Chapter 5 Tax Notes
Chapter 5 Tax Notes ACCT 404
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This 7 page Class Notes was uploaded by Victoria Andreski on Sunday February 14, 2016. The Class Notes belongs to ACCT 404 at Clemson University taught by Sarah Martin in Spring 2016. Since its upload, it has received 14 views. For similar materials see Individual Taxation in Accounting at Clemson University.
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Date Created: 02/14/16
CHAPTER 5 —Gross Income Exclusions Gross Income • Taxpayers report realized & recognized income on their tax returns for the year • Income excluded/deferred is NOT included o Excluded income never taxed o Deferred income taxed when recognized in subsequent year • What is it? o “Gross income means all income from whatever source derived” o “Includes income realized in any form, whether in money, property, or services” • What is included? o Taxpayers recognize gross income when § 1) They receive an economic benefit § 2) They realize the income, and § 3) The tax law does not provide for exclusion/deferral • Economic Benefit o Borrowed funds represent a liability, not gross income • Realization Principle o Taxpayer engages in a transaction w/ another party o Transaction results in a measurable change in property rights • Recognition o Realized income is assumed to be recognized absent a deferral or exclusion provision Other Income Concepts • Form of Receipt • Return of Capital Principle o Tax basis is excluded when calculating realized income § Tax Basis—cost of an asset § Does not represent an economic benefit o Gain from the sale or disposition of an asset is included in realized income • Recovery of amounts previously deducted o Individuals usually claim deductions in the year paid o Deductions may sometimes be reimbursed or refunded in subsequent year o Tax benefit rule—refunds/expenditures deducted in a prior year are included in gross income to extent that the refund reduced taxes in year of the deduction When is Revenue Recognized? • Individual taxpayers file tax returns for a calendar-year period • Corporations often use a fiscal year end • Method of accounting generally determines the calendar year in which realized income is recognized & included in gross income o Accounting Methods § Corporation—accrual method of accounting § Individual—cash method o Constructive Receipt § Taxpayer must realize & recognize income when it is actually/constructively received § Deemed to occur when the income is credited to the taxpayers account Who Recognizes the Income? • Assignment of Income—taxpayer who earns income from services must recognize the income o Income from property (ex: dividends & interest) is taxable to the person who actually owns the income-producing property o To shift income from property to another person, a taxpayer must also transfer the ownership in the property to the other person • Community Property Systems o Implemented by 9 states o Half of the income earned from the services of one spouse is included in the gross income of the other spouse o Half of the income from property held as community property by the married couple is included in the gross income of each spouse o Property that a spouse brings into a marriage is treated as that spouse’s separate property § How income from separate property is treated varies across states (either treated as earned solely by spouse that owns property or equally by each spouse) Types of Income • Income from Services (Earned Income) o Income from labor § Taxpayer actually had to do something o Most common source of gross income o Generated by the efforts of taxpayer • Income from Property (Unearned Income) o Include gain or losses from sale of property, dividends, interests, rents, royalties, & annuities o Depends on type of income & type of transaction generating income • Annuities o Investment that pays a stream of equal payments over time o A portion of each annuity payment as a non-taxable return of capital & the remainder as gross income o Taxpayers use the annuity exclusion ratio to determine the return of capital (non-taxable) portion of each payment Annuity Exclusion Ratio = Original Investment Expected Value of the Annuity o For annuities w/ a fixed term, the expected value is § # of payments X payment amount o For annuities over a life, taxpayers must use IRS tables to determine the expected value based on the taxpayer’s life expectancy • Property Dispositions o Taxpayers usually realize a gain or loss when disposing of an asset o Taxpayers are allowed to recover their investment in property (tax basis) before they realize any gain Sales Proceeds Less: Selling Expenses = Amount Realized Less: Basis (Investment) in Property Sold = Gain (loss) on Sale • Other Sources of Income o Income other than wages or business and property o Income from Flow-through Entities § Individuals may invest in various business entities § The legal form of the business affects how the income generated by the business is taxed § If entity is a flow-through entity (Partnership or S Corporation), the entity’s income and deductions “flow through” to the owners of the entity (Partners & Shareholders) • Alimony o Transfer of cash made under a written separation agreement or divorce decreeà NOT property o Separation or divorce decree does not designate the payment as nonalimony o In the case of legally separated (or divorced) taxpayers under a separation or divorce decree, the spouses do NOT live together when the payment is made o Payments cannot continue after the death of the recipient o Types of payments that do not qualify as alimony: § Property divisions § Child support payments fixed by the divorce or separation agreement o Anti-front Loading—IRS can investigate when earlier years have larger payments than later years • Prizes & Awards o Taxable income o Excluded only if: § 1) Made for scientific, literary, or charitable achievement and § 2) Transferred to a qualified charity OR § Employee awards for length of service or safety achievement • Amount of gift can’t be more than $400 to remain tax free • Social Security Benefits o Taxable up to 85% of Social Security Benefits in gross income depending on the taxpayer’s filing status, Social Security Benefits, & modified AGI o Modified AGI is regular AGI (including 50% of Social Security benefits) plus tax-exempt interest income, excluded foreign income, & certain other deductions for AGI o Single Taxpayers § 1) If modified AGI + 50% of Social Security benefits less than or equal to $25,000, Social Security benefits are not taxable § 2) If $25,000 less than modified AGI + 50% of Social Security benefits less than or equal $34,000, taxable Social Security benefits are the lesser of: • a. 50% of the Social Security benefits or • b. 50% of (modified AGI + 50% of Social Security benefits- $25,000) • Imputed Income o Certain employee discounts or low interest loans generate income via indirect benefits o For low interest loans, the amount of imputed income is the difference between the amount of interest using the applicable federal interest rate & the amount of interest the taxpayer actually pays o The borrower is deemed to pay imputed interest (interest expense to borrower, interest income to lender), and then the lender is deemed to have returned the imputed amount (the tax consequences depend on relationship between borrower and lender) o Imputed interest rules do not apply to aggregate loans of $10,000 or less between the lender & borrower • Discharge of Indebtedness o 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 o To provide tax relief for insolvent (debt grater than value of assets) taxpayers, a discharge of indebtedness is not taxable o If the discharge of indebtedness makes the taxpayer solvent, the taxpayer recognizes taxable income to the extent of his solvency Exclusion Provisions • Congress allows certain specific types of income to be excluded or deferred o Subsidize or encourage particular activities or o To mitigate inequity • Municipal Interest o Bonds issued by state & local governments located in the US § Exclusion generally recognized as a subsidy to state & local governments o “City of” or “state of” o Encourages taxpayers to buy certain investments • Gains on sale of personal residence o Taxpayers may exclude up to $250,000 ($500,000 if married filed jointly) of gain on sale of their principal residence o Must satisfy ownership & use tests o Any excess gain generally qualifies as long-term capital gain • Fringe Benefits o The value of these benefits is included in the employee’s gross income as compensation for services o Certain fringe benefits (“qualifying” fringe benefits) are excluded from gross income § Common qualifying fringe benefits are medical & dental health insurance coverage, life insurance coverage, De minimis (small) benefits o “No additional cost” services—won’t cost business additional money • Education-Related Exclusions o As an incentive for taxpayers to participate in higher education, Congress excludes certain types of income if the funds are used for higher education o Scholarships § Students seeking a college degree can exclude scholarships that pay for required tuition, fees, books, & 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 & research assistants) • Other Educational Subsidies o Taxpayers allowed to exclude from gross income earnings on investments in qualified education plans (529 plans or Coverdell education savings accounts) as long as they use the earnings to pay on qualifying higher education expenses o Exclusion on interest on Series EE savings bonds is restricted to taxpayers w/ modified AGI below specific limits • Exclusions to mitigate double taxation o Congress provides certain exclusions to eliminate the potential double tax that may arise o Gifts & inheritances § Individuals may receive property as gifts or from a decedent’s estate (inheritance) § Value of gifts & inheritances are excluded from gross income because these transfers are subject to the Federal Gift & Estate tax o Life Insurance Proceeds § Amounts received due to the death of the insured are excluded from the income of the recipient § Typically subject to Federal Estate tax § If proceeds are paid over a period of time instead of in a lump sum, a portion of the payments represents interest & must be included in gross income § Exclusion generally does NOT apply when: • A) Life insurance policy is transferred to another party for valuable consideration • B) Taxpayer cancels life insurance contract & receives proceeds in excess of previous premiums paid § Exclusions available for accelerated death benefits in certain circumstances • Foreign Income Earned o Maximum of $100,800 (2015) of foreign earned income can be excluded from gross income for qualifying individuals o Maximum of $14,112 (2015) of employer-provided foreign housing may be excluded (but only to the extent that costs exceed $16,128 (2015)) o To be eligible for the foreign earned income & housing exclusions, taxpayer must have her tax home in a foreign country &: § 1) Considered a resident of the foreign country OR § 2) Live in the foreign country for 330 days in a consecutive 12- month period • Sickness & Injury-Related Exclusions o Workers; Compensation § Payments from workers’ comp plans are excluded from gross income § Never taxable income to employee • Payments Associated w/ Personal Injury o Awards that relate to physical injury or sickness or payments for the medical costs of treating emotional distress are excluded from gross income o Other payments including punitive damages are fully taxable • Health Care Reimbursement o Reimbursements by health & accident insurance policies for medical expenses paid by the taxpayer are excluded from gross income • Disability Insurance o Aka Wage Replacement Insurance o Pays the insured individual for wages lost when individual misses work due to injury or disability o If an individual purchases disability insurance & they exclude the benefit from compensation, then disability benefits are excluded from gross income o If individual’s employer purchases the disability insurance & individual excludes the benefit from their compensation, then disability benefits are taxable • Deferral Provisions o Allow taxpayers to defer (but not permanently exclude) the recognition of certain types of realized income o Transactions generating deferred income include: § Installment sales § Like-kind exchanges § Involuntary conversions § Contributions to non-Roth qualified retirement accounts
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