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  1. 1. McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.Chapter 05Gross Income and Exclusions
  2. 2. 5-2Learning Objectives1. Apply the concept of realization and explain whentaxpayers recognize gross income2. Understand the distinctions between the varioussources of income, including income from servicesand property3. Apply basic income exclusion provisions tocompute gross income
  3. 3. 5-3Realization and Recognitionof Income Gross Income: Taxpayers report realized and recognizedincome on their tax returns for the year Income that is excluded or deferred is notincluded in gross income. Excluded income is never taxed Deferred income is taxed when recognized in asubsequent year.
  4. 4. 5-4What Is Included in GrossIncome? Definition of gross income for tax purposes §61(a) – “gross income means all income fromwhatever source derived” Reg. §1.61-(a) – “includes income realized in anyform, whether in money, property, or services”
  5. 5. 5-5 Taxpayers recognize gross income when(1) they receive an economic benefit(2) they realize the income, and(3) the tax law does not provide for exclusion ordeferralWhat Is Included in GrossIncome?
  6. 6. 5-6 Economic Benefit Borrowed funds represent a liability, not gross income Realization Principle Taxpayer engages in a transaction with another party Transaction results in a measurable change inproperty rights Recognition Realized income is assumed to be recognized absenta deferral or exclusion provisionWhat Is Included in GrossIncome?
  7. 7. 5-7Other Income Concepts Form of Receipt – Does it Matter? Return of capital principle The cost of an asset is called tax basis Return on capital means the tax basis is excludedwhen calculating realized income. Return of capital does not represent an economic benefit Gain from the sale or disposition of an asset isincluded in realized income
  8. 8. 5-8Other Income Concepts Recovery of amounts previously deductedIndividuals typically claim deductions in theyear paid.Deductions may sometimes be reimbursed orrefunded in a subsequent year.Tax benefit rule - Refunds of expendituresdeducted in a prior year are included in grossincome to the extent that the refund reducedtaxes in year of the deduction.
  9. 9. 5-9When to Recognize Income? Individual taxpayers file tax returns for acalendar-year period Corporations often use a fiscal year end The method of accounting generallydetermines the calendar year in whichrealized income is recognized and included ingross income
  10. 10. 5-10 Accounting Methods Corporation: accrual method of accounting Individuals: Cash method Constructive Receipt Taxpayer must realize and recognize income when it isactually or constructively received Deemed to occur when the income is credited to thetaxpayers account Claim of Right Income recognized when there are no restrictions on useof income (e.g., no obligation to repay)When to Recognize Income?
  11. 11. 5-11 In addition to determining when taxpayersrealize and recognize income, it is importantto consider who (which taxpayer) recognizesthe income This question arises when an income-shiftingstrategy is involved Assignment of Income Community Property SystemsWho Recognizes the Income?
  12. 12. 5-12 Assignment of Income The assignment of income doctrine holds that thetaxpayer who earns income from services mustrecognize the income Income from property such as dividends and interestis taxable to the person who actually owns theincome-producing property To shift income from property to another person, ataxpayer must also transfer the ownership in theproperty to the other personWho Recognizes the Income?
  13. 13. 5-13 Community Property Systems The state laws of nine states implement communityproperty systems The income earned from services by one spouse istreated as though it was earned equally by bothspouses Property acquired by either spouse during themarriage is usually community property and is treatedas though it is owned equally by each spouse Property that a spouse brings into a marriage istreated as that spouse’s separate propertyWho Recognizes the Income?
  14. 14. 5-14Types of Income Income from services (Earned Income) Income from labor most common source of grossincome Generated by the efforts of tax payer Income from property (Unearned Income) Include gain or losses from sale of property,dividends, interests, rents, royalties, and annuities Depends on type of income and type of transactiongenerating income
  15. 15. 5-15 Annuities An investment that pays a stream of equal paymentsover time A portion of each annuity payment as a non-taxablereturn of capital and the remainder as gross income Taxpayers use the annuity exclusion ratio todetermine the return of capital (non-taxable) portion ofeach paymentAnnuity exclusion ratio = original investment /expected value of the annuityTypes of Income
  16. 16. 5-16 Annuities For annuities with a fixed term, the expected value is thenumber of payments times the payment amount For annuities over a life, taxpayers must use IRS tables todetermine the expected value based upon the taxpayer’s lifeexpectancyTypes of Income
  17. 17. 5-17 Property Dispositions Taxpayers usually realize a gain or loss whendisposing of an asset Taxpayers are allowed to recover their investment inproperty (tax basis) before they realize any gainTypes of Income
  18. 18. 5-18 Other Sources of Income Income other than wages or business and property Income from Flow-through Entities Individuals may invest in various business entities The legal form of the business affects how the incomegenerated by the business is taxed If the entity is a flow-through entity such as a partnership or Scorporation, the income and deductions of the entity “flowthrough” to the owners of the entity (partners or shareholders)Types of Income
  19. 19. 5-19 Alimony: For tax purposes alimony is defined as: a transfer of cash made under a written separationagreement or divorce decree, the separation or divorce decree does not designate thepayment as nonalimony, and the payments cannot continue after the death of therecipient Types of payment that do not qualify as alimony: property divisions and child support payments fixed by the divorce or separationagreementTypes of Income
  20. 20. 5-20 Prizes and awards Excluded only if (1) made for scientific, literary, or charitableachievement and (2) transferred to a qualified charity. Social Security Benefits Taxable up to 85 percent of Social Security Benefits in grossincome depending on the taxpayer’s filing status, SocialSecurity Benefits, and modified AG. Modified AGI is regular AGI (including 50 percent of SocialSecurity benefits) plus tax-exempt interest income, excludedforeign income, and certain other deductions for AGI.Types of Income
  21. 21. 5-21 Social Security Benefits Single taxpayers (1) If modified AGI + 50% of Social Security benefits <= $25,000,Social Security benefits are not taxable. (2) If $25,000 < modified AGI + 50% of Social Security benefits <= $34,000, taxable Social Security benefits are the lesser of (a)50 percent of the Social Security benefits or (b) 50 percent of(modified AGI + 50% of Social Security benefits - $25,000). (3) If modified AGI + 50% of Social Security benefits > $34,000,taxable Social Security benefits are the lesser of (a) 85 percentof Social Security benefits or (b) 85 percent of (modified AGI +50% of Social Security benefits - $34,000), plus the lesser of (1)$4,500 or (2) 50 percent of Social Security benefits.Types of Income
  22. 22. 5-22 Imputed Income Certain employee discounts or low interest loans generateincome via indirect benefits. For low interest loans, the amount of imputed income is thedifference between the amount of interest using theapplicable federal interest rate and the amount of interest thetaxpayer actually pays. The borrower is deemed to pay imputed interest (interestexpense to borrower, interest income to lender), and then thelender is deemed to have returned the imputed amount (thetax consequences depend on relationship between borrowerand lender). Imputed interest rules do not apply to loans of $10,000 orless.Types of Income
  23. 23. 5-23 Discharge of Indebtedness When a taxpayer’s debt is forgiven by a lender, thetaxpayer must usually include the amount of debt reliefin gross income Exceptions exist for certain types of loans To provide tax relief for insolvent taxpayers—tax-payers with liabilities, including tax liabilities, exceedingtheir assets—a discharge of indebtedness is nottaxable If the discharge of indebtedness makes the taxpayersolvent, the taxpayer recognizes taxable income to theextent of his solvencyTypes of Income
  24. 24. 5-24Exclusion Provisions Congress allows certain specific types of incometo be excluded or deferred Subsidize or encourage particular activities or To mitigate inequity Municipal interest Bonds issued by state and local governments locatedin the United States, and this exclusion is generallyrecognized as a subsidy to state and localgovernments
  25. 25. 5-25Exclusion Provisions Gain on the sale of personal residence Taxpayers may exclude up to $250,000 ($500,000 ifmarried filing jointly) of gain on the sale of their principalresidence. Must satisfy ownership and use tests. Any excess gain generally qualifies as long-term capitalgain.
  26. 26. 5-26Exclusion Provisions Fringe benefits The value of these benefits is included in theemployee’s gross income as compensation forservices Certain fringe benefits, called “qualifying” fringebenefits, are excluded from gross income Common qualifying fringe benefits are medical anddental health insurance coverage, life insurancecoverage, De minimis (small) benefits
  27. 27. 5-27Exclusion Provisions
  28. 28. 5-28Exclusion Provisions Education- Related Exclusions As an incentive for taxpayers to participate in highereducation, Congress excludes certain types of income ifthe funds are used for higher education Scholarships Students seeking a college degree can excludescholarships that pay for required tuition, fees, books,and supplies Exclusion applies only if the recipient is not required toperform services in exchange for receiving thescholarship (limited exception for tuition waivers forstudent employees and teaching and researchassistants)
  29. 29. 5-29Exclusion Provisions Other Educational Subsidies Taxpayers are allowed to exclude from gross incomeearnings on investments in qualified education planssuch as 529 plans and Coverdell education savingsaccounts as long as they use the earnings to pay forqualifying educational expenditures Taxpayers can elect to exclude interest earned onSeries EE savings bonds when the redemptionproceeds are used to pay qualified higher educationexpenses The exclusion of interest on Series EE savings bondsis restricted to taxpayers with modified AGI belowspecific limits
  30. 30. 5-30Exclusion Provisions Exclusions to mitigate double taxation Congress provides certain exclusions to eliminate thepotential double tax that may arise for Gifts and inheritances Individuals may receive property as gifts or from adecedent’s estate (an inheritance) While the receipt of property is most certainly real income tothe recipient, the value of gifts and inheritances areexcluded from gross income because these transfers aresubject to the Federal Gift and Estate tax
  31. 31. 5-31 Life Insurance Proceeds Amounts received due to the death of the insured areexcluded from the income of the recipient Similar to inheritances, life insurance proceeds are typicallysubject to the Federal Estate tax If the proceeds are paid over a period of time rather than in alump sum, a portion of the payments represents interest andmust be included in gross income Exclusion generally does not apply when (a) a life insurancepolicy is transferred to another party for valuable considerationor (b) taxpayer cancels life insurance contract and receivesproceeds in excess of previous premiums paid Exclusion available for accelerated death benefits in certaincircumstancesExclusion Provisions
  32. 32. 5-32 Foreign earned income A maximum of $92,900 (2011) of foreign earned income can beexcluded from gross income for qualifying individuals A maximum of $13,006 (2011) of employer-provided foreignhousing also may be excluded (but only to the extent that costsexceed $14,864(2011)) To be eligible for the foreign earned income and housingexclusions, the taxpayer must be a resident or live in the foreigncountry for 330 days in a consecutive 12-month periodExclusion Provisions
  33. 33. 5-33Exclusion Provisions Sickness and Injury- Related Exclusions Several exclusion provisions apply to taxpayers who aresick or injured to reflect their inability to pay the tax andfacilitate recovery Workers’ compensation Payments from workers’ compensation plans are excludedfrom gross income
  34. 34. 5-34Exclusion Provisions Payments Associated with Personal Injury Awards that relate to physical injury or sickness orare payments for the medical costs of treatingemotional distress are excluded from gross income Other payments including punitive damages arefully taxable Health care reimbursement Reimbursements by health and accident insurancepolicies for medical expenses paid by the taxpayerare excluded from gross income
  35. 35. 5-35Exclusion Provisions Disability insurance Also called wage replacement insurance Pays the insured individual for wages lost when theindividual misses work due to injury or disability If an individual purchases disability insurancedirectly, any disability benefits are excluded fromgross income If the individual’s employer purchases the disabilityinsurance and the individual excludes the benefitfrom her compensation, then disability benefits aretaxable
  36. 36. 5-36 Deferral Provisions Allow taxpayers to defer (but not permanently exclude)the recognition of certain types of realized income Transactions generating deferred income include installment sales like-kind exchanges involuntary conversions, and contributions to non-Roth qualified retirement accountsExclusion Provisions