Chapter 2
Gross Income & Exclusions
©2003 South-Western College Publishing, Cincinnati, Ohio
Objective
Know the definition of
Gross Income
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Income Classifications
 All sources of income are included unless
specifically excluded
 Non-cash items recorded at fair market value
 There are three classifications of income:
 Active - salary, wages and self employed
 Portfolio - dividends and interest
 Passive - real estate and limited partnership
Can only offset passive losses against passive gains
Can carry forward losses to future years
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Objective
Be familiar with the tax
treatment of significant elements
of gross income
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Interest Income
 Must report interest earned on Form 1040,
Schedule B if total interest income >$1,500
 Data from brokerage statements and/or 1099-INT
 Sometimes interest is called dividends
 credit unions, money market accounts, co-ops,
etc.
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Municipal Bonds
 Interest earned on municipal bonds is taxexempt
 Attractive to high income taxpayers
 Calculation to compare yields
When a municipal bond earns 6% (taxpayer in 30%
bracket )
 Need a taxable yield of [.06 / (1-.30)] = 8.571%
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US Government Bonds (EE or HH)
 EE bonds
 Purchase at discount and then redeem for face
value
Can pay taxes on interest each year as value increases
or all in year of redemption
Interest is nontaxable if bonds are redeemed for higher
education tuition
 HH bonds
 Issued at face value
pay interest twice a year (interest taxed currently and no
exemption for higher education)
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Dividend Income
 3 kinds of dividends
 Ordinary - return of corporate net income to
shareholders (distribution of wealth)
reflected on Schedule B when total dividend income > $1,500
 Nontaxable - return of original investment (reduces basis in
stock)
 Capital gain distributions - when mutual funds sell stock
for capital gains taxpayers get capital gains distributions
report on Schedule D, not Schedule B
 Data from brokerage statements and/or 1099DIV (cash or reinvested dividends)
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Alimony
 To be alimony (deductible to payer, taxable to
payee):
1. Must be in cash and received by ex-spouse
2. Must be made in connection with written
instrument of divorce
3. Can’t be called anything else or contingent upon
age/status of kids
4. Must stop with death of ex-spouse
5. Can’t live in same household as ex-spouse
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Alimony (continued)
 Recapture provisions prevent front end load
alimony payments
 Property transfer is not alimony because it’s
not cash
 Transferor doesn’t have to recognize gain on
property - but transferee’s basis is same as
transferors
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Child Support
 Not deductible by payer
 If payer falls behind on child support, must
bring this current before any portion of
payments considered alimony
 No income to payee
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Prizes/Awards
 Taxable income equal to cash or FMV of
property
 Exception: Employee awards of tangible personal
property received for recognition of length of
service or safety up to $400 (or $1600 if “qualified
plan”)
Example: employee receives a clock for 20 years
of service valued at $1500. $400 is excluded and
$1,100 would have to be included as income
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Objective
Be familiar with the tax rules
for significant exclusions
from gross income
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Life Insurance Proceeds
 Generally tax free
 Unless the policy was transferred for value
Except if transferred to partner in a partnership or officer in a
corporation
 Taxable amount = Proceeds - Cash Surrender Value (at
time of transfer) - Premiums paid by transferee
 Viatical settlements (when company buys out your
life insurance policy knowing you are going to die)
are excluded from income
 Death benefits excludable for terminally ill
 Excludable for chronically ill to extent used for long term care
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Gifts/ Inheritances
 Gifts received are excluded from income
 Gifts in business settings usually considered
income
 Inheritances are tax free to recipient
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Scholarships
 Exclude amount received for fees, books,
tuition, course required supplies or equipment
 Include in income
 Any amounts applied to room and board
 Any amounts received as compensation for
required work
 Any tuition covered by scholarship may not
be used towards educational credits
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Accident/Health Insurance
 Premiums paid by employer on employee’s
behalf for medical or accidental death and
dismemberment insurance are excludable
from gross income
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Meals/Lodging Provided by
Employer
Exclude from gross income
(1) meals provided by employer on premises
during working hours solely for the benefit
of the employer
(2) lodging provided by employer on
premises solely for the benefit of the
employer and required as condition of job
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Objective
Be able to calculate
taxable and nontaxable portions of
annuity payments
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Annuities/Pensions
 Definition: Taxpayer buys a contract (usually
in retirement) in return for periodic payments
for the remainder of life, or life plus survivor.
 Amount of annuity is based on purchase price and
choice of life or life plus survivor
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Annuities/Pensions (continued)
 Payments received are both taxable (interest)
and nontaxable (return of capital)
 Employee contributions are never taxable as it’s a
return of original investment
 Employer contributions always taxable
 Data from1099-R
May show portion taxable and portion nontaxable or
preparer may need to calculate)
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Annuities/Pensions (continued)
 General Rule
1. Calculate exclusion ratio =
Amount of Investment / (Annual payment x life expectancy)
2. Taxable amount =
(1 - exclusion ratio) x annuity received
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Annuities/Pensions (continued)
 Simplified General Rule
If annuity started after 11/18/1996, taxpayer must use fill
in worksheet provided by IRS unless:
1. The annuitant is age 75 (and certain other requirements are
met, and
2. Annuity is a nonqualified plan annuity.
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Annuities/Pensions Example
Example
Din invested $750,000 into his retirement account. His
annuity pays $4,800/month. He’s expected to live 19 years.
How much is taxable in the first year of retirement? Assume
that Din is required to use the general rule.
Answer
$750,000/($4,800 x12 mo X19 yr) = .685 exclusion ratio
.685 = 68.5% of pension is excluded from tax
.685 x ($4,800 x12) = $39,456
total annuity $57,600
exclusion
(39,456)
taxable
$18,144
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Objective
Understand the rules governing
inclusion of Social Security payments
as income
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Social Security
 Amount that is taxable is based on total AGI
 Before 1984 completely excludable
 From 1984 -1993 up to 50% of benefits may be
taxable
 From 1993 forward up to 85% of benefits may be
taxable
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Social Security
 Calculate modified AGI (MAGI)
 AGI + foreign income + tax-exempt interest
 If MAGI + .5(SS) < base amount, benefits are not
taxed
 If > base amount, must compute taxable portion
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SS - Calculating Taxable Amount: 50% level
If (MAGI + 50% SS) is between lower base and upper
base amounts (below)
Lower Upper
$32,000 $44,000 MFJ
$
0
$
0
MFS
$25,000 $34,000 All others
Taxable amount is lesser of:
(a) 50% of SS
or
(b) 50% (MAGI + [.50% x SS] - Lower Base)
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SS - Calculating Taxable Amount: 85% level
If (MAGI + 50%SS) is greater than upper base,
Taxable amount is lesser of:
(a) 85% x SS
or
(b) 85% (MAGI + .50[SS] - upper base) plus
lesser of: (i) 50% level formula
or (ii) $4,500 ($6,000 for MFJ)
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SS Example
Holly is single. She has taxable pension of $22,000, tax exempt
interest of $10,000 and receives SS benefits of $8,000. Her
MAGI = $22,000 + $10,000 = $32,000. First calculation finds that
MAGI + .5(SS) = $36,000 (over upper base), so you must
compute both levels:
50% level
85% level
Lesser of:
Lesser of:
(.5)x(8,000) = $4,000
(.85)x(8,000) = $6,800
or
or
(.5)x(36,000 -25,000) = $5,500
(.85)x(36,000-34,000) = $1,700
Added to lower of: $4,000 or $5,500
Therefore: $1,700 + $4,000 = $5,700
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Another SS Example
Sam has retirement income of $21,000 and SS benefits of
$15,000. His wife Heidi also has retirement income of $10,000,
dividends of $4,000 and SS of $11,000. Their combined MAGI =
21,000 + 10,000 + 4,000 = $35,000. MAGI + .50(SS Benefits) =
$48,000, which is over upper base.
Answer:
50% level to find amount to put in second formula
lesser of
(.50)x(26,000) = $13,000
or (.50)x(48,000 - 32,000) = $8,000
85% level to find taxable amount
lesser of
(.85)x(26,000) = $22,100
or (.85)x(48,000-44,000) = $3,400
plus the lesser of
$8,000 (from above) or $6,000 (MFJ amount)
Therefore, taxable amount is $3,400 + $6,000 = $9,400
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Some Fringe Benefits are Not Taxable
 No-Additional-Cost benefits
 Employee discounts
 unless discount is on real estate or the discount is > 20%
 Parking (up to $180/month is tax free)
 Working Condition - if you could deduct on your own as an
employee
 Can exclude from income if company paid (for example - subscription
to professional journal)
 de minimis fringe benefits (so small not worth keeping track of)
 Tuition reduction undergraduate - excludable if available to all employees
 graduate - excludable if currently teaching/researching at that institution
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The End
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