Determining Gross Income

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DeterminingGross Income

Chapter 3

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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...”

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What is Income?

Gross income is realized income that is not excludedRealization takes place when arm’s length

transaction occurs (sale of goods) Taxable income is gross income less all

deductions

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Tax vs. Financial Accounting

Objectives are not the sameFinancial accounting seeks to provide

information that decision makers find usefulTax reporting seeks to collect revenue

equitably Differences fall into two categories

Temporary (timing) differencesPermanent differences

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Temporary Differences

Arise when income is taxed either before or after it is accrued for accounting purposesExample: 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

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Permanent Differences

Income that is not taxed but is reported for financial accounting purposesExample: municipal bond interest

generally is not taxed but is recorded as income in financial accounting records

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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

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Investment Alternatives

Investments yielding appreciationTax deferred until gain is recognizedGain 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

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The Tax Year

Calendar yearIndividualsS corporations and partnerships have

restrictions on allowable tax years, so usually use a calendar year

Fiscal year12-month period ending on month other than

December52-to-53 week year (ends on same day)Corporations freely select tax year

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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 yearNot required in year entity begins or ends

business

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Accounting Methods

Taxpayers can use different methods for financial accounting and taxCash 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

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Cash Method

Income is recognized when cash or cash equivalents receivedCash equivalents broadly defined to include

property and servicesCash equivalents included at fair market value

A cash-basis taxpayer must recognize income when an amount isCredited to the taxpayer’s accountSet apart for the taxpayer, orMade available in some other way to the taxpayer

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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 incomeThe payor has insufficient funds from which to

make payment, orThere are substantial limitations or restrictions

placed on actual receipt

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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

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Accrual Method

Income is recognized when “all events test” is metAll events have occurred that establish the

right to the income andThe income amount can be determined with

reasonable accuracy If liability is in dispute, the all events test is

not satisfied until dispute is resolved

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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

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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 receivedExamples: rent, interest, and royalty

paymentsRefundable deposits are not prepaid income

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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 servicesCommunity 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

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Interest Income

Interest income from most sources is taxable, but interest on state and local (municipal) bonds is excluded from gross incomeHigh income taxpayers may have a higher after-

tax 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

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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 accruesException: Series EE and Series I bonds

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Market Discount

Bonds purchased after issue in the open or secondary market at a price below their stated maturity valueExcess 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

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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

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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 $100,000Imputed interest cannot exceed the borrower’s

net investment income for the yearIf borrower’s net investment income is no

more than $1,000, imputed interest is zero

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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

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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

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)

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Dividend Income

15% rate applies to most dividends (zero rate for individuals in 10% or 15% tax bracket) in 2009 and 2010

Qualified dividends are reported on two lines on an individual’s tax return Line 9a “ordinary dividends” includes dividend income in

adjusted gross income Line 9b “qualified dividends” indicates that the dividend

income qualifies for the special lower tax rate

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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 assetsThese dividends are actually net long-term capital

gains and are called capital gains distributions

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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 incomeAmount included in income becomes the

shareholder’s basis for these shares of stock

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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 shareholderShareholder 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

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Annuity Income

Usually consists of a taxable and nontaxable amountNontaxable 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

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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

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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 taxableException: the first $2,400 of unemployment

benefits received in 2009 were excluded (but this exception was not extended to 2010)

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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

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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

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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

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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 payorFirst 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

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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 taxationExceptions are provided for debtors who are

bankrupt or insolventExceptions for the forgiveness of some

student loans when the students work in certain professions

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Discharge of Debt

Mortgage Forgiveness Debt Relief Act of 2007 provided relief for homeowners whose mortgage debt was forgivenForgiveness on up to $2 million of qualified debt on a

principal residence from 2007 through 2009 was excluded from income

This provision was then extended through 2012 and applies to restructuring, short sales, and deeds-in-lieu of foreclosure

Basis of residence is reduced (but not below zero) for amount excluded

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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 deductionExample: bad debt recovery or refund of taxes

previously deducted

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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

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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 workIf 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

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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

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Scholarships

Any grant received in return for past, present, or future services must be included in gross incomeFunds 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

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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

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International Issues

Source principal - countries tax income earned within their borders but exclude income from activities taking place (sourced) in other countriesApplies to foreign persons and foreign

corporations Residency principle – countries tax worldwide

incomeApplies to resident individuals and

corporations

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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

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Minimizing Double Taxation

Tax treaties and tax credits minimize the impact of this double taxationA 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

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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. throughGreen card orSubstantial presence test (183 days)

Individuals typically exempt from substantial presence test include diplomats, teachers, students, and certain professional athletes

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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 onEffectively connected income – U.S. business

income subject to U.S. income taxU.S. investment income – taxed at flat 30% (or

treaty rate if lower)

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U.S. Corporations Doing Business in a Foreign Country

A U.S. corporation can operate in a foreign country through a branch or a subsidiaryA branch is viewed as an extension of the U.S.

corporationBranch’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

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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 dividendsWhen the U.S. parent receives a dividend, the

dividend is included in its incomeThe parent is entitled to a foreign tax credit when

the dividend is received based on the income tax paid by the foreign corporation

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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 incomeAs 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

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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 onIncome derived from business activity within

that state andIncome from property in that state

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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

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Total Effective Tax Rate

For federal tax purposes, state income tax is deductible in computing taxable incomeTax 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

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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 ifMarginal tax rate is expected to increaseUnused losses are expiring

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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

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The End