PART 1 OF GROSS INCOME LECTURE
1
Calculating Federal Individual Income Tax
Gross Income
LESS Above the Line Tax Deductions
Adjusted Gross Income
LESS standard OR
LESS itemized deductions
= Taxable Income
X Individuals Income Tax Rate
= Income Tax Owed
LESS Tax Credits
LESS Federal Tax Withheld
LESS Estimated Federal Tax Paid
= Federal Tax Owed or Tax Refund
2
What is Income?
• Computation of taxpayers’ income tax liability begins with
the determination of their income. BUT the definition of
income for federal tax purposes is broader than the
dictionary definition of income.
Dictionary Definition of Income (from Investopedia):
• Income is money that an individual or business receives in
exchange for providing a good or service or through
investing capital.
• For individuals, income includes salary or wages earned
from a job, investments, pensions, Social Security benefits,
dividends, interest
• For businesses, income generally is a company or other
entities remaining revenues after all expenses and taxes
have been paid (i.e., earnings)
3
What is Income?
• US Supreme Court (USSC) defined income as: any
undeniable accession to wealth, which is clearly
realized by the taxpayer, and over which the
taxpayer has complete dominion (Comm. v.
Glenshaw Glass Co., 348 U.S. 426 (1955))
• Under Internal Revenue Code (IRC) Sec. 61(a)
states that “Except as otherwise provided [in the
IRC). . . gross income means all income from
whatever source derived.”
4
What is Income?
In other words, for federal tax purposes:
• Unless the IRC explicitly states that an amount is not
income, everything is income and subject to federal
income tax
• Income can be in the form of money, property or
services
• Some amounts that meet the dictionary definition of
income are not income for federal tax purposes.
• Likewise, some amounts that are income for federal tax
purposes, are not income as defined in the dictionary.
5
What is Income?
• Generally, IRC excludes amounts from being
treated as income because many amounts that
seem to be income are not true accessions to
wealth
• Rather the amounts compensate for something
(insurance proceeds replacing a roof damaged by
a tree), putting something back to what it once
was (insurance proceeds for stolen car) or there is
something that offsets the amount (loan
proceeds offset by repayments)
6
Types of Income For Federal Tax
Purposes
Types of income: For federal tax purposes, there
are various types of income including:
• Ordinary: Income from wages, self-employment
income, interest
• Dividend: amounts corporations distribute to
shareholders
• Capital: Income from the sale of assets like land,
buildings, patents, stocks
• Passive: Income from investments in real estate,
limited partnerships or business activities where
participation is immaterial
7
Sec 61(a): Examples of Income
Sec 61(a) does not list every item of gross income, rather it lists some gross
income items for tax purposes
1. Compensation for services, including fees, commissions, fringe benefits
2. Gains derived from selling assets (e.g., land, patents, trademarks)
3. Interest, Rents, Royalties, Dividends
4. Pensions
5. Income from discharge of debt (cancellation of debt (COD) income)
6. Trading of goods and services (bartering income)
7. Social Security benefits, unemployment compensation
8. Prizes, lottery winnings, gambling winnings
9. Illegal income
8
Are Loans Income?
• Rule: taxpayers are not taxed on borrowed
amounts on the theory that the obligation to
repay the loan offsets the amount borrowed
• Even though borrowers appear to have an
accession to wealth because they have received
cash from taking out a loan, their overall wealth
does not increase from the loan as they have to
pay back the loan
• A loan is not an accession to wealth because the
loan proceeds are accompanied by an equal and
offsetting liability
9
What is Gross Income?
10
Income Versus Gross Income
• Definition of Gross Income: For federal income
tax purposes, gross income is a taxpayer’s total
amount of income LESS the amounts IRC states is
not income for federal income tax purposes
• Total Income: $100 wages + $400 gain on selling
principal residence = $500 taxpayer’s total
income
• Gross Income: gain from selling principal
residence is excluded from tax under IRC: ($100
wages + $400 gain on selling principal residence)
LESS $400 gain = $100 taxpayer’s gross income
11
Al Capone: "The income tax law is a
lot of bunk. The government
can't collect legal taxes from
illegal money."
12
Gross Income: Illegal Income
US v Sullivan 274 U.S. 259 (1927):
• Bootlegger charged with tax evasion argued that to report his
illegal bootlegging income would violate his 5th Amendment
right against self incrimination
• SCT held: illegal income is not exempt from federal tax,
therefore it must be reported despite 5th Amend
• Justice Holmes: “We see no reason to doubt the interpretation
of the [IRC] Act, or any reason why the fact that a business is
unlawful should exempt it from paying the taxes that, if lawful,
it would have to pay.”
IRC does not define illegal income
Treas. Reg. Sec. 1.61-14(a):“Illegal gains constitute gross income”
13
Tax Evasion & Al Capone
• By the time Capone was 26 years old, he was the head of
an organization involved in bootlegging, extortion,
gambling, bribery of government officials and prostitution
• Capone used only cash and did not have a bank account in
his name.
• Capone endorsed only one check in his lifetime, which was
proceeds from a gambling racket
• After being told by Pres Hoover that he wanted Capone in
jail, Treasury Secretary Mellow told the head of Treasury’s
Special Intelligence Unit, Elmer Irey that the unit was
responsible for prosecuting and convicting Capone
• IRS estimated that from 1924-1929, Capone failed to report
about $1M as income ($13M in 2013)
14
Tax Evasion & Al Capone
Evidence tying Capone to tax evasion:
• 1930: Treasury investigators found in their possession 3
ledgers seized in a 1926 raid of one of Capone’s
gambling halls
• The ledger referred to amounts of revenue from
gambling and how the revenue was divided among
several people including one called “A” or Al
• By comparing the handwriting in the ledgers with
handwriting on bank deposit slips, the Feds identified
Leslie Shumway as the bookkeeper of the ledgers and
“convinced” him that he had to testify against Capone
• Shumway described the nature of the gambling
businesses and stated that "I took orders relating to the
business [from] Mr. Alphonse Capone."
15
Tax Evasion & Al Capone
• 1929: Capone was indicted on charges that from 19251929, his unreported income was about $1M ($13M in
2013) and that he owed about $200,000 in unpaid
income taxes and about $164,000 in penalties (total of
$5M in 2013
• Jury found Capone guilty of tax evasion from 1925 to
1927 and failure to file a tax return in 1928 and 1929
• Capone was sentenced to 11 years in prison, fined
$50,000 and ordered to pay the costs of the trial,
$30,000 (total of $1M in 2013)
• In 1939, Capone released from Alcatraz for medical
reasons and died in 1947
16
Gross Income: Illegal Income
• Treas Reg Sec 1.61-14(a): “illegal gains constitute
gross income”
• Rule: Persons who earn income by illegal means
are required to report unlawful gains as income
when filing tax return and pay applicable taxes
• IRS wants to tax your illegal income, Steve
Hargreaves, CNN Money 2013: “As ridiculous as
it sounds, the federal government requires that
money acquired through illegal means be
reported and taxed just like legitimate income.”
17
Gross Income: Illegal Income
• IRS tax instructions: "Income from illegal
activities, such as money from dealing illegal
drugs, must be included in your income on
Form 1040, line 21, or on Schedule C or
Schedule C-EZ (Form 1040) if from your selfemployment activity."
18
Reporting Illegal Income
According to Stephen Moskowitz, a tax attorney,
who has helped several clients document their
illegal gains:
• Some criminals do declare their illegal income on
their tax returns
• Often declare illegal income when the criminals
have been caught or are about to get caught
• The criminals’ goal is to avoid getting charged
twice: once for their initial crime, and again for
evading the taxes on their windfall
19
Does the IRS Tip Off Other Legal Authorities?
Reporting by IRS:
• Sec 6013: tax return confidentiality: IRS is not
suppose break tax return confidentiality or
proactively alert other legal agencies about
taxpayers’ illegal activities, unless ordered by a
court or terrorism is involved.
• IRS Guide: But IRS can divulge supplemental
information obtained from outside sources (e.g.,
witnesses "to apprise federal criminal law
enforcement agencies of possible crimes
20
Does the IRS Tip Off Other Legal Authorities?
Reporting by the IRS:
• Tax attorney, Moskowitz: "Do they report you
to other agencies?...Absolutely."
• Joseph Henchman, VP, the Tax Foundation:
"The IRS would most certainly immediately
report it to law enforcement"
21
Homework Prob 1: Illegal Income
• Dan, an accountant at Safeway Foods Corp, over heard
Safeway’s CEO tell the CFO that Safeway was being sold
on April 1, 2014.
• Based on the conversation, on March 31, 2014, Dan
bought 100 shares of Safeway stock for $100 and sold
them for $500 on April 1, 2014 after Safeway’s sale was
publicly announced, realizing a $400 gain
• Dan was convicted and sentenced to 10 years in prison
for insider trading.
• Should Dan include the $400 proceeds from his insider
trading as income? Why or why not?
22
Homework Prob 2: Illegal Income
• When Mary was running for governor of
California, she accepted $1M from one of her
campaign donors in exchange for her vetoing a
bill that would make her donor’s activities
illegal, which she did not report as income
• Should the $1M from her campaign donor be
included in her income?
• Why or why not?
23
SPECIFIC GROSS INCOME RULES
24
GROSS INCOME: COMPENSATION & BUSINESS
INCOME
• Compensation income (individuals): payment
for personal services and includes salaries,
wages, fees, commissions, tips, bonuses, jury
duty, employee gifts and some employee
fringe benefits
• Business income: Gross income
– For service provider businesses is the total
amount received
– For manufactures or other non service businesses,
is total sales less the cost of goods sold (COGS)
25
GROSS INCOME: GRADUTE STUDENT TUITION
WAIVERS
• Rule: Tuition waivers for graduate tuition are
not included in gross income, therefore not
taxable
• A provision to tax tuition waivers as income
was scuttled after widespread protests by
graduate students.
26
GROSS INCOME: ALIMONY & CHILD SUPPORT
PAYMENTS
• Alimony Rule: receipt of alimony payments
are not included in gross income (i.e., not
taxable income)
• Child Support Rule: receipt of child support
payments are not included in gross income
(i.e., not taxable income)
27
Capital Gains & Losses &
Dividend Income
28
TAXATION OF DIVIDENDS
• Amount of dividends received is taxable dividend
income
• Dividend tax rates as of 2018
1. Tax rate is 0% up to $77,200 for married filing
jointly and up to $38,600 for singles
2. Tax rate is 15% up to $479,000 for married filing
jointly and up to $425,800 for singles
3. Tax rate is 20% for income in excess $479,000
for married filing jointly and in excess of
$425,800 for singles
29
Capital Gains & Losses: Capital Assets
Defined
• Capital Assets Defined: Almost everything
taxpayers own and/or use for personal or
investment purposes is a capital asset
• Examples: 1) home; 2) personal use items
(e.g., household furnishings; 3) stocks & bonds
held for investment
30
Property Transactions: Capital Gains & Losses
Property Transactions: Capital Gains and Losses:
• Capital gain defined: if a capital asset is sold for
more than the asset’s basis, this amount is a capital
gain
• Capital loss defined: if a capital asset is sold for less
than the asset’s basis, this amount is a capital loss
• Exception: losses from the sale of personal use
property like taxpayers’ home or car is not deductible
• Basis: generally, basis equals the cost to acquire a
capital property
31
Long Term & Short Term Capital Gains
& Losses
Long Term & Short Term Capital Gains & Losses:
• Rule: Capital gains and losses are classified as long term or
short term.
• Long term defined: If taxpayers hold a capital asset for
more than 1 year before they selling it, the amount they
receive is a long term capital gain or a long term capital loss
• Short term defined: If taxpayers hold a capital asset for 1
year or less before they selling it, the amount they receive
is a short term capital gain or a short term capital loss
• Determining holding period: to determine the holding
period, count from the day the capital asset was acquired
up to and including the day it was disposed of
32
Taxation of Capital Gains & Losses
• Capital gains are taxed and capital losses are
deductible
Offsets:
• Capital gains can be offset by capital losses, but
not below $0
• If the total capital losses exceed the total capital
gains, taxpayer can claim a deduction (amount of
the capital loss) against total capital gains up to
$3,000 or the total amount of capital loss,
whichever is less
33
CARRYFORWARD OF CAPITAL GAINS & CAPITAL
LOSSES
• Carrying capital losses forward to following tax years:
When total capital losses exceeds $3,000 limits, the excess
amount of losses can be carried to future tax years to offset
capital gains.
• In the 1st year capital losses are carried forward, the capital
losses first offset capital gains arising that year
• If in the 1st year, the capital losses still exceed capital gains,
taxpayer can claim up to $3,000 as a capital loss and
continue in the following years until the capital losses are
used up (i.e., reduced to $0)
• Carrying capital gains are not carried forward: in the year
capital gains are recognized the total amount must be
declared
34
Capital Gains & Capital Losses Tax Rates
• As of 2018 short term capital gains: are taxed as
ordinary income, thus tax rate is the individual’s,
corporation’s etc. tax rate
• As of 2018, tax rates on long term capital gains are:
1. Tax rate is 0% up to $77,200 for married filing jointly
and up to $38,600 for singles
2. Tax rate is 15% up to $479,000 for married filing
jointly and up to $425,800 for singles
3. Tax rate is 20% for income in excess $479,000 for
married filing jointly and in excess of $425,800 for
singles
35
Bequests Made Upon Person’s Death &
Gifts Made During Person’s Life
36
Sec 102: Bequests Made in a Deceased
Person’s Will
Sec 102: Beneficiaries of Wills: the amount of
cash and/or the value of property that taxpayers
receive from someone after that person has
died is not taxable. Usually, taxpayers are
beneficiaries pursuant to the deceased person’s
will, but a will is not always required.
37
Sec 102: Gifts
Sec 102: Receivers of Gifts:
• Gift Rule: the amount of cash and/or the value of
property that individuals receive as a gift is not taxable
(i.e., not included in their gross income)
Taxation on the amount of taxpayers’ gifts:
• taxpayers can give annual gifts to anyone without the
taxpayer be taxed on the amount of the gift, if the gift
does not exceed $15,000
• The amount of the gift that exceeds $15,000 will be
subtracted from the giver’s estate & gift tax exemption
(this exemption is $11.2M per individual; $22.4M per
married couple)
38
DEFINITION OF GIFT
Gift defined: US Sct held (Comm v. Duberstein, 363 U.S.
278 (1960)):
• A gift occurs is when a donor gives something to
another (donee) which “…proceeds from a detached
and disinterested generosity, out of affection, respect,
admiration, charity, or like impulses…” of the donor
• The donor’s intent is controlling to determine if a
transfer of something is a gift
• In determining a donor’s intention, all the facts and
circumstances surrounding the transfer of something is
a gift
39
GIFTS FROM EMPLOYERS TO EMPLOYEES
Employers- Employee Gift Rule:
• the amount of cash and/or the value of property
that taxpayers receive as a gift from their
employer is included in gross income
• Employers’ gifts are treated as compensation for
services, past or future and are subject to
withholding and payroll deductions
• View is that employers’ intention in giving gifts to
employees is to reward employees for past
performance or provide an incentive for
employees’ future performances
40
EX: Romantic Gift or Compensation
• After Amy met Bob through a mutual friend, they began dating ,
their relationship became more intimate and Amy moved into Bob’s
house
• Amy did some housekeeping and cooking, but she did not work for
Bob under a written or oral contract for services and she did not
have the skills or experience to work in Bob’s art business
• In 2005, Bob gave Amy $10,500, treated the amount as the
payment of wages to her and deducted the amount on his tax
return
• Is the amount that $10,500 Amy received from Bob a gift or
compensation for her services to Bob?
• Depending on your answer, would the amount be included or not
included in Amy’s income?
41
Answer: Romantic Gift or
Compensation
• Because Bob made the $10,500 payment to Amy with
“detached and disinterested generosity” out of his affection
for her at the time of payment, the amount was a gift and
not included in Amy’s income. (Jue-Ya Yang v. Comm, T.C.
Sum Op2008-156)
• During the actual trial about the tax treatment of the
“wages”, the man admitted in cross-ex that his relationship
with the taxpayer was more than a professional one, but he
could not recall them going on dates or any intimacy in
their relationship.
• The Tax Court held that the man had made a gift to the
woman who lived with him and therefore was not included
in her income
2016
42
Homework Prob 3: Bequests & Gifts
• If on his 39th birthday, Steven receives a
$10,000 gift from his mother and $15,000 as a
beneficiary of his grandma’s will, are the gift
and the bequest included in gross income,
therefore taxable income? Why or why not?
43
Homework Prob 4: Bequests & Gifts
• Because Sam provided names of potential
customers to a metal manufacturer, it
provided Sam with a new Cadillac, which he
was not expecting. Is Sam taxed on the
Cadillac’s FMV? Why or why not?
44
Homework Prob 5: Gifts From
Employers
• Alice was surprised when her employer gave
her a Rolex watch.
• Does Alice have to pay tax on the FMV of the
Rolex?
• Why or why not?
45
Homework Prob 6: Gifts From
Employers
• Apple Corp’s tax exempt Charitable
Foundation awarded a $1,000 grant to each of
its 10 Apple employees because they were
suffering from financial hardship
• Are the amount of the grants Apple’s
employees received gifts or compensation?
• Depending on your answer, would the
amounts be included or not included in the
employees’ income?
46
Sec 108: Gross Income: Cancellation of
Debt Income (COD Income)
47
Sec 108: Gross Income: Cancellation of
Debt Income (COD Income)
Sec 108: COD Income Rule: If a taxpayer’s debt is
paid another or a creditor forgives it, the amount of
the debt that discharged (forgiven) is included in
gross income
Exception: BUT, if the debt was discharged
(forgiven) in 1 of the following events, the amount
of the forgiven debt is not gross income:
1. Debt was discharged in title 11 case (taxpayer
files for bankruptcy) OR
2. Debt was discharged when taxpayer was
insolvent, but had not filed for bankruptcy
48
Sec 108: Concept of Cancellation of Debt Income
(COD Income)
• Taxpayers are not taxed on borrowed amounts
on the theory that the obligation to repay the
loan offsets the amount borrowed
• But, if the debt is forgiven (discharge of
indebtedness) it is an accretion (increase) to
the taxpayer’s wealth, because the taxpayer
does not have to pay back the debt
49
COD INCOME EXAMPLES
• What are the tax consequences if after June
borrowed $100,000 from Comerica Bank in 2000
to start her business, the bank discharged
$80,000 of the loan in 2001?
• Would your answer change if June filed for
bankruptcy in 2001 and as part of the bankruptcy
proceedings, Comerica agrees to discharge
$80,000 of the loan?
• Would your answer change if instead of filing for
bankruptcy June’s business was instead
insolvent?
50
Homework Prob 7: Debt Forgiveness
(COD Income)
• In order to buy a boat, Clay took out a bank loan for
$10,000 in March 2014.
• After he made a $1,000 payment on the loan, Clay lost
his job and could not pay the balance on the loan
• The bank agreed that Clay did not have to pay the
remaining $9,000 on the loan
• Does Clay include in his gross income the $9,000 of the
$10,000 that he does not have to pay as discharged
debt income? Why or why not?
• Would your answer change if Clay had filed for
bankruptcy? Why or why not?
2016
51
EX: Taxable COD Income or Non
Taxable Gift?
• Tom loaned his daughter, Jane, $10,000, which was
evidenced by a note to help her purchase a car.
• Jane paid $1,000 of the $10,000 loan to her father in
March 2014.
• When Jane married in April 2014, at the wedding
reception, her father told Jane that she did not have to
pay the $9,000 balance on the loan because he was
tearing up the note as a wedding present
• Does Jane include in her gross income the $9,000 of
the $10,000 that she does not have to pay as
discharged debt income? Why or why not?
52
Sec 108(f): Gross Income: Forgiveness of
Student Loans
53
COD INCOME & STUDENT LOANS
54
Sec 108(f): Gross Income: Forgiveness of
Student Loans
Sec 108(f): Student Loan Forgiveness:
• Rule: the amount of a taxpayer’s student loans that are
discharged (forgiven) is taxable income
• Exception 1: If a student dies or becomes totally and
permanently disabled, their student debt income is
forgiven, the forgiven amount is not taxed
• Exception 2: the amount of a taxpayer’s student debt
that is discharged is not taxed if the debt was forgiven
because the taxpayer participated in government or
private programs such as Teacher Loan Forgiveness
Program & National Health Service Corps Program (see
slides below)
55
Sec 108(f): Gross Income: Student Loan
Forgiveness
Qualifying government programs:
• Teacher Loan Forgiveness Program: If taxpayers teach
full-time for 5 complete and consecutive academic
years in certain elementary and secondary schools and
educational service agencies that serve low-income
families, then a portion of their student debt is
forgiven and is not taxed
• National Health Service Corps Program: Same rule as
above except the taxpayers work as medical
professionals in areas that have a need for doctors and
other medical professionals
56
Students’ Loans Forgiven for Participating in
Private Not Government Programs
Law School Forgiveness Program (Rev. Rul. 2008-34):
• Issue: if student’s student debt is forgiven pursuant to a private
program, is the private program treated like a government
program?
• In order to encourage its law school grads to enter into public
service jobs, under its program, a grad’s school debts were forgiven
if the grad worked in (1) a public interest or community service
organization, (2) a legal aid office or clinic, (3) a prosecutor’s office,
(4) a public defender’s office, or (5) a state, local, or federal
government office.
• IRS found: If a grad’s school debt was forgiven under the law
school’s program, the amount of the grad’s forgiven debt was not
taxable. Thus, students who student debt is forgiven under a private
program the amount of the debt forgiveness is excluded from their
income just as if their debt was given under a government program.
57
Homework Prob 8: School Loan
Forgiveness
• Under the federal government’s school loan
program, Nancy borrowed $50,000 to attend law
school.
• Under a federal program her school debt will be
forgiven after she practices law at a legal aid clinic
for 5 years
• After working at the legal aid clinic for 5 years,
her $50,000 student loan was forgiven
• Does Nancy include in her gross income the
$50,000 as discharged debt income? Why or why
not?
2016
58
Sec 74: Gross Income: Awards &
Prizes
59
Sec 74: Gross Income: Awards & Prizes
Sec 74(a) & Reg Sec 1.74-1(a): Gross income Prizes & Awards:
• Except for scholarships and fellowships, gross income
includes amounts received as prizes and awards. The
taxable amount can be cash or FMV of the award or prize
• The amount for the following prizes and awards are taxable
income:
–
–
–
–
Radio & TV game shows
Door prizes
Lotteries, bingo, raffle tickets
Employer has given an award for an employees achievements
(BUT the employee achievement award is not taxable to the
employee if the employer gives the awarded SOLELY for number
of years the employee worked for the employer AND the award
was given at a ceremony)
60
EX: Awards & Prizes
• In 1962, a sports magazine awarded a new
Corvette to Hall of Fame running back Paul
Hornung, who played for the Packers when
they won in the 1st Super Bowl
• Is the value of the Corvette is excluded from
Hornung’s income as a nontaxable prize or
award? Why or why not?
61
Answer EX Awards & Prizes
The value of Corvette is not a nontaxable prize or
award because:
• Congress did not intend that pro football be an
activity for which proficiency could be recognized
with a tax exempt award
• Pro football cannot be viewed as an educational,
artistic, scientific or civic field of endeavor “no
matter how fond of the sport we may be.”
• Therefore, the Corvette’s value is included in
Hornung’s income (Hornung v. Comm, 47 T.C. 42
(1967)
2016
62
Homework Prob 10: Awards & Prizes
• Tina received a free truck for being the ten
millionth paying guest at an amusement park.
• Is the value of the free truck included in Tina’s
gross income? Why or why not?
63
Sec 74(a): Employee
Achievement Awards
64
Sec 74(a): Employee Achievement Awards
• Rule: Employee achievement awards given for length
of service or safety achievement are not taxable to
employees, but only if the award is tangible personal
property (e.g., watch for service)
• Rule: the following are not tangible personal property:
1) cash; 2) cash equivalents; 3) gift certificates (except
if employees can choose from a limited array of items
pre-selected or approved by employer)
• Rule: employees are taxed on employee achievement
awards that exceed $1,600
65
Homework Prob 11: Employee
Achievement Awards
• If Tony received $1,000 in cash from his
employer for working at the company for 20
years, does he have to pay income tax on the
cash?
• Why or why not?
66
Homework Prob 11: Employee
Achievement Awards
• If Tony received $1,000 in cash from his
employer for working at the company for 20
years, does he have to pay income tax on the
cash?
• Why or why not?
67
Homework Prob 12: Employee
Achievement Awards
• If Libby receives a gold watch from her
employee for working at the company for 10
years, does she have to pay tax on the FMV of
the watch?
• Why or why not?
68
Sec 117: Gross Income: Athletic &
Education Scholarships
69
Sec 117: Gross Income: Athletic &
Education Scholarships
• Athletic & Education Scholarships Definition: amounts
paid or allowed to students at an educational institution for
the purpose of study
• General Rule Sec 117 & Reg Sec 1.117-1: Gross income
does not include the amount of athletic and education
scholarships that is allocated to tuition for fees, books,
supplies, and equipment required for courses at the
educational institution and fees to enroll and attend (i.e.,
student organization fees)
• Exception to Rule: the amount of a scholarship that is
allocated to room and board and non-school related
expenses is taxable income
• Requirement: Students are candidates for a degree at an
educational institution with faculty, curriculum and
students attend a place where educational activities occur
70
Sec 117: Gross Income: Athletic
Scholarships
Additional Requirement for Athletic Scholarships:
for athletic scholarships to be tax free, the above
requirements and the one below must be met
• Rule: Athletic scholarship must 1) have no grade
requirements; 2) not require the athlete to do a
particular activity; 3) athlete received the
scholarship because of his or her athletic skill; 4)
scholarship cannot be cancelled if athlete stops
playing his or her sport; AND 5) student is not
required to do other activities if he or she stops
playing their sport
71
Homework Prob 13: Athletic & Education
Scholarships Homework
• If Donna used her $36,000 college scholarship
to pay for the following expenses: 1) $20,000
for tuition; 2) $2,000 for books and supplies;
3) $10,000 for room and board; 4) $1,000 for
sorority dues; and 5) $3,000 for a laptop, is
any of scholarship taxable to Donna? Why or
why not?
72
Gross Income: Insurance Proceeds
73
Gross Income: Casualty, Theft &
Property Insurance Proceeds
Casualty, Theft & Property Insurance Proceeds:
• Rule: the amount of insurance proceeds a
taxpayer receives for damaged or stolen
property is not taxable
• Exception: But If the amount of the insurance
proceeds exceeds the basis (e.g., cost to
purchase a building or a watch) the of the
damaged or stolen property, the excess
amount of the insurance proceeds taxable
74
Gross Income: Casualty, Theft &
Property Insurance Proceeds
Casualty, Theft & Property Insurance Proceeds:
• Reasoning: insurance proceeds generally will
not increase a taxpayer’s wealth, rather the
proceeds are meant to replace and/or put the
damaged or stolen property as it was prior to
the casualty, theft and/or property loss (i.e., to
make the taxpayer whole)
75
Sec 101: Gross Income: Life Insurance
Proceeds
Sec 101(a); Reg. Sec 1.101-1: Life insurance proceeds:
• Life insurance defined: a policy taken out by someone that
upon his or her death, an amount is paid to someone named
as the life insurance policy’s beneficiary (can be a person,
charity, business entity)
• Life insurance proceeds : amounts paid to someone named in
a life insurance policy upon the death of the insured person
(usually the insured person is the person who paid the life
insurance policy premiums)
• Rule: the amount beneficiaries receive are not taxable to then
• EX: As the sole beneficiary under her mom’s life insurance
policy, Anne is not taxed on the life insurance proceeds of
$100,000.
76
Gross Income: Accident & Health
Insurance Benefits
Accident and health insurance benefits:
• Rule: amounts received by taxpayers under an
accident and health insurance policy that they
purchased are excluded from their income
77
Homework Prob 14: Casualty Loss & Theft
Insurance Proceeds
Are the following insurance proceeds included in
Anne’s income? Why or why not?
• On Christmas Eve, Anne’s house was broken into
and all of her family’s presents were stolen. Anne
received $10,000 in theft loss insurance proceeds
to replace the Christmas presents.
• As a result of a tornado damaging her home,
Anne received $100,000 as casualty loss
insurance proceeds.
78
Gross Income: Damage Awards in Civil
Lawsuits
79
COMPENSATORY & PUNITIVE DAMAGE AWARDS
2 types of damages awarded in civil lawsuits:
• Compensatory damage awards are a sum of
money and/or property awarded in civil lawsuits
by courts to compensate parties for loss,
detriment and/or injury suffered as the result of
another’s (wrongdoer’s) unlawful conduct
• Punitive damage awards are a sum of money
and/or property awarded in civil lawsuits by
courts to punish wrongdoers for their unlawful
conduct and deter them (or others) from the
same or similar conduct
80
Personal Injury Example: McDonald's Coffee
Case
Liebeck v. McDonald's Restaurants, 1995 WL 360309
(Bernalillo County, N.M. Dist. Ct. (1994):
• In 1992,Stella Liebeck brought a product liability suit
against McDonald’s after she accidently spilled McDonald’s
hot coffee in her lap after buying it, causing 3rd degree
burns in her pelvic region
• Liebeck underwent skin grafting & 2 years of medical
treatment
• Jury awarded Liebeck $2.86M in damages: $160,000 for
medical expenses and compensatory damages and $2.7M
in punitive damages
• Trial judge reduced the jury award to $640,000
• Parties settled out of court
81
TAXATION OF COMPENSATORY & PUNITIVE DAMAGE
AWARDS
• Rule: Compensatory & punitive damage awards
may be included in gross income and therefore
taxable, depending on what the damages were
awarded for
• Physical injury lawsuits: compensatory damages,
including lost wages and medical expenses, that
are awarded on the account of physical injury or
sickness are not taxed, but punitive damages are
taxed
• Non physical injury lawsuits (e.g., breach of
contract): both compensatory and punitive
damages awarded not on the account of physical
injury or sickness are taxed
82
EXAMPLES OF TAXABLE NON PHYSICAL INJURY
COMPENSATORY & PUNITIVE DAMAGE AWARDS
Damages awarded below are taxable because not
awarded on the account of physical injury:
• Slander
• Libel
• Defamation
• Breach of contract
• Age, race, sexual or other types of discrimination
• Wrongful arrest
• Lost profits (e.g., patent infringement)
83
Homework Prob 15: Damage Awards
Which amounts are included and not included in these
parties income? Why or why not?
• EX: In his personal injury lawsuit against Luke for
breaking his arm, Dan was awarded $100 for lost
wages, $300 for emotional distress and $400 for
punitive damages.
• EX: In her age discrimination lawsuit against her
employer, Kay was awarded compensatory damages of
$100 in compensatory damages, $200 for lost wages
and $300 in punitive damages
• EX: In Google’s suit for patent infringement by Uber, it
was awarded $100 in compensatory damages and $200
in punitive damages
84
Homework Prob 16: Damage Awards
• After he was paralyzed in a diving accident at
Lochmoor Club, Tom filed a negligence suit claiming
that the club had not given adequate warnings about
the dangers of diving.
• What are the tax consequences if: 1) Tom was awarded
$20,000 for medical expenses, $30,000 for emotional
distress, and $40,000 in punitive damages and; 2) his
wife Mary was awarded $50,000 for loss of
consortium, which is deprivation of the benefits of a
family relationship due to injuries caused by another)
• They filed married filed jointly
85
Reg. Sec 1.61-2(a)(1): Gross Income: Bartering
Income-Exchange of Goods & Services
86
Reg. Sec 1.61-2(d): Gross Income: Bartering
Income: Exchange of Goods & Services
• Bartering defined: Bartering is an exchange of
property or services
• Tax Rule: In a bartering transaction in which
goods and/or services are exchanged, each
participant in the transaction must include in
his or her income the FMV of the property or
services received from the other participant and
that amount is subject to tax
• In other words, the FMV of goods or services a
taxpayer receives in a bartering transaction is
treated as income to the taxpayer, which is
subject to tax
87
EX: Exchange of Goods & Services
• Mark, an attorney, provided $100 worth of
legal services to Apple, a construction
company, in exchange for Apple to roof Mark’s
office. Apple provided $100 worth of roofing
services
• Is Mark taxable on the $100 value of Apple’s
roofing services? Why or why not?
88
Homework Prob 17: Exchange of
Goods & Services
• Exchange of services: David, who is a CPA,
prepared Bobbie’s 2014 federal and state
individual income tax returns, in exchange,
Bobbie, who is a mechanic repaired David’s car.
• Does David have to include in his gross income
the value of Bobbie repairing his car? Why or why
not?
• Exchange of goods and services: If David received
a new engine for his car from Bobbie for doing
Bobbie’s tax returns, would your answer above
change? Why or why not?
89