Chapter I:3 Gross Income: Inclusions Learning Objectives

After studying this chapter, the student should be able to: 1. 2. 3. 4. 5. 6. Explain the difference between the economic, accounting, and tax concepts of income. Explain the principles used to determine who is taxed on a particular item of income. Determine when a particular item of income is taxable under both the cash and accrual methods of reporting. Apply the rules of Sec. 61(a) to determine whether items such as compensation, dividends, alimony, and pensions are taxable. Describe tax planning considerations for inclusions of gross income. Describe compliance and procedural considerations for gross income.

Areas of Greater Significance

It is important for the student to understand that the tax definitions of income items may vary significantly from lay definitions, and even accounting definitions. Statutory tax definitions of income items should be stressed.

Areas of Lesser Significance

In the interest of time, the instructor may determine that the following area is best covered by student reading, rather than class discussion: 1. Economic and accounting concepts of income.

Problem Areas for Students

The following areas may prove especially difficult for students: 1. 2. The differences between legal alimony and tax alimony. The mechanics and tax consequences of alimony recapture.

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3. 4.

Determination of the taxable portion of social security benefits received. Properly including/excluding subsequent payments related to previously deducted amounts (tax benefit rule).

Highlights of Recent Tax Law Changes

The following item has changed from the 2012 edition of this chapter: 1. The floors for phase-out of the Series EE savings bond interest exclusion have increased. (See page I3-14.)

Teaching Tips
1. The calculation for taxable social security benefits may be the students first exposure to a major complex tax calculation. You may want to spend considerable time in helping the students master the calculation so that they develop confidence in their abilities to deal with the complex calculations that follow (and to avoid undue discouragement). The distinction between inclusions (Chapter I3) and exclusions (Chapter I4) is not an important distinction for theoretical or practice purposes. Specific items discussed in Chapter I3 may also have an exclusion effect (i.e., portion of annuities excluded from gross income, exclusion of municipal bond interest). You may want to take an overall approach to gross income as detailed in Chapter I3 and Chapter I4.

2.

Lecture Outline
I. Tax Concept of Income A. Administrative Convenience The concept of objectivity and administrative convenience support the tax law selection of income on realization, rather than taxing unrealized appreciation. EXAMPLE: If a piece of land owned by the taxpayer appreciates from $100,000 at the beginning of the tax year to $130,000 at the end of the tax year, there is no tax on the $30,000 appreciation until the disposal of the land. B. Wherewithal-to-Pay Taxing unrealized appreciation would cause cash flow problems for taxpayers.

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EXAMPLE: If the $30,000 appreciation described in the previous example was taxed at a 25% marginal rate (short-term capital gain), the taxpayer could be hard pressed to come up with the $7,500 tax due without liquidation of the investment. C. Gross Income Defined (Examples I:3-3 through I:3-7) Code Sec. 61 includes in gross income all income from whatever source derived. Specific examples listed in the statute include: 1. Compensation for services 2. Business income 3. Gains from sale or exchange of property 4. Interest 5. Rents 6. Royalties 7. Dividends 8. Alimony 9. Pensions and annuities 10. Income from certain life insurance contracts 11. Income from the discharge of indebtedness 12. Distributive share of partnership or S-corporation income 13. Income in respect of a decedent 14. Income from an estate or trust

II.

To Whom is Income Taxable? A. Assignment of Income 1. Income from personal services is taxed to the taxpayer who rendered the services, and income from property is taxed to the owner of the property. 2. Family trusts are not effective to change the incidence of tax on personal service income from the taxpayer earning the income to trust beneficiaries. B. Allocating Income Between Married Persons (Example I:3-8) 1. Income allocation between husband and wife is dependent on state law (i.e., common law state vs. community property state). 2. The law may be different between community property states.

EXAMPLE: Income from separate property for California residents is separate income. Income from separate property for Texas residents is community income. 3. Allocation of income between married persons is important only if separate returns are to be filed. All income of the spouses is included on a joint return. I:IO3-3 Copyright 2013 Pearson Education, Inc. publishing as Prentice Hall

C.

Income of Minor Children (Question I:3-11) 1. Children are taxed on their own earned income.

2. Even though minor children are taxed on their own earned income, minors under the age of 18 may be taxable on certain unearned income at their parents marginal rates. (See Chapter I2.) III. When is Income Taxable? (Topic Review I:3-1) A. Cash Method (Examples I:3-11, I:3-12; Question I:3-13) 1. The cash method is used by most individuals, with income being reported in the year of actual or constructive receipt. 2. Constructive receipt occurs when the taxpayer has access to the income, but does not actually receive it (i.e., interest credited to a savings account). 3. Exceptions exist for certain U.S. Savings Bonds, crop insurance proceeds, and certain draught-related livestock sales. B. Accrual Method (Example I:3-15; Question I:3-14) 1. Accrual method taxpayers generally report income in the year the income is earned (i.e., when all events have occurred to fix the right to income, and the amount of income can be determined with reasonable accuracy). 2. Prepaid income (i.e., prepaid rent) is generally taxable in the year of receipt. Exceptions are available on certain prepayments for goods not on hand and prepayments for services not rendered until the following tax year. C. Hybrid Method Certain small businesses may be on the accrual method for purchases and sales, while using the cash method in computing all other income and expense items. IV. Items of Gross Income - Sec. 61(a) A. Compensation Payments for personal services, however titled, are included in gross income. These include salaries, wages, fees, commissions, tips, bonuses, and other specialized forms of compensation.

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B.

Business Income 1. Total receipts are gross income for service businesses.

2. Gross margin (total sales less cost of good sold) is gross income for manufacturing, merchandising, and mining businesses. C. Gains from Dealings in Property 1. Unless one of the several statutory non-recognition provisions applies, gains from dealings in property are included in gross income. 2. Statutory non-recognition provisions include involuntary conversions, likekind exchanges, sale of a personal residence, and reorganizations. (See Chapter I12.) D. Interest (Problem I:3-44) 1. Interest is generally included in gross income.

2. An exclusion for interest on municipal bonds is available as long as the bonds are not (1) issued for certain private activities, (2) issued in excess of the statutory limit, (3) guaranteed by the federal government, or (4) issued for the purpose of acquiring higher interest investments (arbitrage). 3. An exclusion is also available for interest from Series EE U.S. saving bonds if the proceeds are used to pay certain college expenses for the taxpayers or dependents. The exclusion is phased out over certain AGI levels. E. Rents and Royalties (Examples I:3-18, I:3-19) 1. Gross income includes rents and royalties. Security deposits are not income until forfeited. 2. Losses from these activities may be subject to the passive loss rules. (See Chapter I8.) 3. Leasehold improvements in lieu of rent are included in gross income at their FMV upon completion. Leasehold improvements not in lieu of rent are not gross income. 4. Amounts received by the lessor to cancel or modify a lease are included in gross income.

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F.

Dividends (Examples I:3-20, I:3-21; Instructor Aid I:3-1) 1. Distributions from corporations to shareholders are taxable as dividends to the extent of the shareholders pro rata share of current or accumulated earnings and profits. 2. Corporate distributions that exceed a shareholders pro rata share of earnings and profits are treated as return of capital to the extent of the shareholders adjusted basis in the subject stock. 3. Corporate distributions exceeding both E&P and adjusted basis are subject to gain (usually capital) treatment. 4. Qualified dividends are subject to special tax rates (0%, 15%) under the same rules as net long-term capital gain.

G.

Alimony and Separate Maintenance Payments (Examples I:3-25 through I:3-27; Topic Review I:3-2; Problem I:3-38) 1. Tax alimony, as defined in the Code, is included in gross income. Currently tax alimony must be pursuant to an approved written agreement between the parties, paid in cash for spousal benefit, must terminate at death, and the parties must be living in separate households. 2. Disparity in the amount of tax alimony exceeding $15,000 between tax years can result in recapture (i.e., deduction for the payee and income for the payer).

H.

Pensions and Annuities (Examples I:3-29, I:3-30; Table I:3-1; Problem I:3-46; Instructor Aid I:3-2) 1. Annuities and pensions are partially included in gross income based on a calculation involving the excess of the expected return over the taxpayers cost. Exclusion % = Cost Expected return

The exclusion percentage is applied to each receipt in a particular tax year until the cost is fully recovered. 2. Qualified retirement plan annuities use a simplified method to determine the taxable portion of the payments. Under the simplified method the nontaxable portion of each annuity payment is equal to the taxpayers after-tax investment divided by an anticipated number of payments determined by a statutory table based on the taxpayers age at the start date.

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3. Even if the taxpayer outlives the calculated life expectancy, only the actual cost of the annuity is excluded from income. 4. If the taxpayer dies before the entire cost is recovered tax free, any unrecovered cost is deducted on the decedents final income tax return. I. Income from Life Insurance and Endowment Contracts 1. Interest income from life insurance proceeds left with the insurance company is included in gross income. 2. Proceeds collected by the insured prior to death (i.e., endowment-type policy) which exceed premiums paid are treated as income. J. Income from Discharge of Indebtedness 1. Generally, the forgiveness of debt is included in gross income.

2. Exceptions to this general rule exist for bankruptcy and certain other insolvency situations. (See Chapter I4.) K. Income Passed through to Taxpayer 1. Taxpayers may receive gross income from their interests in partnerships, S corporations, estates, trusts, and income in respect of a decedent. 2. Any losses from these entities should be evaluated in light of the passive loss rules. (See Chapter I8.) V. Other Items of Gross Income A. Prizes, Awards, Gambling Winnings, and Treasure Finds (Example I:3-32) 1. Generally, prizes, awards, gambling winnings, and treasure finds are included in gross income. 2. Certain achievement awards properly transferred to qualifying charitable organizations will not be included in gross income. (See Chapter I4.) B. Illegal Income 1. Illegal income must be included in gross income.

2. Examples of illegal income include embezzlement proceeds, ransom, bookmaking profits, robbery proceeds, sales of illegal narcotics, and bribes. I:IO3-7 Copyright 2013 Pearson Education, Inc. publishing as Prentice Hall

C.

Unemployment Compensation Both government-financed and employer-financed unemployment compensation are fully included in gross income. Social Security Benefits (Example I:3-33) 1. A maximum of 85% of social security benefits may be included in gross income for certain taxpayers. 2. Married taxpayers filing jointly whose total of adjusted gross income (without FICA) plus 50% of FICA, plus tax-exempt interest and certain excluded foreign income is less than or equal to $32,000 will pay no tax on their FICA. Single taxpayers whose total of the above-described items is less than or equal to $25,000 will pay no tax on his/her FICA.

D.

E.

Insurance Proceeds and Court Awards (Example I:3-34; Problem I:3-53) 1. The potential inclusion of insurance proceeds and court awards in gross income is affected by the reason the amounts were received. EXAMPLE: Recoveries of lost profits, whether as insurance proceeds or damages, are includible in gross income. 2. Amounts received because of personal injury or sickness are generally excluded from gross income. Punitive damages awarded on the basis of sickness or physical injury are taxable.

F.

Recovery of Previously Deducted Amounts (Examples I:3-36, I:3-37) Recovery of previously deducted amounts in a subsequent year may cause income recognition (i.e., Tax Benefit Rule). EXAMPLE: Receipt of a state income tax refund in a tax year subsequent to a year in which state income taxes were deducted on the cash method may give rise to gross income.

G.

Claim of Right (Example I:3-38; Problem I:3-54) 1. A taxpayer may receive funds, which have disputed ownership. Under the claim of right doctrine, the taxpayer must report the disputed amount as income, unless the use of funds is restricted. 2. If the taxpayer is subsequently required to repay the disputed amount, a deduction is available in the year of repayment. An adjustment may be available if I:IO3-8 Copyright 2013 Pearson Education, Inc. publishing as Prentice Hall

the taxpayers marginal tax rate in the year of inclusion exceeds the taxpayers marginal tax rate in the year of deduction. VI. Tax Planning Considerations A. Shifting Income Shifting income from high-bracket taxpayers to low-bracket taxpayers can reduce the overall family tax burden. EXAMPLE: Taxpayer irrevocably transfers income-producing property (i.e., bonds) to his/her daughter. Income from property is taxed to the new owner. If the daughters marginal tax rate is lower than the transferors, the overall family tax burden may be lower (subject to kiddie tax considerations). WATCH OUT FOR GIFT TAX PROBLEMS. Additional administrative expenses, if any, should also be considered in this type of planning. B. Alimony (Example I:3-41) 1. Tax alimony shifts taxable income from the payor to the payee.

2. The marginal tax rates of the payor and payee should be an important factor in determining the amount set (i.e., after-tax cost to payor and after-tax benefit to payee). C. Prepaid Income 1. Lessors may want to collect the first months rent plus a deposit, rather than first and last months rent to avoid prepaid income. 2. There is a risk of recharacterization to income if the amount of the deposit is similar to the amount of one months rent. D. Taxable, Tax-Exempt, or Tax-Deferred Bonds (Example I:3-43) The taxpayer should compare after-tax yields when comparing among taxable, tax-exempt, and tax-deferred bonds. Reporting Savings Bond Interest It may be a tax advantage to report interest from U.S. savings bonds owned by minor children on an annual income tax return. If the amount of interest is less than the standard deduction, such annual reporting will result in no tax. This approach will avoid the bunching of income in the year of redemption. I:IO3-9 Copyright 2013 Pearson Education, Inc. publishing as Prentice Hall

E.

F.

Deferred Compensation Arrangements (Example I:3-44) Advance contractual agreements to defer income (such as those common for professional athletes) are respected for tax purposes and are not treated under the constructive receipt rules.

VII.

Compliance and Procedural Considerations (Example I:3-45; Topic Review I:3-3, Figure I:3-1) Gross income is summarized on Form 1040 (Page 1) from various supporting schedules, including Schedule B (interest and dividends), Schedule C (business income), Schedule D (capital gains), Schedule E (rents and royalties), Schedule F (Farm income), and Form 4797 (supplemental gains).

Court Case Briefs

Elizabeth C. Sympson v. CIR, 67 TCM 1914 (1994). Mrs. Sympson was the executor of her husbands estate. Mr. Sympson was hired as a financial manager by Mr. Roderick. When Mr. Roderick died, Mr. Sympson had sole authority to pay all bills from Mrs. Rodericks checking accounts. In addition to paying Mrs. Rodericks bills, however, Mr. Sympson also made frequent transfers from Mrs. Rodericks account to his own personal account ($1,376,647). Mr. Sympson reported only about $400,000 in income over this period. The government claimed that the difference of approximately $900,000 was embezzlement income. Mr. Sympson claimed before his death that the excess amounts were loans, even though there was no documentation of any kind. Also, Mrs. Roderick denied any knowledge or intent to loan money to Mr. Sympson. The Tax Court held that there was no evidence to support the loan theory, and that the $900,000 was taxable as embezzlement income in the years the transfers were made. G. Gordon Liddy v. CIR, 59 AFTR 2d 87-387, 86-1 USTC & 9102 (4th Cir., 1986). Mr. Liddy received $386,000 from the Committee to Re-Elect the President (CREEP) and from the Finance Committee to Re-Elect the President (FCREEP). This money was to be used to finance intelligence activities. The activities involved surveillance operations which culminated in the Watergate break-in. Mr. Liddy kept receipts of all expenditures concerning the intelligence operation until the time of the discovery of the break-in. At this point, he destroyed all records in his possession concerning the intelligence operation. Of the $386,000 received by Mr. Liddy, only $340,000 was held accounted for as spent on the intelligence activities. Mr. Liddy failed to prove that the remaining $46,000 was received by him as agent for the committees. This amount is includible in the taxpayers gross income, unless the taxpayer can show that he has no claim of right because he is required to make prompt payments of amounts received or because he is acting as agent. The court ruled that Mr. Liddys uncorroborated testimony, which was his only proof, was insufficient to establish that he had not diverted this sum of $46,000 for his personal use. I:IO3-10 Copyright 2013 Pearson Education, Inc. publishing as Prentice Hall

Instructor Aid I:3-1 Taxation of Distributions from Corporations

1) Distributions from regular (C) corporations are treated as dividends to the extent of the shareholders pro-rata share of the corporations current and accumulated earnings and profits.

2)

Distributions in excess of the corporations current and accumulated earnings and profits are treated as return of capital (nontaxable) to the extent of the shareholders adjusted basis in the relevant stock.

3)

Distributions that exceed both the corporations current and accumulated earnings and profits and the shareholders adjusted basis in the relevant stock are treated as gain. If the stock is a capital asset, the gain will be capital gain (long-term or short-term based on the holding period of the stock).

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Instructor Aid I:3-2 Pension or Annuity Inclusion

Single Life Annuity

Cost = employees nondeductible contributions for a pension; otherwise = investment Expected Return = Annual payment x Life expectancy (from IRS tables)

Exclusion Ratio =

Cost Expected return

Current Years Exclusion = Exclusion ratio x Total pension or annuity payments received during the year Total pension or annuity payments Current Years Inclusion = received during the year current years exclusion

For qualified retirement plan annuities, see page I3-22 of text for simplified calculation.

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