Chapter 2
Gross Income & Exclusions
Income Tax Fundamentals 2007 edition
Gerald E. Whittenburg & Martha Altus-Buller
©2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star
logo, and South-Western are trademarks used herein under license.
Income Classifications

All sources of income are included unless
specifically excluded


Non-cash items included at fair market value
Three income classifications



Active
salary, wages and self employed
Portfolio dividends and interest
Passive rental real estate and limited partnership
 Can
only take passive losses against
passive gains
 Can carry forward unused losses to future
years
©2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star
logo, and South-Western are trademarks used herein under license.
Interest Income

If total interest income >$1,500 must report on
Schedule B (1040) or Schedule 1 (1040A)



Fair market value of gifts/services a taxpayer receives
for making long term deposits or opening an account
is taxable interest
Taxpayer may exclude interest on state and
local government obligations
After-tax return rate for tax-free municipal bond
calculated as follows
After-tax return = Tax-free interest rate / [1 – taxpayer’s tax rate]
©2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star
logo, and South-Western are trademarks used herein under license.
Dividend Income

3 kinds of dividends



Ordinary dividends

Return of net income to shareholders

Schedule B (1040) when total dividend income > $1,500
Nontaxable distributions

Return of original investment - not paid from net income

Therefore not included in taxpayer’s income

Reduces basis in stock
Capital gain distributions (CGD)

When stock reaches zero basis, further distributions are CGD

Report on page 1 of 1040 or Schedule D
©2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star
logo, and South-Western are trademarks used herein under license.
Alimony


Alimony is deductible to payer and taxable to
payee
Alimony payments must meet requirements as
follows if subject to divorce agreements after
1984
1.
2.
3.
4.
5.
Must be in cash and received by ex-spouse
Must be made in connection with written instrument
Can’t continue after death of ex-spouse
Can’t be designated as anything other than alimony
Parties may not be members of the same
household
©2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star
logo, and South-Western are trademarks used herein under license.
Annuities/Pensions



Taxpayer buys a contract (usually in retirement) in return
for periodic payments for the remainder of his/her life
Taxable portion of these periodic payments, called
annuities, are calculated based on mortality tables
provided by IRS and the annuity purchase price
General Rule for exclusion - Payments received are both
taxable (interest) and nontaxable (return of capital)

Must calculate amount to exclude from income
1. To calculate exclusion ratio
Investment in Contract / (Annual payment x life expectancy)
2. Exclusion amount =
Exclusion Ratio x Amount Received
©2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star
logo, and South-Western are trademarks used herein under license.
Life Insurance Proceeds

Life insurance proceeds are excluded from gross income



Viatical settlements are excludable from gross income in
certain situations


If proceeds paid to beneficiary by reason of death of the insured
Interest on proceeds paid over several years is generally taxable
income
Chronically or terminally ill taxpayer collects early payout from
insurance company or sells/assigns policy to a viatical settlement
provider
If policy is transferred for value, then all or part of the proceeds
may be taxable to recipient
Taxable amount =
Proceeds from death of insured
- Cash surrender value (at time of transfer)
+ Premiums paid by beneficiary
©2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star
logo, and South-Western are trademarks used herein under license.
Gifts and Inheritances and Scholarships



Inheritances are excluded from income

Income received from property after transfer is taxable

Estate may incur taxes
Gifts received are excluded from income

Gifts in business settings usually considered taxable
income

If recipient renders services for the gift, amount is taxable
Scholarships received for fees, books, tuition, courserequired supplies or equipment are excluded from
income

Must include scholarship amounts in income if

Any amounts apply to room and board

Any amounts received are compensation for required work
©2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star
logo, and South-Western are trademarks used herein under license.
Social Security

All or part of Social Security benefits may be
excluded from income

Based on taxpayer’s Modified AGI (MAGI)


MAGI = AGI + tax-exempt interest*
If [MAGI + (50%)(SS benefits)] < base amount**
then benefits are not taxed

If this number exceeds base amount, must compute
taxable portion
*Plus, on rare occasions, other items
**See next screen
©2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star
logo, and South-Western are trademarks used herein under license.
Calculating Taxable Amount of
SS Benefits at 50% Level
If [MAGI + (50%)(SS benefits)] is between lower
base and upper base amounts…
Lower Upper
Filing Status
$32,000 $44,000
MFJ
$ 0
$ 0
MFS
$25,000 $34,000
All others
…then, the taxable amount is lesser of:
(a) 50% (SS benefits) or
(b) 50% [MAGI + (50% x SS Benefits) - Lower
Base]
©2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star
logo, and South-Western are trademarks used herein under license.
Calculating Taxable Amount of
SS Benefits at 85% Level
If [MAGI + (50%)(SS benefits)] is greater than upper
base, the formula changes; then the taxable amount is
lesser of:
1.
85% (SS benefits)
or
2. 85% [MAGI + (50% x SS Benefits) - Upper Base]
plus
lesser of: ( i) result from formula on prior screen
or (ii) $4,500 ($6,000 for MFJ)
©2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star
logo, and South-Western are trademarks used herein under license.