Ch.5 Gross Income and Exclusions

What amounts are included in gross income for the following taxpayers? Explain your answers.

(a)Janus sued Tiny Toys for personal injuries from swallowing a toy. Janus was paid $30,000 for medical costs and $250,000 for punitive damages. -The $30,000 is excluded from Janus's gross income because it is a payment for a physical injury. However, the $250,000 of punitive damages is included in Janus's gross income because the payment is intended to punish Tiny Toys rather than compensate Janus for her injuries. b.Carl was injured in a car accident. Carl's insurance paid him $500 to reimburse his medical expenses and an additional $250 for the emotional distress Carl suffered as a result of the accident. -The reimbursed medical costs and the payment for emotional distress associated with a physical injury are excluded. c.Ajax published a story about Pete and as a result Pete sued Ajax for damage to his reputation. Ajax lost in court and paid Pete an award of $20,000. -Pete must include the payments in gross income because the payments are not associated with a physical injury d.Bevis was laid off from his job last month. This month he drew $800 in unemployment benefits. -Bevis must include the unemployment benefits in his gross income because unemployment benefits are a replacement for lost wages

Louis files as a single taxpayer. In April of this year he received a $900 refund of state income taxes that he paid last year. How much of the refund, if any, must Louis include in gross income under the following independent scenarios? Assume the standard deduction last year was $6,350.

(a)Last year Louis claimed itemized deductions of $6,600. Louis's itemized deductions included state income taxes paid of $1,750. -Louis must include $250 of the $900 refund in gross income. (b)Last year Louis had itemized deductions of $4,800 and he chose to claim the standard deduction. Louis's itemized deductions included state income taxes paid of $1,750. -Because he didn't itemize his deductions, Louis received no tax benefit from the $900 tax overpayment. Hence, none of the refund is included in his gross income. (c)Last year Louis claimed itemized deductions of $7,790. Louis's itemized deductions included state income taxes paid of $2,750. -Louis received a tax benefit for the lesser of the refund ($900) or the excess of the itemized deductions above the standard deduction ($7,790-$6,350= $1,440). Hence, Louis must include the entire $900 refund in gross income.

Clyde is a cash method taxpayer who reports on a calendar-year basis. This year Paylate Corporation has decided to pay Clyde a year-end bonus of $1,000. Determine the amount Clyde should include in his gross income this year under the following circumstances:

(a)Paylate Corporation wrote the check and put it in his office mail slot on December 30 of this year, but Clyde did not bother to stop by the office to pick it up until after year-end. -Clyde is taxed on the $1,000 under the constructive receipt doctrine. (b)Paylate Corporation mistakenly wrote the check for $100. Clyde received the remaining $900 after year-end. -Clyde is taxed on the $100 - the remaining $900 is taxed in the next year. (c)Paylate Corporation mailed the check to Clyde before the end of the year, (and it was delivered before year-end). Although Clyde expected the bonus payment, he decided not to collect his mail until after year-end. -Clyde is taxed on $1,000 unless the mail was not delivered until after year-end. Clyde would need to check his mail on December 31 or he would have the burden of proving he didn't receive the check before year-end if the IRS alleges that the check was delivered before year-end. (d)Clyde picked up the check in December, but the check could not be cashed immediately because it was postdated January 10. -Clyde is not taxed until next year because the postdated check is a substantial restriction.

For each of the following independent situations, indicate the amount the taxpayer must include in gross income and explain your answer:

(a)Phil won $500 in the scratch-off state lottery. There is no state income tax. -All $500 is economic income realized this year and is, therefore, included in gross income b.Ted won a compact car worth $17,000 in a TV game show. Ted plans to sell the car next year. The value of the car, $17,000, is economic income realized this year and is, therefore, included in gross income. c.Al Bore won the Nobel Peace Prize of $500,000 this year. Rather than take the prize, Al designated that the entire award should go to Weatherhead Charity, a tax-exempt organization. -The entire award is excluded and therefore tax exempt. The award is excluded because it was for scientific, literary, or charitable achievement, and the taxpayer immediately transferred the award to a qualified charity. d.Jerry was awarded $2,500 from his employer, Acme Toons, when he was selected most handsome employee for Valentine's Day this year. -All $2,500 is economic income realized this year and is, therefore, included in gross income. e.Ellen won a $1,000 cash prize in a school essay contest. The school is a tax-exempt entity, and Ellen plans to use the funds to pay her college education. -All $1,000 is economic income realized this year and is, therefore, included in gross income. f.Gene won $400 in the office March Madness pool. -Gene should include $400 in his gross income.

Annuities

-An investment that pays a stream of equal payments over time -The tax law deems a portion of each annuity payment as a nontaxable return of capital and the remainder as gross income.

Imputed Income

-Certain employee discounts or low interest loans generate income via indirect benefits. -For low interest loans, the amount of imputed income is the difference between the amount of interest using the applicable federal interest rate and the amount of interest the taxpayer actually pays.

Prize and Rewards are excluded when

-For scientific, literary, or charitable achievement and transferred to a qualified charity -For employee length of service or safety achievement ($400 tangible property limit per employee per year) -To Team USA athletes from U.S. Olympic Committee on account of their competition in Olympic and Paralympic games (AGI limit applies)

When to Recognize Income

-Individual taxpayers file tax returns for a calendar-year period. -Corporations often use a fiscal year-end. -The method of accounting generally determines the calendar year in which realized income is recognized and included in gross income.

Social Security Benefits

-Taxable up to 85 percent of Social Security benefits in gross income depending on the taxpayer's filing status, Social Security benefits, and modified AGI -Modified AGI is regular AGI (including 50 percent of Social Security benefits) plus tax-exempt interest income, excluded foreign income, and certain other deductions for AGI.

Gross Income

-Taxpayers report realized and recognized income on their tax returns for the year. -Income that is excluded or deferred is not included in gross income. Excluded income is never taxed. Deferred income is taxed when recognized in a subsequent year.

Types of Income

1. earned income : salary bonuses, tips 2. unearned income 3.annuties 4. Property Disposition 5. Other Sources of Gross Income: Income other than wages or business and property 6.Income from Flow-Through Entities 7.Alimony: For tax purposes alimony is defined as: A transfer of cash made under a written separation agreement or divorce decree. 8.Prizes and Awards 9.Social Security Benefits 10.Imputed Income-Certain employee discounts or low interest loans generate income via indirect benefits. 11.Discharge of Indebtedness-When a taxpayer's debt is forgiven by a lender, the taxpayer must usually include the amount of debt relief in gross income. 12.

Dewey is a lawyer who uses the cash method of accounting. Last year Dewey provided a client with legal services worth $55,000, but the client could not pay the fee. This year Dewey requested that in lieu of paying Dewey $55,000 for the services, the client could make a $45,000 gift to Dewey's daughter. Dewey's daughter received the check for $45,000 and deposited it in her bank account. How much of this income is taxed, if any, to Dewey? Explain.

A cash method taxpayer recognizes income on the value of property received, so $45,000 of income will be recognized in this year. The assignment of income doctrine holds that earned income is taxed to the taxpayer providing the goods or services. Hence, Dewey and not his daughter is taxed on the entire amount of service income. Because the money went to Dewey's daughter, his daughter will be treated as though she received a gift from Dewey.

Last year Courtney reported $9,550 in itemized deductions including $3,500 of state income taxes paid last year (the standard deduction last year was $9,350). In March of this year, Courtney received a $420 refund of the $3,500 in state income taxes paid last year. Under the tax benefit rule, how much of the $420 refund should Courtney include in her gross income this year

Answer: $200 - the deduction of $420 only reduced Courtney's taxable income by $200 because the total itemized deductions ($9,550) cannot drop below the standard deduction ($9,350).

Based on the definition of gross income in §61, related regulations, and judicial rulings, what are the three criteria for recognizing taxable income?

Based on §61(a), Reg. §1.61-(a), and various judicial rulings, taxpayers recognize gross income when: (1) they receive an economic benefit, (2) they realize the income, (3) no tax provision allows them to exclude or defer the income from gross income for that year.

Tomiko is a 50 percent owner (partner) in the Tanaka partnership. During the year, the partnership reported $1,000 of interest income and $2,000 of dividends. How much of this income must Tomiko include in her gross income?

Because Tanaka is a partnership (a flow-through entity), Tomiko must include her share of the partnership's income in her gross income. In this case, Tomiko's ownership interest is 50%, so she will include $500 of interest income and $1,000 of dividends in her gross income and report it on her tax return just as if she had received these amounts directly.

[LO 1] Andre constructs and installs cabinets in homes. Blair sells and installs carpet in apartments. Andre and Blair worked out an arrangement whereby Andre installed cabinets in Blair's home and Blair installed carpet in Andre's home. Neither Andre nor Blair believes they are required to recognize any gross income on this exchange because neither received cash. Do you agree with them? Explain.

Both Andre and Blair are required to recognize gross income equal to the value of the goods and services they received. Reg. §1.61-(a) indicates that taxpayers realize income whether they receive money, property, or services in a transaction. That is, the form of the receipt does not matter. In this case, Andre should report gross income equal to the carpet he received and Blair should report gross income equal to the value of the cabinets he received.

exclusion provisions

Congress allows certain types of income to be excluded or deferred. -To subsidize or encourage particular activities -To mitigate inequity (double taxation) Municipal Interest -Bonds issued by state and local governments located in the United States -This exclusion is generally recognized as a subsidy to state and local governments.

Exclusion Provisions

Deferral Provisions -Allow taxpayers to defer (but not permanently exclude) the recognition of certain types of realized income Transactions generating deferred income include: -Installment sales -Like-kind exchanges -Involuntary conversions -Contributions to non-Roth qualified retirement accounts.

Exclusion Provisions

Disability Insurance -Also called wage replacement insurance -Pays the insured individual for wages lost when the individual misses work due to injury or disability -If an individual purchases disability insurance directly, any disability benefits are excluded from gross income.

What Is Included in Gross Income?

Economic Benefit -Taxpayer must receive an item of value. -Borrowed funds represent a liability, not gross income. Realization Principle -Taxpayer engages in a transaction with another party. -Transaction results in a measurable change in property rights. Recognition -Realized income is assumed to be recognized absent a deferral or exclusion provision.

Exclusion Provisions

Education-Related Exclusions -As an incentive for taxpayers to participate in higher education, Congress excludes certain types of income if the funds are used for higher education. Scholarships -Students seeking a college degree can exclude scholarships that pay for required tuition, fees, books, and supplies. -Exclusion applies only if the recipient is not required to perform services in exchange for receiving the scholarship (limited exception for tuition waivers for student employees and teaching and research assistants).

Exclusion Provisions

Exclusions That Mitigate Double Taxation -Congress provides certain exclusions to eliminate the potential double tax that may arise for: Gifts and Inheritances -Individuals may receive property as gifts or from a decedent's estate (an inheritance). -While the receipt of property is most certainly real income to the recipient, the value of gifts and inheritances is excluded from gross income because these transfers are subject to a federal gift and estate tax.

Exclusion Provisions

Foreign-Earned Income -A maximum of $103,900 (2018) of foreign-earned income can be excluded from gross income for qualifying individuals. -A maximum of $14,546 (2018) of employer-provided foreign housing also may be excluded (but only to the extent that costs exceed $16,624 (2018). To be eligible for the foreign-earned income and housing exclusions, the taxpayer must have her tax home in a foreign country and (1) be considered a resident of the foreign country by living in the country for the entire year (calendar year) (2) live in the foreign country for 330 days in a consecutive 12-month period.

Exclusion Provisions

Fringe Benefits -The value of these benefits is included in the employee's gross income as compensation for services. -Certain fringe benefits, called "qualifying" fringe benefits, are excluded from gross income. Common qualifying fringe benefits are medical and dental health insurance coverage, life insurance coverage, and de minimis (small) benefits.

exclusion provisions

Gains on the Sale of Personal Residence Taxpayers may exclude up to $250,000 ($500,000 if married filing jointly) of gain on the sale of their principal residence. -Must satisfy ownership and use tests Ownership test: Owned the residence for a total of two or more years during the five-year period ending on the date of sale Use test: Used the property as principal residence for a total of two or more years (noncontiguous use is permitted) during the five-year period ending on the date of the sale Any excess gain generally qualifies as long-term capital gain.

Explain why taxpayers are allowed to exclude gifts and inheritances from gross income even though these payments are realized and clearly provide taxpayers with the wherewithal to pay.

Gifts and inheritances are taxed by a separate tax system (the unified Federal gift and estate tax). Taxing gifts and inheritances as income to the recipient would subject these payments to double taxation.

This year Jorge received a refund of property taxes that he deducted on his tax return last year. Jorge is not sure whether he should include the refund in his gross income. What would you tell him?

If the refund is made for an expenditure deducted in a previous year, then under the tax benefit rule the refund is included in gross income to the extent that the prior deduction produced a tax benefit. In this case, if Jorge deducted the property taxes (and received a tax benefit or tax savings from the deduction) on his prior year tax return, he must include the refund in his gross income this year to the extent the property taxes resulted in a tax benefit. If he did not deduct property taxes on his tax return last year, he is not required to include the refund in his gross income.

What are some common examples of taxable and tax-free fringe benefits?

In addition to paying salary and wages, many employers provide employees with fringe benefits. For example, an employer may provide an employee with an automobile to use for personal purposes, pay for an employee to join a health club, or pay for an employee's home security. In general, the value of these benefits is included in the employee's gross income as compensation for services. However, certain fringe benefits, called "qualifying" fringe benefits, are excluded from gross income.4 Exhibit 5-3 lists some of the most common fringe benefits that are excluded from an employee's gross income. ex medical and dental insurance

Types of Income

Income from services (earned income) -Income from labor most common source of gross income -Generated by the efforts of taxpayer Income from property (unearned income) -Includes gains or losses from sale of property, dividends, interests, rents, royalties, and annuities -Depends on type of income and type of transaction generating income

How are state-sponsored 529 educational savings plans taxed if investment returns are used for educational purposes? Are the returns taxed differently if they are not ultimately used to pay for education costs?

Investment returns from state sponsored 529 plans are never taxed if used to pay for "qualified higher education expenses" for college students (no annual limit) or for tuition expenses for students at public, private or religious elementary or secondary schools (subject to a $10,000 limit per beneficiary per year). Qualified higher education expenses include tuition, books, supplies, required equipment and supplies, computer equipment and software, and reasonable room and board costs attending a higher education institution. If distributed investment returns are used for any other purpose, or exceed the $10,000 limit for tuition expenses attributable to public, private or religious elementary or secondary schools, the distributee will pay tax on the investment returns in the year received at ordinary rates. In many instances, the distributee will also be required to pay an additional 10% penalty tax in addition to the normal tax on the investment returns.

Exclusion Provisions

Life Insurance Proceeds -Amounts received due to the death of the insured are excluded from the income of the recipient. -Similar to inheritances, life insurance proceeds are typically subject to the federal estate tax. -If the proceeds are paid over a period of time rather than in a lump sum, a portion of the payments represents interest and must be included in gross income. Exclusion generally does not apply when -life insurance policy is transferred to another party for valuable consideration or -taxpayer cancels life insurance contract and receives proceeds in excess of previous premiums paid. Exclusion available for accelerated death benefits in certain circumstances.

Exclusion Provisions list

Municipal Interest Gains on the Sale of Personal Residence Fringe Benefits Education-Related Exclusions Exclusions That Mitigate Double Taxation Life Insurance Proceeds Foreign-Earned Income Sickness and Injury-Related Exclusions Payments Associated with Personal Injury Health Care Reimbursement Disability Insurance Deferral Provisions

Exclusion Provisions

Payments Associated with Personal Injury -Awards that relate to physical injury or sickness or are payments for the medical costs of treating emotional distress are excluded from gross income. -Other payments including punitive damages are fully taxable. Health Care Reimbursement -Reimbursements by health and accident insurance policies for medical expenses paid by the taxpayer are excluded from gross income.

Conceptually, when taxpayers receive annuity payments, how do they determine the amount of the payment they must include in gross income?

Payments taxpayers receive from an annuity they have purchased consist of both income and return of the initial cost or investment in the annuity. Consistent with the return of capital principle the proceeds are not income to the extent of the taxpayer's investment in the asset. As proceeds are collected over several periods, the law provides that the return of capital occurs evenly (pro rata) over the collection period for fixed term annuities or over the expected collection period for life annuities.

Realization VS. Recognition

Realization is an economic principle. (The wealth of the individual has been enhanced.) Recognition is a taxable event, which follows realization.

Other Income Concepts

Return of capital principle -The cost of an asset is called tax basis. -Return of capital means the tax basis is excluded when calculating realized income. *Return of capital does not represent an economic benefit. Gain from the sale or disposition of an asset is included in realized income.

Formula for Calculating Gain (Loss) from Sale of an Asset (Property Dispositions)

Sales Proceeds <Selling Exp> ------------------ =Amount Realized <Basis Investment in property Sold> --------------------------------------- =Gail/(Loss) on Sale

Exclusion Provisions

Sickness and Injury-Related Exclusions -Several exclusion provisions apply to taxpayers who are sick or injured to reflect their inability to pay the tax and facilitate recovery. Workers' Compensation -Payments from workers' compensation plans are excluded from gross income

Tax Benefit Rule

Tax benefit rule - Refunds of expenditures deducted in a prior year are included in gross income to the extent that the refund reduced taxes in year of the deduction. The amount included in gross income is limited to the amount for which a TAX BENEFIT was received in the prior year.

What are the basic requirements to exclude the gain on the sale of a personal residence?

Taxpayers meeting certain home ownership and use requirements can permanently exclude up to $250,000 ($500,000 if married filing jointly) of realized gain on the sale of their principal residence. Gain in excess of the excludable amount generally qualifies as long-term capital gain subject to tax at preferential rates. To satisfy the ownership test, the taxpayer must have owned the residence (house, condominium, trailer, or houseboat) for a total of two or more years during the five-year period ending on the date of the sale. To satisfy the use test, the taxpayer must have used the property as her principal residence for a total of two or more years (noncontiguous use is permissible) during the five-year period ending on the date of the sale. The tax law limits each taxpayer to one exclusion every two years. Married couples filing joint returns are eligible for the full $500,000 exclusion if either spouse meets the ownership test and both spouses meet the principal-use test. However, if either spouse is ineligible for the exclusion because he or she personally used the $250,000 exclusion on another home sale during the two years before the date of the current sale, the couple's available exclusion is reduced to $250,000.

] Janet is a cash-basis calendar-year taxpayer. She received a check for services provided in the mail during the last week of December. However, rather than cash the check, Janet decided to wait until the following January because she believes that her delay will cause the income to be realized and recognized next year. What would you tell her? Would it matter if she didn't open the envelope? Would it matter if she refused to check her mail during the last week of December? Explain.

The constructive receipt doctrine states that a taxpayer realizes and recognizes income when it is actually or constructively received. Constructive receipt is deemed to occur when the income has been credited to the taxpayer's account or when the income is unconditionally available to the taxpayer, the taxpayer is aware of the income's availability, and there are no restrictions on the taxpayer's control over the income. This doctrine prevents Janet, a cash basis taxpayer, from arbitrarily shifting income to a later period by postponing the delivery or acceptance of a payment. It does not matter if she refuses to open the envelope or check her mail, because the income is unconditionally available to her, she is aware of the income's availability, and there are no restrictions on her control over the income.

Brad purchased land for $45,000 this year. At year-end Brad sold the land for $51,700 and paid a sales commission of $450. What effect does this transaction have on Brad's gross income? Explain.

The sale increases Brad's gross income by $6,250. The selling expenses reduce the amount realized on the sale from $51,700 to $51,250 and the $45,000 cost of the land is a return of capital. The excess of the amount realized over the cost is included in his gross income ($51,700 - $450 - $45,000 = $6,250).

Taxpayers recognize gross income when:

They receive an economic benefit They realize the income, and The tax law does not provide for exclusion or deferral.

Explain why an insolvent taxpayer is allowed to exclude income from the discharge of indebtedness if the taxpayer remains insolvent after receiving debt relief.

This provision is meant to provide tax relief to taxpayers experiencing extreme financial difficulties. Taxpayers who are insolvent after being relieved of debt, likely do not have the wherewithal to pay taxes on income generated by the debt relief.

Discharge of Indebtedness

When a taxpayer's debt is forgiven by a lender, the taxpayer must usually include the amount of debt relief in gross income. Exceptions exist for certain types of loans. -To provide tax relief for insolvent taxpayers—taxpayers with liabilities, including tax liabilities, exceeding their assets—a discharge of indebtedness is not taxable. -If the discharge of indebtedness makes the taxpayer solvent, the taxpayer recognizes taxable income to the extent of his solvency. ex) Total debt 60,000 assets are 40,0000 your insolvent 20,000 if your discharged of 30,000 then you become solvent by 10,000 ( only recognizes the 10,000 because that's what your solvent for)

. A. and Paula file as married taxpayers. In August of this year they received a $5,200 refund of state income taxes that they paid last year. How much of the refund, if any, must L. A. and Paula include in gross income under the following independent scenarios? Assume the standard deduction last year was $12,700.

a. Last year L. A. and Paula had itemized deductions of $10,200, and they chose to claim the standard deduction. - Because they did not itemize their deductions, L. A. and Paula received no benefit from the $5,200 tax overpayment. Hence, none of the refund is included in gross income. b. Last year L. A. and Paula claimed itemized deductions of $23,300. Their itemized deductions included state income taxes paid of $7,500. -L. A. and Paula received a tax benefit for the lesser of the refund ($5,200) or the excess of the itemized deductions above the standard deduction ($23,300-$12,700= $10,600). Hence, they must include the entire $5,200 refund in gross income. c. Last year L. A. and Paula claimed itemized deductions of $15,500. Their itemized deductions included state income taxes paid of $10,500. -L. A. and Paula received a tax benefit for the lesser of the refund ($5,200) or the excess of the itemized deductions above the standard deduction ($15,500-$12,700= $2,800). Hence, they must include $2,800 of the $5,200 refund in gross income.

This year, Leron and Sheena sold their home for $750,000 after all selling costs. Under the following scenarios, how much taxable gain does the home sale generate for Leron and Sheena?

a. Leron and Sheena bought the home three years ago for $150,000 and lived in the home until it sold. -$100,000. Because Leron and Sheena satisfy the 2-year ownership and 2-year use test, they may exclude up to $500,000 of gain from the sale of their home. Thus, Leron and Sheena may exclude $500,000 of the $600,000 gain ($750,000 - $150,000 = $600,000 realized gain) that they realized on the sale. b. Leron and Sheena bought the home 1 year ago for $600,000 and lived in the home until it sold. Because Leron and Sheena do not satisfy the 2-year ownership or 2-year use test, the entire $150,000 realized gain ($750,000 - $600,000= $150,000) is taxable. c.Leron and Sheena bought the home five years ago for $500,000. They lived in the home for three years until they decided to buy a smaller home. Their home has been vacant for the past two years. -Despite not living in the house the past 2 years, Leron and Sheena still meet the 2-year ownership and 2-year use tests, and therefore, they may exclude up to $500,000 gain on the sale. Thus Leron and Sheen may exclude the entire $250,000 gain realized on the sale ($750,000 - $500,000 = $250,000 realized gain).

This year, Janelle received $200,000 in life insurance proceeds. Under the following scenarios, how much of the $200,000 is taxable?

a.Janelle received the proceeds upon the death of her father, Julio. -None of the $200,000 is taxable as life insurance proceeds are generally not taxable for income tax purposes. The $200,000 proceeds, however, would be included in her father's estate, and thus, may be subject to estate tax. b.Janelle received the $200,000 proceeds because she was diagnosed with colon cancer (life expectancy of 6 months), and she needed the proceeds for her care. -None. Because Janelle was medically certified as terminally ill with an illness expected to cause death within 24 months. c.The proceeds related to a life insurance policy she purchased for $35,000 from a friend in need. After purchase, Janelle paid annual premiums that total $22,000. -$143,000. Because Janelle purchased the life insurance policy from a friend for valuable consideration, she may exclude the $200,000 proceeds up to the sum of the purchase price of the policy ($35,000) and any subsequent premiums ($22,000) with the remaining proceeds ($200,000 - $35,000 - $22,000 = $143,000) taxable as ordinary income.

For each of the following situations, indicate how much the taxpayer is required to include in gross income and explain your answer:

a.Steve was awarded a $5,000 scholarship to attend State Law School. The scholarship pays Steve's tuition and fees. -The $5,000 scholarship is excluded from gross income because it is used to pay Steve's tuition and fees. b.Hal was awarded a $15,000 scholarship to attend State Hotel School. All scholarship students must work 20 hours per week at the school residency during the term. -The $15,000 scholarship is included in gross income because the terms of the scholarship require Hal to perform services