Chapter 4

Gross Income:
Concepts and Inclusions
Individual Income Taxes
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The Big Picture

Calculation Of Gross Income

(slide 1 of 3)

At the beginning of the year, Dr. Cliff Payne opened

his dental practice as a sole proprietorship.
For his new business, he selected a December 31
year-end.
He also entered into a contract to have a building
constructed for his medical practice.
He used $12,000 of extra money to purchase some
stock.

The Big Picture

Calculation Of Gross Income

(slide 2 of 3)

The following financial information shows the results of Dr.

Paynes first year of operation.
Revenues (amounts billed patients for dental services)
Accounts receivable: January 1
Accounts receivable: December 31

$385,000
0
52,000

The accounts receivable represent amounts billed patients.

During the year, Sam Jones, a contractor who owed Dr. Payne
$4,000 for dental services, satisfied the account by installing
solar panels on the roof of Dr. Paynes new medical building.

The Big Picture

Calculation Of Gross Income

(slide 3 of 3)

Based on his accounting records he concludes

that gross income for Federal income tax
purposes is the $385,000 he billed his patients
for dental services rendered.
Has Dr. Payne correctly calculated the gross
income of this dental practice?
Read the chapter and formulate your response.
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Gross Income (slide 1 of 3)

Definition: Gross income includes all income
from whatever source derived, unless
specifically excluded under the Code
Concept is interpreted broadly by the courts

Gross Income (slide 2 of 3)

Taxability of income follows the realization
principle from accounting
Income is recognized (taxed) when realized

Mere appreciation in wealth (economic

income) is not considered realized income

Gross Income (slide 3 of 3)

Income is recognized whether it is in the form
of cash, or in-kind cash equivalents (i.e.,
property or services)
The amount of income from in-kind receipts is
equal to the FMV of the property or services

Income does not include recovery of the

taxpayers capital investment

The Big Picture - Example 1

Recovery Of Capital Doctrine

Return to the facts of The Big Picture on p. 4-1.
Dr. Payne sells common stock for $15,000.
He had purchased the stock for $12,000.

Dr. Paynes gross receipts are $15,000.

This amount consists of a $12,000 recovery of capital
and $3,000 of gross income.

Accounting Periods
Taxable year is generally a 12-month period
Taxable year for most individual taxpayers is the
calendar year
A fiscal year can be elected if taxpayer maintains
adequate records
A fiscal year is a 12-month period ending on the last
day of a month other than December
Example: July 1 to June 30

Accounting Methods (slide 1 of 2)

There are 3 primary methods of accounting for
tax purposes:
Cash receipts and disbursements method
Accrual method
Hybrid method

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Accounting Methods (slide 2 of 2)

In addition to overall accounting methods,
taxpayers may choose (elect) tax treatment for
various transactions, for example
Taxpayers can elect to use the installment method
Certain contractors may elect to use either the
percentage of completion method or the completed
contract method

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Cash Receipts Method

Income is recognized in the year it is actually
or constructively received in cash or cash
equivalent
An amount is constructively received when it
is set aside and made available to taxpayer
without substantial restrictions

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The Big Picture - Example 10

Constructive Receipt (slide 1 of 2)

Return to the facts of The Big Picture on p. 4-1.
On December 31, Dr. Payne has $10,000 in
patients' checks that have not been deposited.
One check for $3,000 is from a patient who asked him
not to deposit it until after January 4th , because her
account did not contain sufficient funds to pay the debt.

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The Big Picture - Example 10

Constructive Receipt (slide 2 of 2)

Under the cash method, Dr. Payne must recognize
$7,000 income from the checks on hand
The checks are a cash equivalent that is actually received.

The income from the $3,000 check is neither actually

nor constructively received
An insufficient account means the funds are not available.

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The Big Picture - Example 12

Constructive Receipt (slide 1 of 2)

Return to the facts of The Big Picture on p. 4-1.

Assume Dr. Payne elected to use the cash basis of

accounting.
If he accepted credit cards, Dr. Payne would receive
immediate credit in his bank account for 96% of the
charge.
The other 4% would be retained by the credit card issuer.

To avoid the 4% charge, Dr. Payne chose not to accept

credit cards.
Instead, his policy required all bills to be paid within 30 days after
dental services were provided.
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The Big Picture - Example 12

Constructive Receipt (slide 2 of 2)

At year end, several patients owed a combined
$2,000.
They offered to pay with credit cards, but his
office rejected their offers.
The $2,000 was not constructively received at the
end of the year.
Dr. Payne could have received payment by credit card,
he contracted to receive payment at a later date before
the dental services were performed.
Moreover, the 4% charge by the credit card company
would be a substantial limitation.
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Exceptions To Cash
Receipts Method
Original Issue Discount (OID) interest is
taxable when earned rather than when interest
is received
Series E and EE bonds are not subject to the
OID rules
However, a cash basis taxpayer may elect to
recognize the interest when earned

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Accrual Method (slide 1 of 2)

Income is recognized in the year that it is earned
regardless of when it is collected
Income is earned when:
All events have occurred that fix taxpayers right to the
income, and
The amount can be determined with reasonable accuracy

The accrual method is required for determining

purchases and sales when inventory is an incomeproducing factor

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Accrual Method (slide 2 of 2)

Claim of right doctrine
Requires amounts received to be included in
income even though the amount is in dispute and
might be returned to the payor at a later date
If payment has not been received, no income is
recognized until the claim is settled

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The Big Picture - Example 7

Claim Of Right Doctrine

Return to the facts of The Big Picture on p. 4-1.

On completing construction of the medical office

building in 2014, the contractor submitted a bill.
Dr. Payne refused to pay the bill, claiming the contractor
had not met specifications.
The contractor did not reach a settlement with Dr. Payne
until 2015.

No income accrues to the contractor until 2015.

If Dr. Payne had paid for the work, then filed suit, the
contractor could not defer the income
The income would be taxable in 2014.
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Exceptions to Accrual Method

(slide 1 of 2)

Taxpayer can elect to defer recognition of

income from advance payment for goods if
same method of accounting is used for tax and
financial reporting purposes

21

Exceptions to Accrual Method

(slide 2 of 2)

Advance payment for services to be performed

after year-end is included in income in the year
following receipt
The portion of the advance payment that is earned
in the current year is included in income in the
year of receipt

Prepaid rents or interest income are always

recognized in the year received rather than
when earned
22

Hybrid Method
A combination of cash and accrual methods
Generally, used when inventory is a material
income-producing factor, for example
Use accrual method to account for inventory
Use cash method for other income and expenses

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Income Sources (slide 1 of 2)

Income from personal services is taxable to the
person who performs the services
Fruit and tree metaphor

Income from property is taxable to the owner

of the property
Assignment of income is not permitted

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Income Sources (slide 2 of 2)

Interest income accrues daily
If interest bearing instrument (e.g., bonds) is
transferred, must allocate interest income between
transferor and transferee based on the number of
days during the period that each owned the
property

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The Big Picture - Example 20

Services of an Employee
(slide 1 of 2)

Return to the facts of The Big Picture on p. 4-1.

Assume that instead of operating as a sole
proprietorship, Dr. Payne incorporated his dental
practice to limit his liability.
He entered into an employment contract with his
corporation and was to receive a salary.
All patients contract to receive their services from the
corporation.
Those services are provided by the corporations employee,
Dr. Payne.

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The Big Picture - Example 20

Services of an Employee
(slide 2 of 2)

Return to the facts of The Big Picture on p. 4-1.

Thus, the corporation earned the income from
patients services and must include the patients
fees in its gross income.
Dr. Payne must include his salary in his gross
income.
The corporation is allowed a deduction for the
reasonable salary paid to Dr. Payne.

27

Dividends (slide 1 of 4)
Unlike interest, dividends do not accrue on a
daily basis
Dividends are generally taxed to the party who
is entitled to receive them
The shareholder of record as of the corporations
record date

Dividends on stock transferred by gift after

declaration date but before record date are
generally taxed to the donor
28

Dividends (slide 2 of 4)
Recent legislation has provided partial relief from
double taxation of corporate dividends
Generally, dividends received are taxed at the same
marginal rate that is applicable to a net capital gain
Thus, individuals otherwise subject to the 10% or 15% marginal
tax rates in 2014 pay 0% tax on qualified dividends received
Individuals subject to the 25, 28, 33, or 35 percent marginal tax
rates pay a 15% tax on qualified dividends
Individuals subject to the 39.6% marginal tax rate pay a 20% tax
on qualified dividends

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Dividends (slide 3 of 4)
The following dividends are not eligible for
the reduced tax rates
Dividends from certain foreign corporations,
Dividends from tax-exempt entities, and
Dividends that do not satisfy the holding period
requirement
Stock on which the dividend is paid must have been
held for more than 60 days during the 121-day period
beginning 60 days before the ex-dividend date to
qualify for the reduced tax rates
30

Dividends (slide 4 of 4)
Dividends from foreign corporations are
eligible for qualified dividend status only if:
The foreign corporations stock is traded on an
established U.S. securities market, or
The foreign corporation is eligible for the benefits
of a comprehensive income tax treaty between its
country of incorporation and the United States

31

Income Received By An Agent

Income received by the taxpayers agent is
considered to be received by the taxpayer
A cash basis principal must recognize the income
at the time it is received by the agent

32

Income From Partnerships

A partnership is not a separate taxable entity
Files an information return (Form 1065)
Provides data necessary for determining each partners
distributive share of partnerships income and
deductions
Each partner reports distributive share of partnership
income and deductions
Reported in year earned, even if not actually distributed

Because a partner pays tax on income as the partnership

earns it, distributions are treated under the recovery of
capital rules
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Income From S Corporations

A small business corporation may elect to be
taxed similarly to a partnership
Referred to as an S corporation
The shareholders, rather than the corporation, pay the
tax on the corporations income
Generally, shareholders report their share of the corps
income and deductions for the year, even if not actually
distributed

34

Income From Estates And Trusts

Beneficiaries of estates and trusts
Generally, taxed on the income earned by the
estates or trusts that is actually distributed or
required to be distributed to them
Any income not taxed to the beneficiaries is
taxable to the estate or trust

35

Income In Community
Property States
All property is deemed either to be separately owned
by the spouse or to belong to the marital community
Community income is allocable equally to each spouse
Separate income may be allocable to owner-spouse

Separate property may produce community income

(e.g., TX, LA)
No allocation of community income for some spouses
living apart for entire year and filing separately

36

Alimony and Separate Maintenance

Payments (slide 1 of 4)
Alimony is:
Deductible by payor
Includible in gross income of recipient

37

Alimony and Separate Maintenance

Payments (slide 2 of 4)
Payments may qualify as alimony if:
Payments are in cash
Agreement or decree does not specify that the
payments are not alimony
Payor and payee are not members of the same
household at the time the payments are made
There is no liability to make the payments for any
period after the death of the payee

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Alimony and Separate Maintenance

Payments (slide 3 of 4)
Property settlements
Transfer of property to former spouse
No deduction or recognized gain or loss for
transferor
No gross income and carryover of transferors
basis for transferee
Front-loading of alimony payments
Alimony recapture (gross income) for payor
Deduction from gross income for recipient
39

Alimony and Separate Maintenance

Payments (slide 4 of 4)
Child support payments
Payments made to satisfy legal obligation to support child
of taxpayer
Nondeductible by payor and not taxed to recipient (or
child)

May be difficult to determine whether an amount

received is alimony or child support
If amount of payment would be reduced due to some future
event related to the child (e.g., child reaches age 21), such
reduction is deemed child support
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Imputed Interest on Below-Market

Loans (slide 1 of 4)
Interest is imputed, using Federal government rates,
when a loan does not carry a market rate of interest
Imputed interest = the difference between the amount that
would have been charged at the Federal rate and the
amount actually charged

Applies to:

Gift loans
Compensation-related loans
Corporate-shareholder loans
Tax avoidance loans

41

Imputed Interest on Below-Market

Loans (slide 2 of 4)
The table below presents the effect of certain below-market loans on the
lender and borrower

Concept Summary 4.2

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Imputed Interest on Below-Market

Loans (slide 3 of 4)
Gift loans
Exemption for loans of $10,000 between
individuals
If loan proceeds are used to purchase income-producing
property, the following limitation applies

On loans of $100,000 or less between individuals

Imputed interest is limited to borrowers net investment
income for year
No imputed interest if net investment income is $1,000
or less
43

Imputed Interest on Below-Market

Loans (slide 4 of 4)
$10,000 exemption also applies to
compensation-related and corporationshareholder loans
No exemption if principal purpose of loan is tax
avoidance
Makes practically all loans of this type suspect

Interest expense imputed to borrower may be

deductible
44

Annuity Income
(slide 1 of 6)

Purchaser pays fixed amount for the right to

receive a future stream of payments
Generally, early collections and loans against
annuity increases in cash value are included in
gross income
Amounts > increases in cash value are treated as a
recovery of capital until cost recovered; additional
amounts are included in income

Early distributions may also be subject to a 10%

penalty
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Annuity Income
(slide 2 of 6)

For collections on and after the annuity

starting date
The exclusion ratio is applied to annuity
payments received under contract to determine
amount excludable:
Exclusion ratio =

Investment in contract
Expected return under contract

Once investment is recovered, remaining

payments are taxable in full
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Annuity Income
(slide 3 of 6)

Examples:
Taxpayer pays $10,000 for annuity that will pay
$1,000 a year
A: For a term of 15 years
B: For lifetime (life expectancy = 15 years)

Exclusion ratio for A & B =

$10,000 = .667
$15,000

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Annuity Income
(slide 4 of 6)

Example (contd)
A: 15 years of annuity payments
Years 1-15: $333 taxable and $667 excludable

48

Annuity Income
(slide 5 of 6)

Example (contd)
B: Lifetime payments and taxpayer lives 18 years
Years 1-15: $333 taxable and $667 excludable
Years 16-18: $1,000 taxable each year

B: Lifetime payments and taxpayer lives 10 years

Years 1-10: $333 taxable and $667 excludable, and
$3,330 deduction on final return

49

Annuity Income
(slide 6 of 6)

The simplified method is required for annuity

distributions from a qualified retirement plan
Exclusion amount is investment in contract
divided by number of anticipated monthly
payments (table amount based on age)

50

Prizes and Awards

General rule: FMV of item is included in
income
Exceptions:
Taxpayer designates qualified organization to receive
prize or award (subject to other requirements)
Employee achievement awards of tangible personal
property made in recognition of length of service or
safety achievement (limits apply)

51

Group Term Life Insurance

Exclude premiums paid by employer on first $50,000
of coverage
Premiums on excess coverage are included in gross income
Inclusion amount based on IRS provided tables

If plan discriminates in favor of key employees (e.g.,

officers), key employees are not eligible for exclusion
In such a case, the key employees must include in gross
income the greater of:
The actual premiums paid by the employer, or
The amount calculated from the Uniform Premiums table

52

Unemployment Compensation
Unemployment compensation is taxable in full

53

Social Security Benefits

(slide 1 of 6)

Up to 85% of benefits may be taxable

Taxability based on taxpayers modified
adjusted gross income (MAGI)
MAGI = AGI (excluding Social Security) +
foreign earned income exclusion + tax exempt
interest

Two formulas for computing taxable benefits

54

Social Security Benefits

(slide 2 of 6)

Formula 1 - If MAGI plus of Social Security

benefits exceeds the base amounts below, but not the
second set of base amounts,
Include in income the lesser of:
.50 (Social Security Benefits), or
.50 [MAGI + .50 (SSB) - base amount]

Base amounts:
$32,000 MFJ,
$0 MFS and not living apart,
$25,000 for all other taxpayers
55

Social Security Benefits

(slide 3 of 6)

Formula 2 - If MAGI plus of Social Security

benefits exceeds the base amounts below
Include in income the lesser of:
.85(Social Security benefits), or
Sum of: .85[MAGI + .50(Social Security benefits) - second base
amount], and the lesser of:
Amount included through application of the first formula
$4,500 ($6,000 for married filing jointly).

Base amounts:
$44,000 MFJ,
$0 MFS and not living apart
$34,000 for all other taxpayers
56

Social Security Benefits

(slide 4 of 6)

Example of Social Security income:

A: Married with AGI = $30,000; tax exempt
interest income = $3,000; Social Security benefits
= $10,000
B: Married with AGI = $40,000; tax exempt
interest income = $6,000; Social Security benefits
= $10,000

57

Social Security Benefits

(slide 5 of 6)

Example (contd)
A: Formula 1: Lesser of:
.50 ($10,000) = $5,000, or
.50 [($30,000 + $3,000) + .50 ($10,000) - $32,000)] =
$3,000
Therefore, $3,000 of Social Security benefits included
in gross income

58

Social Security Benefits

(slide 6 of 6)

Example (contd)
B: Formula 2: Lesser of:
.85 ($10,000) = $8,500, or
Sum of
.85[($40,000 + $6,000) + .50 ($10,000) - $44,000] = $5,950,
and
Lesser of:
.50 ($10,000) = $5,000, or
$6,000

Therefore, $8,500 of Social Security benefits included

in gross income
59

Refocus On The Big Picture

Using the accrual method of accounting, Dr. Cliff
Payne has correctly calculated the gross income of his
sole proprietorship.
He will report the $385,000 amount on Schedule C of Form
1040.

What if Dr. Payne elects the cash method of

accounting? He will only report the following:
Revenues
$385,000
Plus: Accounts receivable: January 1
0
Less: Accounts receivable: December 31 (52,000)
Gross income
$333,000
60

If you have any comments or suggestions concerning this

PowerPoint Presentation for South-Western Federal
Taxation, please contact:
Dr. Donald R. Trippeer, CPA
trippedr@oneonta.edu
SUNY Oneonta

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