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Taxation for Decision Makers, 2020

Tenth Edition

Dennis-Escoffier

Chapter 3

Determining Gross Income

What is Gross Income?

Code Section 61(a) defines gross income as

“except as otherwise provided in this subtitle, gross income means all income from whatever source derived...”

What is Income?

Gross income is realized income that is not excluded

Realization takes place when arm’s-length transaction occurs (sale of goods)

Taxable income is gross income less all deductions

Tax versus Financial Accounting

Objectives are not the same

Financial accounting seeks to provide information that decision makers find useful

Tax reporting seeks to collect revenue equitably

Differences fall into two categories

Temporary (timing) differences

Permanent differences

Temporary Differences

Arise when income is taxed either before or after it is accrued for accounting purposes

Example: prepaid rent generally is taxable when received but is only included in financial accounting income as it is earned

Create a deferred tax asset or deferred tax liability on financial statements

Permanent Differences

Income that is not taxed but is reported for financial accounting purposes

Example: interest income from state and local bonds generally is not taxed but is recorded as income in financial accounting records

Return of Capital Principle

Basis = amount invested in an asset

Basis can be recovered tax free

If the taxpayer’s return is more than basis, the taxpayer has a gain

If taxpayer’s return is less than basis, the taxpayer has a loss

Investment Alternatives

Investments yielding appreciation

Tax deferred until gain is recognized

Gain is frequently taxed at lower capital gains rates

Investments yielding annual income

Interest income is taxed annually at the marginal tax rate for ordinary income

Dividend income taxed annually but currently at lower capital gains rates

Capital Gain Tax Rates

Table 3.1 Long-Term Capital Gains Tax Rates for 2019

Long-term capital gains tax rate	Taxable income for single individuals	Taxable income for married couples filling a joint return
0%	$0−$39,375	$0−$78,750
15%	$39,376−$434,550	$78,751−$488,850
20%	Over $434,550	Over $488,850

The Tax Year

Calendar year

Individuals

S corporations and partnerships have restrictions on allowable tax years, so usually use a calendar year

Fiscal year

12-month period ending on last day of month other than December

52-to-53-week year (ends on same day)

Short-year tax return reports less than 12 months of operating results

Accounting Methods

Taxpayers can use different methods for financial accounting and tax

Cash method: receipt of cash or cash equivalents determine income/expense recognition (subject to constructive receipt doctrine)

Accrual method: the all events test determines income/expense recognition

Cash Method

Income is recognized when cash or cash equivalents received

Cash equivalents broadly defined to include property and services

Cash equivalents included at fair market value

A cash-basis taxpayer must recognize income when an amount is

Credited to the taxpayer’s account

Set apart for the taxpayer or

Made available in some other way to the taxpayer

Constructive Receipt Doctrine

Constructive receipt is a modification that prevents cash-basis taxpayers from “turning their backs” on income

Income is not constructively received if

Taxpayer is not entitled to the income

Payor has insufficient funds from which to make payment or

Substantial limitations or restrictions are placed on actual receipt

Limits on Cash Method

Large corporations (with average annual gross receipts of more than $26 million) cannot use the cash method for tax reporting

Personal service corporations, no matter how large, can always use the cash method

Accrual Method

Income is recognized when “all events test” is met

All events have occurred that establish the right to the income and

The income amount can be determined with reasonable accuracy

If liability is in dispute, the all events test is not satisfied until dispute is resolved

Claim of Right Doctrine

Claim of right doctrine modifies the normal recognition rules for accrual-basis taxpayers

Requires taxpayer to recognize income when payment is received, regardless of whether money may have to be repaid later

If taxpayer must return all or part of the income, deduction allowed in repayment year

Prepaid Income

Prepaid Income is another exception to the accrual method of accounting

Based on wherewithal to pay concept – taxpayer should be taxed when best able to pay the tax

Income must be reported when received

Examples: rent, interest, and royalty payments

Refundable deposits are not prepaid income

Special Methods

Completed Contract Method – no income is recognized and no deductions taken until contract completion

Percentage-of-Completion Method – income is recognized as contract progresses based on an estimate of actual costs incurred to total projected costs for contract

Installment Method - gain is recognized as proceeds from sale are received

Assignment of Income Doctrine

A taxpayer cannot assign earned income to a third party to escape taxation

Earned income must be taxed to the taxpayer rendering the services

Community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, Wisconsin)

Allocate half of income to each spouse

Income from property is taxed to taxpayer who owns the property

Interest Income

Interest income from most sources is taxable, but interest on state and local (municipal) bonds is excluded from gross income

High income taxpayers may have a higher after-tax return on municipal bonds than taxable bonds offering a higher interest rate

Gain on the sale of tax-exempt securities must be included in gross income

Interest from private activity municipal bonds may be subject to A M T

Original Issue Discount

Some debt instruments are issued at prices below their maturity values

This original issue discount (O I D) is effectively interest paid at maturity rather than periodically over the debt instrument’s life

Both cash and accrual basis taxpayers recognize O I D income as it accrues

Exception: Series EE and Series I bonds

Market Discount

Bonds purchased after issue in the open or secondary market at a price below their stated maturity value

Excess of redemption proceeds over cost is recognized as ordinary income in year of redemption

Electively, market discount can be accrued as interest income over life of bond

Below-Market-Rate Loans

Interest-free or below-market-rate loans are frequently made between related parties

Interest income that is not actually received or accrued may be imputed (treated as received or accrued and taxed) at the applicable federal rate of interest

Gift Loan Exceptions

Any gift loan of $10,000 or less is exempt from the imputed interest rules

For gift loans greater than $10,000 but less than $100,000

Imputed interest cannot exceed the borrower’s net investment income for the year

If borrower’s net investment income is no more than $1,000, imputed interest is zero

Other Loans

Loan to employee – loan interest is imputed income to employer, returned to employee as compensation; taxable compensation to employee and deductible by employer

Loan to shareholder – loan interest is imputed income to corporation, returned as dividend to shareholder; taxable dividend to shareholder but no corporate deduction

$10,000 exception if no tax avoidance motive

Dividend Income

Cash and F M V of other assets distributed by a corporation from earnings and profits (E&P) are treated as dividends includable in the shareholder’s income

Dividend income is taxed at the same rates as long-term capital gains

Distributions in excess of E&P are nontaxable return of capital (reducing stock basis)

Distributions in excess of stock basis are taxed as capital gain (as if stock is sold)

Mutual Fund Dividends

Distributions to mutual fund shareholders of dividends received on stock the fund holds

Distributions of gains the fund realizes on the sale of investment assets

These dividends are actually net long-term capital gains and are called capital gains distributions

Dividend Reinvestment Plans

Treated as if the shareholder received the cash and then purchased additional shares of stock with the dividend income (constructive receipt doctrine)

Value of dividend included in income

Amount included in income becomes the shareholder’s basis for these shares of stock

Stock Dividends

Stock dividends are distributions of a corporation’s own stock to its shareholders (treated the same as a stock split)

Usually stock dividends are not taxable to the shareholder

Shareholder owns a greater number of shares and the basis in the original shares is divided between all shares of stock now held

If shareholder has option of receiving cash or stock, then dividend is taxable

Annuity Income

Usually consists of taxable and nontaxable portions

Nontaxable portion represents a return of capital and is equal to the (Investment in annuity / expected return from annuity) × annuity payment received

If the total investment in the annuity is made by the employer (or by the employee using pre-tax dollars), then the employee’s investment is treated as zero

Prizes and Awards

Prizes, awards, gambling winnings, and treasure finds are taxable

The fair market value of goods or services received is included in gross income

Government Transfer Payments

Need-based payments, such as welfare payments, school lunches & food stamps, are excluded from income

Unemployment compensation is taxable because it is a substitute for wages that would be taxable

Social Security Benefits 1

Government devised a complex formula that can result in the taxation of up to 85% of social security benefits for taxpayers who have significant other income while leaving benefits completely tax free for those who have little other income

MAGI = A G I before any Social Security benefits + exempt interest income + ½ of Social Security benefits

Social Security Benefits 2

If MAGI is less than $25,000 for single individuals or $32,000 for married couples, then none of the social security benefits received are taxable

Single taxpayers with MAGI above $34,000 and married taxpayers with income above $44,000 can be taxed on up to 85% of their benefits

Taxpayers between the above thresholds include in income the lesser of 50% of their Social Security benefits or 50% of the excess of MAGI over the tier 1 base amount

Damage Awards

Damages for physical injuries are not taxed (under the return of capital doctrine)

Damages for all other awards are taxed (viewed as substitute for income that would otherwise be taxable income)

Punitive damages are taxable

Divorce-Related Payments

A property settlement is simply a division of assets (no income, no deduction)

Child support fulfills a legal obligation to support a child (no income, no deduction)

Alimony is a legal shifting of income – taxable income to recipient and deductible by payor (if divorce agreement finalized before 2019)

For divorce agreements finalized after 2018, alimony is excluded from income and not deductible by payor (no change for agreements finalized by end of 2018)

Discharge of Debt 1

If a legal obligation is satisfied for less than the outstanding debt, the amount of debt forgiven represents an increase in the taxpayer’s wealth and is subject to taxation

Exceptions are provided for debtors who are bankrupt or insolvent

Exceptions for the forgiveness of some student loans when the students work in certain professions

Discharge of Debt 2

Mortgage Forgiveness Debt Relief Act provided relief for homeowners whose mortgage debt was forgiven

Forgiveness on up to $2 million of qualified debt on a principal residence through 2017 was excluded from income

This provision applied to restructuring, short sales, and deeds-in-lieu-of foreclosure

Basis of residence is reduced (but not below zero) for amount excluded

Tax Benefit Rule

If a taxpayer deducted an expense or loss in one year but recovers the amount deducted in a subsequent year, all or a portion of the amount recovered may have to be included in gross income in the year it is recovered

Amount included in income is limited to the extent the taxpayer benefited from the tax deduction

Example: bad-debt recovery or refund of taxes previously deducted

Forms Reporting Payments

Table 3.3 Forms Reporting Payments

Form	Type of payment
W-2	Salaries and wages
W-2G	Gambling winnings
1099-B	Sale of a security
1099-C	Cancellation of debt
1099-DIV	Dividends
1099-G	Government payments including unemployment compensation and tax refunds
1099-INT	Interest
1099-MISC	Miscellaneous income including nonemployee compensation and royalties
1099-0ID	Original issue discount
1099-R	Distributions from retirement plans
SSA-1099	Social Security benefits

Exclusions from Income

Gifts

Inheritances

Life Insurance

Proceeds received are tax free but any interest income on proceeds is taxable

Inside buildup (increase in cash surrender value) is not taxable income unless policy is liquidated for more than premiums paid

Accident & Health Insurance

Accident & health insurance proceeds are tax free to extent they pay qualified medical or dental expenses; excess benefits taxable if employer provided policy

Disability insurance is a substitute for lost pay if an employee cannot work

If premiums for disability insurance paid by employer, then benefits received are taxable

If premiums paid by employee, exception allows benefits to be received tax free

Scholarships 1

Qualified scholarships are excluded from gross income

“Scholarship” includes only tuition, fees, books, supplies, equipment, and related expenses required for courses

Amounts designated or spent for room, board, and laundry are included in taxable income

Scholarships 2

Any grant received in return for past, present, or future services must be included in gross income

Funds received by students in return for teaching or research services are taxable

When taxable portion cannot be determined until end of academic year, taxable income can be deferred until the taxable year in which the academic year ends

Education Benefits

Universities can provide tuition waivers for their employees (and their immediate family members) on a tax-free basis only for undergraduate tuition

This and other employee fringe benefits are discussed in Chapter 4

Other Exclusions

Improvements made on leased property are excluded from landlord’s income unless improvements made in lieu of paying rent

Exclusion of gain on sale of home (Ch. 8)

$250,000 if single, $500,000 if married and both spouses qualify

Must have owned and lived in home as principal residence for at least 2 of previous 5 years

International Issues

Source principle - countries tax income earned within their borders but exclude income from activities taking place (sourced) in other countries

Applies to foreign persons and foreign corporations

Residency principle – countries tax worldwide income

Applies to resident individuals and corporations

International Taxation

A business is usually only taxed in country of residence unless it maintains a permanent establishment (e.g. office) in another country

Source country can tax income earned within its borders when a permanent establishment exists

Double taxation can result when more than one jurisdiction has the right to tax the same income

Minimizing Double Taxation

Tax treaties and tax credits minimize the impact of this double taxation

A tax treaty is an agreement between two countries that explains how a taxpayer of one country is taxed when conducting business in another country

Foreign tax credits can offset domestic taxes on foreign source income

Taxpayers Subject to U.S. Tax

U.S. citizens, corporations, and resident aliens are subject to U.S. tax on their worldwide income

Resident alien – individual who is not a U.S. citizen but who has established legal residence in U.S. through

Green card or

Substantial presence test (183 days)

Individuals typically exempt from substantial presence test include diplomats, teachers, students, and certain professional athletes

Nonresident Aliens and Foreign Corporations

Nonresident alien – individual who is not U.S. citizen and does not satisfy test to be resident alien

Nonresident aliens and foreign corporations are subject to U.S. tax on

Effectively connected income – U.S. business income subject to U.S. income tax

U.S. investment income – taxed at flat 30% (or treaty rate if lower)

U.S. Corporations Doing Business in a Foreign Country 1

A U.S. corporation can operate in a foreign country through a branch or a subsidiary

A branch is viewed as an extension of the U.S. corporation

Branch’s income is combined with U.S. operations and subject to U.S. tax (no income deferral)

A controlled foreign corporation (C F C) is a corporation whose U. S. shareholder-ownership exceeds 50% but which is incorporated outside the U.S.

U.S. Corporations Doing Business in a Foreign Country 2

Until 2018, a U.S. parent corporation was usually not taxed on the earnings of the foreign subsidiary until the earnings were repatriated to the U.S. as dividends

When the U.S. parent received a dividend, the dividend was included in its income

The parent was entitled to a foreign tax credit when the dividend was received based on the income tax paid by the foreign corporation

U.S. Corporations Doing Business in a Foreign Country 3

If the U.S. parent did not need cash from its overseas operations, it could direct its subsidiary to withhold paying dividends which postponed the payment of U.S. taxes on this income

As long as the parent received no repatriated earnings, it could postpone the payment of U.S. taxes

Certain foreign source income (Subpart F income) earned by a C F C was subject to U.S. tax when earned

No additional U.S. tax was paid on this income when the parent received it as a dividend

U.S. Corporations Doing Business in a Foreign Country 4

In 2018, the U.S. moved to a new hybrid territorial system featuring

100% dividend received deduction (D R D)

Current taxation of certain foreign income

Minimum tax on low-taxed foreign earnings

Base erosion anti-abuse tax (B E A T)

A one-time transition tax was imposed on untaxed accumulated foreign earnings

To prevent a windfall for corporations with untaxed accumulated foreign earnings that are now eligible for the 100% D R D

U.S. Corporations Doing Business in a Foreign Country 5

A new category of Subpart F income imposes a tax on net C F C income that is global intangible low-taxed income (G I L T I)

New complex rules determine the amount of a corporation’s foreign derived intangible income (F D I I)

These new laws added by T C J A significantly change the way foreign income is taxed for U.S. corporations

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