CHAPTER 4

GROSS INCOME
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WHAT IS INCOME?

• Section 61(a) of the Internal Revenue Code defines the

term gross income as follows: Except as otherwise
provided in this subtitle, gross income means all income
from whatever source derived. (Taken straight from the
Sixteenth Amendment to the Constitution.)
• The definition makes it clear that all sources of income
are subject to tax unless the Internal Revenue Code
specifically excludes a type of income.
• Congress left it to the judicial and administrative
branches to specifically determine the meaning of
income.
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Recovery of Capital Doctrine

• The Supreme Court has held that gross income is not synonymous with gross receipts.
Rather, a taxpayer does not have income until recovering any amount of capital that
might have been invested in the item sold. This concept is known as the recovery of
capital doctrine. In its simplest application, this doctrine means that sellers can reduce
their gross receipts (selling price) by the adjusted basis of the property sold to
determine the amount of gross income.
• Example) You purchased inventory for $100 and sold it for $125. Gross income is equal
to $25.
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Economic and Accounting Concepts of Income

• Early in the development of the income tax law, a choice had to be made between two competing
models: economic income and accounting income.
1. We use the accounting income concept
2. If we were to use economic income we would need to determine what is the fairmarket value
of our assets to determine income
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Accounting Concepts of Income

• The accounting concept deals with the realization of income.
• Realization also means that there must be a transaction for income to exist.
a. A homeowner does not report income for the rental value of the home, though if the home
was rented, rental income would be reported.
b. No tax is due on the value of vegetables grown and consumed by the taxpayer. However, if
those vegetables were sold, the proceeds would be included in gross income.
c. On the other hand, under the economist’s approach, the increase in value would be taxed as
it occurs and the tax would be payable whether or not the asset was sold.
• The primary reasons for the realization requirement are that it serves administrative convenience
and the wherewithal to pay concept.
• The realization requirement provides an incentive for holding assets that have appreciated.
1. Because, if the asset is sold, a tax usually is due.
• Thus, for example, the realization requirement favors investments in appreciating land rather than in
interest paying accounts.
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REALIZATION
The realization test is satisfied when:
• The taxpayer has completed a transaction with another party, and
• The transaction results in a significant change in the taxpayer’s property rights.
• Example: Ted is a secondary school teacher. Instead of teaching summer school, he built a log
cabin for his personal use. The cost of the land, materials, and labor Ted purchased from
others was $40,000. The fair market value of the completed cabin was $60,000. He
experienced an increase in wealth of $20,000 ($60,000 fair market value – $40,000 cost)
because of the time and effort he devoted to constructing his cabin. However, Ted has no
gross income because the realization requirement has not been satisfied. That is, Ted did not
receive anything from another entity. His efforts were expended on his property which he still
retained at the end of the year.
• The following year, Ted sold the cabin to Sally for $65,000. He realized a $25,000 ($65,000 –
$40,000) gain from the sale of the cabin because his property rights were substantially
changed (he received cash for real estate) as a result of the transaction with Sally.
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REALIZATION
• Realization does not require the receipt of cash.
• Gross income:
a. Includes income realized in any form (money, property, or services).
b. Can be realized/recognized as services, meals, accommodations, stock, or
property.
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EXAMPLES OF INCOME?

• Income is realized value that increases your net worth UNLESS it is specifically excluded by law:
• Wages
• Interest
• Dividends
• Gains on sale of assets (stock, bonds, personal assets, business assets, other)
• Share of income from businesses (Rental Income, Sole proprietorships, S Corps, Partnerships (LLCs, Farm Income)
• Income from trusts and estates
• Found money
• Goods received for services
• Embezzled funds
• Employee awards
• Gains from ilegal activities
• Gambling winnings
• Punitive damages
• Judicial awards that replace wages
• Rewards
• Royalties
• Severance Pay
• Unemployment Benefits
• Alimony (pre-2019 divorces)
• Social Security Benefits (Partial recognition may apply)
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TIMING OF INCOME RECOGNITION
Taxable Year
• In determining a person’s tax liability, it is important that the income be recognized in the correct tax year.
• The annual accounting period, or taxable year, is a basic component of the U.S. tax system.
1. Generally, an entity must use the calendar year to report its income.
2. A fiscal year (a period of 12 months ending on the last day of any month other than December) can be selected if the
taxpayer maintains adequate records. Generally, the fiscal year option is not available to partnerships, S corporations,
and personal service corporations.
Accounting Methods
• The year an item of income is recognized often depends upon which accounting method the taxpayer regularly uses.
1. The taxpayer may elect to use the cash receipts method or the accrual method of accounting.
2. Taxpayers may also use a hybrid method that is a combination of the cash and accrual methods of accounting (e.g., the
accrual method for sales and cost of goods sold and the cash method for all other items of income and expenses).
3. Once a method is elected, a change can be made only if the IRS grants approval.
4. Most individuals use the cash method. However, if the individual’s trade or business requires inventories, the accrual
method must be used to account for sales and cost of goods sold (any inventory-related amounts).
5. The taxpayer may choose to spread the gain from a sale of property over the collection period by using the installment
method of income recognition.
6. In reality no one uses a true cash method or true accrual method. We all use some sort of hybrid method. For tax
purposes the words cash or accrual don’t match exactly the accounting definition (GAAP definition).
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CASH RECEIPTS METHOD
• Under the cash receipts method, income is recognized in the year of actual or constructive
receipt by the taxpayer or the taxpayer’s agent, regardless of whether the income was earned
in that year.
1. The taxpayer need not receive cash to be required to recognize income.
2. The receipt of anything with a fair market value, or a cash equivalent, is taxable. The
major exception is for accounts receivable. A long line of cases holds that a mere
receivable, not evidenced by a note, does not have a market value.
3. Generally, a check is considered a cash equivalent and must be recognized as income
by a cash basis taxpayer. Not cashing a check does not keep a taxpayer from having to
recognize income.
• Example (A taxpayer receives a check on 12/26/2020 but doesn’t deposit the money
until January 1, 2021. The income is recognized on 12/26/2020.
4. Because a taxpayer can have some control over when income is recognized, such as by
delaying the sending of invoices to customers, not all businesses are permitted to use
the cash receipts method. Most corporations with average annual gross receipts
greater than $26 million over the preceding three-year period must use the accrual
method.
5. Income received by the taxpayer’s agent is considered to be received by the taxpayer.
6. If a taxpayer could have received money on 12/28/2020 but he/she refuses to accept
the money until January 3, 2021, from a tax standpoint the income was received on
12/28/2020.
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Special Rules Applicable to Cash Basis Taxpayers
• Constructive Receipt. Determining whether income is constructively received (set aside or otherwise made available to the
taxpayer) depends on the facts and circumstances.
1. Income is constructively received if the amount is made readily available to the taxpayer and not subject
to substantial limitations or restrictions.
2. The purpose of the constructive receipt doctrine is to prevent a cash basis taxpayer from deferring the
recognition of income that, although not yet received, has been made practically available to the taxpayer.
• Original Issue Discount. The difference between the amount due at maturity and the amount of the original loan is actually
interest but is referred to as original issue discount (OID). Under the OID rules, the cash basis taxpayer is taxed the same as
an accrual basis taxpayer.
1. Example) A taxpayer purchases a Bond for $900 which matures in 2 years and when it matures the
taxpayer receives $1,000. The difference of $100 is referred to as OID and it is taxed as it is earned as
interest income.
2. U.S. savings bonds are exempted from the OID rules.
3. OID rules do not apply to obligations with a maturity date of one year or less from the date of issue.
• Series E and Series EE Bonds. Certain government savings bonds (Series E and EE) are issued at a discount and are
redeemable for fixed amounts that increase at stated intervals. The income from these bonds generally is deferred until the
bonds are redeemed or mature. A cash basis taxpayer can elect to include in gross income the annual increment in
redemption value.
• Amounts Received under an Obligation to Repay. The receipt of loan proceeds is not a taxable event because the taxpayer’s
net worth is not increased. In Comm. v. Indianapolis Power & Light Co. [90–1 USTC ¶ 50,007, 65 AFTR2d 90–394, 110 S.Ct. 589
(USSC, 1990)], the Supreme Court found that customer utilities deposits more nearly resembled a loan than a prepayment of
income. Therefore, the utility was not required to recognize as prepaid income the receipt of the customer deposit. No
income was realized until the deposit was forfeited by the customer.
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Accrual Method
• Income is recognized when all the events that determine the taxpayer’s rights to
receive income have occurred and the amount of the income can be determined
with reasonable accuracy.
1. When the rights to the income are fixed but the income may be refunded if a subsequent
event occurs (e.g., a warranty claim), the income must be reported when the rights are first
created. The refund will result in a deduction for the taxpayer when the customer’s rights
to the refund accrue.
a. Under GAAP, a deduction would be taken for potential warranty claims.
2. The amount of the income is the amount the taxpayer has the right to receive regardless of
the value of the receivable.
a. Under GAAP, an allowance for bad receivables would be established.
3. Amounts received before the all events test is satisfied are often taxed at the time of
receipt.
4. If there is a dispute, and payment is received before the dispute is settled, a claim of right
doctrine requires the taxpayer to recognize the income in the year of receipt.
a. This doctrine states that the taxpayer has to report the income during the period
she had control of it.
b. Under GAAP a liability would be established for the receipt of the payment.
5. Income received by the taxpayer’s agent is considered to be received by the taxpayer.
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Exceptions Applicable to Accrual Basis Taxpayers
• Unearned Income. For financial reporting purposes, advance payments received
from customers are reflected in the financial statements of the seller as a liability
and recognized as income over the period in which the income is earned.
1. For tax purposes, unearned income generally is taxed in the year of receipt.
• An accrual basis taxpayer who receives advance payments may elect to include in
gross income in the year of receipt only the amounts that would be recognized as
income in the financial statements with the remaining amount recognized in the
subsequent year. See Reg. § 1.451–5(b).
• The special deferral method will result in differences in the timing of the reporting
of revenue when financial reporting rules require the revenue to be reported over
three or more years.
• The special election is available for advance payments for goods and services.
• It is not available, however, for unearned rent, interest, insurance premiums, and
certain other advance payments. Advance payments for these items are taxed in
the year of receipt.
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Hybrid Method
• This accounting method is a combination of the accrual
method and the cash method. Generally, a taxpayer using the
hybrid method is in the business of buying and selling
inventory but is not otherwise required to use the accrual
method. The accrual method can be used for determining
sales and cost of goods sold, and the cash method for all
other income and expense items.
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GENERAL SOURCES OF INCOME AND TO WHOM THEY ARE TAXED
• Personal Services
1. Income from personal services must be included in gross income of the
person who performs the services (called the fruit and tree doctrine: income
from services). Income from services (the fruit) is generally taxed to the
person who provides the services (the tree). A mere assignment of income
does not shift the liability for the tax.
Example: Alice contracts to provide architectural services to a client for $100. She
performs the services and instructs the client to pay the $100 to Diane, her
daughter. The $100 received by Diane is included in Alice’s gross income.
• Services of an Employee
1. Services performed by an employee for the employer’s customers or clients
are considered performed by the employer and therefore taxed as income to
the employer and compensation to the employee.
• Services of a Child
1. The Code specifically provides that amounts earned from personal services
must be included in the child’s gross income.
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GENERAL SOURCES OF INCOME AND TO WHOM THEY ARE TAXED
Income from Property
• The fruit and tree metaphor is used to determine who should be taxed on income from property. The income from
property is generally taxed to the owner of the property (the owner of the tree).
• Interest.
1. Interest is considered to accrue daily. Therefore, the interest on an obligation for the period that includes a transfer of ownership is
allocated between the transferor and transferee based on the number of days during the period that each owned the obligation.
• If the transfer is a sale, then the transferor must recognize the accrued income at the time of the sale.
• Dividends. A corporation is taxed on its earnings, with those earnings taxed again as dividends when distributed to
shareholders. Therefore, corporate earnings distributed as dividends are subject to double taxation.
• Partial relief from double taxation is provided by taxing qualified dividends received by individuals at the same rate as
capital gains.
1. Depending on the individual’s taxable income, capital gain tax rates of 0%, 15%, and 20% apply.
2. There is a holding period for the special rates to apply: the stock must be held for more than 60 days during the 121-day period
beginning 60 days before the ex-dividend date.
3. Qualified dividends are not included as capital gains in the gains and losses netting process; therefore, they are not reduced by
capital losses.
4. Corporations are permitted a dividend received deduction ranging from 50% to 100% of the dividends received from another
domestic corporation
5. Dividends do not accrue on a daily basis.
• If a donor makes a gift of stock to someone after the declaration date but before the record date, the Tax Court has held
that the donor does not shift the dividend income to the donee.
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GENERAL SOURCES OF INCOME AND TO WHOM THEY ARE TAXED
Income from Partnerships, S Corporations, Trusts, and Estates
• Partnerships and S corporations are conduits and typically serve as tax
reporters rather than as taxpayers.
• The income of the partnership is taxed at the partner level rather than at the
partnership level.
1. The partnership files an informational return (Form 1065).
• A small business corporation may elect to be taxed similarly to a partnership
(i.e., as an S corporation).
• The S corporation files its tax return on Form 1120S.
• In a few limited circumstances, however, tax is levied at the S corporation level (beyond
the scope of this class).
• The beneficiaries of estates and trusts generally are taxed on the income
earned by the estates or trusts that is actually distributed or required to be
distributed. Any income not taxed to the beneficiaries is taxable to the estate
or trust.
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Income in Community Property States
• General. The basic difference between common law and community
property systems centers on the property rights of married persons.
1. Community property is a system where one-half of the income earned by a spouse is deemed
earned by the other spouse and one-half of the income from property accumulated during the
marriage is deemed earned by each spouse.
2. The community property states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico,
Texas, Washington, and Wisconsin. In Alaska, spouses can choose to have the community
property rules apply.
3. The laws of Idaho, Louisiana, Texas, and Wisconsin distinguish between separate property and
the income it produces.
a. In these states, the income from separate property belongs to the community and is
taxed accordingly.
b. In the remaining community property states, separate property produces separate
income that the owner-spouse must report on his or her Federal income tax return.
4. The general rules for allocating income to the members of the community are not followed on
the income from personal services in the case of spouses who
(a) live apart for the entire year,
(b) do not file a joint return with each other, and
(c) have no earned income transferred between them. A spouse (or former spouse) is taxed
only on his or her actual earnings from personal services.
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Alimony and Separate Maintenance Payments
When a married couple divorce or become legally separated, one spouse may have a legal obligation to support
the other spouse. The Code distinguishes between the support payments (alimony or separate maintenance) and
the property division in terms of the tax consequences.
• Alimony and separate maintenance payments made under a divorce agreement executed after 2018 are neither
taxable to the recipient nor deductible by the payor. Payment made under an agreement entered into before
December 31, 2018, are includible in the gross income of the party receiving the payments and deductible by
the party making the payments.
• For payments related to pre-2019 agreements, income is shifted from the income earner to the income
beneficiary.
• What is Alimony? Payments made under pre-2019 agreements and decrees are classified as alimony only if the
following conditions are satisfied.
a. The payments are in cash.
b. The agreement (or court order) does not specify that the payments are not alimony.
c. The spouses must be living apart (i.e., not members of the same household) at the time the payments
are made.
d. The payments must cease upon the death of the payee.
• Front-Loading. Front loading refers to paying a large amount of alimony in the first two years. If the payments
are excessively front-loaded, you must recapture in the third year some of the deductions you claimed in the
first two years. There’s a 17 step formula to calculate recapture.
• Note that there is no recapture after three years of payments.
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Alimony and Separate Maintenance Payments

• Property Settlements. A transfer of property other than cash to a former spouse
under a divorce decree or agreement is not a taxable event.
• The transferor is not entitled to a deduction and does not recognize gain or
loss on the transfer.
• The transferee does not recognize income and has a basis equal to the
transferor’s basis.
• Child Support. Child support payments to the custodial spouse are not deductible
by the payor because the payments merely satisfy a legal obligation that would
exist regardless of whether the spouses were divorced. Likewise, such payments
are not included in the gross income of the custodial spouse.
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Imputed Interest on Below-Market Loans
• The reason for imputing interest on below-market loans is to prevent income shifting.
Imputed interest is calculated using the rate the Federal government pays on new
borrowings, compounded semiannually. This Federal rate is adjusted monthly. There are
three Federal rates: short-term (not over three years), mid-term (over three years but not
over nine years), and long-term (over nine years).
• Gift loans. Some times, gifts are really loans. In those circumstances, gift loans result in
income to the donor and interest expense for the donee. However, the interest may be
nondeductible, and the net effect of the scheme may be to create income.
• Compensation-related loans. Employer-employee loans create offsetting income and
deductions for the employer, income for the employee, and interest expense that may not
be deductible by the employee. Large corporations often offer low-interest rate loans to
relocated employees to assist in the purchase of a residence. In these cases, any imputed
interest (i.e., qualified residence interest) will be deductible by the employee (as an itemized
deduction) offsetting the imputed compensation income.
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Imputed Interest on Below-Market Loans
• Corporation-shareholder loans. Corporation-shareholder loans create income for the corporation and
the shareholder, and interest expense that may not be deductible by the shareholder. Or the loan can be
re-characterized as a dividend to the shareholder.
Exceptions and Limitations.
• A $10,000 loan per donee exception can frequently be applied to gift loans. However, the exception does not
apply if the funds are used to purchase income-producing property. (See Concept Summary 4.4 in the text.)
• As with gift loans, there is a $10,000 exemption for compensation-related loans and corporation-shareholder
loans. However, this exemption does not apply if tax avoidance is one of the principal purposes of the loan.
• On loans of $100,000 or less between individuals, the ceiling on imputed interest is the borrower’s net
investment income for the year.
1. Thus, if there is no net investment income, then there is no imputed interest.
2. In addition, if the borrower’s net investment income does not exceed $1,000, no interest will be
imputed on the loan.
3. However, these ceilings on imputed interest do not apply if a principal purpose of the loan is tax
avoidance.
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Prizes and Awards
• The general rule is that the fair market value of prizes and awards is includible in the taxpayer’s gross income.
• Exception for scholarship. An exclusion is provided for certain scholarships.
• Limited exception for employee achievement awards. A limited amount can be excluded from gross income for
certain employee achievement awards in the form of tangible personal property (e.g., a gold watch).
1. The award must be made in recognition of length of service or safety achievement.
2. Generally, the ceiling on the excluded amount is $400.
3. However, if the award is made as part of a tax qualified plan, the ceiling on the exclusion is $1,600.
• A narrow exception permits a prize or an award to be excluded from gross income if all of the following requirements
are met.
1. The prize or award is received in recognition of religious, charitable, scientific, educational, artistic, literary, or civic
achievement.
2. The recipient transfers the prize or award to a qualified governmental unit or nonprofit organization.
3. The recipient was selected without any action on his or her part to enter the contest or proceeding (Example – Nobel Prize)
4. The recipient is not required to render substantial future services as a condition for receiving the prize or award.
• A final exception allows certain participants in the Olympic and Paralympic Games to exclude the value of any medal
and cash award received (for those with adjusted gross income of $1 million or less). The rationale offered for this
tax preference is that the athletes “perform a valuable patriotic service.”
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Unemployment Compensation
• Current law provides that unemployment compensation benefits are includible in gross income.
Social Security Benefits
• The amount of Social Security benefits included in a taxpayer’s gross income is based on two factors: (1) the taxpayer’s
ability to pay and (2) the amount of benefits considered to be a recovery of the taxpayer’s contributions, or a recovery
of capital.
1. Modified adjusted gross income (MAGI) is equal to the taxpayer’s adjusted gross income from all sources other
than Social Security benefits increased by the foreign earned income exclusion and any tax-exempt income.
2. If a taxpayer’s MAGI plus 50% of his or her Social Security benefits, often referred to as provisional income,
does not exceed a threshold amount ($32,000 for married taxpayers filing a joint return or $25,000 for single
taxpayers), the taxpayer need not include any Social Security benefits in gross income.
3. If provisional income exceeds this threshold, the taxpayer must include a portion of the Social Security benefits
in gross income, determined as follows.
a. The amount included in gross income is equal to 50% of the amount by which the provisional income
exceeds the threshold, limited to 50% of the benefits themselves.
4. If the taxpayer’s provisional income also exceeds a second threshold ($44,000 for a married couple filing a
joint return or $34,000 for a single taxpayer), the amount included in gross income is equal to 85% of the
amount that provisional income exceeds the higher threshold, plus the smaller of the following.
a. The amount determined in (3) above, or
b. 50% of the difference between the two threshold amounts (i.e., $6,000 for a married taxpayer filing
jointly or $4,500 for a single taxpayer).
5. The total amount included in gross income is limited to 85% of the benefits themselves.
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WHAT IS NOT INCOME?

• EXHIBIT 3.1 Partial List of Exclusions from Gross Income

Accident insurance proceeds (unless the insurance pays Life insurance paid upon death
more than the loss) Meals and lodging (if furnished for employer’s
Alimony (divorces after 2018) convenience)
Property Settlements between divorced tax payers Military allowances
Annuities (cost element) Minister’s dwelling rental value allowance
Bequests Railroad retirement benefits (to a limited
Child support payments extent)
Cost-of-living allowance (for military) Scholarship grants (to a limited extent)
Damages for personal injury or sickness Social Security benefits (to a limited extent)
Disability Benefits Veterans’ benefits
Gifts received Welfare payments
Group term life insurance, premium paid by employer (for Workers’ compensation benefits
coverage up to $50,000)
Inheritances
Interest from state and local (i.e., municipal) bonds *Federally issued bonds are taxable by the Federal Government