Income Sources Murphy Higgins Concepts in Federal Taxation, 2012 edition

1. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Chapter 3 Income Sources Murphy & Higgins Concepts in Federal Taxation, 2012 edition

2. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. What is Income? All-inclusive income concept Defined by exception: “Except as otherwise provided…” § 61 Judicial findings Income is the gain derived from labor and capital Any increase in wealth that has been realized is income Current View A change in the form and/or substance of the taxpayer’s property, and Involvement of a second party in the income process

3. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Overview of Types of Income Earned Unearned Transfer Imputed Capital Gains and Losses

4. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Earned Income Compensation received for the provision of labor is earned income Two problems may arise when determining taxability of earned income Cash-equivalent approach Assignment of income

5. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Unearned Income Unearned income: Earnings from investments and gains from the sale, exchange or disposition of investment assets Examples: Interest and Dividend Income Rental and Royalty Income Annuities

6. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Annuities Annuity: A series of equal payments received at set time intervals for a determinable period Capital Recovery Concept Excludes the amount of original investment from taxable income Must be spread over the time of receipt

7. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Annuity Exclusions If the payment term and amount are fixed: If the payment term depends on the life of the taxpayer Must estimate the number of payments, or Use the “simplified method”

8. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Simplified Method Annuity payments beginning after November 18, 1996 Use Tables 3-1 or 3-2 to determine number of payments Example George, age 64, purchased an annuity for $30,000. He begins receiving $300 per month in January. What amount is included in his gross income? From Table 3-1, the number of payments to use is 260. $30,000 / 260 = $115 monthly exclusion $115 X 12 = $1,380 excluded per year $300 X 12 = $3,600 amount received $3,600 - $1,380 exclusion = $2,220 gross income

9. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Gains and Losses Gains or losses may occur upon disposal of investment property

10. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Income from Conduit Entities Income from a conduit entity is reported by the owners and taxed on the owners’ returns Distributions from conduit entities to the owners are treated as a recovery of capital

11. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Overview of Transfer Income Some amounts of income are neither fully earned nor fully unearned: Prizes and Awards Unemployment Compensation Social Security Benefits Alimony Received

12. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Prizes and Awards &Unemployment Compensation Prizes and awards Amounts received as prizes and awards are generally taxable Exceptions: Scientific and literary achievements Must be given by recipient to a qualified charity or government unit Employee achievements Must be given to employee for length of service or safety Amount is limited to $400 per employee (or $1,600 if qualified plan) Unemployment compensation Amounts received from unemployment compensation plans are considered substitutes for earned income and are always taxable

13. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Social Security Benefits A portion of Social Security benefits received may be taxable if modified AGI exceeds certain limits Example A single taxpayer received $3,000 from Social Security payments. Her AGI without the Social Security is $30,000 Modified AGI = $30,000 + $1,500 = $31,500

14. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Social Security Benefits: Tier One Tier One Unmarried individuals with modified AGI between $25,000 and $34,000, and MFJ individuals with modified AGI between $32,000 and $44,000 Calculation The taxable portion of Social Security is equal to the lesser of: 1/2 Social Security received, OR 1/2 of the amount by which modified AGI exceeds the base amount Where the base amounts are $25,000 for unmarried individuals $32,000 for MFJ $0 for others

15. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Tier One Example With modified AGI = $31,500, the taxable portion of her $3,000 Social Security income is the lesser of: $1,500, or 1/2 ($31,500 - $25,000) = $3,250 Therefore, taxable SS is $1,500

16. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Social Security Benefits: Tier Two Tier Two Calculation For individuals whose income exceeds Tier One amounts taxable portion of Social Security is equal to the lesser of: 85% of Social Security received, or 85% of the amount by which modified AGI exceeds the base amount, plus the smaller of Amount of SS benefits included under the 50% formula, or $4,500 for unmarried individuals ($6,000 for MFJ) Where the base amounts are $34,000 for unmarried individuals $44,000 for MFJ $0 for others

17. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Tier Two Example

18. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Alimony Received Amounts received for alimony payments are taxable income if: Payments are made in cash There is a written agreement Payments are not disguised child support or property settlement Payments cannot be made to payee’s estate Payer and payee do not live in the same household

19. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Imputed Income:Personal Consumption & Below Market Rate Loans Personal consumption The value of the goods and services produced by individuals for personal consumption generally are not taxable Realization concept Administrative Convenience concept Below market rate loans Interest income and expense are imputed on below market-rate loans Relationship between the lender and the borrower determines the tax treatment Lender has imputed interest income Borrower has imputed interest expense Administrative Convenience grants exceptions for Loans of $10,000 or less Gift loans of $100,000 or less

20. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Imputed Income:Payment of Expense by Others & Bargain Purchases Payment of Expense by others A taxpayer whose expenses are paid by another has realized an increase in wealth Payments made by family members may be considered nontaxable gifts Payments made by employers are taxable income Bargain purchases When a bargain purchase price does not result from an arms-length transaction, the bargain amount is taxable income.

21. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Capital Gains and Losses Capital asset: Any asset other than inventory, receivables, and depreciable or real property used in a trade or business A sale or other disposition of capital assets results in a capital gain or loss Capital gains and losses receive special tax treatment Holding period Holding period for capital assets is how long the taxpayer owned the asset Short Term = held for < 12 months Long Term = held for > 12 months Determining holding period is the first step in determining tax treatment

22. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Capital Gains and LossesNetting Procedures (slide 1 of 2)

23. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Capital Gains and LossesNetting Procedures (slide 2 of 2) If one is a loss and one is a gain, then:

24. © 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Tax Treatment for Net Gains Net short-term capital gain is taxed as ordinary income Adjusted net long-term capital gain is taxed at a maximum 15% (0% if marginal rate 10 or 15%) Adjusted NLTG = NLTG - [28% rate gain - Unrecaptured §1250 gain + Eligible dividends] 28% rate gain = [Net collectibles gain + Small business stock gain - STCL - LTCL carryover] Net Collectibles gain and Small Business Stock gain is taxed at a maximum 28% Unrecaptured §1250 gain is taxed at a maximum 25%

25. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Capital Gains and LossesHolding Period & Maximum Rate

26. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Tax Treatment for Net Losses by Individuals Only $3,000 of net capital losses may be deducted in one year Use short-term losses first Carryover net loss > $3,000 Capital gains and losses of conduit entities flow-through to owners’ returns

27. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. When is Income Reported? Accounting Method chosen by a taxpayer dictates when income is reported Cash Method: Taxpayers report income when cash is actually or constructively received Accrual Method: Taxpayers report income when it is earned Hybrid Method: Taxpayers mix accrual and cash methods

28. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cash Method Cash method taxpayers must follow the Constructive Receipt Concept Exceptions to the cash method: Taxpayers who sell inventory must use the accrual method for inventory Taxpayers must use the accrual and the effective interest method with Original Issue Discount securities Taxpayers who hold Series EE Bonds may elect to use the accrual method

29. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Accrual Method Under tax law, income is accrued when All events have occurred that fix the right to receive the income, and The amount of income earned can be determined Exceptions: Wherewithal-to-Pay concept requires income be reported in the year pre-payment is received for rents, insurance, interest and royalties One year deferral is allowed for some pre-payments Report amount = Financial Accounting in first year Balance amount in full in second year Pre-payments for goods may be accrued if the payment is less than the Cost of Goods Sold

30. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Hybrid Method Taxpayers may mix the cash and accrual methods, using accrual for sales of inventories and cash for other revenues and expenses

31. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exceptions to All Methods Installment Sales Method: Any time one payment is received after the year of sale, taxpayers must recognize income proportionately as the selling price is received unless they elect to report in the year of sale Long-term Construction Contracts: The percentage-of-completion method must be used for all long-term construction