Chapter 3
Determining
Gross Income
3-1
What is Gross Income?
Code Section 61(a) defines gross
income as
“except as otherwise provided in this
subtitle, gross income means all income
from whatever source derived...”
3-2
What is Income?

Gross income is realized income that is
not excluded
 Realization takes place when arm’s length
transaction occurs (sale of goods)

Taxable income is gross income less all
deductions
3-3
Tax vs. Financial Accounting

Objectives are not the same
Financial accounting seeks to provide
information that decision makers find useful
Tax reporting seeks to collect revenue
equitably

Differences fall into two categories
Temporary (timing) differences
Permanent differences
3-4
Temporary Differences

Arise when income is taxed either before or
after it is accrued for accounting purposes
Example: prepaid rent generally is taxable
when received but is only included in
financial accounting income as it is earned

Create a deferred tax asset or deferred tax
liability on financial statements
3-5
Permanent Differences

Income that is not taxed but is reported
for financial accounting purposes
Example: municipal bond interest
generally is not taxed but is recorded as
income in financial accounting records
3-6
Return of Capital Principle


Basis = amount invested in an asset
Basis can be recovered tax-free
If the taxpayer’s return is more than basis, the
taxpayer has a gain
If taxpayer’s return is less than basis, the
taxpayer has a loss
3-7
Investment Alternatives

Investments yielding appreciation
Tax deferred until gain is recognized
Gain is frequently taxed at lower capital gains
rates

Investments yielding annual income
Interest income is taxed annually at the
marginal tax rate for ordinary income;
dividends taxed annually but currently at lower
capital gains rates
3-8
The Tax Year

Calendar year
Individuals
S corporations and partnerships have
restrictions on allowable tax years, so usually
use a calendar year

Fiscal year
 12-month period ending on month other than
December
52-to-53 week year (ends on same day)
Corporations freely select tax year
3-9
Short Tax Year


A short-year tax return reports less than 12
months of operating results
Income must be annualized (adjusted to
reflect 12 months of operations)
Required by businesses that change their
tax year
Not required in year entity begins or ends
business
3 - 10
Accounting Methods

Taxpayers can use different methods for
financial accounting and tax
Cash method: receipt of cash or cash
equivalents determine income/expense
recognition (subject to constructive receipt
doctrine)
Accrual method: the all-events test determines
income/expense recognition
3 - 11
Cash Method

Income is recognized when cash or cash
equivalents received
Cash equivalents broadly defined to include
property and services
Cash equivalents included at fair market value

A cash-basis taxpayer must recognize income
when an amount is
Credited to the taxpayer’s account
Set apart for the taxpayer, or
Made available in some other way to the taxpayer
3 - 12
Constructive Receipt Doctrine


Constructive receipt is a modification that
prevents cash basis taxpayers from “turning
their backs” on income
Income is not constructively received if:
The taxpayer is not entitled to the income
The payor has insufficient funds from which to
make payment, or
There are substantial limitations or restrictions
placed on actual receipt
3 - 13
Limits on Cash Method



Businesses that carry inventory and sell
merchandise to customers generally must
use the accrual method to account for sales
and purchases
Hybrid method – accrual for sales of inventory
& cost of goods sold; cash method for other
income and expenses
Large corporations (gross receipts of more
than $5 million) cannot use cash method
3 - 14
Accrual Method

Income is recognized when “all events test” is
met
All events have occurred that establish the
right to the income and
The income amount can be determined with
reasonable accuracy

If liability is in dispute, the all events test is
not satisfied until dispute is resolved
3 - 15
Claim of Right Doctrine



Claim of right doctrine modifies the normal
recognition rules for accrual basis taxpayers
Requires taxpayer to recognize income when
payment is received, regardless of whether
money may have to be repaid later
If taxpayer must return all or part of the
income, deduction allowed in repayment year
3 - 16
Prepaid Income



Prepaid Income is another exception to the
accrual method of accounting
Based on wherewithal to pay concept –
taxpayer should be taxed when best able to
pay the tax
Income must be reported when received
Examples: rent, interest, and royalty
payments
Refundable deposits are not prepaid income
3 - 17
Assignment of Income Doctrine


A taxpayer cannot assign earned income to a
third party to escape taxation
Earned income must be taxed to the taxpayer
rendering the services
Community property states (Arizona,
California, Idaho. Louisiana, Nevada, New
Mexico, Texas, Washington, Wisconsin)
Allocate half of income to each spouse

Income from property is taxed to taxpayer
who owns the property
3 - 18
Interest Income

Interest income from most sources is taxable,
but interest on state and local (municipal)
bonds is excluded from gross income
 High income taxpayers may have a higher aftertax return on municipal bonds than taxable bonds
offering a higher interest rate
 Gain on the sale of tax-exempt securities must be
included in gross income
 Interest from private activity municipal bonds may
be subject to AMT
3 - 19
Original Issue Discount



Some debt instruments are issued at prices
below their maturity values
This original issue discount (OID) is
effectively interest paid at maturity rather than
periodically over the debt instrument’s life
Both cash and accrual basis taxpayers
recognize OID income as it accrues
Exception: Series EE and Series I bonds
3 - 20
Market Discount

Bonds purchased after issue in the open or
secondary market at a price below their
stated maturity value
Excess of redemption proceeds over cost is
recognized as ordinary income in year of
redemption
Electively, market discount can be accrued as
interest income over life of bond
3 - 21
Below-Market-Rate Loans


Interest-free or low interest rate loans are
frequently made between related parties
Interest income that is not actually
received or accrued may be imputed
(treated as received or accrued and
taxed) at the applicable federal rate of
interest
3 - 22
Gift Loan Exceptions


Any gift loan of $10,000 or less is exempt
from the imputed interest rules
For gift loans greater than $10,000 but less
than $100,000
Imputed interest cannot exceed the borrower’s
net investment income for the year
If borrower’s net investment income is no
more than $1,000, imputed interest is zero
3 - 23
Other Loans



Loan to employee – imputed exchange of
cash is treated as taxable compensation
(income to employee and deduction for
employer)
Loan to shareholder – imputed exchange of
cash is treated as a dividend (taxable
income to shareholder, no deduction for
corporation)
$10,000 exception if no tax avoidance
motive
3 - 24
Dividend Income

Cash and FMV of other assets distributed by
a corporation from earnings and profits (E&P)
are treated as dividends includable in the
shareholder’s income
15% rate applies to most dividends (zero rate
for individuals in 10% or 15% tax bracket in
2009)


Distributions in excess of E&P are nontaxable
return of capital (reducing stock basis)
Distributions in excess of stock basis are
taxed as capital gain (as if stock is sold)
3 - 25
Mutual Fund Dividends


May distribute dividends received on stock
they hold to their mutual fund shareholders
May also pay dividends from gains they
realize on the sale of investment assets
 These dividends are actually net long-term capital
gains and are called capital gains distributions
3 - 26
Dividend Reinvestment Plans


Treated as if the shareholder receives the
cash and then purchases additional shares of
stock with the dividend income (constructive
receipt doctrine)
Value of dividend included in income
 Amount included in income becomes the
shareholder’s basis for these shares of stock
3 - 27
Stock Dividends


Stock dividends are distributions of a
corporation’s own stock to its shareholders
(treated the same as a stock split)
Usually stock dividends are not taxable to the
shareholder
 Shareholder owns a greater number of shares and
the basis in the original shares is divided among
all shares of stock now held

If shareholder has option of receiving cash or
stock, then it is taxable
3 - 28
Annuity Income

Usually consists of a taxable and nontaxable
amount
 Nontaxable amount represents a return of capital
 Nontaxable amount of a payment is equal to the
Investment in annuity / expected return from
annuity x annuity payment received

If the amounts invested in the annuity were all
made by the employer (or by the employee
using pre-tax dollars), then the employee’s
investment is treated as zero
3 - 29
Prizes and Awards


Prizes, awards, gambling winnings, and
treasure finds are taxable
The fair market value of goods or
services received is included in gross
income
3 - 30
Government Transfer Payments


Need-based payments, such as welfare
payments, school lunches & food stamps, are
excluded from income
Unemployment compensation is taxable
because it is a substitute for wages that
would be taxable
 Exception: the first $2,400 of unemployment
benefits received in 2009 are excluded
3 - 31
Social Security Benefits


Government devised a complex formula that
can result in the taxation of up to 85% of
social security benefits for taxpayers who
have significant other income while leaving
benefits completely tax free for those who
have little other income
MAGI = AGI before any social security
benefits + exempt interest income + ½ of
social security benefits
3 - 32
Social Security Benefits



If MAGI is less than $25,000 for single
individuals or $32,000 for married couples,
then none of the social security benefits
received are taxable
Single taxpayers with MAGI above $34,000
and married taxpayers with income above
$44,000 can be taxed on up to 85% of their
benefits
Taxpayers between the above thresholds can
be taxed on up to 50% of their social security
benefits
3 - 33
Damage Awards



Damages for physical injuries are not taxed
(under the return of capital doctrine)
Damages for all other awards are taxed
(viewed as substitute for income that would
otherwise be taxable income)
Punitive damages are taxable
3 - 34
Divorce-Related Payments


A property settlement is simply a division of
assets (no income, no deduction)
Alimony is a legal shifting of income – taxable
income to recipient and deductible by payor
 First year’s alimony should not exceed average of
2nd and 3rd year payments by more than $15,000


Child support fulfills a legal obligation to
support a child (no income, no deduction)
Both parties may benefit by negotiating an
increase in payment if it qualifies as alimony
3 - 35
Discharge of Debt

If a legal obligation is satisfied for less than
the outstanding debt, the amount of debt
forgiven represents an increase in the
taxpayer’s wealth and is subject to taxation
Exceptions are provided for debtors who are
bankrupt or insolvent
Exceptions for the forgiveness of some
student loans when the students work in
certain professions
3 - 36
Discharge of Debt

Mortgage Forgiveness Debt Relief Act of
2007 provides relief for homeowners whose
mortgage debt is forgiven
Forgiveness on up to $2 million of qualified
debt on a principal residence from 2007
through 2009, is not included in income
3 - 37
Tax Benefit Rule


If a taxpayer deducted an expense or loss in one
year but recovers the amount deducted in a
subsequent year, all or a portion of the amount
recovered may have to be included in the gross
income in the year it is recovered
Amount included in income is limited to the
extent the taxpayer benefited from the tax
deduction
Example: bad debt recovery or refund of taxes
previously deducted
3 - 38
Exclusions



Gifts
Inheritances
Life Insurance
Proceeds received are tax-free but any
interest income on proceeds is taxable
Inside buildup (increase in cash surrender
value) is not taxable income unless policy is
liquidated for more than premiums paid
3 - 39
Accident & Health Insurance


Accident & health insurance proceeds are
tax-free to extent they pay qualified medical
or dental expenses; excess benefits taxable if
employer provided policy
Disability insurance is a substitute for lost pay
is an employee cannot work
If premiums for disability insurance paid by
employer, then benefits received are taxable
If premiums paid by employee, exception
allows benefits to be received tax free
3 - 40
Scholarships

Qualified scholarships are excluded from
gross income
“Scholarship” includes only tuition, fees,
books, supplies, equipment, and related
expenses required for courses
Amounts designated or spent for room,
board, and laundry are included in taxable
income
3 - 41
Scholarships

Any grant received in return for past,
present, or future services must be included
in gross income
Funds received by students in return for
teaching or research services are taxable

When taxable portion cannot be determined
until end of academic year, taxable income
can be deferred until the taxable year in
which the academic year ends
3 - 42
Other Exclusions



Improvements made on leased property are
excluded from landlord’s income unless
improvements made in lieu of paying rent
Fringe benefits (discussed in next chapter)
Exclusion of gain on sale of home
$250,000 if single, $500,000 if married and
both spouses qualify
Must have owned and lived in home as
principal residence for at least 2 of previous 5
years
3 - 43
International Issues

Source principal - countries tax income
earned within their borders but exclude
income from activities taking place (sourced)
in other countries
Applies to foreign persons and foreign
corporations

Residency principle – countries tax worldwide
income
Applies to resident individuals and
corporations
3 - 44
International Taxation



A business is usually only taxed in country of
residence unless it maintains a permanent
establishment (e.g. office) in another country
Source country can tax income earned within
its borders when a permanent establishment
exists
Double taxation can result when more than
one jurisdiction has the right to tax the same
income
3 - 45
Minimizing Double Taxation

Tax treaties and tax credits minimize the
impact of this double taxation
 A tax treaty is an agreement between two
countries that explains how a taxpayer of one
country is taxed when conducting business in
another country
 Foreign tax credits can offset domestic taxes on
foreign source income
3 - 46
Taxpayers Subject to U.S. Tax


U.S. citizens, corporations, and resident
aliens are subject to U.S. tax on their
worldwide income
Resident alien – individual who is not a U.S.
citizen but who has established legal
residence in U.S. through
 Green card or
 Substantial presence test (183 days)
Individuals typically exempt from substantial presence
test include diplomats, teachers, students, and certain
professional athletes
3 - 47
Nonresident Aliens and
Foreign Corporations


Nonresident alien – individual who is not U.S.
citizen and does not satisfy test to be resident
alien
Nonresident aliens and foreign corporations
are subject to U.S. tax on
 Effectively connected income – U.S. business
income subject to U.S. income tax
 U.S. investment income – taxed at flat 30% (or
treaty rate if lower)
3 - 48
U.S. Corporations Doing
Business in a Foreign Country

A U.S. corporation can operate in a foreign
country through a branch or a subsidiary
 A branch is viewed as an extension of the U.S.
corporation
Branch’s income is combined with U.S. operations and
subject to U.S. tax (no income deferral)
 A controlled foreign corporation (CFC) is a
corporation incorporated outside the U.S. that is
owned more than 50% by U.S. shareholders
3 - 49
U.S. Corporations Doing
Business in a Foreign Country

A U.S. parent corporation is usually not taxed
on the earnings of the foreign subsidiary until
the earnings are repatriated to the U.S. as
dividends
 When the U.S. parent receives a dividend, the
dividend is included in its income
 The parent is entitled to a foreign tax credit when
the dividend is received based on the income tax
paid by the foreign corporation
3 - 50
U.S. Corporations Doing
Business in a Foreign Country

If the U.S. parent does not need cash from its
overseas operations, it can direct its subsidiary
to not pay dividends postponing the payment of
U.S. taxes on this income
 As long as the parent receives no repatriated
earnings, it can postpone the payment of U.S. taxes

Certain foreign source income (Subpart F
income) earned by a CFC is subject to U.S. tax
when earned
 No additional U.S. tax is paid on this income when the
parent receives it as a dividend
3 - 51
State and Local Taxation


Most states (and some local governments)
impose both corporate and individual income
taxes on both residents and nonresidents
Nonresidents can only be taxed on
Income derived from business activity within
that state and
Income from property in that state
3 - 52
State Tax Issues


Nexus is the type and degree of connection
between a business and a state necessary for
the state to have the right to impose a tax
Multi-state businesses may be able to reduce
their overall tax cost by shifting income from a
high-tax state to a low-tax state
3 - 53
Total Effective Tax Rate

For federal tax purposes, state income tax is
deductible in computing taxable income
 Tax savings from this federal deduction reduce the
cost of the state income tax

When a taxpayer pays income tax at both the
federal and state levels, it increases the total
effective tax rate and decreases the after-tax
cash flow
3 - 54
Installment Method



Gain is recognized as proceeds from sale are
received
Use severely restricted – generally available
for casual sales only (excludes sales of
inventory and securities)
May not want to use if
Marginal tax rate is expected to increase
Unused losses are expiring
3 - 55
Long-Term Contracts


Completed Contract Method – no income is
recognized and no deductions taken until
contract completion
Percentage-of-Completion Method – income
is recognized as contract progresses based
on an estimate of actual costs incurred to
total projected costs for contract
3 - 56
The End
3 - 57