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GROSS INCOME: INCLUSIONS

After reviewing this chapter, you should be able to: 1. Define income and recognize items included in income 2. Explain the principles used to determine who is taxed on a particular item of income 3. Apply the rules of Sec. 61(a) to determine whether items such as compensation, dividends, alimony, and pensions are taxable Reference Materials: IRS Publication 17Your Federal Income Tax (2006) IRS Publication 525Taxable and Nontaxable Income (2006) Section 61(a) of the Internal Revenue Code offers the following definition and listing of income items. General DefinitionExcept as otherwise provided for in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items: 1. Compensation for services, including fees, commissions, fringe benefits, and similar items- is payment for personal services. It includes salaries, wages, fees, commissions, tips, bonuses, and specialized forms of compensation such as directors fees, jury fees, and marriage fees received by clergymen (Pub. 525, page 13). What the compensation is called, how it is computed, the form and frequency of payment, and whether the compensation is subject to withholding is of little or no significance. The fact that services are part-time, one-time, seasonal, or temporary is immaterial. There are
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exclusions, however, for a variety of employer-provided fringe benefits such as group term life insurance premiums, health and accident insurance premiums, employee discounts, contributions to retirement plans, and free parking. There is also a limited exclusion applicable to foreign-earned income. 2. Gross income derived from business- usually refers to the total amount received from a particular source. In the case of businesses that provide services, the gross business income is the total amount of services billed. In the case of manufacturing, merchandising, and mining, gross income is total sales less the cost of goods sold. The cost of goods sold is, in effect, treated as a return of capital. It is a well-established tax concept that a return of capital is not income and, therefore, cannot be subject to income tax. 3. Gains derived from dealings in property- realized from property transactions are included in gross income unless a nonrecognition rule applies. Taxpayers may deduct the cost of property in order to arrive at the gain from a property transaction. The tax law contains over 30 nonrecognition rules, which allow taxpayers to postpone the recognition of gains and losses from certain types of property transactions. In some instances, these rules allow taxpayers to permanently exclude gains from gross income. Losses are not offset against gains in computing gross income. Most losses are deductions for adjusted gross income. Net capital losses for individuals are subject to provisions that limit the amount that can be

deducted from other income to $3,000 per year (Pub. 17, page 105). Losses from the sale or disposition of an asset held for personal use are not deductible. 4. Interest- is compensation for the use of money (Pub. 17, page 52). Taxable interest includes interest on bank deposits, corporate bonds, mortgages, life insurance policies, tax refunds, most U.S. government obligations, and foreign government obligations. Since the inception of the federal income tax in 1913, interest on obligations of states, territories, and U.S. possessions and their political subdivisions has been taxexempt. Bonds issued by school districts, port authorities, toll road commissions, counties, and fire districts have also been held to be exempt. 5. Rents- or royalties are included in gross income (Pub. 525, page 14). Prepaid rent is taxable when received. Security deposits, which are refundable to tenants upon the expiration of a lease, are not included in gross income. The deposit is included in gross income only if it is forfeited at the termination of the lease. Royalties from copyrights, patents, and oil, gas, and mineral rights are all taxable as ordinary income. Royalties are proceeds paid to an owner by others who do business under some right belonging to the owner. Amounts received by a lessor to cancel, amend, or modify a lease also are taxable. Improvements made by a lessee that increase the value of leased property are included in the lessors income only if the improvements are made in lieu of paying rent or if rent is reduced because of the improvements. In such situations, the lessor must include the fair market value of the improvements in gross income when they are made to the property. Improvements not made in lieu of rent are not income to the lessor. No adjustment is made to the lessors basis in the property and, therefore, no depreciation is
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allowable 6. Royalties 7. Dividends- is a distribution by a regulated investment company (a mutual fund) of capital gains from the sales of investments in the fund (Pub. 17, page 62). These dividends also include any undistributed capital gains allocated to shareholders by investment companies. Capital gain dividends are long-term regardless of how long the shareholder has owned the stock of the regulated investment company. At times, the same individuals are both shareholders and employees. A corporation may not deduct dividends paid to shareholders but is permitted to deduct
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reasonable compensation 8. Alimony and separate maintenance payments9. 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 This definition is not all-inclusive. It does not indicate whether specific items of income such as insurance settlements, gambling winnings, or illegal income are taxable.

The phrase except as otherwise provided means that all sources of income are presumed to be taxable unless there is a specific exclusion in the income tax law. The IRS does not have to prove that an item of income is taxable; rather, the taxpayer must prove that the
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item of income is excluded. Therefore, gambling winnings and illegal income are taxable because no specific provisions in the tax law exclude these amounts from taxation. Gross income is not limited to amounts received in the form of cash. According to Reg. Sec. 1.61-1(a), income may be realized in any form, whether in money, property, or services. The important question is whether or not the taxpayer receives an economic benefit. If a taxpayer benefits from an item, it is taxable. Often an employer may make an expenditure that incidentally or indirectly benefits its employees. Examples might include the following: Security guards patrol an employers plant, protecting both the employers property and the employees. The employees receive an indirect benefit for the protection provided by the security guards. An employer requires employees to undergo an annual checkup, the cost of which is paid by the employer. An employer provides uniforms and protective clothing worn by employees while on the job. A shipping company provides sleeping accommodations to sailors while ships are at sea. A company requires certain employees to wear shoes manufactured by the company and provide regular reports on the quality of the shoes. It is well established that taxpayers may exclude indirect benefits from gross income. This rule holds that an expenditure is excludible if it is made in order to service the business needs of the employer and any benefit to the employee is secondary and incidental. This rule has evolved over time. As early as 1951, the Tax Court concluded that employees need not report income if personal wants and needs of employees are satisfied secondarily and incidentally. In 1961, an appeals court required that expenditures must serve a business purpose other than compensating an employee if a benefit is to be excluded from the employees gross income. Congress also has established rules dealing with situations where expenditures are made primarily to benefit employees. While expenditures made by employers that primarily benefit employees are generally taxable, there are instances whereby such expenditures are not taxable. These rules permit employees to exclude certain fringe benefits (such as employee discounts) from gross income (Pub. 525, page 5). Once it has been established that income is taxable, it is necessary to determine to whom it is taxable. Although such determinations are normally easy, there are
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circumstances where income is not necessarily taxed to the person who receives it. If physical receipt of income was the only test, a family might reduce or eliminate its income tax by having income paid to children and other members who are in low tax brackets or have no tax liability. In 1930, the Supreme Court held in a landmark case, Lucas v. Earl, that an individual is taxed on the earnings from his or her personal services. The Supreme Court held that a husband was taxed on the earnings from his law practice, even though he had signed a legally enforceable agreement with his wife that the earnings would be shared equally. An agreement to assign income does not permit a

person to avoid being taxed on the income. In 1940, the Supreme Court, in Helvering v. Horst, extended the assignment of income doctrine to income from property. In this case, the taxpayer detached interest coupons from bonds and gave the coupons to his son. The son collected the interest and reported it on his own return. The Supreme Court held that the taxpayer was taxed on the income because he owned the bonds. This holding leads to a basic rule that the income from property is taxed to the owner of the property. To transfer the income from property, the taxpayer must transfer ownership of the property itself. Although married couples may file joint returns today, this privilege was not available until 1948. Assignment of income can be an issue today when other individuals such as parents and children are involved, and it can still be an issue with married couples if they file separate returns. For federal income tax purposes, allocation of income between a husband and wife depends on the state of residence. Forty-two states follow a common law property system and eight states use a community property system (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, and Washington) (Pub. 17, page 6). Under common law, income is generally taxed to the individual who earns the income, either through labor or capital. In the case of a married couple, if the wife owns stock in her separate name and receives dividends from the stock, the income is taxed entirely to the wife. Generally, the only joint income in a common law state is income from jointly owned property. In community property states, income may be either separate or community. Community income is considered to belong equally to the spouses. In all community property states, the income from the personal efforts of either spouse is considered to belong equally to the spouses. Income from community property is
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considered to be community income. Couples can have separate property even in community property states. Separate property consists of all property owned prior to marriage and gifts and inheritances acquired after marriage. Whether income from separate property is community or separate depends on state law. In Idaho, Louisiana, and Texas, income from separate property is community income. In Arizona, California, Nevada, New Mexico, and Washington, income from separate property is separate income. These rules are important if couples file separate returns. The community income rules can prove to be a problem if one spouse conceals income from the other. Normally, each spouse is expected to report one-half of all community income. This treatment is inequitable if one spouse is not aware that the community income was earned. Special rules excuse an innocent spouse who fails to report community income on a separate return, provided that the spouse had no knowledge or reason to know of the item and, as a result, the inclusion of the community income would be inequitable (see Publication 555, Community Property, for more information). A corresponding provision permits the IRS to include the entire amount in the income of the other spouse. State law as discussed above determines whether a husband or wife is taxed on income. Earnings of a minor child are taxed to the child regardless of the states property laws. Earnings of a child from either personal services or from property are taxed to the child, not to the childs parents. Unearned income in excess of $1,700 of a child under the age of 18 at the close of the tax year may be taxed at the parents tax rate if it is higher than the childs rate. The parents may, however, elect to include the childs unearned income on their return (Pub. 17, page 219).

Section 61 (a) states that gross income includes, but is not limited to, fifteen specifically listed types of income. Several of these items will be discussed. Compensation Gross income Gains Interest This exclusion does not extend to interest paid on most U.S. government obligations or foreign government obligations, nor does the exclusion exempt from taxation any gains from the sale of state or local government bonds or interest on tax refunds by state and municipal governments. Taxpayers may, however, purchase and eventually redeem Series EE bonds tax-free if
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they use the proceeds to pay certain college expenses for themselves, a spouse, or dependents (Pub. 17, page 56). To qualify for the exclusion: The bonds must have been purchased after 1989 by an individual who is age 24 or older at the time of purchase. The bonds must be purchased by the owner and cannot be a gift to the owner. The receipts from the bond redemption must be used for tuition and fees, which are first reduced by tax-exempt scholarships, veterans benefits, Hope and Lifetime Learning Credits, and other similar amounts. Married couples living together must file a joint return to obtain the exclusion. The full amount of interest is excluded only if the combined amount of principal and interest received during the year does not exceed the net qualified educational expenses. If the net qualified education expenses are less than the total principal and interest, a portion of the interest is excluded on the basis of the ratio of the qualified educational expenses to the total principal and interest. The exclusion is subject to phaseout in the years in which the bonds are cashed and the tuition is paid. The exclusion is computed on Form 8815, which is filed with the annual tax return. The exclusion is not available to married taxpayers who file separate returns. . Amounts received as rents . Gain or loss is recognized only when the lessor disposes of the property. Whether the improvements are in lieu of rent depends on the intent of the parties. This determination is based on the facts of the situation. The rental rate, the terms of the rental agreement, and whether the improvements have an estimated useful life exceeding the term of the lease may all be indications of intent. Distributions to shareholders are taxable as dividends only to the extent they are made from either the corporations current earnings and profits or accumulated earnings and profits (Pub. 17, page 61). Distributions in excess of current and accumulated earnings and profits are treated as a nontaxable recovery of capital. Such distributions reduce the shareholders basis in the stock but not below zero. Distributions in excess of the basis of the stock are classified as capital gains. A stock dividend is a distribution by a corporation to its shareholders of the corporations own stock (Pub. 17, page 62). The Supreme Court has held that simple stock dividends are not to be taxed because they are not income. Income has not been realized because there is no real change in the

ownership taxpayers interest or the risks faced by the taxpayer. The exclusion of stock dividends as income has been narrowed over the years. If a shareholder has the option of receiving either cash or stock, the shareholder is taxed even if he or she opts to receive stock. The option to receive cash constitutes constructive receipt of the cash. The recipient of a taxable stock dividend must include the value of the stock received in gross income, and the amount becomes the basis of the shares received. A nontaxable stock dividend has no effect on a shareholders income in the year received. The basis of the old shares is allocated between the old shares and the new shares (see IRS Publication 550). The holding period for the new shares starts on the same date as the holding period of the old. A capital gain . Questions can be raised as to whether amounts identified as compensation are actually disguised dividends. If an amount called compensation is unreasonable, it will be disallowed. Often the reasonableness of compensation is determined by comparing the compensation paid to employee-shareholders with amounts paid to others performing similar services. Constructive dividends are not limited to shareholder-employee compensation payments but may include situations where the shareholder is also a landlord. A shareholder may also receive a constructive dividend because of a vendor or creditor relationship. It is not necessary that a dividend be formally declared or that distributions be in proportion to stock holdings. Constructive dividends are often distributions that are intended to result in a deduction to the corporation and taxable income to the shareholder. Other constructive dividends are intended to produce a nonreportable benefit to the shareholder, or even result in a deduction to the corporation without income to the shareholder. Any payment pursuant to a divorce or legal separation must be classified as alimony, child support, or a property settlement for tax purposes (Pub. 525, page 28, and Pub. 17, pages 124127). The treatment of a payment depends on its classification. Alimony is deductible by the payor spouse and taxable to the payee spouse. Neither child support payments (Pub. 17, page 85) nor property settlements have any tax ramifications, that is, they are not subject to tax to the payee spouse nor deductible to the payor spouse. The tax law has rather specific rules (Pub. 17, pages 124126) that distinguish alimony, child support, and property settlements. Under current law, in order to be treated as alimony, payments must meet all of the following requirements: Be made in cash Be made pursuant to a divorce, separation, or a written agreement between the spouses Terminate at the death of the payee Not be designated as being other than alimony (child support) Be made between people who are living in separate households A property settlement is a division of property pursuant to a divorce. In general, each spouse is entitled to the property brought into the marriage and a share of the property accumulated during marriage. A division of property does not result in any income to either spouse, nor does either spouse receive a tax deduction. The basis of
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property received by either spouse as a result of the divorce or separation remains unchanged. One unusual rule found in the current tax law that relates to alimony is the so-called recapture provision (Pub. 17, page 126). This provision was established to

prevent a large property settlement that might take place after a divorce from being treated as alimony so as to produce a deduction for the payor. In essence, the concept of recapture in connection with a divorce means that the payor of the alimony must report the recapture amount in his or her gross income in the third year following the divorce or separation. The payee receives a deduction for the recaptured amount in the same year. This recapture occurs because the payments that originally were reported as alimony are being reclassified as property settlements. Recapture occurs if payments decrease sharply in either the second or third year. Specifically, the amount of second-year alimony recaptured is equal to the second-year alimony reduced by the total of $15,000 plus the third-year alimony. The amount of first-year alimony recaptured is equal to the first-year alimony reduced by the total of $15,000 plus the average alimony paid in the second year (reduced by the recapture for that year) and the third year. Both first- and second-year amounts are recaptured by requiring the payor to report the excess as income (and allowing the payee to deduct the same amount) in the third year. Recapture is not required if payments cease because of the death of either spouse or remarriage of the recipient. An annuity is a series of regular payments that will continue for a fixed period of time or until the death of the recipient (Pub. 17, page 74). Individuals receiving an annuity are permitted to exclude their cost but are taxed on the remaining portion of the annuity. The following steps should be followed to determine the nontaxable portion of the annuity: Determine the expected return multiple. This multiple is the number of years that the annuity is expected to continue and may be a stated term or may be for the remainder of the taxpayers life. In the latter situation, the expected return multiple is determined by referring to a table developed by the IRS. Determine the expected return. This return is computed by multiplying the amount of the annual payment by the expected return multiple. Determine the exclusion ratio. This ratio is computed by dividing the investment in the contract (cost) by the expected return.
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Determine the current years exclusion. This exclusion is computed by multiplying the exclusion ratio times the amount received during the year. After the entire cost of an annuity has been recovered, the full amounts of all future payments are taxable. If an individual dies before recovering the entire cost, the remaining unrecovered cost can be deducted as an itemized deduction on that individuals final return. Insurance companies and businesses with retirement plans will often compute the taxable portion of annuities and report the amounts to recipients on Form 1099. Distributions from pensions and other qualified retirement plans are frequently paid in the form of an annuity. Both the employer and employee often contribute funds to plans during the years of employment. When an employee retires, the amounts contributed and income accumulated, thereon, become available to the retired employee. In some cases, the retired employee has the option of receiving a lump-sum payment or an annuity. The employees cost is limited to amounts contributed by the employee that

were previously taxed to the employee. The employee may recover this cost tax-free. The employees cost does not include employer contributions. A simplified method must be used to determine the taxable portion of an annuity paid from a qualified retirement plan if the annuity start date is after November 18, 1996 (Pub. 17, page 72). Many pensions contain provisions that allow taxpayers to withdraw amounts before the normal starting date. Under current law, an amount withdrawn from a pension before the starting date is considered to be partly a recovery of the employees contributions and partly a recovery of the employers contributions. After all contributions have been withdrawn, additional withdrawals are fully taxable. In addition to being subject to the regular income tax, any amount withdrawn may also be subject to a 10% nondeductible penalty (Pub. 17, page 74). The penalty is not applicable to certain taxpayers, such as one who is age 59 or older. The face amount of life insurance received because of the death of the insured is not taxable (Pub. 525, page 19). If the proceeds are left with the insurance company and as a result earn interest, the interest payments are taxable.
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The forgiveness of debt is a taxable event (Pub. 525, page 18). The person who owed the money must report the amount forgiven as income unless one of several exceptions found in the tax law applies. Certain types of entities are not subject to income taxation, as the taxable income is taxed directly to the owners of the entity rather than the entity itself. Such entities are referred to as flow-through entities. Section 61 specifically lists three instances where income flows-through the entity: the distributive share of a partnerships income, income in respect of a decedent, and income from an interest in an estate or trust. Similar treatment is accorded S corporation income. The income that is produced by the entity merely flows through to the owner or beneficiary of the entity. Prizes, awards, gambling winnings, and treasure finds are taxable. Winnings in contests, competitions, and quiz shows as well as awards from an employer to an employee in recognition of some achievement in connection with his or her employment are taxable. The amount to be included in gross income is the fair market value of the goods or services received. Total gambling winnings must be included in gross income (Pub. 17, page 87). This includes proceeds from lotteries, raffles, sweepstakes, and the like. Gambling losses (up to the amount of the current years winnings) are allowable as an itemized deduction. The Regulations state that a treasure find constitutes gross income to the extent of its value in the year in which it is reduced to undisputed possession. Income from illegal activities is taxable (Pub. 525, page 31). Some people find this part of the tax law surprising, but this fact serves as the basis for many criminal convictions, given that few criminals report their illegal income. It is not necessary to prove that an individual had illegal income but merely that the individual had income that was not reported. For many years, unemployment compensation was excluded from gross income. In 1978, Congress changed the law to tax unemployment compensation because these benefits are a substitute for taxable wages (Pub. 525, page 26). Initially, unemployment compensation was taxable only if adjusted gross income exceeded certain base amounts. However, now all unemployment compensation is fully taxable for both governmentfinanced programs and employer-financed benefits.

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Social Security benefits were excluded from gross income until 1984. Between 1984 and 1993, up to 50% of Social Security benefits were taxable. As of 1994, up to 85% of Social Security benefits may be taxable (Pub. 525, page 32).
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Under Sec. 86, the portion of Social Security benefits that are taxable depends on the taxpayers provisional income and filing status (Pub. 17, pages 76 and 77). Provisional income is computed with the following formula: Adjusted gross income (excluding Social Security) $XX,XXX Plus: Tax-exempt interest XXX Excluded foreign income XXX 50% of Social Security benefits XXX Provisional Income $XX,XXX In the case of a married person filing separately, taxable Social Security benefits are equal to the lesser of 85% of Social Security benefits or 85% of provisional income. For married couples filing jointly, the computation of the taxable portion of Social Security is as follows: If provisional income is $32,000 or less, no Social Security benefits are taxable. If provisional income is over $32,000 (but not over $44,000), taxable Social Security benefits equal the lesser of 50% of the Social Security benefits or 50% of the excess of provisional income over $32,000. If provisional income is over $44,000, taxable Social Security benefits are equal to the lesser of 85% of the Social Security benefits or 85% of provisional income over $44,000, plus the lesser of $6,000 or 50% of Social Security benefits. For single taxpayers, the computation of the taxable portion of Social Security benefits is as follows: If provisional income is $25,000 or less, no Social Security benefits are taxable. If provisional income is over $25,000 (but not over $34,000), taxable Social Security benefits are equal to the lesser of 50% of the Social Security benefits or 50% of the excess of provisional income over $25,000. If provisional income is over $34,000, taxable Social Security benefits are equal to the lesser of 85% of the Social Security benefits or 85% of provisional income over $34,000, plus the lesser of $4,500 or 50% of Social Security benefits. The result of the computation excludes from gross income the Social Security benefits received by lower-income individuals but taxes a portion (up to 85%) of the benefits received by taxpayers with higher incomes. The term Social Security refers to basic monthly retirement and disability benefits paid by the Social Security Administration and also to tier-one railroad retirement benefits. It does not include
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supplementary Medicare benefits that cover the cost of doctors services and other

medical benefits. Insurance proceeds or court awards received because of the destruction of property are included in gross income only to the extent that the proceeds exceed the adjusted basis of the property (Pub. 525, page 28). Involuntary conversion provisions permit taxpayers to avoid being taxed if they reinvest the proceeds in a qualified replacement property. If the proceeds are less than the propertys adjusted basis, they reduce the amount of any deductible loss. Proceeds of insurance guarding against loss of profits because of casualty are taxable. If a taxpayer has to sue a customer to collect income owed to the taxpayer, the amount collected is taxable just as it would have been had the taxpayer collected the income without going to court. Sec. 104(a)(2) excludes damages (other than punitive damages) received on account of personal physical injuries or sickness. Thus, amounts collected because of physical injury suffered in an automobile accident are excluded from gross income. Occasionally, a taxpayer may deduct an amount in one year but recover the amount in a subsequent year (such as state income tax withholding deducted on Schedule A as an itemized deduction) (Pub. 525, page 20). The amount recovered must be included in the gross income in the year it is recovered. Cash-basis taxpayers encounter this situation more often than accrual-basis taxpayers because their expenses are generally deductible in the year they are paid. If the amount was overpaid, the taxpayer can anticipate a refund. Any recovery of a previously deducted amount may lead to income recognition. Several rules should be noted: If the refund or other recovery occurs in the same year, the refund or recovery reduces the deduction and is not reported as income. Interest on the amount refunded is taxable and is not subject to the tax benefit rule. The character of the income reported in the year of repayment is dependent on the type of deduction previously reported. If the taxpayer deducted a short-term capital loss in one year, the subsequent recovery would be a short-term capital gain. A taxpayer who recovers an amount deducted in a previous year must report as gross income the amount recovered in the current year. The amount recovered need not be included in income, however, if the taxpayer received no tax benefit. A tax benefit
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occurs only if the deduction reduced the tax for the year. Tax benefit may be absent in other situations. A taxpayers total itemized deductions may have been less than the standard deduction, or the expense may have been less than the applicable floor. If only a portion of an expense produces a tax benefit, only that portion has to be reported as income.
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REVIEW QUESTIONS GROSS INCOME: INCLUSIONS 1. Which of the following bonds do not generate tax-exempt Federal income? a. school district bonds b. bonds issued by fire districts c. U.S. Treasury bonds d. bonds issued by port authorities 2. Jane redeemed EE bonds, which qualify for the educational exclusion. The

redemption consisted of $12,000 principal and $4,000 interest. The net qualifying educational expenses are $6,000. No reduction of the exclusion is required. The taxable interest is: a. $-0-. b. $2,500. c. $1,500. d. $6,000. 3. Tom has rented a house from Linda since last year. The rent is usually $600 per month, but Linda reduced the monthly rent down to $400 for all twelve months this year in exchange for Tom constructing an addition to the house. The addition has a fair market value of $3,300. How much total rental income must Linda report this year? a. $ 8,100 b. $10,500 c. $ 7,200 d. $ 7,600 4. Mrs. Lee purchased stock in Jones Corporation two years ago for $2,000. Last year, she received a distribution of $800, when Jones had no current or accumulated earnings or profits. This year, Mrs. Lee received a $200 dividend, when Jones had earnings and profits in excess of its distribution. There has been no other activity related to this stock. What is Mrs. Lees taxable dividend income for last year and this year, and what is her basis in the Jones Corporation stock as of December 31, this year? a. $-0-, last years income; $200, this years income; $2,000, this years basis b. $800, last years income; $200, this years income; $1,200, this years basis c. $800, last years income; $-0-, this years income; $2,000, this years basis d. $-0-, last years income; $200, this years income; $1,200, this years basis
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5. Sergio bought stock in Kat Corporation for $2,000 ten years ago. Sergio received a distribution of $600 in a year when Kat Corporation had no current or accumulated earnings or profits. Sergio sold his Kat Corporation stock this year for $4,500. What is the amount of long-term capital gain to be reported by Sergio? a. $4,500 b. $3,100 c. $2,500 d. $-06. George is the sole shareholder of Ho-Ho Corporation. The basis of his stock is $100,000. Accumulated earnings and profits at the beginning of this year were $15,000, and current earnings and profits are $5,000. This year Ho-Ho makes a cash distribution to George of $23,000. This year, George will report: a. $23,000 taxable dividend income; $-0- nontaxable return of capital. b. $15,000 taxable dividend income; $8,000 nontaxable return of capital. c. $20,000 taxable dividend income; $-0- nontaxable return of capital. d. $20,000 taxable dividend income; $3,000 nontaxable return of capital. 7. Kermit purchased 1,000 shares of GSX Corporation for $13,200. This year, GSX

declared and distributed a 10% stock dividend, and Kermit received 100 shares. After the dividend, Kermits basis per share is: a. $13.20. b. $ 1.20 c. $14.52. d. $12.00. 8. Mary is a single parent. Marys son, age 18, lives with her. This year, they had the following income: Salary of Mary $44,000 Salary of Marys son 4,000 Mary sold stock in GMC at a loss (5,000) Mary earned interest on county bonds 2,000 Mary received a stock dividend 200 What is Marys adjusted gross income on her tax return? a. $41,000 b. $37,200 c. $38,000 d. $43,200
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9. Larry and Cindy were divorced last year. As a result, Larry must pay Cindy alimony of $25,000 per year starting this year and relinquish the house and car with a combined value of $75,000 and a combined cost of $70,000. The house and car are given as a property settlement. As a result of these transactions, Larry has a deduction of: a. $100,000. b. $ 24,000. c. $ 75,000. d. $ 25,000. 10. Under the terms of their divorce agreement executed in August of this year, Allen transferred Corporation A stock to his former wife, Linda, as a property settlement. At the time of the transfer, the stock had a basis to Allen of $50,000 and a fair market value of $80,000. What is the tax consequence of this transaction to Allen, and what is Lindas basis in the Corporation A stock? a. Allen, $20,000 income reduction; Lindas basis, $50,000 b. Allen, $20,000 income increase; Lindas basis, $70,000 c. Allen, no gain or loss; Lindas basis, $50,000 d. Allen, no gain or loss; Lindas basis, $70,000 11. With respect to alimony and property settlements in a divorce or separation, all of the following are true, except: a. a property settlement does not result in income to either spouse. b. no tax deduction is allowed for payment of a property settlement. c. the spouse receiving a property settlement has a basis equal to the basis of that property to the paying spouse prior to payment. d. no deduction is allowed for alimony paid to the former spouse, if a property settlement is also paid. 12. Under the terms of their divorce agreement, Keith transferred Corporation M stock to his former wife, Karen, as a property settlement. At the time of the

transfer, the stock had a basis to Keith of $40,000 and a fair market value of $50,000. What is the tax consequence of this transaction to Keith, and what is Karens basis in the Corporation M stock? a. Keith has a gain of $10,000; Karens basis is $40,000. b. Keith has a gain of $10,000; Karens basis is $50,000. c. Keith has no gain or loss; Karens basis is $50,000. d. Keith has no gain or loss; Karens basis is $40,000.
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13. As a result of a divorce, Harry pays Wendy $50,000 in year one and $10,000 per year in subsequent years. How much of the $50,000 in year one is properly characterized as alimony and will not be recaptured later? a. $25,000 b. $30,000 c. $10,000 d. $ 5,000 14. Richard purchased an annuity for $21,600 that will pay him $200 per month for ten years. What amount should Richard include in his income each year? a. $ -0b. $ 600 c. $ 240 d. $2,400 15. Jan purchased an antique desk at auction. For two years, the desk sat in Jans garage until she decided to restore it. This year, while cleaning and restoring the desk, Jan discovered $700 in a hidden compartment inside one drawer. With respect to the $700, Jan must: a. amend her previous tax return and report the $700. b. report nothing. c. report $700 on this years tax return. d. report only $350 due to the statute of limitations. 16. A taxpayer had the following income and losses in the current year: Salary $44,000 Sold AT&T stock at a loss (5,000) Lottery prize 2,000 Gambling winnings 7,000 Gambling losses (4,000) What is the taxpayers adjusted gross income? a. $50,000 b. $47,000 c. $44,000 d. $46,000
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17. In addition to Social Security benefits of $6,000, Mr. and Mrs. Smith have adjusted gross income of $36,000 and tax-exempt interest of $1,000 and will file a joint return. The taxable portion of their Social Security benefits will be: a. $ -0-. b. $3,000. c. $5,100.

d. $6,000. 18. Under Sec. 86, a portion of Social Security benefits is taxable if adjusted gross income exceeds certain base amounts. The base amount for married persons filing separately is: a. $ -0-. b. $25,000. c. $32,000. d. $16,000. 19. The term Social Security benefits does not include: a. retirement benefits received under Social Security. b. tier-one railroad retirement benefits. c. disability benefits received under Social Security. d. Medicare benefits. 20. Tyrone brought suit to recover for a physical injury he received in an accident. Tyrone recovered compensatory damages for the injury of $300,000 and $400,000 for punitive damages. Taxable income resulting from this suit is: a. $ -0-. b. $300,000. c. $400,000. d. $700,000. 21. Insurance proceeds received because of the destruction of property are: a. included in gross income only to the extent the proceeds exceed the adjusted basis of the replacement property. b. excluded from gross income completely. c. included in gross income to the extent the proceeds are less than the adjusted basis of the replacement property. d. included in gross income in all cases.
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22. The following items were received as court awards and damages during the year. All should be included in ordinary income for the year by the taxpayer who received them except: a. compensation for lost wages. b. compensatory damages for physical injury. c. damages for breach of contract. d. interest on damages for breach of contract. 23. Janes employer withheld $1,300 from her wages for state income taxes. Jane, who is single, claimed the $1,300 as an itemized deduction on her federal tax return for the year, which showed $8,000 of total itemized deductions. Janes state income tax was only $900 and she received a $400 refund in the next year. As a result, Jane must: a. do nothing since this years return is already filed. b. report $1,300 of income next year. c. report $400 of income next year. d. report $900 of income next year. 24. During the year X1, Bobs employer withheld $1,100 from his salary for state income taxes. Bob files a joint return for X1 with his wife, and together they claimed the $1,100 in taxes withheld as an itemized deduction on their federal tax

return. Their itemized deductions totaled $10,400 on their X1 tax return. The standard married filing jointly deduction for the year X1 was $10,300. Bobs state income tax was only $650 and he received a refund of $450 when he filed his state income tax return in X2. As a result, Bob must: a. amend the X1 federal tax return. b. report income of $100 in X2. c. report income of $100 in X1. d. reduce his deduction for state income taxes for X1 by $450. 25. Gwens marginal tax bracket is 30.5%. Gwen pays alimony of $12,000 per year. Gwens after-tax cost for the $12,000 payment is: a. $12,000. b. $ 8,340. c. $ 3,720. d. $ -0-.
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26. Alimony is: a. deductible by the payor and included in income by the payee. b. deductible by both the payor and the payee. c. included in income by the payor and deducted by the payee. d. an item which does not affect the payors or the payees tax reporting. 27. Child support is: a. deductible by the payor, and included in income by the payee. b. deductible by both the payor and the payee. c. included in income by the payor and deducted by the payee. d. an item which does not affect the payors or the payees tax reporting. 28. Distributions from a corporation to the shareholders in a nonliquidating distribution will usually be classified as a dividend up to the amount of the corporations: a. retained earnings. b. earnings and profits. c. taxable income for the year. d. stock basis. 29. Taxable compensation usually includes all of the following except: a. wages. b. commissions. c. jury fees. d. fringe benefits. 30. The requirements for a payment to be considered as alimony include all of the following except: a. it must be made in cash or property. b. it must be made pursuant to a divorce, separation, or written agreement between the spouses. c. it must terminate at the death of the payee. d. it must not be designated as being other than alimony.
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REVIEW QUESTION SOLUTIONS AND EXPLANATIONS

GROSS INCOME: INCLUSIONS 1. The correct answer is C, U.S. Treasury Bonds. Municipal bonds issued by state and local municipalities are exempt from federal income tax (Pub. 17, page 58). Taxable interest includes interest on bank deposits, corporate bonds, mortgages, life insurance policies, tax refunds, most U.S. Government obligations, and foreign government obligations. Interest on obligations of states, territories, and U.S. possessions and their political subdivisions is tax-exempt. Bonds issued by school districts, port authorities, toll road commissions, counties, and fire districts are exempt from income tax (Pub. 525, Taxable and Nontaxable Income, page 31, Interest on State and Local Government Obligations). 2. The correct answer is B, $2,500. The full amount of interest on Series EE bonds is tax-free if used to pay college expenses for you, your spouse, or dependents if the combined amount of principal and interest does not exceed the net qualified educational expenses. In that case, a portion of the interest is excluded on the basis of the ratio of the qualified educational expenses to the total principal and interest: $12,000 principal and $4,000 interest is equal to $16,000 for the Principal and Interest together. The $6,000 qualified educational expenses are divided by the total of $16,000 and multiplied by the $4,000 interest to find the nontaxable amount of $1,500. Subtract the $1,500 nontaxable amount from the $4,000 total amount of interest to get the $2,500 taxable amount of interest (Pub. 17, page 22). 3. The correct answer is A, $8,100. Linda must report the full amount of $4,800 cash, 12 months times $400 per month rent, and $3,300 value received for the addition to the house, for a grand total of $8,100 (Pub. 17, page 80, and Pub. 525, page 17). 4. The correct answer is D, $-0-, last years income; $200, this years income; $1,200 this years basis. A liquidating distribution is a distribution made when there are no accumulated earnings and profits. The liquidating dividend must be made out of capital contributions. Since this distribution of $800 is a return of capital, it is not taxable. The $800 liquidating distribution is deducted from $2,000 capital to give a new basis of $1,200. This years dividend was out of earnings and profits; therefore, the $200 distribution is taxable income and does not reduce the capital contributions or basis in the company (Pub. 17, Chapter 9, pages 68 to 70). 5. The correct answer is B, $3,100. Similar to #4 above. A liquidating distribution is a distribution made when there are no accumulated earnings and profits. The liquidating dividend must be made out of capital contributions. Since this distribution of $600 is a return of capital, it is not taxable (Pub. 17, page 62). The $600 liquidating distribution is deducted from $2,000 capital, leaving a $1,400
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capital basis. The sale of the interest in the company for $4,500 minus the basis in the company of $1,400 results in a long-term capital gain of $3,100. 6. The correct answer is D, $20,000 taxable income; $3,000 nontaxable return of capital. This question is similar to #4 and #5. A liquidating distribution is a distribution made when there are no accumulated earnings and profits. In this case the earnings and profits are the prior earnings and profits of $15,000 plus current year profits of $5,000, to give end of year earnings and profits of $20,000

The distribution of $23,000 minus the $20,000 earnings and profits indicates a taxable $20,000 dividend and a nontaxable $3,000 liquidating dividend (return of capital) (Pub. 17, page 62). The $3,000 liquidating dividend must be made out of $100,000 capital contributions, leaving $97,000 basis in the stock and $97,000 capital. 7. The correct answer is D, $12.00. After the 10% stock distribution of 100 shares (10% times 1,000 shares), Kermit will have 1,100 shares of stock (100 plus 1,000 shares). The cost of the shares of stock is $13,200 for 1,100 shares, or $12.00 per share ($13,200 divided by 1,100 shares). Information on this topic can be found in Pub. 17 on page 62 under the heading Distribution of Stock and Stock Rights (Basis). Additional information on the topic can be found in IRS Publication 550, Basis of Investment Property. 8. The correct answer is A, $41,000. A child under age 18 pays tax at his or her parents highest marginal rate on the childs unearned income over $1,700 if that tax is higher than what the child would otherwise pay on it (Pub. 17, page 60). The salary of the taxpayers 18-year-old son is not included, nor is the interest on county bonds, which are exempt from federal income tax (Pub. 17, page 58), nor is the stock dividend that merely reduces the basis per share in the stock currently owned (Pub. 17, page 62). This means that the adjusted gross income equals the salary of $44,000 less the $3,000 upper limit on the capital losses reportable in any one year, leaving $41,000 AGI. A $5,000 capital loss gives a capital loss this year of $3,000 and a carryover to next year of $2,000 (Pub. 17, page 106). 9. The correct answer is D, $25,000. The question is what deduction is available on the taxpayers return for a $25,000 alimony payment and a $75,000 property settlement on an asset which cost $70,000. No gain or loss is recognized on a transfer of property to or in trust for the benefit of the transferors spouse or former spouse incident to a divorce (Pub. 17, pages 92 and 96). Payments of alimony or separate maintenance made under a divorce or separation instrument are deductible by the payor spouse and taxable to the payee spouse (Pub. 17, page 124). 10. The correct answer is C, Allen, no gain or loss; Lindas basis, $50,000. The transferee is treated as acquiring the property by gift, and the transferees basis in the property received is the adjusted basis that the transferor had in the property (Pub. 17, pages 92 and 96, Transfers between Spouses).
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11. The correct answer is D, no deduction is allowed for alimony paid to a former spouse, if a property settlement is also paid. The question is similar to #9 and #10. The explanations and reference to Pub. 17 material are the same as under those questions. 12. The correct answer is D, Keith has no gain or loss; Karens basis is $40,000. No gain or loss is recognized on a transfer of property to or in trust for the benefit of the transferors spouse or former spouse incident to a divorce (Code, Sec. 1041(a)). The transferee is treated as acquiring the property by gift, and the transferees basis in the property received is the adjusted basis that the transferor had in the property (Pub. 17, pages 92 and 96, Transfers between Spouses). 13. The correct answer is A, $25,000. See the recapture rule discussed on page 126 in Publication 17. The amount of second-year alimony recaptured is equal to

the second-year alimony reduced by the total of $15,000 plus the third-year alimony. The amount of first-year alimony recaptured is equal to the first-year alimony reduced by the total of $15,000 plus the average alimony paid in the second year, reduced by the recapture for that year, and the third year. The $50,000 first-year alimony is reduced by $15,000 plus the average of the next two years of $10,000 each or $25,000. 14. The correct answer is C, $240. The expected return on an annuity equals the amount of the annual payment times the expected return multiple. The expected return multiple is the number of years that the annuity is contracted for or, if for life, the number of years shown within the Internal Revenue Service actuarial tables. The exclusion ratio is computed by dividing the investment in the contract (the cost of the contract) by the expected return. The exclusion is computed by multiplying the exclusion ratio times that amount received during the year. The expected return is $200 per month times 12 months in a year times 10 years (expected return multiple) equals $24,000 return. The $24,000 return minus the $21,600 cost gives the taxable portion or $2,400 for ten years. Divide the total amount of $2,400 by the number of years (10) to get the $240 amount taxable per year (Pub. 17, page 71). 15. The correct answer is C, report $700 on this years tax return. Regulations state that a treasure find constitutes gross income to the extent of its value in the year in which it is reduced to undisputed possession. Information on the taxability of found property is in Publication 17 on page 87, under the heading Found Property. 16. The correct answer is A, $50,000. Add the salary of $44,000, subtract the stock loss at the maximum loss per year of $3,000 (Pub. 17 page 105), add the $2,000 lottery prize, add the $7,000 gambling winnings, ignore the gambling losses since they go on schedule A (Pub. 17, page 87 and page 190), and you get $50,000 for the adjusted gross income. Net capital losses for individuals are subject to provisions that limit the amount that can be deducted from other income to $3,000 per year. Prizes, awards, gambling winnings, and treasure finds are taxable.
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17. The correct answer is B, $3,000. Under Internal Revenue section 86, the portion of Social Security benefits that are taxable depends upon the taxpayers provisional income and filing status. Provisional income ($40,000) equals adjusted gross income ($36,000) plus tax-exempt interest ($1,000), plus excluded foreign income, plus 50% of Social Security benefits ($3,000). See page 76 of Publication 17 for a discussion on how to compute the taxable portion of your Social Security benefits. The taxable amount equals 50% of the excess of the provisional income over $32,000, for married filing jointly (MFJ) and $25,000 for single (S) but not over $44,000 MFJ and $34,000 S. If the provisional income is over $44,000 MFJ or $34,000 S, add 85% of the benefits over the limits to taxable income determined above. The taxable portion of the Social Security benefits in this problem is $3,000. 18. The correct answer is A, $ -0-. In the case of a married person filing separately, taxable Social Security benefits are equal to the lesser of 85% of Social Security benefits or 85% of provisional income. There are no limits for Married Filing Separately (Pub. 17, pages 76 and 77, How to Report your Benefits).

19. The correct answer is D, Medicare benefits. Social Security benefits do not include supplementary Medicare benefits that cover the cost of doctors (physicians) services and other medical benefits. 20. The correct answer is C, $400,000. Punitive damages are taxable, even if related to a personal injury judgment. Sec. 104(a)(2) excludes damages, except for punitive damages, received on account of personal injuries or sickness. Additional information can be found on page 85 in Publication 17 under the heading Other Income (Court Award and Damages). 21. The correct answer is A, included in gross income only to the extent the proceeds exceed the adjusted basis in the property. Insurance proceeds or court awards for the destruction of property are included in gross income only to the extent that they exceed the adjusted basis of the property. This is discussed in Publication 17 on page 85, under the heading Reimbursements from Casualty Insurance. Further information on this topic can be found in IRS Pub. 547. 22. The correct answer is B, compensatory damages for physical injury. Internal Revenue Code section 104(a)(2) excludes damages, except for punitive damages, received on account of personal injuries or sickness. Interest is compensation for the use of money and is taxable (Pub. 17, page 53). 23. The correct answer is C, report $400 of income next year. A taxpayer may report an amount in one year as a deduction and recover that amount in the next year. The recovered amount ($400) must be included in gross income in the year of recovery. This is discussed on page 82 in Publication 17 under the heading Itemized Deduction Recoveries.
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24. The correct answer is B, report income of $100 in X2. The amount recovered need not be included in income if the taxpayer received no tax benefit, as in the case where the taxpayers itemized deductions barely exceed the standard deduction. In this case only that portion that produced a tax benefit need be reported. The total itemized deductions for the prior year equaled $10,400, and the standard deduction for married filing jointly was $10,300 in year X1; this means that only $100 of the $1,100 deducted benefited the taxpayer in computing his federal taxable income. Only $100 need be added back in X2 on the individual income tax Form 1040. This is discussed on page 82 in Publication 17 under the heading Itemized Deduction Recoveries. 25. The correct answer is B, $8,340. The after-tax cost or after-tax benefit can be computed by multiplying the tax rates by the amount of income indicated. The income of $12,000 is multiplied by the after-tax percentage, or 69.5% (100% minus the 30.5% tax bracket), giving us an $8,340 after-tax cost for the payment. The tax rate schedules can be found in Publication 17 on page 262. 26. The correct answer is A, deductible by the payor and included in the income of the payee. Payments of alimony or separate maintenance made under a divorce or separation instrument are deductible by the payor spouse and taxable to the payee spouse. Alimony is discussed in Publication 17, beginning on page 124. 27. The correct answer is D, an item which does not affect the payors or the payees tax reporting. Neither child support payments nor property settlements have any tax ramifications; that is, they are not subject to tax to the payee spouse, nor are they deductible by the payor spouse. Information on payments, such as

child support, which are not alimony can be found in Publication 17 on page 124. 28. The correct answer is B, earnings and profits. Distributions to shareholders are taxable as dividends only to the extent that they are made from either the corporations current earnings and profits or accumulated earnings and profits (Pub. 17, page 60, Ordinary Dividends). 29. The correct answer is D, fringe benefits. There are exclusions from taxable income for a variety of employer-provided fringe benefits such as group term life insurance premiums, health and accident insurance premiums, employee discounts, contributions to retirement plans, and free parking (Pub. 525, pages 4 to 8). 30. The correct answer is A, it must be made in cash or property. In order to be treated as alimony, payments must meet all the following requirements: they must be made in cash (no reference to other property); they must be made pursuant to a divorce, separation, or a written agreement between the spouses; they must terminate at the death of the payee; they must not be designated as being other than alimony, such as child support; and they must be made between people who are living in separate households (Pub. 17, pages 124 and 125).
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