Chapter 5 Outline Gross Income and Exclusions RECALL gross income is income that taxpayers realize and recognize

e (report) on their tax returns for the year. LO1 What Is Included in Gross Income? All-inclusive definition of income (Section 61) includes a list of examples of gross income such as compensation for services, business income, rents, royalties, interest, and dividends. Current view (Form of Receipt) Reg. Section 1.61-(a) definition: Gross income means all income from whatever source derived, unless excluded by law. Gross income includes income realized in any form, whether in money, property, or services. Based on Section 61(a), Reg. 1.61-(a), and various judicial rulings, taxpayers recognize gross income: (1) They receive an economic benefit, (2) They realize the income, and (3) No tax provision allows them to exclude or defer the income from gross income for that year. Judicial Findings: Income is the gain derived from labor and capital (1920) Any increase in wealth that has been realized is income (1955) Economic Benefit Common examples where a taxpayer receives economic benefit include: (1) Being paid for services rendered (typically cash received, but includes property or even services), (2) Proceeds from property sales (typically cash, property, or debt relief), and (3) Income from investments or business activities (such as business income, rents, interest, and dividends). Note: Borrowed funds represent a liability, NOT gross income. Realization Principle Under this principle, income is realized when: (1) A taxpayer engages in a transaction with another party, and (2) The transaction results in a measurable change in property rights. Adopting the realization principle for defining gross income provides two major advantages: (1) Because parties to the transaction must agree to the value of the exchanged property rights, the transaction allows the income to be measured objectively. (2) The transaction often provides the taxpayer with the wherewithal to pay taxes (at least when the taxpayer receives cash in the transaction).

Recognition Realized income is assumed to be recognized absent a deferral or exclusion provision. *Code Section 61: Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items: compensation for services, including fees, commissions, fringe benefits, and similar items; gross income derived from business; gains derived from dealings in property; interest; rents; royalties; dividends; alimony and separate maintenance payments; 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; and income from an interest in an estate or trust.

Example 5-1 Realization Principle:

In April, Gram used part of the life insurance proceeds she received from Grampss death to purchase 50 shares in Acme Corporation for $30 per share. From April to the end of December, the value of the shares fluctuated between $40 and $25, but on December 31, the shares were worth $35. If Gram does not sell the shares, how much income from her stockholdings in Acme Corporation does she realize for the year? Solution: $0. Unless Gram sells the stock, she does not enter into a transaction resulting in a measurable change of property rights with a second party. Thus, she does not realize income even though she experienced an economic benefit from the appreciation of the stock from $30 per share to $35 per share.

Example All-Inclusive Income (Notes):

After buying food at Meijers, Tom finds a $100 bill in the parking lot. Does Tom have gross income to report? Solution: Yes, $100. Economic benefit Realized No exclusion/deferral

Example All-Inclusive Income (Notes):

Dan is a building contractor. Sue is an accountant. Sue needs remodeling work done in her home. Can needs someone to prepare his tax return. So, Dan agrees to do Sues remodeling work in return for her preparing his tax return. The value of the remodeling work is $750. Preparation of Dans tax return is worth $750. Since cash is not exchanged, how much gross income, if any, must Dan and Sue recognize? Solution: According to Treasury Regulation 1.61-1(a), gross income includes income realized in any form, whether in money, property, or services. In this case, both Dan and Sue would recognize $750 in gross income.

Example 5-2 Recognition:

During March, Gram paid no rent to her neighbor (also her landlord). Although the neighbor typically charges $350 per month for rent, he allowed Gram to live rent free in exchange for babysitting his infant son. What income must Gram and Grams neighbor realize and recognize on this exchange? Solution: $350. Gram and the neighbor each must recognize $350 of income for March. The neighbor recognizes $350 of rental receipts because this is the value of the babysitting services the neighbor received in lieu of a cash payment for rent from Gram (an economic benefit the neighbor realized through the exchange). Gram recognizes $350 of babysitting income, because this is the value of the services provided to her neighbor (an economic benefit was realized because Gram was not required to pay rent).

Return of Capital Principle refers to exclusion of the tax basis from realized income. Cost of an asset is called tax basis. Gain or loss from the sale or disposition of an asset is included in realized income, NOT the selling price. o Portion of the proceeds that represents tax basis is excluded from realized income, because it does not represent an economic benefit to the seller.

Example Capital Recovery (Notes):

Natalie sold 100 shares of common stock for $5,000. She paid a sales commission of $500 on the sale and had purchased the shares three years ago for $3,000. What amount of gross income must she recognize? Solution: $1,500. [($5,000 $500) - $3,000]

Recovery of Amounts Previously Deducted A refund is not typically included in gross income because it usually represents a return of capital. Expenditures are typically deducted in the year paid. Tax Benefit Rule: However, if the refund is made for an expenditure deducted in a previous year, then under the tax benefit rule the refund is included in gross income to the extent that the prior deduction produced a tax benefit. A previous years deductions may be reimbursed or refunded in a following year. Referred to as recovery of a previous years deduction. Tax Benefit Rule determines how much, if any, of the recovery/refund is included in gross income and when. In the year a previous years expenditure is recovered/refunded, taxpayer must include in gross income an amount equal to the tax benefit received from the deduction. Tax benefit = amount that previous years taxable income was reduced by the deduction. o Previous years excess deduction