Chapter 3 – Income Inclusions- Working definition of realizationo 2 elements1. A change in form and/or substance of the taxpayer’s property 2. The involvement of a second party in the income process- Earned Incomeo Income earned from laboro Most common forms 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 activitieso 2 problems that arise1. Income shifting2. 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 Incomeo Income earned from capitalo Most common forms Interest income Dividend income Income from rental and royalty-producing activities- Gross income from the property, less the related expenses to produce the income Income from annuities- Annuity – a string of equal payments received over equal time periods for a determinable period- Annuity Exclusion Ratioo Exclusion per payment = Cost of contract/number of paymentso One-time calculation – good for the life of the contracto Simplified Method – the number of anticipated monthly payments if determined based on the age of the taxpayer at theannuity 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 taxpayero Qualified Plan – allow the deferral of tax on payments into the plan and earning on the plan’s assets until they are withdrawn Whole payment is considered income Income from conduit entities- Taxpayers who own investments in conduit entities must recognize theirshare of the conduit’s income on their tax return- Distributions from a conduit entity are not taxed; considered a return ofcapital investment in the entityo Reduction in basis Gains from the sale of investments producing any of the five forms of unearned income- Proceeds from sale of property- Selling ExpensesAmount Realized from Sale of Property- Adjusted BasisRealized Gain/Loss on Sale(tax laws)Recognized Gain/Loss on Sale- Transfers From Otherso 5 Common Sources of Taxable Transfer Income1. Prizes and Awards- 2 exclusions1. An award that is immediately transferred to a government bodyor other qualified charitable organization No effort to achieve the award (did not enter a contest) No future services required2. 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/year2. Unemployment Compensation3. Social Security Benefits- 50% Formulao Use when income < $34,000 (individual), $44,000 (married-joint)o The taxable portion of Soc. Sec. is equal to the lesser of 1. ½ of the Soc. Sec. benefits received during the yearo Or2. ½ of the amount by which modified adjusted gross income exceeds the base amounto Where Modified Adjusted Gross Income = A.G.I. + ½ of the Soc. Sec. benefits received during the year + any foreignearned income exclusion + any tax-exempt interesto And Base Amount = $25,000 (individual)- $32,000 (married-joint)- $0 (others)- Second Tier Formulao 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 yearo Or2. The sum of:a) 85% of the amount by which modified adjusted gross income exceeds the base amountPLUSb) The smaller of the amount of Soc. Sec. benefits included in gross income under the 50% formula- Oro $4500 for individualso $6000 for married-jointo 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 income4. 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 Alimony1. The payment must be in cash2. The payment must be in a written agreement3. The written agreement must not specify that the payments are for some other purpose4. The payer and payee cannot be members of the same household at the time of the payment5. 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 separationo Spouse making payment include excess deduction taken when the property settlement was disguised as alimony in incomeo Spouse receiving payment is allowed a deduction to offset the overstated alimony5. Death Benefit Payments- A payment made by an employer to a deceased employee’s beneficiarieso Fully taxableo Imputed Income – assigning income to a person or activity- Added to gross income 3 Forms Subject to Tax1. Below Market-Rate Loanso Interest-free loano 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 paido 2 exceptions Interest on any loan of $10,00 or less Interest on Gift loans of $100,000 or lesso 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 effecto Assumptions – because no interest is actually being paid1. Interest is paid from the borrower to the lender2. Lender gives interest back to borrower (because it was never paid to begin with) in 1 of the following 3 forms:1. If gift loan: no income No tax effects2. If employement-related :o Borrower – compensation- Taxable incomeo Lender – Deductible interest3. If Corp/Shareholder:o Borrower – Dividend income- Taxable incomeo Lender – no deduction for dividends paid2. Payment of Expenses by Otherso When one taxpayer pays another taxpayer’s