chapter 3 income sources ©2006 south-western kevin murphy mark higgins kevin murphy mark higgins
TRANSCRIPT
Chapter 3Chapter 3
Income SourcesIncome Sources
©2006 South-Western©2006 South-Western©2006 South-Western©2006 South-Western
Kevin MurphyKevin MurphyMark HigginsMark Higgins
Kevin MurphyKevin MurphyMark HigginsMark Higgins
Transparency 3-2Transparency 3-2© 2006 South-Western© 2006 South-Western
What is Income?What is Income?
All-inclusive Income ConceptDefined by exception: “Except as
otherwise provided…” § 61
Judicial findingsIncome is the gain derived from labor and
capitalAny increase in wealth that has been
realized is income
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What is Income?What is Income?
Current ViewA change in the form and/or substance of
the taxpayer’s property, andThe involvement of a second party in the
income process
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Types of IncomeTypes of Income
Earned Unearned Transfer Imputed Capital Gains and Losses
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Earned Income: DefinitionEarned Income: Definition
Two problems may arise when determining taxability of earned incomeCash-equivalent approach Assignment of income
Compensation received for the provision of labor is earned income.
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Unearned Income: DefinitionUnearned Income: Definition
Examples of unearned income are:Interest and Dividend IncomeRental and Royalty IncomeAnnuities
The earnings from investments and gains from the sale, exchange or disposition of investment assets is unearned income.
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Unearned Income: AnnuitiesUnearned Income: Annuities
An annuity is 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 incomeMust be spread over the time of receipt
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Annuity ExclusionsAnnuity Exclusions
If the payment term and amount are fixed:
Exclusion Ratio = Cost of the contract
Total expected return
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Annuity ExclusionsAnnuity Exclusions
If the payment term depends on the life of the taxpayerMust estimate the number of paymentsUse the “simplified method”
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Annuity ExclusionsSimplified MethodAnnuity ExclusionsSimplified Method
Annuity payments beginning after November 18, 1996use Tables 3-1 or 3-2 to determine number
of payments
Excluded portion = Contract Cost
Number of payments
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Annuity ExampleAnnuity 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
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Unearned Income: Gains and LossesUnearned Income: Gains and Losses
Proceeds from sale or dispositionless: Selling expenses
Amount realized from dispositionless: Adjusted basis of property
Gain or loss from disposition
Gains or losses may occur upon disposal of investment property.
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Unearned Income:Income from Conduit EntitiesUnearned Income: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
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Transfer Income: DefinitionTransfer Income: Definition
Some amounts of income are neither fully earned nor fully unearned.Prizes and AwardsUnemployment CompensationSocial Security BenefitsAlimony Received
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Transfer Income: Prizes and AwardsTransfer Income: Prizes and Awards
Amounts received as prizes and awards are generally taxable.Exceptions exist for:
Scientific and literary achievementsmust be given by recipient to a qualified charity or
government unit
Employee achievementsmust be given to employee for length of service or
safetyamount is limited to $400 per employee (or $1,600 if
qualified plan)
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Transfer Income:Unemployment Compensation
Transfer Income:Unemployment Compensation
Amounts received from unemployment compensation plans are considered substitutes for earned income and are always taxable.
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Transfer Income: Social Security BenefitsTransfer Income: Social Security Benefits
A portion of Social Security benefits received may be taxable if modified AGI exceeds certain limits.
Adjusted gross income
plus: 1/2 social security benefits
plus: tax exempt income
plus: foreign earned income exclusions
Modified AGI
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Modified AGI ExampleModified AGI Example
A single taxpayer received $3,000 from Social Security payments. Her AGI without the SS is $30,000.
Modified AGI = $30,000 + $1,500
= $31,500
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Transfer Income:Social Security Benefits - Tier One
Transfer Income:Social Security Benefits - 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
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Tier One CalculationTier One Calculation
The taxable portion of Social Security is equal to the lesser of:
1. 1/2 Social Security received,OR 2. 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, and $0 for others
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Example continuedExample continued
With modified AGI = $31,500, the taxable portion of her $3,000 Social Security income is the lesser of:
1. $1,500, or
2. 1/2 ($31,500 - $25,000) = $3,250
Therefore, taxable SS is $1,500
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Transfer Income:Social Security Benefits - Tier Two
Transfer Income:Social Security Benefits - Tier Two
• For individuals whose income exceeds
Tier One amounts . . .
Tier Two CalculationTier Two Calculation
The taxable portion of Social Security is equal to the lesser of:
1. 85% of Social Security received,OR 2. 85% of the amount by which
modified AGI exceeds the base amount*, PLUS the smaller of
a. the amount of SS benefits included under the 50% formula, orb. $4,500 for unmarried individuals ($6,000 for MFJ)
*Where the base amounts are $34,000 for unmarried individuals, $44,000 for MFJ, and $0 for others
© 2004 South-Western College Publishing© 2004 South-Western College Publishing
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Example for Tier TwoExample for Tier Two
If our taxpayer receives Social Security of $12,000 and has AGI of $50,000 before SS:
Modified AGI = $50,000 + $6,000* = $56,000
Taxable SS is $10,200, which is the smaller of:
1. .85( $12,000) = $10,200, or
2. [.85 ($56,000 - $34,000)] + [(1/2 of $12,000 SS) or $4,500]
= $18,700 + $4,500
= $23,200.
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Transfer Income: Alimony ReceivedTransfer Income: Alimony Received
Amounts received for alimony payments are taxable income if:the payments are made in cashthere is a written agreementthe payments are not disguised child supportthe payments cannot be made to payee’s estatethe payer and payee do not live in the same
household
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Imputed Income: Personal ConsumptionImputed Income: Personal Consumption
The value of the goods and services produced by individuals for personal consumption generally are not taxableRealization conceptAdministrative Convenience concept
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Imputed Income:Below Market-Rate LoansImputed Income:Below Market-Rate Loans
Interest income and expense are imputed on below market-rate loans.The relationship between the lender and
the borrower determines the tax treatment The lender has imputed interest income The borrower has imputed interest expense
Administrative Convenience grants exceptions for loans of $10,000 or less gift loans of $100,000 or less
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Imputed Income:Payment of Expense by Others
Imputed Income:Payment of Expense by Others
Payments made by family members may be considered nontaxable gifts
Payments made by employers are taxable income
A taxpayer whose expenses are paid by another has realized an increase in wealth.
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Imputed Income: Bargain PurchasesImputed Income: Bargain Purchases
When a bargain purchase price does not result from an arms-length transaction, the bargain amount is taxable income.
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Capital Gains and Losses: IntroductionCapital Gains and Losses: Introduction
A sale or other disposition of capital assets results in a capital gain or loss
Capital gains and losses receive special tax treatment
A capital asset is any asset other than inventory, receivables, and depreciable or real property used in a trade or business.
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Capital Gains and Losses:Holding Period
Capital Gains and Losses:Holding Period
The holding period for capital assets is how long the taxpayer owned the asset.Short Term = held for < 12 monthsLong Term = held for > 12 months
Determining holding period is the first step in determining tax treatment.
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Capital Gains and Losses:Netting ProceduresCapital Gains and Losses:Netting Procedures
Long-term gains netted againstLong-term losses
Net Long-termGain or Loss
Short-term gains netted againstShort-term losses
Net Short-termGain or Loss
=
=
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Capital Gains and Losses:Netting ProceduresCapital Gains and Losses:Netting Procedures
Net Short-term Gain or Lossnetted against
Net Long-term Gain or Loss
Net CapitalGain or Loss=
If one is a loss and one is a gain, then:
If both are losses or both are gains, no further netting is done.
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Tax Treatment for Net GainsTax 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%Adjusted NLTG = NLTG - [28% rate gain -
Unrecaptured §1250 gain + Eligible dividends]
28% rate gain = [Net collectibles gain + Small business stock gain - STCL - LTCL carryover]
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Net Collectibles gain and Small Business Stock gain is taxed at a maximum 28%
Unrecaptured §1250 gain is taxed at a maximum 25%
Tax Treatment for Net GainsTax Treatment for Net Gains
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Capital Gains and Losses: Holding Period & Maximum Rate
Capital Gains and Losses: Holding Period & Maximum Rate
Holding Period
Category
15% MTR > 15% MTR
< 12 months Short-term MTR MTR
> 12 months Long-term 5% 15%
> 12 months Collectibles (& excess small business gain)
15% 28%
> 12 months Unrecaptured Sec. 1250 gain
15% 25%
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Tax Treatment for Net Losses by IndividualsTax Treatment for Net Losses by Individuals
Only $3,000 of net capital losses may be deducted in one yearUse short-term losses firstCarryover net loss > $3,000
Capital gains and losses of conduit entities flow-through to owners’ returns
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When is Income Reported?When is Income Reported?
The 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
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Accounting MethodCash
Accounting MethodCash
Cash method taxpayers must follow the Constructive Receipt Concept.Exceptions to the cash method:
Taxpayers who sell inventory may not use the cash 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
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Accounting MethodAccrual
Accounting MethodAccrual
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
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Accounting MethodAccrual ExceptionsAccounting MethodAccrual Exceptions
Exceptions to the accrual method:The 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 Remainder of amount in full in second year
Pre-payments for goods may be accrued if the payment is less than the Cost of Goods Sold.
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Accounting MethodHybrid
Accounting MethodHybrid
Taxpayers may mix the cash and accrual methods, using accrual for sales of inventories and cash for other revenues and expenses.
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Accounting MethodExceptions to All Methods
Accounting MethodExceptions 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.
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End of Chapter 3End of Chapter 3