2013 cch basic principles ch04

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Chapter 4 Gross Income ©2012 CCH. All Rights Reserved. 4025 W. Peterson Ave. Chicago, IL 60646-6085 1 800 248 3248 www.CCHGroup.com

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Page 1: 2013 cch basic principles ch04

Chapter 4

Gross Income

©2012 CCH. All Rights Reserved.4025 W. Peterson Ave.Chicago, IL 60646-60851 800 248 3248www.CCHGroup.com

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1. Constructive Receipt Doctrine

2. Community Property Income

3. Items Included in Gross Income

4. Compensation vs. Gift

5. Prizes and Awards

6. Employee Achievement Awards

7. Scholarships and Fellowships

8. Business Income

9. Below-Market Interest Loans—Types of Loans

Chapter 4 Exhibits

Chapter 4, Exhibit Contents A

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10. Below-Market Interest Loans—Tax Effect

11. Rental Income

12. Tenant Improvements

13. Dividend Income

14. Alimony—Post-1984 Agreements

15. Alimony and Child Support (Post-1984 Divorces)

16. Alimony Recapture

17. Discharge of Debt

18. Discharge of Debt—Bankruptcy

Chapter 4 Exhibits

Chapter 4, Exhibit Contents B

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Constructive Receipt Doctrine

“When is income taxable?”

Generally, any compensation granted to an individual to which the individual has an absolute right is regarded as constructively received income.

Chapter 4, Exhibit 1

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Community Property Income

Property acquired after marriage is community property. Income from community property is community income

Property acquired before marriage remains separate property. What happens to income from separate property?

Chapter 4, Exhibit 2a

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CA Rule – Income from separate property remains separate.

Applies to California, Arizona, Nevada, New Mexico, Washington and Wisconsin.

TX Rule - Income from separate property is community income. Therefore, if spouses filed separate returns, the income would be shared between them.

Applies to Texas, Idaho and Louisiana.

Chapter 4, Exhibit 2b

Community Property Income

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Items Included in Gross Income

Compensation for services, including fees, commissions, fringe benefits, and similar items

Gross income derived from business Gain derived from dealings in

property Interest Rents Royalties Dividends Alimony and separate maintenance

payments

Annuities Income from life insurance and

endowment contracts Pensions Income from discharge of

indebtedness Distributive share of partnership

gross income Income in respect of a decedent Income from an interest in an estate

or trust

Code Sec. 61(a) lists 15 items that generally must be included in gross income:

Special circumstances may result in the exclusion or deferral of any of these items.

Chapter 4, Exhibit 3

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Compensation vs. Gift

Example

FACTS: Grandma offers 16-year-old Billy $10,000 if he quits smoking and playing pinball over the next five years. He does, and upon attaining the age of 21, she pays him $10,000.

QUESTION: Is the $10,000 received by Billy taxable income or a gift?

SOLUTION: The $10,000 is taxable income since there were strings attached.

The facts and circumstances dictate whether something received is taxable compensation or a tax-free gift

  Compensation is generally included in gross income.  Gifts are generally excluded from gross income.

Chapter 4, Exhibit 4

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Prizes and Awards

Prizes and awards are generally taxable based on fair market value at time of receipt.

However, if ALL of the following 4 conditions occur, then they are excludable :

 1. Connected with the fields of science, charity, or the arts2. Involuntary selection process (i.e., through no effort of recipient)3. No future services required of recipient4. Assigned to a governmental agency or tax-exempt charitable organization (rather than constructively received).

Chapter 4, Exhibit 5a

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Example

FACTS: Mother Tanesha, a U.S. citizen, is awarded the Nobel Peace Prize, which includes a $500,000 cash award. The award was unsolicited and no future services were required of Mother Tanesha. Furthermore, she endorsed the check over to the Sisters of Charity, a qualified tax-exempt charity, rather than depositing it in her bank account.

QUESTION: Does Mother Tanesha have taxable income?

SOLUTION: YES! She constructively received the $500,000 when she endorsed the check over to the charity. By endorsing the check, she exercised dominion and control over the money, even though she did not deposit it. She could have avoided taxable income if she had directed the Nobel Committee to pay the Sisters of Charity directly.

Chapter 4, Exhibit 5b

Prizes and Awards

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Employee Achievement Awards

Employee achievement awards are generally taxable, except that the value of awards for length of service or safety achievement delivered at a “meaningful presentation” are excluded up to

1. $400 if the plan is non-qualified (i.e., discriminates in favor of highly paid employees), or

2. $1,600 if the plan is qualified (i.e., does not discriminate in favor of highly paid employees).

 (If an employee receives both qualified and nonqualified awards, then the overall exclusion may not exceed $1,600.)

Chapter 4, Exhibit 6

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Scholarships and Fellowships

The value of scholarships or fellowships are generally taxable, but may be excluded if they are:

1. To a degreed candidate attending an educational institution

2.   For tuition and course related material (not room and board)

3.   As a result of academic achievement, and not connected with

services provided.

Example: A “scholarship” received by a beauty queen for winning the Miss Georgia Peanut contest would actually be a taxable award for services rendered, even if she were a degreed candidate and the money was spent on tuition. It would really be compensation disguised as a scholarship.

Chapter 4, Exhibit 7

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Business Income Sole proprietor

Include all business income (less cost of goods sold) in gross income.

Partnerships and S corps Partnerships and S corps are not taxed, but their taxable

income is taxed to individual partners and shareholders. Partners and shareholders must include their proportionate

share of business income in their gross income, regardless of whether or not the income was distributed.

Chapter 4, Exhibit 8

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Below-Market Interest Loans—Types of Loans

What types of loans are subject to imputed interest calculations?

All of the following loans are subject to imputed interest:

  Gift loans (made out of love or generosity). Note that the “gift” is NOT the principal

portion of the loan, rather, the amount of interest that is below market. Compensation-related loans (employer loans to employees) Corporation-shareholder loans (a corporation’s loans to ANY of its shareholders)

 

If all of the following apply: Interest charged is less than the applicable federal rate (AFR) Sum of all loans between lender and borrower exceeds $10,000 The loan was made after June 7, 1984

Chapter 4, Exhibit 9

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Below-Market Interest Loans—Tax Effect

The two steps for each of the three below-market interest loans are not easy to conceptualize. See if this makes sense:

Step 1: “Pretend” that the borrower has “paid” the imputed interest to the lender as an interest payment.

Step 2: “Pretend” that the lender has returned the imputed interest back to the borrower as either a gift, compensation, or a dividend.

Chapter 4, Exhibit 10a

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What is the tax effect of imputed interest on below-market loans?

Type of Loan Step Lender Borrower

Gift Loan Step 1:Step 2:

Interest income.Nondeductible gift, possibly subject to gift tax.

Interest expense.

Tax-free gift received.

Compensation-related Loan

Step 1:

Step 2:

Interest income.

Compensation expense.

Interest expense.

Compensation income.

Corporation to Shareholder

Loan

Step 1:

Step 2:

Interest income.Nondeductible dividend deemed paid.

Interest expense.

Dividend income.

 

Chapter 4, Exhibit 10b

Below-Market Interest Loans—Tax Effect

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Rental Income

Tax Effect on Landlord: ALL rent received is taxable income, including future years’ rent received in advance

Tax Effect on Tenant with a Business Lease: If rent is paid in advance, no deduction for rent expense is allowed until the year the payment is due.

Example

FACTS: Tenant pays Landlord $10,000, covering the first and last year’s rent.

QUESTION: What is the tax effect on Landlord and Tenant?

SOLUTION: $10,000 taxable income to Landlord; $5,000 deduction to Tenant.

Chapter 4, Exhibit 11

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Tenant Improvements

When are tenant improvements taxable to cash-basis landlords?

1.  If in lieu of rent (or if repairs paid for by lessee are the

responsibility of the lessor): lessor has rental income to the extent

of the market value of the improvements.

2.  If NOT in lieu of rent: Not taxable.

When the property is sold, the improvements will be taxed assuming

they add value that results in a higher sales price.

Chapter 4, Exhibit 12

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Dividend Income

The term “dividend” means any distribution of property made by a corporation to its shareholders out of its earnings and profits.

There are two common types of dividends: Cash Dividends – taxable. Stock Dividends – generally not taxable. There are 5

exceptions to this rule. If a stock dividend meets one or more of these exceptions, it is taxable.

Chapter 4, Exhibit 13

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Alimony—Post-1984 Agreements

Payments under instruments executed after December 31, 1984, that meet the following requirements are deductible as alimony:

Payments must be made in cash Payments must be made under a divorce or separation

instrument Parties must live in separate households after a

divorce or separation decree is entered Alimony must end at the payee’s death Parties involved may not file a joint return

Chapter 4, Exhibit 14

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Alimony and Child Support (Post-1984 Divorces)

What is the tax treatment for alimony and child support?

Alimony Child Support

Taxable to Payee? Yes No

Deductible to Payor? Yes (“for” AGI) No

Chapter 4, Exhibit 15

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Alimony Recapture

Alimony is required to be recaptured if:

1) Payments made in the 2nd post-separation year exceed payments in the 3rd post-separation year by more than $15,000 and/or

2) Payments made in the 1st post-separation year exceed the average payments made in the 2nd and 3rd post-separation years by more than $15,000.

Chapter 4, Exhibit 16a

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Step 1: Year 2 Recapture

Year 2 Payment

Less Year 3 Payment

= Excess Payment

Less $15,000

= Amount subject to recapture for Year 2

Chapter 4, Exhibit 16b

Alimony Recapture

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Step 2: Year 1 Recapture

Year 1 Payment

Less (Year 2 Payment - Year 2 Recapture + Year 3 Payment) / 2

= Excess Payment

Less $15,000

= Amount subject to recapture for Year 1

Chapter 4, Exhibit 16c

Alimony Recapture

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Step 3: Total recapture

The total amount subject to recapture equals Year 2 recapture plus Year 1 recapture.

The amount recaptured is included in the payor’s income and allowed as a deduction from the payee’s income in Year 3.

Chapter 4, Exhibit 16d

Alimony Recapture

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Example:

Bob makes the following alimony payments to Mary:

Year 1 - $70,000

Year 2 - $40,000

Year 3 - $20,000

Chapter 4, Exhibit 16e

Alimony Recapture

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Step 1: Year 2 Recapture

$40,000 (Year 2)

- $20,000 (Year 3)

= $20,000 (excess)

- $15,000

= $5,000

Chapter 4, Exhibit 16f

Alimony Recapture

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Step 2: Year 1 Recapture

$70,000 - $27,500 (40,000 – 5,000 + 20,000)/2= $42,500 - $15,000 = $27,500

Step 3: Total Recapture $5,000 + $27,500 = $32,500

Chapter 4, Exhibit 16g

Alimony Recapture

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Tax Effects of Alimony Payments and Recapture

Bob Mary

Year 1 ($70,000) deduction $70,000 income

Year 2 ($40,000) deduction $40,0000 income

Year 3

($20,000) deduction

$32,500 recapture

$12,500 income

$20,000 income

($32,500) recapture

($12,500) deduction

Chapter 4, Exhibit 16h

Alimony Recapture

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Discharge of Debt

Forgiveness of debt is generally includable in gross income.

There are 2 exceptions in which taxes on a forgiveness of debt are deferred (i.e. excluded from gross income): 1. The debt is discharged in a Chapter 11 bankruptcy filing. The amount of debt discharged reduces certain tax attributes that

otherwise could have provided a tax benefit in the future.

2. The borrower is insolvent outside of bankruptcy

(i.e., Liabilities > FMV of assets immediately prior to discharge) However, the amount excluded from gross income cannot exceed the amount by which the taxpayer is insolvent.

Chapter 4, Exhibit 17

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Offsetting reduction of tax attributes. As a price for the deferral (exclusion from gross income), the Code requires that the amount deferred be applied to reduce seven tax attributes in the order listed below. However, the Code offers a special election to first reduce the tax basis of depreciable property or real property held as inventory.

             1.    Net operating losses and loss carryovers             2.    General business credits under Code Sec. 38             3.    Minimum tax credits under Code Sec. 53             4.    Net capital loss and loss carryovers             5.    Basis of depreciable assets or nondepreciable real assets held as inventory             6.    Passive activity losses 7. Foreign tax credit carryovers under Code Sec. 27

Discharge of Debt—Bankruptcy

Chapter 4, Exhibit 18