Gross Income, Part 1 - Module 1 of 5

Module 1: Gross Income, Part 1

Overview of Federal Income Taxation

The Internal Revenue Code, or Title 26 of the United States Code, sets forth the statutory basis for federal tax law. In addition to these statutes, “tax law” includes many other sources of law that clarify the relevant statutes. Treasury regulations are promulgated by the Internal Revenue Service (the “IRS”) under the authority to interpret tax law given to it by Congress. Revenue rulings are administrative decisions issued by the IRS, while private letter rulings are individual rulings requested (and paid for) by taxpayers who need guidance on how the IRS would interpret a novel question of tax law. There is also case law from tax courts and other federal courts that is generated when disputes between the IRS and taxpayers spill into the general court system.

            While “tax law” includes much more than just income tax, this video-course covers this most commonly applied and most lucrative of the federal taxes. States and municipalities are free to, and of course often do, apply their own income taxes in addition to the federal one. To make things simpler for the taxpayers and for the state agencies, state income tax rules often borrow concepts from federal tax law and interpretations of federal tax law are highly influential on state taxing authorities. So, while state income taxes can be applied differently than federal income taxes, the study of federal income taxes provides a good framework of knowledge under which to apply state income tax laws as well.

            To start with, “gross income” is defined under the Internal Revenue Code as meaning “all income from whatever source derived.”[1] Specifically included are wages and other compensation, business income, capital gains, interest, dividends, rents, royalties, etc. Other sources of income, such as gambling winnings and found money and similar windfalls[2] also count as income. In fact, anything not specifically excluded by the tax code is considered taxable income. Some of the most important categories that are excluded by the code as gross income include gifts (which may be subject to gift tax in some rare cases, but are not subject to income tax), inheritances (which may be subject to estate tax, but are not subject to income tax) and many types of life insurance payouts.

            In our first two modules, we will look at many of the most important categories of income. The last three modules will cover deductions, tax credits and relevant exemptions. In another course on federal income tax, we will look at the nuances of capital gains tax, tax deferral mechanisms, such as qualified retirement plans and the mechanics of preparing and filing for income taxes.

Wages and Business Income

            The quintessential income is that earned as wages, or compensation for services. This includes amounts paid as salary or wages for personal services provided by employees, independent contractors, professionals (such as doctors or lawyers) and personal service providers (such as baby-sitters, house cleaners, lawn maintenance workers, carpenters, house painters and auto mechanics).[3]  Gross income includes regular paychecks, tips, overtime wages, bonuses, sales commissions, compensation based on a percentages of profits,  severance pay, rewards, jury fees and merit pay.[4]

Compensation may also take the form of payment of obligations of the employee. For example, an employer’s payment of the taxes (income or otherwise) for her employee is itself considered compensation and thus taxable income.[5]  

Compensation may also take the form of transfers of property to an employee or independent contractor.[6] For example, if people trade services, the value of the services received as compensation for the services provided are technically taxable income to both parties. So, if Joe agrees to mow Jane’s lawn for the summer in exchange for Jane’s agreeing to paint Joe’s car, each has earned taxable income in the amount of the value of the services received. The values don’t necessarily have to be equal. If Joe’s lawnmowing for the season has a fair market value of $1,000 while Jane’s car painting is worth $800 on the open market, then Jane has earned $1,000 of gross income while Joe must report $800.

Similarly, imagine that Doug’s boss normally pays him $20 per hour and Doug works 40 hours in a given week, entitling him to $800. Instead, Doug’s boss agrees to give him a used motorcycle worth $1,000 in lieu of wages for that week. Doug must report gross income of $1,000 for that week even though his amount of work would have normally entitled him to only $800.[7] However, since gifts are not taxable, if the used motorcycle were structured as an $800 salary payment and a $200 gift, only $800 of it would be taxable.

Gross income derived from a business that is run by the taxpayer is also taxable.[8] Businesses take many forms. Depending on the type of business, the income may be taxed to the owners under separate provisions.  Income from sole proprietorships (where the taxpayer is the sole owner of the business) is taxed as ordinary income to the taxpayer and reported on Schedule C of the taxpayer’s personal income tax return (Form 1040).

Partnerships file their own informational tax returns (Form 1065). Their incomes are taxed directly to the partners as there is no taxation on the partnership itself.[9] Sections starting at 701 the Code spell out a variety of rules on taxation of the partners and how payments, distributions and incomes must be allocated.

Most corporations are taxed under subchapter C of the Code and are thus referred to as “C Corporations.”  C Corporation income is taxed to the corporation which must file its own income tax return (Form 1120).[10]  In some cases, corporations may also elect to be “disregarded” and have their incomes pass through to their shareholders. If they do so, they are governed under subchapter S of the Code and are referred to as “S Corporations.”   

Calculation of gross income derived from business also varies by industry.  In a manufacturing, merchandising or mining business, “gross income” means the total sales, less the cost of goods sold, plus any income from investments and other incidental sources or outside operations.[11] For businesses providing services – like hotels, airlines, railroads and hospitals – and for individuals providing personal services – like physicians and lawyers – gross income is the compensation received for services. Expenses incurred in the provision of those services and various other deductions are subtracted from gross income to determine “net” or “taxable” income.

Employee Benefits

While the values of most types of employee benefits are taxable as income, the Code and regulations also exempt certain fringe benefits from treatment as income.

Fringe benefits come in the forms of money, property or services apart from regular compensation paid to the employee. These benefits are taxable unless otherwise excluded. Examples of fringe benefits that are taxable as additional income to the employee include:[12]

-       The Cost of life insurance on the life of the employee. The premiums are included in gross income of the employee when the employee’s rights to own the life insurance contract is substantially vested.[13] “Substantially vested” means that the employee has the right to transfer ownership of the insurance and/or that the ownership is not contingent on the performance of future services.

-       Use of a company car for personal purposes (including commuting).[14]

-       Use of company equipment (such as a computer or smartphone) for personal purposes.

-       Use of a flight on an employer-provided aircraft for free or discounted commercial flight, assuming the trip is for personal purposes and not business. If the flight is discounted, the taxable benefit is the difference between the commercial value of the flight and the amount the employee paid.

-       Mileage reimbursement in excess of the IRS-provided rate. When an employee drives for business purposes, she may be compensated up to $0.58 per mile (as of 2019).[15] Compensation in excess of this amount is considered taxable work compensation.

Employee fringe benefits that are exempted from taxation by the Code, and thus may be provided to the employee tax-free, include:

-       Cafeteria Plans. These are plans maintained by employers that provide participants the opportunity to receive certain benefits related to health, accident care, dependent care, group life insurance and similar benefits. The employee-participant agrees to have a portion of her salary withheld. For 2019, the employee can have up to $2,700 withheld, tax-free, to pay for benefits provided by the cafeteria plan.[16] The amount withheld can then be used by the employee towards one of these qualifying purposes.

-       Employer-paid contributions towards qualifying health insurance or accident insurance plans.[17]

-       Employer-paid qualified adoption expenses incurred by an employee to adopt a child.[18]

-       Use of athletic facilities maintained on-site for use by employees and their dependents.[19]

-       Employer-provided financial assistance for dependent care (limited to $5,000 per year) so the employee can work.[20]

-       Employer-provided financial assistance for employees’ educations – including the costs of books, equipment, fees, supplies and tuition, though the deduction is limited to $5,250, as of 2019.[21]

-       Employee discounts in the purchase of goods or services as long as the discount doesn’t exceed 20% of the price charged regular customers.[22] Also included are services that are offered to customers in the ordinary course of the employer’s business – and therefore that do not cause the employer to incur additional cost. For example, if a car dealership’s service section puts out coffee and snacks for waiting customers and allows employees access to these as well, these would be nontaxable fringe benefits.[23]

-       Employee stock options: Employers with plans that are qualified under the Code allow for employees to purchase shares of the employer corporation, and the shares are not taxable to the employee.[24] This, of course, applies only when the employee is purchasing the shares. If the employee receives shares outright as part of compensation, that is taxable as compensation.

-       Group-term life insurance coverage with death benefits up to $50,000 that are provided by employer plans to groups of employees.[25]  

-       Health Savings Accounts provided by the employers but owned by the employees. Contributions can be made with pre-tax dollars by the employer and used to pay qualifying medical expenses of the employee or dependents.[26]

-       Meals and lodging for the employee provided on the premises of the employer are not taxable as long as they are provided for the convenience of the employer; such as, for example, to allow the employee to work longer hours or avoid taking an off-site meal break.[27]

-       Retirement Plans: Employer contributions to employee profit sharing plans, defined benefit plans, defined contribution plans and certain pension plans are not included in the employee-participant’s income. These are typically tax deferral mechanisms and are taxable as income when later withdrawn by the employee.[28]

-       Employer payment of retirement planning services for the employee is also not taxable to the employee if the employer maintains a qualified retirement plan approved by the IRS.[29]

-       Finally, property and services provided to an employee so she can perform her job is not taxable to the employee. Examples include company-furnished cars, cell phones and job-related education costs that are used for business purposes.[30]

Capital Gains

Gains from the sale or exchange of property are typically included in gross income.[31] “Property” includes tangible items, such as buildings, land and cars, and intangible items, such as stocks, bonds and “goodwill” (meaning good reputation or name in the industry). Generally, the taxable gain that is subject to income tax is the amount by which the sum received when the property is sold exceeds the price paid to purchase the property.[32] The price paid for the property is referred to as the “cost basis.” Modifications to the property- such as depreciation of land or equipment (decreasing their value) or capital improvements (increasing their value)- can cause the cost basis to increase or decrease, thus affecting a capital gain (or loss) realized by sale. After the amount paid for the property is adjusted for these factors, the result is called the “adjusted cost basis,” and is the measuring stick to determine whether a sale has produced a capital gain or loss.

            A capital gain (or loss) has only been “realized” when the property sold is considered a “capital asset.”

The following assets are NOT considered “capital assets”:[33]

-       Inventory items owned by the taxpayer’s trade or business for sale to customers.

-    Property used in the taxpayer’s business that may be “depreciated” under the Internal Revenue Code, which generally means property that tends to decrease in value under normal use, including cars and other vehicles.[34] So, for example, you cannot buy a new car for $20,000, drive it around for five or six years, sell it for $10,000 and then claim a $10,000 capital loss.

-       Supplies used in the taxpayer’s trade or business (such as an oven used in a restaurant).

-       A patent, invention, formula, copyright, literary musical or artistic creation created by the taxpayer;

-      A letter or document that has value only for the person for whom it was created. So, for example, if the taxpayer hires a lawyer to draft a complicated will or agreement, although he may have paid a lot of money for the document and it might be valuable to him, it is not a capital asset.

-       Accounts or notes receivable acquired in the ordinary course of a trade or business; so, a check or contract has no inherent value other than in what it represents and so is not a capital asset.

-       Publications of the United States Government, except when the taxpayer purchased the publication from the government or another person.

-       Some types of commodity and hedging transactions.

When a capital asset that has been owned for more than a year is sold, any gain from the sale is considered a “long-term” capital gain and receives favorable tax treatment, which means that it is taxed at the lower “capital gains” tax rates. If the capital asset was held for less than a year, any gain is treated as ordinary income.

Other Types of Income

Let’s now turn to some other types of income.

Taxable interest income[35] includes interest on savings or other bank deposits, coupon bonds, promissory notes and  corporate bonds. However, some interest payments are not taxable, such as those paid on state or municipal bonds.[36]  

Rents received or accrued for the occupancy of real estate or the use of personal property is included in gross income.[37]

Royalties received from books, stories, plays, copyrights, trademarks, formulas, patents and from the exploitation of natural resources are included in gross income.[38] 

Dividends in cash or other property (typically paid out by corporations to their shareholders) are included in gross income.[39] However, dividends are taxable only to the extent of the earnings and profits of the payor corporation. Dividends that are in excess of accumulated earnings and profits of the corporation are not income, though they may constitute capital gains.[40]

Dividends are taxed at different rates depending on whether they are “qualified” or “non-qualified.”[41] While this is a bit of an oversimplification, dividends are generally considered qualified when the shareholder held the stock for at least two months before the dividends were declared. Qualified dividends are taxed at the same rates as long-term capital gains, while nonqualified dividends are taxed as ordinary income.

Under the Tax Cuts and Jobs Act of 2017[42], alimony payments are no longer deductible to the payor, nor are they considered taxable income to the payee. Still, the “old” rules apply to judgments or agreements signed before December 31, 2018. Under those arrangements, the payor ex-spouse may deduct the alimony payments, and those payments are considered income to the recipient.[43] Child support payments are not taxable to the recipient parent and are not deductible for the parent making the payments.[44] A child tax credit is typically available to the custodial parent and not the non-custodial parent, though the parties may change this by agreement.

In our next module, we will continue our discussion of gross income by looking at various other types of incomes and their specific rules and limitations.