Revised 11-21-2011
Individual Income Tax
ACCT 1070
Chapter 3: Gross Income
Code Section 61(a) “ Except as otherwise provided..... gross income means all income from
whatever source derived.”
1.
2.
3.
Income makes you better off than you were before.
Income must be realized - income is realized when the earnings process is complete and a
transaction with another party takes place that permits an objective measure of the
income.
Income must be recognized under the tax law.
Common Items in Gross Income
1.
Compensation
2.
Business Income
3.
Dividend Income, Interest Income, Gains on sale of property
4.
Annuities, Pensions, Social Security Benefits, and Life Insurance proceeds from
settlement prior to death
5.
Alimony
6.
Inherited income (called income in respect of a decedent)
7.
Income from partnerships, estates, and trusts
Other less Common sources of Gross Income
1.
Gambling Income, Prizes, and awards
2.
Illegal Income (Only an Accountant could catch Al Capone) (receipt of money from theft,
embezzlement, illegal sale of drugs, forgery, taking bribes, etc.)
3.
Discovered Income - You find $20 beside your car in the parking lot (Would you put this
on your tax return?? – a strict application of the law would require this to be included.
4.
Babysitting Money - a teenager who earns $3,000 working part time at a store and makes
another $3,000 babysitting (even if received in cash)(Any amount - The amount is not
important)
Accounting Methods (Assume Cash basis in this course unless otherwise indicated)
1.
2.
3.
Cash Method - income is recognized in the year it is received. Receipt can be
constructive or actual. Nearly all individuals are on the cash basis for tax purposes. The
cash basis is modified for certain types of income - the modified method is a hybrid of the
cash and accrual methods. Unless specifically state otherwise in an individual situation,
this course assumes the cash method.
Accrual Method - income is recognized in the year it is earned.
Hybrid Method – income is recognized under the accrual method and most expenses are
recognized under the cash method.
Note: Each taxpayer chooses the accounting method when their first tax return is filed. Most taxpayers file their tax
returns for the first time when they are teenagers and they elect, without realizing it, the cash method of accounting.
-2Indirect Economic Benefit: An indirect economic benefit is not usually sufficient to cause
an item to be considered income. Indirect are incidental benefits received by a person. Airline
companies often provide medical exams for their pilots to ensure safe operation of the planes.
The pilot received an indirect economic benefit the benefit does not represent income. The text
has more examples on page 3-5.
Assignment of Income: Income can not usually be assigned. Income is taxed to the person
who rendered the service or owns the property.
Community Property States: In community property States, state law attributes income
from personal services or community property equally to both spouses. There are eight
community property States and the exact definition of community property varies from State to
State.
Constructive Receipt: Cash basis taxpayers (nearly all individual taxpayers) report income
on their tax returns in the year actually or constructively received. Constructive receipt means
that the income was available to the taxpayer even thought the taxpayer may not have chosen to
receive it.
Specific Items of Gross Income
Compensation: Compensation is payment for personal services. Compensation Includes:
salaries, wages, fees, commissions, bonuses, etc. Compensation can be received in the form of
cash or property or other benefits. The tax laws exclude a variety of benefits from taxation (later
chapters) and permit some compensation to be excluded under deferred compensation
arrangements. Deferred compensation will be taxed in future tax years when received or
constructively received.
Business Income: Gross income includes amounts received from a service business. Where the
business sells a product, gross income includes amounts received less cost of goods sold - this
amount is also known as the gross profit of the business.
Gains from dealing in property: Gross income includes amounts received in excess of the cost
(or adjusted cost) of the property when property is sold. In general cost is what a taxpayer paid
for an item but sometimes cost, for tax purposes is quite different from actual cost. In tax
terminology, cost or adjusted cost is often called the “basis” of the property.
Interest: Interest is amounts received for the use of money. Interest is included in gross income
except for those kinds of interest receipts specifically exempt under the law.
-3Series EE U.S. Savings Bonds have special rules about taxability – series EE Bonds do not
follow the constructive receipt rules.- the exception is legislative.
1.
Taxpayer has right to recognize the interest ratably (constructive receipt) or in a lump
sum when the bonds are redeemed (Cashed in).
2.
Some series EE Savings Bonds are exempt from tax if the proceeds are used for the
education of the owner of the bonds or the spouse or dependent of the owner – to have
Series EE Savings Bonds exempt certain rules must be met – see text page 3-14.
Municipal Bonds issued by the individual States or political subdivisions of the individual
States are usually tax exempt (details in next chapter)
Rents & Royalties: Amounts received as rents or royalties for the use of property are included in
gross income. Gross income from rents and royalties includes all of the revenue received before
deducting any of the related expenses.
Dividends: Dividends received are included in gross income unless the dividend represents a
recovery of capital. In general dividends are paid by the corporation out of earnings and profits
and therefore represent gross income to the recipient. Starting in 2003, qualifying dividends are
subject to a special tax rate - the maximum tax on qualified dividends is 15% - in some cases it is
0%. Not all dividends are qualifying dividends, but most are. The 1099 dividend information
return identifies whether or not the dividends are qualifying.
Qualifying Dividends are:
1.
2.
Dividends paid by a U.S. Corporation or a qualified foreign corporation.
Dividends that meet the holding period. In general, the taxpayer must have held the stock
for 60 days out of the 120 days that begins 60 days before the ex-dividend date. In
counting days, count the day of sale but not the day of purchase.
Not all dividends are qualified dividends - Pub 17 discusses this on page 69 - in general,
the taxpayer’s broker or the corporation paying the dividends will disclose if the
dividends are qualified dividends. Corporations will not usually be aware of the holding
periods – they may report dividends as qualified when they are in fact not qualified.
Note on Dividends:
(1)
Credit Unions and S & L’s sometimes refer to the amounts paid to depositors as
dividends. These amounts are included in gross income as interest and not as
dividends.
(2)
Stock Dividends do not represent income and are not included in gross income.
(3)
Capital Gain Dividends represent gains from the disposition of property. They
represent gross income but are separate from ordinary dividends.
(4)
Constructive Dividends represent payments Adeemed to be dividends@ by the
facts and circumstances of a given situation.
(5)
Qualified dividends, although taxable, are taxed at either 0% or 15%. Qualified
dividends are dividends identified as such by the distributing corporation. Even if
the Corporation identifies the dividends as qualifying, they must meet a holding
requirement to be qualified. Qualified dividends must have been owned for a
period of at least 60 days that begins 60 days prior to the ex-dividend date and
ends 60 days after the ex-dividend date. The holding period is longer for
dividends on preferred stock – information not available in text – see 1040
instructions or IRS Publication 17.
-4Alimony: Alimony received is gross income. Alimony is separate from child support. Alimony
is separate from a property settlement incident to a divorce. The receipt of child support does not
represent gross income. Amounts received as a property settlement are not gross income.
Alimony must meet all (no exceptions) of the following tests:
(1)
Alimony payments must be made in cash
(2)
Alimony payments must be made pursuant to a divorce, separation, or written
agreement between the divorcing spouses
(3)
Alimony payments must terminate at the death of the payee (recipient)
(4)
Alimony payments do not include amounts designated as something else i.e. child
support or part of the property settlement.
(5)
Alimony payments must be made between people who are living in separate
households.
Recapture: When alimony decreases sharply in the second and third year of payment,
the tax laws may view the alimony as a “disguised property settlement.” When Alimony
decreases sharply, the taxpayer paying the alimony may have to recapture (take back into
income) a portion of the alimony paid. And the taxpayer receiving the alimony may have
to decrease the amount of alimony reported and taxed. (Text p 3-20)
(The recapture formula and computations will not be on the test)
Pensions and Annuities: Amounts received from pensions and annuities are taxed if the
amounts received are in excess of the tax basis (cost for tax purposes) of the contract. Many
employer provided pensions and annuities have a zero tax basis and are therefore 100%
includible in gross income. Amounts received from a pension or annuity, with a tax basis, is
divided into a taxable portion and a recovery of cost portion. The division is based on the total
expected return of the annuity contract over the life expectancy of the recipient or recipients.
(Text 3-20 through 3-22)
A simplified annuity computation method is available where the distribution s from a qualified
retirement plan. This method is available only if the employee made after tax contributions to
the retirement plan. (Text 3-22)
Life Insurance and Endowment Contracts: Amounts received on account of death of the
insured are generally exempt from tax and not includible in the recipient=s gross income.
Amounts received from the sale or surrender of a life insurance or annuity contract are includible
in gross income to the extent the amount exceeds the cost basis of the contract. A lot more on
this topic is presented in Chapter 4.
Discharged Debt: In general the forgiveness of debt creates taxable income. There are
exceptions under bankruptcy proceedings (Including Insolvency) and where it can be shown that
the debt forgiveness was intended to be a gift. There are also exceptions related to home
mortgage settlements. More information on this topic will be in later chapters
-5Pass through Income: Income received by some entities is passed through to the recipients.
Pass through income is a part of the recipient’s gross income. Examples include income received
by Partners from a partnership and income received by recipients of an estate or trust. Income
from Subchapter S corporations and limited liability companies is also passed through. Perhaps
the most common pass through income is income received by a mutual fund and passed through
to the mutual fund investors who are (at least in theory) the owners of the fund.
Prizes and Awards: Prizes and awards usually represent taxable income. There are exceptions
for non cash prizes and awards and redirected prizes and awards. These will be covered in future
chapters.
Gifts A gift is not the same as a prize or award. Gifts are not typically taxable for income tax
purposes. A large gift (over $13,000 in 2011 may be subject to a gift tax but gifts are not subject
to income tax.
Unemployment Compensation: Amount received as unemployment compensation is included
in gross income.
Social Security Benefits: Social Security Benefits in excess of prescribed amounts are includible
in gross income. If a taxpayer’s modified adjusted gross income is low enough, none of the
social security benefits is includible in income. (Text p 3-25) (IRS has a fool proof worksheet in
the instructions for the form 1040 – ignore the text rules – download the IRS form and use it – if
you do you will always get the correct amount)
Insurance Proceeds and Court Awards: Insurance contracts and court awards related to the
destruction of property are includible in gross income only to the extent the amounts exceed the
tax basis (tax cost) of the property. Furthermore, if destroyed property is replaced within the
time period prescribed by regulations and at a cost equal to or greater than the insurance or award
proceeds received; then none of the proceeds are includible in gross income.
Amounts of insurance proceeds or damages received on account of physical injury are generally
excluded from gross income (more in later chapters).
Amounts of insurance proceeds or damages received on account of non physical injury are
generally included in gross income (more in later chapters).
Recoveries of amounts previously deducted, amounts received under claim of right, and
prepaid amounts are usually includible in gross income.
What form should be used? The text has a nice table on page 3-31 that identifies many
different kinds of gross income along with the proper form on which to report the income for tax
purposes.