Whittenburg Gerald E., Altus-Buller Martha. Income Tax Fundamentals
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Chapter 2
Gross Income
and Exclusions
LEARNING OBJECTIVES
.............................................. .........................
After completing this chapter, you should be able to:
LO 2.1 Understand and apply the definition of gross income.
LO 2.2 Determine the tax treatment of significant elements of
gross income such as interest, dividends, alimony, and
prizes.
LO 2.3 Calculate the taxable and nontaxable portions of annuity
payments.
LO 2.4 Understand the tax rules for significant exclusions from
gross income including life insurance benefits, inheritances,
scholarships, health insurance benefits, meals and lodging,
municipal bond interest, and fringe benefits.
LO 2.5 Apply the rules governing inclusion of Social Security
payments as income.
Overview
This chapter starts with the definition of gross income. Tables 2.1 and 2.2 are lists of the
common inclusions in and exclusions from gross income. Detailed coverage is provided for
inclusions and exclusions that may present spe cific problems to taxpayers. The coverage
includes the special tax treatment for interest an d dividends, alimony, prizes and awards,
annuities, life insurance, and gifts and inheritances. Coverage of important exclusions
includes scholarships, accident and health insurance benefits, cert ain meals an d lodging,
municipal bond interest, and the special treatment of Social Security benefits. The ele-
ments of gross income discussed here represent much of what is included in the first
line of the individual tax formula.
2-1
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SECTION 2.1
THE NATURE OF GROSS INCOME
Gross income is the starting point for calculating a taxpayer’s tax liability. The tax law
states that gross income is:
...all income from whatever source derived, including (but not limited to) the follow-
ing items:
1. Compensation for services, including fees, commissions, fringe benefits, and similar items
2. Gross income derived from business
3. Gains derived from dealings in property
4. Interest
5. Rents
6. Royalties
7. Dividends
8. Alimony and separate maintenance payme nts
9. Annuities
10. Income from life insurance and endowment contracts
11. Pensions
12. Income from discharge of indebtedness
13. Distributive share of partnership gross income
14. Income in respect of a decedent
15. Income from an interest in an estate or trust
Income earned illegally from any source, including drug sales and organized
crime, is taxable. Al Capone, who headed an enormous, violent, and profitable
crime organization, eluded conviction for criminal activities until 1930 when he
was sent to prison for tax evasion.
The definition of gross income as ‘‘all income from whatever source derived’’ is per-
haps the most well-known definition in the tax law. Under this definition, unless there is an
exception in the law, the U.S. government considers all income taxable. Therefore, prizes
and awards, cash and noncash payments for goods and services, payments made in trade or
‘‘barter’’ (such as car repairs traded for tax preparation services), and illegal income not
generally reported to the IRS are all still taxable income.
Table 2.1 provides an expanded list of items that are included in gross income. When in
doubt, the general rule is that everything a taxpayer receives must be included in gross
income unless specifically excluded. Any noncash items must be included in gross income
at the fair market value of the items received.
The tax law provides that certain items of income are exempt from taxation; these items
are referred to as ‘‘exclusions.’’ The exclusions include such items as life insurance pro-
ceeds, gifts, and veterans’ benefits. A more complete list of exclusions from gross income
is provided in Table 2.2.
The IRS recently has been examining the transaction records of PayPal, the
online payment firm. The IRS suspects many taxpayers have not reported
income earned from sales on eBay. Beginning in 2011, certain larger online pay-
ment amounts must be reported to the IRS automatically.
2-2 Chapter 2
Gross Income and Exclusions
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TABLE 2.1 2010 INCLUSIONS IN GROSS INCOME
Alimony Gambling winnings
Amounts recovered after being deducted
in prior years
Group-term life insurance premium paid by
employer for coverage over $50,000
Annuities Hobby income
Awards Incentive awards
Back pay Interest income
Bargain purchase from employer Jury duty fees
Bonuses Living quarters, meals (unless furnished for
Breach of contract damages employer’s convenience, etc.)
Business income Military pay (unless combat pay)
Clergy fees and contributions Notary fees
Commissions Partnership income
Compensation for services Pensions
Contributions received by members
of the clergy
Prizes
Professional fees
Damages for nonphysical personal injury Punitive damages
Death benefits Reimbursement for moving expenses
Debts forgiven Rents
Directors’ fees Retirement pay
Dividends Rewards
Embezzled funds Royalties
Employee awards Salaries
Employee benefits (except certain fringe
benefits)
Scholarships (room and board)
Severance pay
Employee bonuses Strike and lockout benefits
Employee stock options Supplemental unemployment benefits
Estate and trust income Tips and gratuities
Farm income Travel allowances
Fees
Gains from illegal activities
Unemployment compensation
Wages
Gains from sale of property
TABLE 2.2 2010 EXCLUSIONS FROM GROSS INCOME
Accident insurance proceeds Inheritances
Annuities (to a limited extent) Life insurance proceeds
Bequests Meals and lodging (furnished for
Casualty insurance proceeds employer’s convenience, etc.)
Child support payments Military allowances
Damages for physical personal injury Minister’s dwelling rental value
or sickness allowance
Disability benefits (generally, but not always) Municipal bond interest
Federal Employees’ Compensation Act Relocation payments
payments Scholarships (tuition and books)
Gifts Social Security benefits (with limits)
Group-term life insurance premium paid by Veterans’ benefits
employer (coverage not over $50,000) Welfare payments
Health insurance proceeds Workers’ compensation
Section 2.1
The Nature of Gross Income 2-3
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SECTION 2.2 INTEREST AND DIVIDEND INCOME
Any interest or dividend income a taxpayer receives or that is credited to his or her account
is taxable income, unless it is specifically exempt from tax such as state or municipal bond
interest. If the interest or dividends total more than $1,500, the taxpayer is required to file
Schedule B of Form 1040 (or Form 1040A, Schedule 1), which lists the amounts and sour-
ces of the income.
The fair market value of gifts or services a taxpayer r eceives for making long-term
deposits or opening accounts in savings institutions is also taxable interest income. Interest
is reported in the year it is received by a cash basis taxpayer.
Taxpayers may defer reporting interest income on a bank certificate of deposit
(CD) if the CD has a maturity of 1 year or less, and there is a substantial penalty
for early withdrawal. For example, assume an investor purchases a 6-month CD
on September 1, 2010, which matures on March 1, 2011, and the bank charges
a penalty equal to 2 months of interest in the event of early withdrawal. In this
case, the 4 months of interest earned on the account during 2010 will not have
to be reported until the investor’s 2011 tax return is filed.
When a taxpayer withdraws funds early from a CD and must pay a penalty as
described above, the full amount of the interest is reported as income and the penalty
may be deducted on line 30 of Form 1040 as a deduction for adjusted gross income.
Self-Study Problem 2.1
Indicate whether each of the items listed below should be included in gross
income or excluded from gross income in 2010.
Included Excluded
1. Prizes and awards ____________ ____________
2. Embezzled funds ____________ ____________
3. Child support payments ____________ ____________
4. Alimony ____________ ____________
5. Pensions ____________ ____________
6. Inheritances ____________ ____________
7. Welfare payments ____________ ____________
8. Bequests ____________ ____________
9. Jury duty fees ____________ ____________
10. Royalties ____________ _____ _______
11. Life insurance proceeds paid at death ____________ ____________
12. Hobby income ____________ ____________
13. Rewards ____________ ____________
14. Partnershi p income ____________ ____________
15. Casualty insurance proceeds ____________ ____________
16. G.I. Bill benefits ____________ ____________
17. Scholarshi ps for room and board ____________ ____________
18. Mileage allowance ____________ ____________
19. Gifts ____________ ____________
2-4 Chapter 2
Gross Income and Exclusions
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U.S. Savings Bonds
The United States government issues three basic types of savings bonds to individuals,
Series EE Bonds, Series HH Bonds, and Series I Bonds. Series EE Bonds are issued at
a discount from their face value. These bonds increase in value over their life, and the
increase in redemption value is taxable. For example, a $100 savings bond might be issued
at $50 and be redeemable for $100 at maturity. The second type of savings bond, Series
HH Bond, is issued at face value and pays interest twice a year by check. Interest on
Series HH Bonds is reported in the year received by a cash basis taxpayer. (Note: As
of August 31, 2004, the Treasury stopped issuing Series HH bonds. HH bonds sold
before A ugust 31, 2004, may still be outstandi ng and paying interest.) Series I Bonds,
like Series EE Bonds, do not pay interest un til maturity, but earnings are adjusted for
inflation on a semiannual basis.
Cash basis taxpayers report the increase in redemption value (interest) on a Series EE
Bond or a Series I Bond using one of the following methods:
1. The interest may be reported in the year the bonds are cashed or in the year they
mature, whichever is earlier (no election is required to use this method), or
2. The taxpayer may elect to report the increase in redemption value each year.
If the taxpayer wants to change from method (1) to method (2), he or she may do so
without the permission of the IRS. In the year of change, all interest earned to date and
not previously reported must be reported on all Series EE Bonds and Series I B onds held
by the taxpayer. Once method (2) is selected, the taxpayer must continue to use it for all
Series EE Bonds currently held or acquired in the future. Taxpayers cannot change back
to meth od (1) with out permission of the IRS.
Dividends
Dividends are one type of distribution paid to a taxpayer by a corporation. Taxpayers may
receive the following types of distributions from a corporation:
1. Ordinary dividends
2. Nontaxable distributions
3. Capital gain distributions
Ordinary dividends are by far the most common type o f corporate distribution. They
are paid from the earnings and profits of the corporation.
Nontaxable distributions are a return of invested capital and are not paid from the earn-
ings and profits of the corporation. They are considered a return of the taxpayer’s invest-
ment in the corporation and are not included in the taxpayer’s income. Instead, the
taxpayer’s basis in the stock is reduced by nontaxable distributions until the basis reaches
zero.
1
After the stock has reached a zero basis, distributions that represent a return of cap-
ital are t axed as cap ital gains. Capital gain distributions are reported either on page 1 of
Form 1040 or on Schedule D.
Current Tax Rates for Dividends
The 2003 and 2006 tax acts enacte d special lower tax rates for qualifying dividends that will
‘‘sunset’’ at the end of 2010. For years, experts have argued that corporate dividends are
taxed twice, once when the corporat ion pays tax on profits, and once when the dividend
1
A taxpayer’s basis in an investment is usually the cost of the investment. The basis is used to determine the gain or loss
when the investment is sold.
Section 2.2
Interest and Dividend Income 2-5
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is received by the shareholder. To provide some tax relief for individual taxpayers who
receive corporate dividends, the tax rates on dividends are as follows:
Qualifying Dividend Rate
Ordinary Tax Bracket 2003–2007 2008–2010
10% and 15% 5% 0%
Higher brackets 15% 15%
Dividends qualifying for thi s special treatment m ust be received by an individual who
has held the stock for more than 60 days during the 120-day period beginning 60 days
before the stock’s ‘‘ex-dividend’’ date, the date the stock no longer carries the right to
receive the dividend. Dividends received which do not meet the requirements are taxed
at ordinary rates. For additional rules defining ‘‘qualified’’ divi dends, please see t he IRS
Web site or a tax service. The definition is too lengthy and complex to cover fully in
this text. Corporat ions issuing dividends and broker age companies holding stock invest-
ments for taxpayers are required to classify and report the amount of qualifying dividends
to investors.
SECTION 2.3
ALIMONY
Alimony payments are deductible by the individual making the payments, and are taxable income
to the person receiving the payments. The term alimony, for income tax purposes, includes sep-
arate maintenance payments or similar periodic payments made to a spouse or former spouse.
Payments must meet certain requirements to be considered alimony. These requirements
Self-Study Problem 2.2
Bill and Betty Brown received the following dividend and interest income
during 2010:
Bill
Received by
Betty Jointly
Dividends (all qualified for new rates):
IBM $275 $175
GM $ 450
AT&T 450 300
Interest:
Ford Bonds 425
Big Savings and Loan 2,150
U.S. Bonds 175
Nontaxable Distribution:
Western Gas & Electric 875
Totals
$725 $900 $3,650
The Browns have taxable income, including dividends and interest, of $40,000.
Complete Form 1040, Schedule B, an d the tax calculation worksheet on pages
2-7 and 2-8 for the Brown’s 2010 tax year.
2-6 Chapter 2
Gross Income and Exclusions
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Section 2.3
Alimony 2-7
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2-8 Chapter 2
Gross Income and Exclusions
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
depend on whether the divorce or separation agreement was executed before 1985 or after 1984.
The post-1984 tax rules for divorce agreements are discussed below.
For divorce agreements executed after 1984, alimony payments must meet the following
requirements:
1. The payments must be in cash and must be received by the spouse (or former
spouse).
2. The payments must be made under a decree of divorce or separate maintenance or
under a written instrument incident to the divorce.
3. The payor must have no liability to make payments for any period following the
death of the spouse receiving the payments.
4. The payments must not be designated in the written agreement as anything other
than alimony.
5. If the parties are divorced or legally separated, they must not be members of the
same household at the time the payments are made.
Disguised child support payments may not be treated as alimony. Payments contingent
on the status of a child, such as the age or marital status of the child, are not considered
alimony.
EXAMPLE Under a 2007 divorce agreement, Sam has agreed to pay his former
spouse, Silvia, $1,000 per month. The payments meet all the tests for
classification as alimony, but they will be reduced to $600 per month
when their child, in Silvia’s custody, becomes 18 years of age. In this
situation, $400 of each payment must be treated as nondeductible
child support and cannot be considered alimony. N
During a divorce, the tax impact of structuring payments as alimony rather than
as property settlement payments should be carefully considered. If one spouse is
in a lower tax bracket than the other spouse, both spouses may be better off
structuring payments made to the lower-income spouse as alimony. The tax sav-
ings to the high-income spouse will be larger than the taxes paid by the low-
income spouse. The benefit of the tax savings can then be shared with the low-
income spouse in the form of higher alimony payments, resulting in a ‘‘win–win’’
situation.
Alimony Recapture
Congress has enacted provisions to prevent ‘‘front-end loading’’ of alimony payments. The
tax law may require taxpayers paying alimony to include previ ously deducted payments in
income if the payments significantly decrease in amount during the first few years. The
rules for alimony recapture are complex and vary depending on the year the divorce decree
was granted.
Property Transfers
A spouse who transfers property in settlement of a marital obligation is not required to rec-
ognize any gain as a result of the property’s appreciation. Thus, if in a divorce settlement a
wife transfers property with a fair market value of $10,000 and a tax basis of $3,000 to her
Section 2.3
Alimony 2-9
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husband, she will not be required to rec ognize the gain of $7,000 ($10,000 $3,000).
Of course, the husband would be required to assume the wife’s tax basis ($3,000) in the
property.
Child Support
Payments made for chi ld support are not deductible by the taxpayer making them, nor are
they income to the recip ient. However, they may be an important factor in determ ining
which spouse is entitled to claim the dependency exemption for the child (see Chapter 1).
Child support payments must be up to date before any amount paid may be treated as ali-
mony. That is, if a taxpayer is obligated to pay both child support and alimony, he or she
must first meet the child support obligation before obtaining a deduction for alimony pay-
ments. Payments for child support include payments designated as such in the marital set-
tlement agreement, plus any alimony payments that are contingent upon the status of a
child.
EXAMPLE Jim is required under a 2007 divorce decree to pay $400 alimony and
$250 child support per month. Since the decree separately states that
$250 is child support, only $400 per month is deductible by Jim and
counts as income to his ex-wife. N
The IRS treats an annulled marriage as though it never existed. Therefore, the
IRS requires couples who have received an annulment to refile their tax returns
as unma rried persons for as many as 3 years back. In some cases, this can be a
very expensive procedure.
Self-Study Problem 2.3
Answer the following questions, assuming the divorce agreements were exe-
cuted after 1984.
1. A husband is required to pay his former wife $12,000 in alimony in the
current year. Since he is short of cash, he gives her an automobile worth
$12,000, which she accepts in place of the alimony. How much may the
husband de duct as alimony?
$ ____________
2. A husband is required to pay alimony of $2,000 per month to his ex-wife.
However, the alimony is reduced to $1,200 per month when their child,
who lives with his mother, becom es 18. How much of the monthly pay-
ment is alimony income to the wife?
$ ____________
3. A wife is required to transfer $100,000 worth of property to her ex-hus-
band as a property settlement. The property has a basis to the wife of
$20,000. How much taxable gain must the wife recognize on this transfer?
$ ____________
2-10 Chapter 2
Gross Income and Exclusions
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