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Chapter 2

Chapter 2. Gross Income & Exclusions. Objective. Know the definition of Gross Income. Income Classifications. All sources of income are included unless specifically excluded Non-cash items recorded at fair market value There are three classifications of income:

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Chapter 2

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  1. Chapter 2 Gross Income & Exclusions

  2. Objective Know the definition of Gross Income

  3. Income Classifications • All sources of income are included unless specifically excluded • Non-cash items recorded at fair market value • There are three classifications of income: • Active - salary, wages and self employed • Portfolio - dividends and interest • Passive - real estate and limited partnership • Can only offset passive losses against passive gains • Can carry forward losses to future years

  4. Objective Be familiar with the tax treatment of significant elements of gross income

  5. Interest Income • Must report interest earned on Form 1040, Schedule B if total interest income >$1,500 • Data from brokerage statements and/or 1099-INT • Sometimes interest is called dividends • credit unions, money market accounts, co-ops, etc.

  6. Municipal Bonds • Interest earned on municipal bonds is tax-exempt • Attractive to high income taxpayers • Calculation to compare yields • When a municipal bond earns 6% (taxpayer in 30% bracket ) • Need a taxable yield of [.06 / (1-.30)] = 8.571%

  7. US Government Bonds (EE or HH) • EE bonds • Purchase at discount and then redeem for face value • Can pay taxes on interest each year as value increases or all in year of redemption • Interest is nontaxable if bonds are redeemed for higher education tuition • HH bonds • Issued at face value • pay interest twice a year (interest taxed currently and no exemption for higher education)

  8. Dividend Income • 3 kinds of dividends • Ordinary - return of corporate net income to shareholders (distribution of wealth) • reflected on Schedule B when total dividend income > $1,500 • Nontaxable - return of original investment (reduces basis in stock) • Capital gain distributions - when mutual funds sell stock for capital gains taxpayers get capital gains distributions • report on Schedule D, not Schedule B • Data from brokerage statements and/or 1099-DIV (cash or reinvested dividends)

  9. Alimony • To be alimony (deductible to payer, taxable to payee): 1. Must be in cash and received by ex-spouse 2. Must be made in connection with written instrument of divorce 3. Can’t be called anything else or contingent upon age/status of kids 4. Must stop with death of ex-spouse 5. Can’t live in same household as ex-spouse

  10. Alimony (continued) • Recapture provisions preventfront end load alimonypayments • Property transfer is not alimony because it’s not cash • Transferor doesn’t have to recognize gain on property - but transferee’s basis is same as transferors

  11. Child Support • Not deductible by payer • If payer falls behind on child support, must bring this current before any portion of payments considered alimony • No income to payee

  12. Prizes/Awards • Taxable income equal to cash or FMV of property • Exception: Employee awards of tangible personal property received for recognition of length of service or safetyup to $400 (or $1600 if “qualified plan”) Example: employee receives a clock for 20 years of service valued at $1500. $400 is excluded and $1,100 would have to be included as income

  13. Objective Be familiar with the tax rules for significant exclusions from gross income

  14. Life Insurance Proceeds • Generally tax free • Unless the policy was transferred for value • Except if transferred to partner in a partnership or officer in a corporation • Taxable amount = Proceeds - Cash Surrender Value (at time of transfer) - Premiums paid by transferee • Viatical settlements (when company buys out your life insurance policy knowing you are going to die) are excluded from income • Death benefits excludable for terminally ill • Excludable for chronically ill to extent used for long term care

  15. Gifts/ Inheritances • Gifts received are excluded from income • Gifts in business settings usually considered income • Inheritances are tax free to recipient

  16. Scholarships • Exclude amount received for fees, books, tuition, course required supplies or equipment • Include in income • Any amounts applied to room and board • Any amounts received as compensation for required work • Any tuition covered by scholarship may not be used towards educational credits

  17. Accident/Health Insurance • Premiums paid by employer on employee’s behalf for medical or accidental death and dismemberment insurance are excludable from gross income

  18. Meals/Lodging Provided by Employer • Exclude from gross income (1) meals provided by employer on premises during working hours solely for the benefit of the employer (2) lodging provided by employer on premises solely for the benefit of the employer and required as condition of job

  19. Objective Be able to calculate taxable and nontaxable portions of annuity payments

  20. Annuities/Pensions • Definition: Taxpayer buys a contract (usually in retirement) in return for periodic payments for the remainder of life, or life plus survivor. • Amount of annuity is based on purchase price and choice of life or life plus survivor

  21. Annuities/Pensions (continued) • Payments received are both taxable (interest) and nontaxable (return of capital) • Employee contributions are never taxable as it’s a return of original investment • Employer contributions always taxable • Data from1099-R • May show portion taxable and portion nontaxable or preparer may need to calculate)

  22. Annuities/Pensions (continued) • General Rule 1. Calculate exclusion ratio = Amount of Investment / (Annual payment x life expectancy) 2. Taxable amount = (1 - exclusion ratio) x annuity received

  23. Annuities/Pensions (continued) • Simplified General Rule If annuity started after 11/18/1996, taxpayer must use fill in worksheet provided by IRS unless: 1. The annuitant is age 75 (and certain other requirements are met, and 2. Annuity is a nonqualified plan annuity.

  24. Annuities/Pensions Example • Example • Din invested $750,000 into his retirement account. His annuity pays $4,800/month. He’s expected to live 19 years. How much is taxable in thefirst year of retirement? Assume that Din is required to use the general rule. • Answer • $750,000/($4,800 x12 mo X19 yr) = .685 exclusion ratio • .685 = 68.5% of pension is excluded from tax • .685 x ($4,800 x12) = $39,456 • total annuity $57,600 • exclusion (39,456) • taxable$18,144

  25. Objective Understand the rules governing inclusion of Social Security payments as income

  26. Social Security • Amount that is taxable is based on total AGI • Before 1984 completely excludable • From 1984 -1993 up to 50% of benefits may be taxable • From 1993 forward up to 85% of benefits may be taxable

  27. Social Security • Calculate modified AGI (MAGI) • AGI + foreign income + tax-exempt interest • If MAGI + .5(SS) < base amount, benefits are not taxed • If > base amount, must compute taxable portion

  28. SS - Calculating Taxable Amount: 50% level If (MAGI + 50% SS) is between lower base and upper base amounts (below) LowerUpper $32,000 $44,000 MFJ $ 0 $ 0 MFS $25,000 $34,000 All others Taxable amount is lesser of: (a) 50% of SS or (b) 50% (MAGI + [.50% x SS] - Lower Base)

  29. SS - Calculating Taxable Amount: 85% level • If (MAGI + 50%SS) is greater than upper base, • Taxable amount is lesser of: • (a) 85% xSS • or • (b) 85% (MAGI + .50[SS] - upper base) plus • lesser of: (i) 50% level formula • or (ii) $4,500 ($6,000 for MFJ)

  30. SS Example Holly is single. She has taxable pension of $22,000, tax exempt interest of $10,000 and receives SS benefits of $8,000. Her MAGI = $22,000 + $10,000 = $32,000. First calculation finds that MAGI + .5(SS) = $36,000 (over upper base), so you must compute both levels: 85% level Lesser of: (.85)x(8,000) = $6,800 or (.85)x(36,000-34,000) = $1,700 Added to lower of: $4,000 or $5,500 Therefore: $1,700 + $4,000 = $5,700 50% level Lesser of: (.5)x(8,000) = $4,000 or (.5)x(36,000 -25,000) = $5,500

  31. Another SS Example • Sam has retirement income of $21,000 and SS benefits of $15,000. His wife Heidi also has retirement income of $10,000, dividends of $4,000 and SS of $11,000. Their combined MAGI = 21,000 + 10,000 + 4,000 = $35,000. MAGI + .50(SS Benefits) = $48,000, which is over upper base. • Answer: • 50% level to find amount to put in second formula • lesser of (.50)x(26,000) = $13,000 • or (.50)x(48,000 - 32,000) = $8,000 • 85% level to find taxable amount • lesser of (.85)x(26,000) = $22,100 • or (.85)x(48,000-44,000) = $3,400 • plus the lesser of • $8,000 (from above) or $6,000 (MFJ amount) • Therefore, taxable amount is $3,400 + $6,000 = $9,400

  32. Some Fringe Benefits are Not Taxable • No-Additional-Cost benefits • Employee discounts • unless discount is on real estate or the discount is >20% • Parking (up to $180/month is tax free) • Working Condition - if you could deduct on your own as an employee • Can exclude from income if company paid (forexample - subscription to professionaljournal) • de minimis fringe benefits (so small not worth keeping track of) • Tuition reduction- • undergraduate - excludable if available to all employees • graduate - excludable if currently teaching/researching at that institution

  33. The End

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