Chapter 3 Income Inclusions Working definition of realization o 2 elements Earned Income o Income earned from labor o Most common forms 1 A change in form and or substance of the taxpayer s property 2 The involvement of a second party in the income process Wages salaries tips bonuses and commissions Income from the active conduct of a trade or business Income from the rendering of services Income from the performance of illegal activities o 2 problems that arise Income shifting 1 2 What constitutes a receipt of income Cash equivalent Approach used to measure receipts of income o The receipt of anything with a fair market value will trigger recognition of income Unearned Income o Income earned from capital o Most common forms Interest income Dividend income the income Income from annuities Income from rental and royalty producing activities Gross income from the property less the related expenses to produce Annuity a string of equal payments received over equal time periods for a determinable period Annuity Exclusion Ratio o Exclusion per payment Cost of contract number of payments o One time calculation good for the life of the contract o Simplified Method the number of anticipated monthly payments if determined based on the age of the taxpayer at the annuity starting date Uses one set of tables for an individual taxpayer and another set of tables when the annuity will continue to be paid to a survivor after the death of the taxpayer o Qualified Plan allow the deferral of tax on payments into the plan and earning on the plan s assets until they are withdrawn Transfers From Others o 5 Common Sources of Taxable Transfer Income 1 Prizes and Awards 2 exclusions Income from conduit entities Whole payment is considered income Taxpayers who own investments in conduit entities must recognize their share of the conduit s income on their tax return Distributions from a conduit entity are not taxed considered a return of capital investment in the entity o Reduction in basis Gains from the sale of investments producing any of the five forms of unearned income Proceeds from sale of property Selling Expenses Amount Realized from Sale of Property Adjusted Basis Realized Gain Loss on Sale tax laws Recognized Gain Loss on Sale 1 An award that is immediately transferred to a government body or other qualified charitable organization No effort to achieve the award did not enter a contest No future services required 2 Employee achievement awards that are paid in the form of property and are based on length of service or on safety achievements Maximum 400 employee per year If from qualified plan Max is 1600 year 2 Unemployment Compensation 3 Social Security Benefits 50 Formula o Use when income 34 000 individual 44 000 married o The taxable portion of Soc Sec is equal to the lesser of 1 of the Soc Sec benefits received during the year joint o Or 2 of the amount by which modified adjusted gross income exceeds the base amount o Where o And Modified Adjusted Gross Income A G I of the Soc Sec benefits received during the year any foreign earned income exclusion any tax exempt interest Base Amount 25 000 individual Second Tier Formula 32 000 married joint 0 others o Use when income is 34 000 individual 44 000 married joint o The taxable portion of the Soc Sec is equal to the lesser of 1 85 of the Soc Sec benefits received during the year o Or 2 The sum of a 85 of the amount by which modified adjusted gross income exceeds the base amount PLUS b The smaller of the amount of Soc Sec benefits included in gross income under the 50 formula Or o 4500 for individuals o 6000 for married joint o Where Base Amount 34 000 for individuals 44 000 for married joint 0 for others 85 is the maximum amount that can be included in income 4 Alimony Received Child Support Payments not taxable Alimony the sharing of income between two divorced parties Alimony received is taxable Alimony paid is an allowed deduction for A G I 5 Conditions to be Considered Alimony 1 The payment must be in cash 2 The payment must be in a written agreement 3 The written agreement must not specify that the payments are for some other purpose 4 The payer and payee cannot be members of the same household at the time of the payment 5 There is no liability to make payment for any period after the death of the payee Alimony Recapture property settlements disguised as alimony payments during the first 3 years of separation o Spouse making payment include excess deduction taken when the property settlement was disguised as alimony in income o Spouse receiving payment is allowed a deduction to offset the overstated alimony 5 Death Benefit Payments A payment made by an employer to a deceased employee s beneficiaries o Fully taxable o Imputed Income assigning income to a person or activity Added to gross income 3 Forms Subject to Tax 1 Below Market Rate Loans o Interest free loan o 3 basic types Gift Loans Made between family members not subject to tax Employment Related Loans The imputed exchange of cash is deemed to be compensation to the employee and is taxable It is deductible by the employer Corporation Shareholder Loans The imputed exchange of cash is deemed to be a dividend paid to the shareholder and is taxable No deduction is allowed by corporations for dividends paid o 2 exceptions Interest on any loan of 10 00 or less Interest on Gift loans of 100 000 or less o Imputed interest on the loan cannot exceed the borrower s net investment income for the year Net Investment Income investment income less the cost of producing the income If borrowers net investment income for the year does not exceed 1000 imputed interest is deemed to be 0 The loan has no tax effect o Assumptions because no interest is actually being paid 1 Interest is paid from the borrower to the lender 2 Lender gives interest back to borrower because it was never paid to begin with in 1 of the following 3 forms 1 2 If gift loan no income No tax effects If employement related o Borrower compensation Taxable income o Lender Deductible interest 3 If Corp Shareholder o Borrower Dividend income Taxable income o Lender no deduction for dividends paid 2 Payment of Expenses by Others o When one taxpayer pays another taxpayer s expenses the taxpayer who received the benefit of the payment is taxed on the income Common Situations Payments of expenses of an employee by an employer Taxes of the lessor paid by the lessee of property The payment of the personal expenses of the principal shareholder