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Chapter 4
Gross Income
©2012 CCH. All Rights Reserved.4025 W. Peterson Ave.Chicago, IL 60646-60851 800 248 3248www.CCHGroup.com
CCH Federal Taxation Basic Principles 2 of 31
1. Constructive Receipt Doctrine
2. Community Property Income
3. Items Included in Gross Income
4. Compensation vs. Gift
5. Prizes and Awards
6. Employee Achievement Awards
7. Scholarships and Fellowships
8. Business Income
9. Below-Market Interest Loans—Types of Loans
Chapter 4 Exhibits
Chapter 4, Exhibit Contents A
CCH Federal Taxation Basic Principles 3 of 31
10. Below-Market Interest Loans—Tax Effect
11. Rental Income
12. Tenant Improvements
13. Dividend Income
14. Alimony—Post-1984 Agreements
15. Alimony and Child Support (Post-1984 Divorces)
16. Alimony Recapture
17. Discharge of Debt
18. Discharge of Debt—Bankruptcy
Chapter 4 Exhibits
Chapter 4, Exhibit Contents B
CCH Federal Taxation Basic Principles 4 of 31
Constructive Receipt Doctrine
“When is income taxable?”
Generally, any compensation granted to an individual to which the individual has an absolute right is regarded as constructively received income.
Chapter 4, Exhibit 1
CCH Federal Taxation Basic Principles 5 of 31
Community Property Income
Property acquired after marriage is community property. Income from community property is community income
Property acquired before marriage remains separate property. What happens to income from separate property?
Chapter 4, Exhibit 2a
CCH Federal Taxation Basic Principles 6 of 31
CA Rule – Income from separate property remains separate.
Applies to California, Arizona, Nevada, New Mexico, Washington and Wisconsin.
TX Rule - Income from separate property is community income. Therefore, if spouses filed separate returns, the income would be shared between them.
Applies to Texas, Idaho and Louisiana.
Chapter 4, Exhibit 2b
Community Property Income
CCH Federal Taxation Basic Principles 7 of 31
Items Included in Gross Income
Compensation for services, including fees, commissions, fringe benefits, and similar items
Gross income derived from business Gain derived from dealings in
property Interest Rents Royalties Dividends Alimony and separate maintenance
payments
Annuities Income from life insurance and
endowment contracts Pensions Income from discharge of
indebtedness Distributive share of partnership
gross income Income in respect of a decedent Income from an interest in an estate
or trust
Code Sec. 61(a) lists 15 items that generally must be included in gross income:
Special circumstances may result in the exclusion or deferral of any of these items.
Chapter 4, Exhibit 3
CCH Federal Taxation Basic Principles 8 of 31
Compensation vs. Gift
Example
FACTS: Grandma offers 16-year-old Billy $10,000 if he quits smoking and playing pinball over the next five years. He does, and upon attaining the age of 21, she pays him $10,000.
QUESTION: Is the $10,000 received by Billy taxable income or a gift?
SOLUTION: The $10,000 is taxable income since there were strings attached.
The facts and circumstances dictate whether something received is taxable compensation or a tax-free gift
Compensation is generally included in gross income. Gifts are generally excluded from gross income.
Chapter 4, Exhibit 4
CCH Federal Taxation Basic Principles 9 of 31
Prizes and Awards
Prizes and awards are generally taxable based on fair market value at time of receipt.
However, if ALL of the following 4 conditions occur, then they are excludable :
1. Connected with the fields of science, charity, or the arts2. Involuntary selection process (i.e., through no effort of recipient)3. No future services required of recipient4. Assigned to a governmental agency or tax-exempt charitable organization (rather than constructively received).
Chapter 4, Exhibit 5a
CCH Federal Taxation Basic Principles 10 of 31
Example
FACTS: Mother Tanesha, a U.S. citizen, is awarded the Nobel Peace Prize, which includes a $500,000 cash award. The award was unsolicited and no future services were required of Mother Tanesha. Furthermore, she endorsed the check over to the Sisters of Charity, a qualified tax-exempt charity, rather than depositing it in her bank account.
QUESTION: Does Mother Tanesha have taxable income?
SOLUTION: YES! She constructively received the $500,000 when she endorsed the check over to the charity. By endorsing the check, she exercised dominion and control over the money, even though she did not deposit it. She could have avoided taxable income if she had directed the Nobel Committee to pay the Sisters of Charity directly.
Chapter 4, Exhibit 5b
Prizes and Awards
CCH Federal Taxation Basic Principles 11 of 31
Employee Achievement Awards
Employee achievement awards are generally taxable, except that the value of awards for length of service or safety achievement delivered at a “meaningful presentation” are excluded up to
1. $400 if the plan is non-qualified (i.e., discriminates in favor of highly paid employees), or
2. $1,600 if the plan is qualified (i.e., does not discriminate in favor of highly paid employees).
(If an employee receives both qualified and nonqualified awards, then the overall exclusion may not exceed $1,600.)
Chapter 4, Exhibit 6
CCH Federal Taxation Basic Principles 12 of 31
Scholarships and Fellowships
The value of scholarships or fellowships are generally taxable, but may be excluded if they are:
1. To a degreed candidate attending an educational institution
2. For tuition and course related material (not room and board)
3. As a result of academic achievement, and not connected with
services provided.
Example: A “scholarship” received by a beauty queen for winning the Miss Georgia Peanut contest would actually be a taxable award for services rendered, even if she were a degreed candidate and the money was spent on tuition. It would really be compensation disguised as a scholarship.
Chapter 4, Exhibit 7
CCH Federal Taxation Basic Principles 13 of 31
Business Income Sole proprietor
Include all business income (less cost of goods sold) in gross income.
Partnerships and S corps Partnerships and S corps are not taxed, but their taxable
income is taxed to individual partners and shareholders. Partners and shareholders must include their proportionate
share of business income in their gross income, regardless of whether or not the income was distributed.
Chapter 4, Exhibit 8
CCH Federal Taxation Basic Principles 14 of 31
Below-Market Interest Loans—Types of Loans
What types of loans are subject to imputed interest calculations?
All of the following loans are subject to imputed interest:
Gift loans (made out of love or generosity). Note that the “gift” is NOT the principal
portion of the loan, rather, the amount of interest that is below market. Compensation-related loans (employer loans to employees) Corporation-shareholder loans (a corporation’s loans to ANY of its shareholders)
If all of the following apply: Interest charged is less than the applicable federal rate (AFR) Sum of all loans between lender and borrower exceeds $10,000 The loan was made after June 7, 1984
Chapter 4, Exhibit 9
CCH Federal Taxation Basic Principles 15 of 31
Below-Market Interest Loans—Tax Effect
The two steps for each of the three below-market interest loans are not easy to conceptualize. See if this makes sense:
Step 1: “Pretend” that the borrower has “paid” the imputed interest to the lender as an interest payment.
Step 2: “Pretend” that the lender has returned the imputed interest back to the borrower as either a gift, compensation, or a dividend.
Chapter 4, Exhibit 10a
CCH Federal Taxation Basic Principles 16 of 31
What is the tax effect of imputed interest on below-market loans?
Type of Loan Step Lender Borrower
Gift Loan Step 1:Step 2:
Interest income.Nondeductible gift, possibly subject to gift tax.
Interest expense.
Tax-free gift received.
Compensation-related Loan
Step 1:
Step 2:
Interest income.
Compensation expense.
Interest expense.
Compensation income.
Corporation to Shareholder
Loan
Step 1:
Step 2:
Interest income.Nondeductible dividend deemed paid.
Interest expense.
Dividend income.
Chapter 4, Exhibit 10b
Below-Market Interest Loans—Tax Effect
CCH Federal Taxation Basic Principles 17 of 31
Rental Income
Tax Effect on Landlord: ALL rent received is taxable income, including future years’ rent received in advance
Tax Effect on Tenant with a Business Lease: If rent is paid in advance, no deduction for rent expense is allowed until the year the payment is due.
Example
FACTS: Tenant pays Landlord $10,000, covering the first and last year’s rent.
QUESTION: What is the tax effect on Landlord and Tenant?
SOLUTION: $10,000 taxable income to Landlord; $5,000 deduction to Tenant.
Chapter 4, Exhibit 11
CCH Federal Taxation Basic Principles 18 of 31
Tenant Improvements
When are tenant improvements taxable to cash-basis landlords?
1. If in lieu of rent (or if repairs paid for by lessee are the
responsibility of the lessor): lessor has rental income to the extent
of the market value of the improvements.
2. If NOT in lieu of rent: Not taxable.
When the property is sold, the improvements will be taxed assuming
they add value that results in a higher sales price.
Chapter 4, Exhibit 12
CCH Federal Taxation Basic Principles 19 of 31
Dividend Income
The term “dividend” means any distribution of property made by a corporation to its shareholders out of its earnings and profits.
There are two common types of dividends: Cash Dividends – taxable. Stock Dividends – generally not taxable. There are 5
exceptions to this rule. If a stock dividend meets one or more of these exceptions, it is taxable.
Chapter 4, Exhibit 13
CCH Federal Taxation Basic Principles 20 of 31
Alimony—Post-1984 Agreements
Payments under instruments executed after December 31, 1984, that meet the following requirements are deductible as alimony:
Payments must be made in cash Payments must be made under a divorce or separation
instrument Parties must live in separate households after a
divorce or separation decree is entered Alimony must end at the payee’s death Parties involved may not file a joint return
Chapter 4, Exhibit 14
CCH Federal Taxation Basic Principles 21 of 31
Alimony and Child Support (Post-1984 Divorces)
What is the tax treatment for alimony and child support?
Alimony Child Support
Taxable to Payee? Yes No
Deductible to Payor? Yes (“for” AGI) No
Chapter 4, Exhibit 15
CCH Federal Taxation Basic Principles 22 of 31
Alimony Recapture
Alimony is required to be recaptured if:
1) Payments made in the 2nd post-separation year exceed payments in the 3rd post-separation year by more than $15,000 and/or
2) Payments made in the 1st post-separation year exceed the average payments made in the 2nd and 3rd post-separation years by more than $15,000.
Chapter 4, Exhibit 16a
CCH Federal Taxation Basic Principles 23 of 31
Step 1: Year 2 Recapture
Year 2 Payment
Less Year 3 Payment
= Excess Payment
Less $15,000
= Amount subject to recapture for Year 2
Chapter 4, Exhibit 16b
Alimony Recapture
CCH Federal Taxation Basic Principles 24 of 31
Step 2: Year 1 Recapture
Year 1 Payment
Less (Year 2 Payment - Year 2 Recapture + Year 3 Payment) / 2
= Excess Payment
Less $15,000
= Amount subject to recapture for Year 1
Chapter 4, Exhibit 16c
Alimony Recapture
CCH Federal Taxation Basic Principles 25 of 31
Step 3: Total recapture
The total amount subject to recapture equals Year 2 recapture plus Year 1 recapture.
The amount recaptured is included in the payor’s income and allowed as a deduction from the payee’s income in Year 3.
Chapter 4, Exhibit 16d
Alimony Recapture
CCH Federal Taxation Basic Principles 26 of 31
Example:
Bob makes the following alimony payments to Mary:
Year 1 - $70,000
Year 2 - $40,000
Year 3 - $20,000
Chapter 4, Exhibit 16e
Alimony Recapture
CCH Federal Taxation Basic Principles 27 of 31
Step 1: Year 2 Recapture
$40,000 (Year 2)
- $20,000 (Year 3)
= $20,000 (excess)
- $15,000
= $5,000
Chapter 4, Exhibit 16f
Alimony Recapture
CCH Federal Taxation Basic Principles 28 of 31
Step 2: Year 1 Recapture
$70,000 - $27,500 (40,000 – 5,000 + 20,000)/2= $42,500 - $15,000 = $27,500
Step 3: Total Recapture $5,000 + $27,500 = $32,500
Chapter 4, Exhibit 16g
Alimony Recapture
CCH Federal Taxation Basic Principles 29 of 31
Tax Effects of Alimony Payments and Recapture
Bob Mary
Year 1 ($70,000) deduction $70,000 income
Year 2 ($40,000) deduction $40,0000 income
Year 3
($20,000) deduction
$32,500 recapture
$12,500 income
$20,000 income
($32,500) recapture
($12,500) deduction
Chapter 4, Exhibit 16h
Alimony Recapture
CCH Federal Taxation Basic Principles 30 of 31
Discharge of Debt
Forgiveness of debt is generally includable in gross income.
There are 2 exceptions in which taxes on a forgiveness of debt are deferred (i.e. excluded from gross income): 1. The debt is discharged in a Chapter 11 bankruptcy filing. The amount of debt discharged reduces certain tax attributes that
otherwise could have provided a tax benefit in the future.
2. The borrower is insolvent outside of bankruptcy
(i.e., Liabilities > FMV of assets immediately prior to discharge) However, the amount excluded from gross income cannot exceed the amount by which the taxpayer is insolvent.
Chapter 4, Exhibit 17
CCH Federal Taxation Basic Principles 31 of 31
Offsetting reduction of tax attributes. As a price for the deferral (exclusion from gross income), the Code requires that the amount deferred be applied to reduce seven tax attributes in the order listed below. However, the Code offers a special election to first reduce the tax basis of depreciable property or real property held as inventory.
1. Net operating losses and loss carryovers 2. General business credits under Code Sec. 38 3. Minimum tax credits under Code Sec. 53 4. Net capital loss and loss carryovers 5. Basis of depreciable assets or nondepreciable real assets held as inventory 6. Passive activity losses 7. Foreign tax credit carryovers under Code Sec. 27
Discharge of Debt—Bankruptcy
Chapter 4, Exhibit 18