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Chapter 3

Chapter 3. Gross Income: Inclusions and Exclusions “I like to pay taxes.  With them I buy civilization.”  -- Oliver Wendell Holmes, Jr. LO #1 When and How to Record Income for Tax Purposes. Income Recognition for Tax Purposes Similar to the recognition for accounting purposes

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Chapter 3

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  1. Chapter 3 Gross Income: Inclusions and Exclusions “I like to pay taxes.  With them I buy civilization.”  -- Oliver Wendell Holmes, Jr.

  2. LO #1 When and How to Record Income for Tax Purposes Income Recognition for Tax Purposes Similar to the recognition for accounting purposes Income must be realized and earned However, three additional conditions must be present when the transaction occurs: Economic benefit of the transaction Conclusion of the transaction Income from the transaction must not be tax-exempt income 3-2

  3. LO #2 The Cash Method of Accounting as It Applies to Income Taxes Cash Receipts and Disbursements Method Used by almost all individuals to file their tax returns Constructive receipt Income is reported in the year the taxpayer receives the right to control the income rather than the year in which it’s earned Receipt of property or services will trigger income recognition 3-3

  4. LO #3 The Taxability of Components of Gross Income: Interest, Dividends, Tax Refunds, and Social Security Benefits Interest Taxability Interest from banks, savings and loans, or credit unions is reported on a 1099-INT and is taxable Interest earned on Series E and EE U. S. Savings Bonds is taxable but can be reported gradually on an annual basis or fully at maturity Some interest received is tax-exempt if the debt is issued by a state, U.S. possession, or subdivision thereof 3-4

  5. LO #3 The Taxability of Components of Gross Income: Interest, Dividends, Tax Refunds, and Social Security Benefits Other types of interest that must be reported Payments received from seller-financed mortgages Receipts from installment sale receivables Imputed interest on loans made at below-market interest rate Interest on bonds sold between interest dates How to report interest If the amount of interest is more than $1,500, use Schedule B for Forms 1040A and 1040 3-5

  6. LO #3 The Taxability of Components of Gross Income: Interest, Dividends, Tax Refunds, and Social Security Benefits Dividends Taxability Dividends are distributions to shareholders, thus, income that must be reported on the tax return Dividends are taxed at capital gain rates if they are qualified dividends (from the earnings and profits of the payer corporations, and from domestic or qualified foreign corporations) Tax rate is 15 percent if the taxpayer’s marginal ordinary income is 25 percent or more Tax rate is 0 percent if the taxpayer’s marginal ordinary income is less than 25 percent 3-6

  7. LO #3 The Taxability of Components of Gross Income: Interest, Dividends, Tax Refunds, and Social Security Benefits Other types of dividends Stock dividends and stock splits are generally not taxable to the shareholders How to report dividends If the amount of dividends is more than $1,500, use Schedule B for Forms 1040A and 1040 3-7

  8. LO #3 The Taxability of Components of Gross Income: Interest, Dividends, Tax Refunds, and Social Security Benefits Refund from the State and Local Governments Taxability Refunds are taxable if, in the prior tax year, the refund was deducted as an itemized deduction The taxable amount is: The lesser of (a) the amount received, (b) the amount deducted on Schedule A, or (c) the amount by which the itemized deductions exceed the standard deduction 3-8

  9. LO #3 The Taxability of Components of Gross Income: Interest, Dividends, Tax Refunds, and Social Security Benefits Social Security Benefits Taxability Part of the social security benefits may be taxable Provisional income (also, called modified adjusted gross income) must be calculated and compared to the threshold amounts to determine taxability 3-9

  10. LO #3 The Taxability of Components of Gross Income: Interest, Dividends, Tax Refunds, and Social Security Benefits Provisional income defined Adjusted gross income (before social security benefits) plus: Interest on U.S. Savings Bonds excluded for educational purposes Most tax-exempt interest Employer-provided adoption benefits Excluded foreign income Deducted interest on educational loans Deducted tuition and fees (Tax Extenders Act of 2008) 50% of Social Security Benefits 3-10

  11. LO #3 The Taxability of Components of Gross Income: Interest, Dividends, Tax Refunds, and Social Security Benefits If provisional income exceeds certain thresholds, 50 percent of social security benefits are taxable As provisional income increases, the amount taxable increases to as much as 85 percent 3-11

  12. LO #3 The Taxability of Components of Gross Income: Interest, Dividends, Tax Refunds, and Social Security Benefits Chart with Threshold Amounts showing the lower and upper limits of provisional income Married Filing Jointly Single, Head of Household, or Qualifying Widow(er) Lower and Upper Limits Lower and Upper Limits $32,000 $25,000 $44,000 $34,000 3-12

  13. LO #3 The Taxability of Components of Gross Income: Interest, Dividends, Tax Refunds, and Social Security Benefits Calculations Example: Karen files a return as a qualifying widow. She received $7,000 of social security benefits, $19,000 of interest income, and $5,000 of nontaxable municipal bond interest. Her provisional income is $27,500. Karen will report taxable social security benefits equal to the lesser of 50 percent of Social Security benefits ($3,500) or 50 percent of the excess of provisional income over $25,000 ($1,250). Thus, her taxable benefits are $1,250 3-13

  14. LO #3 The Taxability of Components of Gross Income: Interest, Dividends, Tax Refunds, and Social Security Benefits Other types of taxable income: Jury duty Prizes and awards Forgiveness of debt Insurance proceeds in excess of the adjusted basis of the property 3-14

  15. LO #4 The Rules Concerning Items Excluded from Gross Income Income excluded from gross income Fringe benefits qualify if they meet the nondiscrimination rules Examples: No-additional-cost services provided to an employee Unsold hotel room or airline seats Discounts provided to employees for products or services normally sold by the business In case of products, the discount cannot exceed the gross profit percentage In case of services, the maximum discount is 20 percent of the normal selling price Qualified transportation benefits Moving expense reimbursements De minimis benefits Holiday turkeys, company picnics 3-15

  16. LO #4 The Rules Concerning Items Excluded from Gross Income Other nontaxable income: Some of these items have certain requirements or limitations that must be met: Scholarships and fellowships Qualified tuition program (QTP) withdrawals Life insurance proceeds Gifts and inheritances Compensation for sickness or injury Child support Welfare Employer-provided adoption assistance 3-16

  17. LO #5 The Rules Associated with Tax Accounting for Savings Bond Interest used for Education Expenses, Below-Market Interest Loans, Gift Loans, and Original Issue Discount Debt Savings Bond Interest Taxability Not taxable if used to pay qualified higher education expenses for the taxpayer, spouse or dependent children Full exclusion allowed if the education expenses paid exceed the redemption amount Limitation applies if modified AGI exceeds $109,250 on a joint return or $72,850 on other returns Gift Loans Imputed interest rules apply to gift loans over $13,000 where foregone interest is in the form of a gift 3-17

  18. LO #5 The Rules Associated with Tax Accounting for Savings Bond Interest used for Education Expenses, Below-Market Interest Loans, Gift Loans, and Original Issue Discount Debt Below-Market Interest Loans If the debt instrument was created with interest rates that materially vary from market rates at the time of issuance, then interest is required to be imputed. Examples of when imputed interest does not apply: Sales of property for $3,000 or less Sales in which all payments are due in six months or less 3-18

  19. LO #5 The Rules Associated with Tax Accounting for Savings Bond Interest used for Education Expenses, Below-Market Interest Loans, Gift Loans, and Original Issue Discount Debt Original Issue Discount (OID) Equal to the difference between the acquisition price and the maturity value The holder must report part of the OID as income every year 3-19

  20. LO #5 The Rules Associated with Tax Accounting for Savings Bond Interest used for Education Expenses, Below-Market Interest Loans, Gift Loans, and Original Issue Discount Debt OID is not applicable to: Tax-exempt debt U.S. Savings Bonds Debt with a maturity of 1 year or less on the date of issue Any obligation issued by a natural person before March 2, 1984 Non-business loans of $10,000 or less between natural persons 3-20

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