Chapter 4: Gross Income From Personal & Investment Activities Flashcards
Taxable Year
- generally a 12 month period
- calander year used by most taxpayers
- fiscal year can be elected if adequate records are maintained
- 52-53 week year
- ends on specified day of week of last month of tax year
methods of accounting
cash basis
- recognize income when its received or set aside. (wait until the check is received)
- recognid deductions when they pay the bill
- utilized by individuals and some businesses
methods of accounting
accrual basis
- recognize income when it is earned but not yet received
- most businesses use accrual method
- businesses with less than 29million a year in the last 3 years dont have to use accrual, can use cash method
methods of accounting
hybrid method
- used when inventory is a material incoem producing factor
Realization vs Recognition
realization
occurs when income is received or when a gain on a property trtansaction becomes fixed
realization vs recognition
recognition
occurs when the income is reported on the tax return
realized gains
all realized gains are recognized, unless an exception applies
recognition of income
follows realization principal from accounting
income is recognized (taxed) when realized unless an exception applies
recognition of income
generally, any accretion to wealth is income
- mere appreciation in wealth (economic income) that is not fixed and measurable at a particular point in time is not considered realized income
- Congress has excluded certain accretions of wealth from the definition of income for tax purposes
recognition of income
income is recognized if received:
- received in cash
- in kind (property or services)
- barter services
- income does not include recovery of capital investment (capital recovery doctrine)
sources of income
Investment Income
- doctrine of the fruit & the tree
- income taxed to the owner
- whoever ownd the bond owns the interest income from the bond
- whoever owns the stock owns the income from the dividends
sources of income
employment income
- doctrine of the fruit & the tree
- income taxed to earner
- income may not all be going to the earners pocket, but the earner is getting taxed on it all
- self-employment income
- wages
sources of income
income from personal activities
- alimony (pre 2019 divorce)
income tax & community property
income tax & community property
- half of the income earned belongs to each spouse
- same impact as married filing jointly (MFJ) for income tax
- married filed separately (MFS)
- community property income split equally
- poses a problem if spouses are not cooperating
income from investing activities
income from investment activities
- capital gains
- interest
- original issue discount
- dividend income
- rental and royalty income
- annuity distributions
- income from life insurance and endowment contracts
- traditional IRA’s
- income from partnerships, S-Corps, & LLC’s
- income from Trusts & Estates
income from investment activities
Capital gains exceptions
cap gains tax rate
- collectibles: tax rate of 28% + 3.8%
- Unrecaptured Section 1250 gain: 25% +3.8%
dont forget to tack on the additional 3.8% Medicare tax imposed by the Affordable Care Act
income from investment activities
effective rate may be more than maximum
cap gains tax rate
- capital gains increase a taxpayers AGI
- increased AGI may lead to phaseouts
income from investment activities
Original Issue Discount (OID)
- doctrine of constructive receipt
- taxpayer recognizes imputed interest each year. as interest is recognized:
- OID is amortized (reduced by the amount recognized)
- the taxpayers basis increases (by the amo=unt recognized)
income from investment activities
Original Issue Discount (OID) equation
- OID = Maturity value - purchase price
income from investment activities
Original Issue Discount Exceptions
- series E & EE savings bonds
- or any government bonds that have a maturity less than 1 year
phantom income
- didnt actually receive the cash but have to pay tax on income
income tax issues
income tax issues associated with gifts of debt instruments
- donee and donor report interest income based on # of days the instrument was held, regardless of who receives the payment
- there may also be gift, estate & generation-skipping transfer tax consequences
income from investment activities
Dividends
- distribution of earnings by corporations
- taxable to shareholders to extent of earnings
- if distribution exceeds earnings, its taxed:
- first as a return of basis
- then as capital
- if distribution exceeds earnings, its taxed:
- qualified dividends
income from investing activities
qualified dividends
- tax rates
- follow the capital gains rate table
- paid by the US corporation or qualified foreign corporation
- shareholder must meet holding period requirement
dont forget the 3.8% medicar tax imposed by the Affordable Care Act
annuity taxation
annuity
is a tax favored investment
annuity taxation
annuity taxation
- for annuity starting dates after 12/31/1986
- total exlcusion cannot ecveed investment in the contract
- un-recovered iinvestment is taken as a deduction on the annuitants final income tax return
annuity taxation
exclusion ratio
= (investment in the contract/expected return) x distribution received
annuity taxation
annuity taxation
- withdrawls before age 59.5 are also subject to a 10% early distribution penalty
- exceptions: dealth & disability
- distributions prior to annuitization are taxed on LIFO basis
income taxation & life insurance
Endowment contracts
payout before dealth = taxable income
- if we have a cash basis policy and taking distributions as the decedent, before they die, they are taking the distributions out…this is taxable income
income taxation & life insurance
surrender
amount realized - basis = taxable income
- say the cash value (amount realized was 90,000 but they paid 60,000 in premiums) = 30,000 in taxable income theyd want now instead of waiting for say a 500k death benefit when they die
income taxation & life insurance
death benefit (excluded from income) (see exclusions)
if the decedent dies
- ## unless transfer for value rule applies
the death benefit for this beneficiary, the spouse when they receive it, is gonna be excluded from income
income taxation & IRA’s
traditional IRA
- deduction when $ is put in, and taxed when distributed down the road
income taxation & IRA’s
Roth IRA
- no deduction when $ put in, and if you meet the conditions, then the $ comes out tax free
income taxation & IRA’s
Traditional IRA taxation
- generally the $ coming out of a TIRA is ordinary income
- not all IRA contributions are deductible
income taxation & IRA’s
traditional IRA taxation (exceptions)
return of basis
- use exclusion ratio
income taxation & IRA’s
traditional IRA taxation (penalties)
- if you take out distributions too early (early distribution penalty before age of 59.5): its a 10% penalty
- if you contribute too much (excess contribution penalty): 6% penalty
- take distrubutions out too late (starty at age 73) (late required distribution): 50% penalty
- Secure 2.0 Act: tax years after 12/29/22, penalty decreased from 50% to 25% (or 10% if failure corrected timely)
income taxation of business entities
pass-through entities
- partnerships
- limited liability corporations
- S-corporations
income taxation of business entities
taxation of pass through entities
- income is taxed to owners based on ownership %
- depending on the type of business, adjustments may be necessary to calculate the amount of business income subject to tax in the owner’s hands
- as inome is recognized, owner’s basis increases
5 exceptions to the Transfer-for-Value Rule
the death benefit its received income tax free by the beneficiary if the policy is transferred for valuable consideration to:
1. the insured
2. a corporation in which the insured is a shareholder
3. a partnership in which the insured is a partner
4. a partner of the insured
5. a transferee who takes the transferor’s basis
subjecting gross income to taxation: tax year & accounting method
cash receipts & disbursements method
cash method
- gross income of a cash method taxpayer is reported in the tax year in whcih cash is received or a benefit is conferred in the form of a cash equivalent
subjecting gross income to taxation: tax year & accounting method
accrual method
- gross income is normally reported when earned rather than when received
subjecting gross income to taxation: tax year & accounting method
hybrid method
- other than the cash or accrual method unless the IRS decides that it does not clearly reflect income
subjecting gross income to taxation
gains normally taxed when realized
- gains from property transactinos are normally taxed when they can be objectively determiend through a sale or exchange