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  • 1. Chapter 4 Gross Income©2012 CCH. All Rights Reserved.4025 W. Peterson Ave.Chicago, IL 60646-60851 800 248 3248www.CCHGroup.com
  • 2. Chapter 4 Exhibits 1. Constructive Receipt Doctrine 2. Community Property Income 3. Items Included in Gross Income 4. Compensation vs. Gift 5. Prizes and Awards 6. Employee Achievement Awards 7. Scholarships and Fellowships 8. Business Income 9. Below-Market Interest Loans—Types of LoansChapter 4, Exhibit Contents A CCH Federal Taxation Basic Principles 2 of 31
  • 3. Chapter 4 Exhibits 10. Below-Market Interest Loans—Tax Effect 11. Rental Income 12. Tenant Improvements 13. Dividend Income 14. Alimony—Post-1984 Agreements 15. Alimony and Child Support (Post-1984 Divorces) 16. Alimony Recapture 17. Discharge of Debt 18. Discharge of Debt—BankruptcyChapter 4, Exhibit Contents B CCH Federal Taxation Basic Principles 3 of 31
  • 4. Constructive Receipt Doctrine “When is income taxable?”  Generally, any compensation granted to an individual to which the individual has an absolute right is regarded as constructively received income.Chapter 4, Exhibit 1 CCH Federal Taxation Basic Principles 4 of 31
  • 5. Community Property Income Property acquired after marriage is community property.  Income from community property is community income Property acquired before marriage remains separate property.  What happens to income from separate property?Chapter 4, Exhibit 2a CCH Federal Taxation Basic Principles 5 of 31
  • 6. Community Property Income CA Rule – Income from separate property remains separate. Applies to California, Arizona, Nevada, New Mexico, Washington and Wisconsin. TX Rule - Income from separate property is community income. Therefore, if spouses filed separate returns, the income would be shared between them. Applies to Texas, Idaho and Louisiana.Chapter 4, Exhibit 2b CCH Federal Taxation Basic Principles 6 of 31
  • 7. Items Included in Gross Income Code Sec. 61(a) lists 15 items that generally must be included in gross income:  Compensation for services,  Annuities including fees, commissions, fringe  Income from life insurance and benefits, and similar items endowment contracts  Gross income derived from business  Pensions  Gain derived from dealings in  Income from discharge of property indebtedness  Interest  Distributive share of partnership  Rents gross income  Royalties  Income in respect of a decedent  Dividends  Income from an interest in an estate  Alimony and separate maintenance or trust payments Special circumstances may result in the exclusion or deferral of any of these items.Chapter 4, Exhibit 3 CCH Federal Taxation Basic Principles 7 of 31
  • 8. Compensation vs. Gift The facts and circumstances dictate whether something received is taxable compensation or a tax-free gift  Compensation is generally included in gross income.  Gifts are generally excluded from gross income. Example FACTS: Grandma offers 16-year-old Billy $10,000 if he quits smoking and playing pinball over the next five years. He does, and upon attaining the age of 21, she pays him $10,000. QUESTION: Is the $10,000 received by Billy taxable income or a gift? SOLUTION: The $10,000 is taxable income since there were strings attached.Chapter 4, Exhibit 4 CCH Federal Taxation Basic Principles 8 of 31
  • 9. Prizes and AwardsPrizes and awards are generally taxable based on fair market value at timeof receipt.However, if ALL of the following 4 conditions occur, then they areexcludable :1. Connected with the fields of science, charity, or the arts2. Involuntary selection process (i.e., through no effort of recipient)3. No future services required of recipient4. Assigned to a governmental agency or tax-exempt charitableorganization (rather than constructively received). Chapter 4, Exhibit 5a CCH Federal Taxation Basic Principles 9 of 31
  • 10. Prizes and Awards Example FACTS: Mother Tanesha, a U.S. citizen, is awarded the Nobel Peace Prize, which includes a $500,000 cash award. The award was unsolicited and no future services were required of Mother Tanesha. Furthermore, she endorsed the check over to the Sisters of Charity, a qualified tax-exempt charity, rather than depositing it in her bank account. QUESTION: Does Mother Tanesha have taxable income? SOLUTION: YES! She constructively received the $500,000 when she endorsed the check over to the charity. By endorsing the check, she exercised dominion and control over the money, even though she did not deposit it. She could have avoided taxable income if she had directed the Nobel Committee to pay the Sisters of Charity directly.Chapter 4, Exhibit 5b CCH Federal Taxation Basic Principles 10 of 31
  • 11. Employee Achievement Awards Employee achievement awards are generally taxable, except that the value of awards for length of service or safety achievement delivered at a “meaningful presentation” are excluded up to 1. $400 if the plan is non-qualified (i.e., discriminates in favor of highly paid employees), or 2. $1,600 if the plan is qualified (i.e., does not discriminate in favor of highly paid employees). (If an employee receives both qualified and nonqualified awards, then the overall exclusion may not exceed $1,600.)Chapter 4, Exhibit 6 CCH Federal Taxation Basic Principles 11 of 31
  • 12. Scholarships and FellowshipsThe value of scholarships or fellowships are generally taxable, but may beexcluded if they are: 1. To a degreed candidate attending an educational institution 2. For tuition and course related material (not room and board) 3. As a result of academic achievement, and not connected with services provided.Example: A “scholarship” received by a beauty queen for winning theMiss Georgia Peanut contest would actually be a taxable award forservices rendered, even if she were a degreed candidate and the moneywas spent on tuition. It would really be compensation disguised as ascholarship.Chapter 4, Exhibit 7 CCH Federal Taxation Basic Principles 12 of 31
  • 13. Business Income  Sole proprietor  Include all business income (less cost of goods sold) in gross income.  Partnerships and S corps  Partnerships and S corps are not taxed, but their taxable income is taxed to individual partners and shareholders.  Partners and shareholders must include their proportionate share of business income in their gross income, regardless of whether or not the income was distributed.Chapter 4, Exhibit 8 CCH Federal Taxation Basic Principles 13 of 31
  • 14. Below-Market Interest Loans—Types of Loans What types of loans are subject to imputed interest calculations?All of the following loans are subject to imputed interest: Gift loans (made out of love or generosity). Note that the “gift” is NOT the principal portion of the loan, rather, the amount of interest that is below market. Compensation-related loans (employer loans to employees) Corporation-shareholder loans (a corporation’s loans to ANY of its shareholders)If all of the following apply: Interest charged is less than the applicable federal rate (AFR) Sum of all loans between lender and borrower exceeds $10,000 The loan was made after June 7, 1984Chapter 4, Exhibit 9 CCH Federal Taxation Basic Principles 14 of 31
  • 15. Below-Market Interest Loans—Tax EffectThe two steps for each of the three below-market interestloans are not easy to conceptualize. See if this makes sense:  Step 1: “Pretend” that the borrower has “paid” the imputed interest to the lender as an interest payment.  Step 2: “Pretend” that the lender has returned the imputed interest back to the borrower as either a gift, compensation, or a dividend.Chapter 4, Exhibit 10a CCH Federal Taxation Basic Principles 15 of 31
  • 16. Below-Market Interest Loans—Tax Effect What is the tax effect of imputed interest on below-market loans? Type of Loan Step Lender Borrower Gift Loan Step 1: Interest income. Interest expense. Step 2: Nondeductible gift, possibly subject Tax-free gift received. to gift tax. Compensation Step 1: Interest income. Interest expense. -related Loan Step 2: Compensation expense. Compensation income. Corporation to Step 1: Interest income. Interest expense. Shareholder Step 2: Nondeductible dividend deemed paid. Dividend income. LoanChapter 4, Exhibit 10b CCH Federal Taxation Basic Principles 16 of 31
  • 17. Rental Income  Tax Effect on Landlord: ALL rent received is taxable income, including future years’ rent received in advance  Tax Effect on Tenant with a Business Lease: If rent is paid in advance, no deduction for rent expense is allowed until the year the payment is due. Example FACTS: Tenant pays Landlord $10,000, covering the first and last year’s rent. QUESTION: What is the tax effect on Landlord and Tenant? SOLUTION: $10,000 taxable income to Landlord; $5,000 deduction to Tenant.Chapter 4, Exhibit 11 CCH Federal Taxation Basic Principles 17 of 31
  • 18. Tenant Improvements When are tenant improvements taxable to cash-basis landlords? 1. If in lieu of rent (or if repairs paid for by lessee are the responsibility of the lessor): lessor has rental income to the extent of the market value of the improvements. 2. If NOT in lieu of rent: Not taxable. When the property is sold, the improvements will be taxed assuming they add value that results in a higher sales price.Chapter 4, Exhibit 12 CCH Federal Taxation Basic Principles 18 of 31
  • 19. Dividend Income  The term “dividend” means any distribution of property made by a corporation to its shareholders out of its earnings and profits.  There are two common types of dividends:  Cash Dividends – taxable.  Stock Dividends – generally not taxable. There are 5 exceptions to this rule. If a stock dividend meets one or more of these exceptions, it is taxable.Chapter 4, Exhibit 13 CCH Federal Taxation Basic Principles 19 of 31
  • 20. Alimony—Post-1984 Agreements Payments under instruments executed after December 31, 1984, that meet the following requirements are deductible as alimony:  Payments must be made in cash  Payments must be made under a divorce or separation instrument  Parties must live in separate households after a divorce or separation decree is entered  Alimony must end at the payee’s death  Parties involved may not file a joint returnChapter 4, Exhibit 14 CCH Federal Taxation Basic Principles 20 of 31
  • 21. Alimony and Child Support (Post-1984 Divorces)What is the tax treatment for alimony and child support? Alimony Child SupportTaxable to Payee? Yes NoDeductible to Payor? Yes (“for” AGI) NoChapter 4, Exhibit 15 CCH Federal Taxation Basic Principles 21 of 31
  • 22. Alimony Recapture  Alimony is required to be recaptured if: 1) Payments made in the 2nd post-separation year exceed payments in the 3rd post-separation year by more than $15,000 and/or 2) Payments made in the 1st post-separation year exceed the average payments made in the 2nd and 3rd post-separation years by more than $15,000.Chapter 4, Exhibit 16a CCH Federal Taxation Basic Principles 22 of 31
  • 23. Alimony Recapture Step 1: Year 2 Recapture Year 2 Payment Less Year 3 Payment = Excess Payment Less $15,000 = Amount subject to recapture for Year 2Chapter 4, Exhibit 16b CCH Federal Taxation Basic Principles 23 of 31
  • 24. Alimony Recapture Step 2: Year 1 Recapture Year 1 Payment Less (Year 2 Payment - Year 2 Recapture + Year 3 Payment) / 2 = Excess Payment Less $15,000 = Amount subject to recapture for Year 1Chapter 4, Exhibit 16c CCH Federal Taxation Basic Principles 24 of 31
  • 25. Alimony Recapture Step 3: Total recapture The total amount subject to recapture equals Year 2 recapture plus Year 1 recapture. The amount recaptured is included in the payor’s income and allowed as a deduction from the payee’s income in Year 3.Chapter 4, Exhibit 16d CCH Federal Taxation Basic Principles 25 of 31
  • 26. Alimony Recapture Example: Bob makes the following alimony payments to Mary: Year 1 - $70,000 Year 2 - $40,000 Year 3 - $20,000Chapter 4, Exhibit 16e CCH Federal Taxation Basic Principles 26 of 31
  • 27. Alimony Recapture Step 1: Year 2 Recapture $40,000 (Year 2) - $20,000 (Year 3) = $20,000 (excess) - $15,000 = $5,000Chapter 4, Exhibit 16f CCH Federal Taxation Basic Principles 27 of 31
  • 28. Alimony Recapture Step 2: Year 1 Recapture $70,000 - $27,500 (40,000 – 5,000 + 20,000)/2 = $42,500 - $15,000 = $27,500 Step 3: Total Recapture $5,000 + $27,500 = $32,500Chapter 4, Exhibit 16g CCH Federal Taxation Basic Principles 28 of 31
  • 29. Alimony Recapture Tax Effects of Alimony Payments and Recapture Bob Mary Year 1 ($70,000) deduction $70,000 income Year 2 ($40,000) deduction $40,0000 income ($20,000) deduction $20,000 income $32,500 recapture ($32,500) recapture Year 3 $12,500 income ($12,500) deductionChapter 4, Exhibit 16h CCH Federal Taxation Basic Principles 29 of 31
  • 30. Discharge of Debt Forgiveness of debt is generally includable in gross income. There are 2 exceptions in which taxes on a forgiveness of debt are deferred (i.e. excluded from gross income): 1. The debt is discharged in a Chapter 11 bankruptcy filing. The amount of debt discharged reduces certain tax attributes that otherwise could have provided a tax benefit in the future. 2. The borrower is insolvent outside of bankruptcy (i.e., Liabilities > FMV of assets immediately prior to discharge) However, the amount excluded from gross income cannot exceed the amount by which the taxpayer is insolvent.Chapter 4, Exhibit 17 CCH Federal Taxation Basic Principles 30 of 31
  • 31. Discharge of Debt—BankruptcyOffsetting reduction of tax attributes. As a price for the deferral(exclusion from gross income), the Code requires that the amount deferredbe applied to reduce seven tax attributes in the order listed below. However,the Code offers a special election to first reduce the tax basis ofdepreciable property or real property held as inventory. 1. Net operating losses and loss carryovers 2. General business credits under Code Sec. 38 3. Minimum tax credits under Code Sec. 53 4. Net capital loss and loss carryovers 5. Basis of depreciable assets or nondepreciable real assets held as inventory 6. Passive activity losses 7. Foreign tax credit carryovers under Code Sec. 27Chapter 4, Exhibit 18 CCH Federal Taxation Basic Principles 31 of 31