taxpayers can elect to exclude interest earned on Series EE savings bonds when the redemption proceeds are used to pay qualified higher education expenses.
-The exclusion of interest on Series EE savings bonds is redistricted to taxpayers with modified AGI below specific limits.

Question 39

Gift

Answer 39

a transfer of property where no, or inadequate, consideration is paid for the property. Generally subject to federal gift tax, NOT the income tax.

Question 40

Inheritance

Answer 40

a transfer of property when the owner is deceased (the transfer is made by the decedent’s estate). Generally subject to federal estate tax, NOT the income tax.

Question 41

Accelerated death benefits

Answer 41

early receipt of life insurance proceeds that are not taxable under certain circumstances, such as the taxpayer is medically certified with an illness that is expected to cause death within 24 months.

Question 42

What are the key facts regarding exclusions to mitigate double taxation?

Answer 42

-Gif and inheritances are subject to federal transfer taxes and are therefore excluded from the income of the recipient
-A maximum of $112,000 (for 2022) of foreign-earned income can be excluded from gross income for qualifying individuals
-To be eligible for the foreign-earned income exclusion, the taxpayer must live in the foreign country for 330 days in a consecutive 12 month period.

Question 43

Installment sales

Answer 43

sales for which taxpayers receive payment in more than one period.

Question 44

Qualified retirement accounts

Answer 44

plans meeting certain requirements that allow compensation placed in the account to be tax-deferred until the taxpayer withdraws money from the account.