Economic Benefit Doctrine the What Is Taxed

Chapter 4

Gross Income

(Revised 01-11-2017)

Definition of Income

·  All income from whatever source derived, unless specifically excluded by law (IRC Sec 61(a)). This is different from either the concepts of economic or accounting income.

Economic Benefit Doctrine – “The What” is taxed

·  Taxable income may consist of cash, receivables, property, land, or any other form of economic benefit. Returns of capital are not income, therefore, are non-taxable.

Constructive Receipt Doctrine – “The When” is it taxed

·  Income is received constructively when it is made available to the recipient (or his/her agent) and he/she has no further substantial limitations or restrictions to meet in order to receive the money. This doctrine specifically applies to cash basis taxpayers.

For example: Wheat is delivered in September and the contract calls for payment:

§  Anytime - then income is included in September.

§  In January of next year - it is income in January (the farmer had a legal obligation to wait for payment).

Assignment of Income

·  Income is taxable to the person who earns the income or owns the income producing property.

·  “Fruit-of-the-tree" doctrine: You cannot attribute the fruit to a tree other than the one upon which it grows [Lucas v. Earl]. The taxpayer can give away the income, but not the tax on that income. The taxpayer must give away the income producing property to get rid of the tax on the income from the property.

Community Property Income

·  In a community property state (e.g. AZ, CA, ID, LA, NV, NM, TX, and WA) all property acquired after marriage is considered as owned by the taxpayers in community, and any income is considered joint. If separate returns are filed, each spouse takes one half of each spouse's income. To be distinguished from common law states where income is taxed to the person who earns it.

Types of Ownership Rights

·  Joint Tenancies - Property owned by joint tenants with rights of survivorship (JTWROS) property is owned "jointly & severally" by the joint tenants, and upon the death of one of the joint tenants automatically passes to the surviving tenant(s).

·  Tenants by the Entirety - A joint tenancy reserved for married couples.

·  Tenants in Common - Each partner owns an individual share of the property and is taxed on that share.

Types of Income

·  Sec 61(a) lists 15 specific classes of income, "among others":

-  Compensation for services

-  Gross Business Income

-  Gain derived from dealings in property (Ch 10-12)

-  Interest

-  Rents

-  Royalties

-  Dividends

-  Alimony

-  Annuities & Pensions

-  Income from life insurance & Endowment contracts

-  Income from discharge of indebtedness

-  Distributive share of Partnership income

-  Income in respect of a decedent (IRD)

-  Income from an interest in an estate or trust

·  Exempt Classes of Income

-  Capital contributions, recovery of loan principal, stock dividends, appreciation in value.

Compensation

·  Income received for personal services - sweat of the brow, regardless of the form of payment.

·  Fringe benefits may be included, as well as bonuses, tips, commissions, etc. Bartering income at fair market value (FMV) is included in gross income.

·  Compensation paid in property is included in income at fair market value (FMV) of property received.

·  It does not include "de minimis", non-monetary, fringe benefits (items of very low cost or value to the employer or employee).

·  Political Contributions received by politicians are not compensation and are not taxable if they are used for campaign type expenses.

·  Compensation by paying another's bills - income received indirectly is taxable, e.g. if you pay my bills, I'm better off, so it is income to me.

Compensation v. Gift

·  Determined based on all “facts and circumstances".

·  Was intent to compensate for past services, or out of the goodness of the donor's heart?

o  Duberstein Gift? Must be “detached and disinterested generosity”

Other Types of Gross Income

·  Jury duty payments.

·  Board of Directors payments.

·  Prizes and awards (at FMV). Prizes such as the Pulitzer or Nobel are taxable unless assigned to a government agency or tax-exempt charity.

·  Employee achievement awards unless conforming to certain restrictions ($400/$1,600 for non-qualified or qualified plan awards

·  Scholarships and Fellowships unless received by a degree candidate at an educational institution for tuition and course related expenses, not for room and board, etc.

·  Compensation of government civilian employees.

·  Compensation for members of the armed forces is generally fully taxable; however certain allowances are tax exempt (e.g. housing allowances). Combat pay is generally tax exempt. Retirement pay is usually taxable, except for veteran's disability payments.

·  Insurance & Damages

o  Compensatory damages are non-taxable if reimbursement is for damages, but not for loss of income.

o  Personal injury damages are non-taxable.

o  Libel damages are not considered by most courts to be taxable, but IRS disagrees in some (business) cases. Punitive damages are generally taxable to the recipient.

·  Unemployment compensation benefits.

·  Proportionate share of the firm’s income, whether or not distributed, by partnership or S-Corporation shareholders.

·  Gambling winnings are fully taxable; losses are deductible only as an itemized deduction (NOT subject to 2% of AGI).

·  Gains from illegal activities are fully taxable.

Business Income

·  Gross Income derived from business is total sales less cost of goods sold, plus income from investments and other incidental income.

· 

Interest

·  Interest received or credited is included in gross income, unless specifically exempt, e.g. municipal income.

·  The taxpayer may elect to report US Savings Bond interest annually or at maturity. All bonds must be treated in the same manner.

·  Below-Market interest loan rules usually apply if the loan amount exceeds $10,000. If applicable, interest is imputed at IRS announced rates.

·  Interest resulting from the sale of bonds between interest dates is includible as gross income.

Rent and Royalty Income

·  Amounts received in payment for the use of property are included in income.

·  Cancellation of a lease payment is a substitute for rent.

·  Advance rents are income in the year received as a claim of right, but not security deposits.

·  Expenses of landlord (e.g. taxes) paid by the tenant are income to landlord (forgiveness of debt).

·  Capital improvements to the landlord’s property by the tenant are not taxable, but they do not increase the landlord’s basis which results in a higher gain to the landlord upon sale of the property.

·  Tenant paid repairs, etc. in lieu of rent are rental income to the landlord at FMV.

Dividend Income

·  Any distribution of property made by a corporation to its shareholders out of earnings and profits, as approved by the board of directors.

·  Is included in income unless it is a liquidating dividend, which could result in a capital gain or loss to the shareholder.

·  It does not matter what form the dividend is paid, e.g. property or cash, but dividends paid in the stock of the corporation paying the dividend are non-taxable. The basis of the stock price is adjusted by the value of the stock dividend.

·  The dividend is considered income on the date of distribution, not declaration.

·  Mutual funds payments are reported as ordinary dividends, capital gain distributions, and returns of capital as appropriate.

·  Dividends (not interest) on life insurance policies and annuity contracts are excluded from gross income and are considered as a reduction in the cost of the policy, unless the dividends exceed the net premiums paid.

Alimony (Always a confusing issue!)

Qualifying alimony is taxable to the recipient and deductible by the payer.

·  Pre-1985 Instruments will recognize income if:

o  Payments are required under the decree/separate maintenance agreement.

o  Payments must be to discharge the legal obligation of support.

o  Payments must be periodic.

o  Payments must not be for child support.

·  Post-1984 Instruments Payments are income if:

o  Payments must be made in cash.

o  Payments must be made under divorce or separation instrument.

o  Parties must live in separate households after decree is entered.

o  Alimony must end at the payee’s death.

o  Parties may not file a joint tax return.

·  Alimony recapture rules may apply – see text.

·  Qualifying transfer of property between spouses will result in no gain or loss to either party, and carryover basis rules apply.

·  Child Support is NOT taxable, nor deductible by the respective parties (SSN required).

·  The custodial parent is entitled to an exemption for a dependent child after 1984 unless the right to claim is the exemption is expressly waived, without regard to which parent actually furnished support for the child. Even if the custodial parent transfers the exemption to the non-custodial parent, the custodial parent is still eligible for Head of Household filing status, as well as the earned income, child and dependent care credits.

Discharge of Debt

·  A discharge or cancellation or forgiveness of a debt, where a debt is cancelled for consideration, is taxable income. A gratuitous cancellation of debt may qualify as a gift, and may not be includible as gross income – facts and circumstances determine taxability. Exclusions may apply to the cancellation of some student loans.

·  Mortgage Forgiveness Debt Relief Act of 2007 (up to $2M - through 2016 for principal residence only. Extended????).

Stock Option Plans

·  Stock option plans are used by employers to reward employees as additional compensation.

·  There are many IRC provisions which must be followed to insure that the various type plans are properly established, administered and reported.

·  Vesting requirements, substantial risk of forfeiture, qualified vs. non-qualified plans, incentive options and stock purchase plans are discussed in the text.

·  The key issue related to stock option plans is when income is recognized, and how it is taxed: as ordinary income or long-term capital gain.