Chapter 3Chapter 3

Income SourcesIncome Sources

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Kevin MurphyKevin MurphyMark HigginsMark Higgins

Kevin MurphyKevin MurphyMark HigginsMark Higgins

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What is Income?What is Income?

All-inclusive Income ConceptDefined by exception: “Except as

otherwise provided…” § 61

Judicial findingsIncome is the gain derived from labor and

capitalAny increase in wealth that has been

realized is income

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What is Income?What is Income?

Current ViewA change in the form and/or substance of

the taxpayer’s property, andThe involvement of a second party in the

income process

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Types of IncomeTypes of Income

Earned Unearned Transfer Imputed Capital Gains and Losses

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Earned Income: DefinitionEarned Income: Definition

Two problems may arise when determining taxability of earned incomeCash-equivalent approach Assignment of income

Compensation received for the provision of labor is earned income.

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Unearned Income: DefinitionUnearned Income: Definition

Examples of unearned income are:Interest and Dividend IncomeRental and Royalty IncomeAnnuities

The earnings from investments and gains from the sale, exchange or disposition of investment assets is unearned income.

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Unearned Income: AnnuitiesUnearned Income: Annuities

An annuity is a series of equal payments received at set time intervals for a determinable period

Capital Recovery Concept excludes the amount of original investment from taxable incomeMust be spread over the time of receipt

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Annuity ExclusionsAnnuity Exclusions

If the payment term and amount are fixed:

Exclusion Ratio = Cost of the contract

Total expected return

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Annuity ExclusionsAnnuity Exclusions

If the payment term depends on the life of the taxpayerMust estimate the number of paymentsUse the “simplified method”

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Annuity ExclusionsSimplified MethodAnnuity ExclusionsSimplified Method

Annuity payments beginning after November 18, 1996use Tables 3-1 or 3-2 to determine number

of payments

Excluded portion = Contract Cost

Number of payments

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Annuity ExampleAnnuity Example

George, age 64, purchased an annuity for $30,000. He begins receiving $300 per month in January. What amount is included in his gross income?

From Table 3-1, the number of payments to use is 260.

$30,000 / 260 = $115 monthly exclusion

$115 X 12 = $1,380 excluded per year

$300 X 12 = $3,600 amount received

$3,600 - $1,380 exclusion = $2,220 gross income

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Unearned Income: Gains and LossesUnearned Income: Gains and Losses

Proceeds from sale or dispositionless: Selling expenses

Amount realized from dispositionless: Adjusted basis of property

Gain or loss from disposition

Gains or losses may occur upon disposal of investment property.

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Unearned Income:Income from Conduit EntitiesUnearned Income:Income from Conduit Entities

Income from a conduit entity is reported by the owners and taxed on the owners’ returns

Distributions from conduit entities to the owners are treated as a recovery of capital

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Transfer Income: DefinitionTransfer Income: Definition

Some amounts of income are neither fully earned nor fully unearned.Prizes and AwardsUnemployment CompensationSocial Security BenefitsAlimony Received

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Transfer Income: Prizes and AwardsTransfer Income: Prizes and Awards

Amounts received as prizes and awards are generally taxable.Exceptions exist for:

Scientific and literary achievementsmust be given by recipient to a qualified charity or

government unit

Employee achievementsmust be given to employee for length of service or

safetyamount is limited to $400 per employee (or $1,600 if

qualified plan)

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Transfer Income:Unemployment Compensation

Transfer Income:Unemployment Compensation

Amounts received from unemployment compensation plans are considered substitutes for earned income and are always taxable.

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Transfer Income: Social Security BenefitsTransfer Income: Social Security Benefits

A portion of Social Security benefits received may be taxable if modified AGI exceeds certain limits.

Adjusted gross income

plus: 1/2 social security benefits

plus: tax exempt income

plus: foreign earned income exclusions

Modified AGI

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Modified AGI ExampleModified AGI Example

A single taxpayer received $3,000 from Social Security payments. Her AGI without the SS is $30,000.

Modified AGI = $30,000 + $1,500

= $31,500

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Transfer Income:Social Security Benefits - Tier One

Transfer Income:Social Security Benefits - Tier One Unmarried individuals with modified AGI

between $25,000 and $34,000, and MFJ individuals with modified AGI

between $32,000 and $44,000

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Tier One CalculationTier One Calculation

The taxable portion of Social Security is equal to the lesser of:

1. 1/2 Social Security received,OR 2. 1/2 of the amount by which

modified AGI exceeds the base amount.

where the base amounts are $25,000 for unmarried individuals, $32,000 for MFJ, and $0 for others

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Example continuedExample continued

With modified AGI = $31,500, the taxable portion of her $3,000 Social Security income is the lesser of:

1. $1,500, or

2. 1/2 ($31,500 - $25,000) = $3,250

Therefore, taxable SS is $1,500

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Transfer Income:Social Security Benefits - Tier Two

Transfer Income:Social Security Benefits - Tier Two

• For individuals whose income exceeds

Tier One amounts . . .

Tier Two CalculationTier Two Calculation

The taxable portion of Social Security is equal to the lesser of:

1. 85% of Social Security received,OR 2. 85% of the amount by which

modified AGI exceeds the base amount*, PLUS the smaller of

a. the amount of SS benefits included under the 50% formula, orb. $4,500 for unmarried individuals ($6,000 for MFJ)

*Where the base amounts are $34,000 for unmarried individuals, $44,000 for MFJ, and $0 for others

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Example for Tier TwoExample for Tier Two

If our taxpayer receives Social Security of $12,000 and has AGI of $50,000 before SS:

Modified AGI = $50,000 + $6,000* = $56,000

Taxable SS is $10,200, which is the smaller of:

1. .85( $12,000) = $10,200, or

2. [.85 ($56,000 - $34,000)] + [(1/2 of $12,000 SS) or $4,500]

= $18,700 + $4,500

= $23,200.

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Transfer Income: Alimony ReceivedTransfer Income: Alimony Received

Amounts received for alimony payments are taxable income if:the payments are made in cashthere is a written agreementthe payments are not disguised child supportthe payments cannot be made to payee’s estatethe payer and payee do not live in the same

household

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Imputed Income: Personal ConsumptionImputed Income: Personal Consumption

The value of the goods and services produced by individuals for personal consumption generally are not taxableRealization conceptAdministrative Convenience concept

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Imputed Income:Below Market-Rate LoansImputed Income:Below Market-Rate Loans

Interest income and expense are imputed on below market-rate loans.The relationship between the lender and

the borrower determines the tax treatment The lender has imputed interest income The borrower has imputed interest expense

Administrative Convenience grants exceptions for loans of $10,000 or less gift loans of $100,000 or less

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Imputed Income:Payment of Expense by Others

Imputed Income:Payment of Expense by Others

Payments made by family members may be considered nontaxable gifts

Payments made by employers are taxable income

A taxpayer whose expenses are paid by another has realized an increase in wealth.

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Imputed Income: Bargain PurchasesImputed Income: Bargain Purchases

When a bargain purchase price does not result from an arms-length transaction, the bargain amount is taxable income.

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Capital Gains and Losses: IntroductionCapital Gains and Losses: Introduction

A sale or other disposition of capital assets results in a capital gain or loss

Capital gains and losses receive special tax treatment

A capital asset is any asset other than inventory, receivables, and depreciable or real property used in a trade or business.

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Capital Gains and Losses:Holding Period

Capital Gains and Losses:Holding Period

The holding period for capital assets is how long the taxpayer owned the asset.Short Term = held for < 12 monthsLong Term = held for > 12 months

Determining holding period is the first step in determining tax treatment.

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Capital Gains and Losses:Netting ProceduresCapital Gains and Losses:Netting Procedures

Long-term gains netted againstLong-term losses

Net Long-termGain or Loss

Short-term gains netted againstShort-term losses

Net Short-termGain or Loss

=

=

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Capital Gains and Losses:Netting ProceduresCapital Gains and Losses:Netting Procedures

Net Short-term Gain or Lossnetted against

Net Long-term Gain or Loss

Net CapitalGain or Loss=

If one is a loss and one is a gain, then:

If both are losses or both are gains, no further netting is done.

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Tax Treatment for Net GainsTax Treatment for Net Gains

Net short-term capital gain is taxed as ordinary income

Adjusted net long-term capital gain is taxed at a maximum 15%Adjusted NLTG = NLTG - [28% rate gain -

Unrecaptured §1250 gain + Eligible dividends]

28% rate gain = [Net collectibles gain + Small business stock gain - STCL - LTCL carryover]

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Net Collectibles gain and Small Business Stock gain is taxed at a maximum 28%

Unrecaptured §1250 gain is taxed at a maximum 25%

Tax Treatment for Net GainsTax Treatment for Net Gains

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Capital Gains and Losses: Holding Period & Maximum Rate

Capital Gains and Losses: Holding Period & Maximum Rate

Holding Period

Category

15% MTR > 15% MTR

< 12 months Short-term MTR MTR

> 12 months Long-term 5% 15%

> 12 months Collectibles (& excess small business gain)

15% 28%

> 12 months Unrecaptured Sec. 1250 gain

15% 25%

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Tax Treatment for Net Losses by IndividualsTax Treatment for Net Losses by Individuals

Only $3,000 of net capital losses may be deducted in one yearUse short-term losses firstCarryover net loss > $3,000

Capital gains and losses of conduit entities flow-through to owners’ returns

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When is Income Reported?When is Income Reported?

The Accounting Method chosen by a taxpayer dictates when income is reported.Cash Method taxpayers report income

when cash is actually or constructively received

Accrual Method taxpayers report income when it is earned

Hybrid Method taxpayers mix accrual and cash methods

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Accounting MethodCash

Accounting MethodCash

Cash method taxpayers must follow the Constructive Receipt Concept.Exceptions to the cash method:

Taxpayers who sell inventory may not use the cash method for inventory

Taxpayers must use the accrual and the effective interest method with Original Issue Discount securities

Taxpayers who hold Series EE Bonds may elect to use the accrual method

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Accounting MethodAccrual

Accounting MethodAccrual

Under tax law, income is accrued when All events have occurred that fix the

right to receive the income, and The amount of income earned can be

determined

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Accounting MethodAccrual ExceptionsAccounting MethodAccrual Exceptions

Exceptions to the accrual method:The Wherewithal-to-Pay concept requires

income be reported in the year pre-payment is received for rents, insurance, interest and royalties

One year deferral is allowed for some pre-payments Report amount = Financial Accounting in first year Remainder of amount in full in second year

Pre-payments for goods may be accrued if the payment is less than the Cost of Goods Sold.

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Accounting MethodHybrid

Accounting MethodHybrid

Taxpayers may mix the cash and accrual methods, using accrual for sales of inventories and cash for other revenues and expenses.

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Accounting MethodExceptions to All Methods

Accounting MethodExceptions to All Methods

Installment Sales Method: Any time one payment is received after the year of sale, taxpayers must recognize income proportionately as the selling price is received unless they elect to report in the year of sale.

Long-term Construction Contracts: The percentage-of-completion method must be used for all long-term construction.

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End of Chapter 3End of Chapter 3