Chapter 4: Gross Income
4-1 The Tax Formula
4-1a Components of the Tax Formula
Income (Broadly Defined)This includes all of the taxpayer’s income, both taxable and nontaxable. Although it
essentially is equivalent to gross receipts, it does not include a return of capital or borrowed
funds.
Exclusions
For various reasons, Congress has chosen to exclude certain types of income from the
income tax base. The principal income exclusions that apply to all entities (e.g., life
insurance proceeds received by reason of death of the insured and state and local bond
interest) are discussed later in this chapter, while exclusions that are unique to individuals
are addressed in Chapters 9 through 11.
Gross Income
Code § 61(a) provides the following definition of gross income . Except as otherwise provided in this subtitle, gross income means all income from whatever source derived. Code § 61 provides perhaps the broadest definition of gross income possible. All income is taxable unless the Code says it is not. However, neither the Sixteenth Amendment nor the Code provide a definition of income itself. Rather, Congress left it to the judicial and administrative branches to determine the meaning of income. A small set of items is specified as included in income, including:• Compensation for services.
• Business income.
• Gains from sales and other disposition of property.
• Interest.
• Dividends.
• Rents and royalties.
• Certain income arising from discharge of indebtedness.
• Income from partnerships.
Generally, all ordinary and necessary trade or business expenses are deductible by taxpaying entities. As noted in text Section 1-3g, individuals can use two categories of deductions—deductions for AGI and deductions from AGI. In addition, individuals are unique among taxpaying entities in that they are permitted to deduct a variety of personal expenses (i.e., expenses unrelated to business or investment), and they are allowed a standard deduction if this amount exceeds the deductible personal expenses.
Taxable income is determined by subtracting deductions (reflecting applicable limitations) from gross income. The tax rates then are applied to determine the tax. Finally, tax prepayments (such as Federal income tax withholding on salaries and estimated tax payments) and a wide variety of credits are subtracted from the tax to determine the amount due to the Federal government or the refund due to the taxpayer.
4-2 Gross Income
4-2a Concepts of Income
As noted above, Congress mostly left it to the judicial and administrative branches of government to determine the meaning of the term income. As the income tax law developed, two competing models of income were considered by these branches: economic income and accounting income.
As noted above, Congress mostly left it to the judicial and administrative branches of government to determine the meaning of the term income. As the income tax law developed, two competing models of income were considered by these branches: economic income and accounting income.
Economists measure income (economic income) as the sum of (1) the value of goods and services consumed during a period and (2) the change in the value of net assets (assets minus liabilities) from the beginning to the end of the period. Notice that the change in the value of net assets is not dependent on the sale or exchange of those assets: economic income can be derived by a mere change in the value of assets held. Similarly, economic income includes in consumption the imputed value of personal items, such as as the rental value of an owner-occupied home and the value of food grown for personal consumption.
See example 1
Because the strict application of a tax based on economic income would require taxpayers to determine the value of their assets annually, compliance would be burdensome. Controversies between taxpayers and the IRS inevitably would arise under an economic approach to income determination because of the subjective nature of valuation in many circumstances. In addition, using market values to determine income for tax purposes could result in liquidity problems. That is, a taxpayer’s assets could increase in value but not be easily converted into the cash needed to pay the resulting tax (e.g., increases in the value of commercial real estate). Thus, the IRS, Congress, and the courts have rejected the economic concept of income as impractical.
4-2b Comparing Accounting and Tax Concepts of Income
Although income tax rules frequently parallel financial accounting measurement concepts, differences do exist. Of major significance, for example, is that the unrealized increase in the value of marketable securities is included in financial accounting income but not in taxable income. Because of this and other differences, many corporations report financial accounting income that is substantially different from the amounts reported for tax purposes; these differences were the subject of much of
Chapter 3.
4-2c Form of Receipt
Income is not taxable until it is realized. Realization, however, does not require the receipt of cash. “Gross income includes income realized in any form, whether in money, property, or services. Income may be realized [and recognized], therefore, in the form of services, meals, accommodations, stock or other property, as well as in cash.”
Example 3: Ostrich Corporation allows Cameron, an employee, to use a company car for his vacation. Cameron realizes income equal to the rental value of the car for the time and mileage.
Example 4: Donna is a CPA specializing in individual tax return preparation. Her neighbor, Khalil, is a dentist. Each year, Donna prepares Khalil’s tax return in exchange for two dental checkups. Khalil and Donna both have gross income equal to the fair market value of the services they receive.
4-3 TIMING OF INCOME RECOGNITION
4-3a Taxable Year
The annual accounting period or taxable year is a basic component of our tax system. For the most part, a taxable year entails a period of 12 months ending on the last day of a calendar month. Generally, a taxpayer uses the calendar year to report gross income. However, a fiscal year (a period of 12 months ending on the last day of any month other than December) can be adopted if the taxpayer maintains adequate books and records to make such computations. In most cases, a fiscal year is not available to partnerships, S corporations, and personal service corporations (i.e., one performing services in health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting).4-3b Accounting Methods
The year an item of income is recognized depends upon the accountingmethod the taxpayer employs. The three primary methods of accounting are (1) the cash receipts and
disbursements method, (2) the accrual method, and (3) the hybrid method. Most individuals and many small businesses use the cash receipts and disbursements method of accounting, while most larger businesses use the accrual method. Generally, the tax law requires the use of the accrual method for determining purchases and sales when inventory is an income-producing factor. Some businesses employ a hybrid method that is a combination of the cash and accrual methods (e.g., using the accrual method for sales and inventories and the cash method for everything else). In addition to these overall accounting methods, specialized tax accounting methods are available for certain items or transactions. For instance, a taxpayer may spread the gain from a sale of eligible property over the collection period by using the installment method of income recognition. Contractors may either spread profits from contracts over the period in which the work is done (the percentage of completion method) or defer
all profit until the year in which the project is completed (the completed contract method, which can be used only in limited circumstances).
Cash Receipts Method
Under the cash receipts method , income is recognized in the year of actual or constructive receipt by the taxpayer, regardless of whether the income was earned in that year. Despite the method’s name, the taxpayer need not receive cash to be required to recognize income under the cash receipts method. Rather, the receipt of anything with a fair market value, or a cash equivalent, is includible in income under the cash receipts method. As a result, a cash basis taxpayer that receives a note in payment for services recognizes gross income equal to the fair market value of the note in the year the note is received. However, a creditor’s mere promise to pay (e.g., an account receivable), with no supportingnote, usually is not considered to have a fair market value; it is not a cash equivalent. Thus, a cash basis taxpayer who receives an account receivable in return for goods or services defers income recognition until the receivable is collected.
Generally, a cash basis taxpayer recognizes gross income when a check is received in payment for goods or services rendered in a business setting. This is true even if the taxpayer receives the check after banking hours. But if the person paying with the check requests that the check not be cashed until a subsequent date, the cash basis income is deferred until the date the check can be cashed. The cash receipts method could distort taxable income since income and expenses from the same activity may be recognized in different tax years. Moreover, a taxpayer using the cash receipts method has some degree of control over when income is recognized (e.g., by delaying the sending of invoices to customers). As a result, the tax law restricts the availability of the cash receipts method. For example, most corporations with average annual gross receipts greater than $26 million, computed over the preceding
three-year period, must use the accrual method. Also, businesses with average annual gross receipts in excess of $26 million, whether or not they are corporations, are required to account for their inventory under the accrual method.
Accrual Method
Under the accrual method , an item generally is included in gross income for the year in which it is earned, regardless of when the income is collected. Gross income is earned when (1) all the events have occurred that fix the right to receive the income and (2) the amount to be received can be determined with reasonable accuracy. However, regardless of when these tests are actually met, they are treated as satisfied no later than when the revenue is included in the taxpayer’s applicable financial statements.Generally, a taxpayer’s right to income accrues when title to property being sold passes to the buyer or the services are performed for the customer or client. If the rights to income have accrued but are subject to a potential refund claim (e.g., under a product warranty), the income is reported in the year of sale and a deduction is allowed in subsequent years when actual claims accrue.
Hybrid Method
The hybrid method is a combination of the accrual and cash methods. Generally, a taxpayer using the hybrid method is in the business of buying and selling inventory but not otherwise required to use the accrual method. As a result, the taxpayer using the hybrid method accounts for sales of goods and cost of goods sold using the accrual method, and the cash method is used for all other income and expense items (e.g., services and interest income).
4-3c Special Rules for Cash Basis Taxpayers
4-3c Special Rules for Cash Basis Taxpayers
Constructive Receipt
Income that has not actually been received by the taxpayer is taxed as though it had been received—the income is considered constructively received if the amount is made readily available to the taxpayer and not subject to substantial limitations or restrictions. For example, if an employee receives a paycheck on December 31 that is dated for January 8, it is not constructively received in December due to the date limitation. It would be considered taxable income in January.
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. For instance, a taxpayer is not permitted to defer income earned in December simply by refusing to accept payment until January.
Lenders frequently make loans that require a payment at maturity of more than the amount of the original loan. The difference between the amount due at maturity and the amount of the original loan, or the original issue discount , is actually interest. In these circumstances, the original issue discount must be reported as it is earned, regardless of the taxpayer’s accounting method. The interest earned is calculated using the effective interest rate method.
Example 13
On January 1, year 1, Blue and White, a cash basis partnership, pays $90,703 for a 24-month certificate of deposit. The certificate is priced to yield 5% (the effective interest rate) with interest compounded annually. No interest is paid until maturity, when Blue and White receives $100,000.
The partnership’s gross income from the certificate is $9,297 ($100,000 − $90,703). Blue and White calculates income earned each year as follows.
Year 1 (0.05 x $90,703) = $4,535
Year 2 [0.05 x ($90,703 + $4,535)] = $4,762
$9,297
The original issue discount rules do not apply to U.S. savings bonds or to obligations with a maturity date of one year or less from the date of issue.
Amounts Received under an Obligation to Repay
The receipt of funds with an obligation to repay those funds in the future is the essence of borrowing. The taxpayer’s assets and liabilities increase by the same amount, and no gross income is realized when the borrowed funds are received.
Example 14
A landlord receives a damage deposit from a tenant. The landlord does not recognize income until the deposit is forfeited because the landlord has an obligation to repay the deposit if no damage occurs.34 However, if the deposit is in fact a prepayment of rent, it is taxed in the year of receipt.
4-3d Special Rules for Accrual Basis Taxpayers
Unearned Income
For financial reporting purposes, advance payments received from customers are initially reflected in the financial statements of the seller as a liability and recognized as income over the period in which the income is earned. However, for tax purposes, unearned income generally is taxed in the year of receipt
Example 15
In December 2021, Jared’s sole proprietorship pays its January 2022 rent of $1,000. Jared’s calendar year, accrual basis landlord includes the $1,000 in 2021 gross income for tax purposes, although $1,000 unearned rent income is reported as a liability on the landlord’s financial accounting balance sheet for December 31, 2021.
Advance payments for prepaid rent or prepaid interest, however, always are taxed in the year of receipt, as illustrated in Example 15.
Example 16
Yellow Corporation, an accrual basis calendar year taxpayer, sells its computer consulting services
under 12-month, 24-month, and 36-month contracts. The corporation provides services to each
customer every month. On May 1, year 1, Yellow sold the following contracts.
Length of Contract Total Proceeds
12 months $3,000
24 months 4,800
36 months 7,200
Yellow may defer until year 2 all of the income that will be reported on its financial statements
after year 1.
Length of Contract Income Recorded in Year 1 Income Recorded in Year 2
12 months $2,000 ($3,000 × 8/12) $1,000 ($3,000 × 4/12)
24 months 1,600 ($4,800 × 8/24) 3,200 ($4,800 × 16/24)
36 months 1,600 ($7,200 × 8/36) 5,600 ($7,200 × 28/36)
Notes:
Customer Deposits vs Advance Payments
4-4 General Sources of Income
4-4a Income from Personal Services
It is a well-established principle of taxation that income from personal services are included in the gross income of the person who performs the services. This principle was first established in a Supreme Court decision, Lucas v. Earl.36 Mr. Earl entered into a binding agreement with his wife under which Mrs. Earl was to receive one-half of Mr. Earl’s salary. Justice Holmes used the celebrated fruit and tree metaphor to explain that the fruit (income) must be attributed to the tree from which it came (Mr. Earl’s services). A mere assignment of income to another party does not shift the liability for the tax.
As discussed above, the income from personal services generally is taxable to the person performing the services. However, services performed by an employee for an employer’s customers are considered performed by the employer. Thus, the employer is taxed on the income from the services provided, and the employee is taxed on any compensation received from the employer.
4-4b Income from Property
Income earned from property (e.g., interest, dividends, rent) is included in the gross income of the owner of the property. For example, if a father gives his daughter the right to collect the rent from his rental property (the “fruit”), the father will nonetheless be taxed on the rent because he retains ownership of the property (the “tree”).
Often income-producing property is transferred after income from the property has accrued but before the income is recognized under the transferor’s method of accounting. The IRS and the courts have developed rules to allocate the income between the transferor and the transferee. These allocation rules are addressed below. Other allocation rules address income in community property states.
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 the transferee based on the number of days during the period that each owned the obligation
Example 18
Floyd, a cash basis taxpayer, gives his son, Seth, corporate bonds with a face amount of $12,000
and a 5% stated annual interest rate. The interest is payable on the last day of each quarter. Floyd
makes the gift to Seth on February 28. Floyd recognizes $100 interest income at the time of the gift
($12,000 × 5% × 3/12 interest for the quarter × 2/3 months in the quarter earned before the gift).
For the transferor, the timing of the recognition of gross income from the property depends upon the pertinent accounting method and the manner in which the property was transferred. In the case of a gift of income-producing property, the donor’s share of the accrued income is recognized at the time it would have been recognized had the donor continued to own the property.39 If the transfer is a sale, however, the transferor recognizes the accrued income at the time of the sale, because the accrued amount is included in the sales proceed
Dividends
As a separate taxable entity, 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 the double taxation of dividends has been provided to noncorporate taxpayers in that qualified dividends are taxed at the same marginal rate that is applicable to a net capital gain. Generally, net capital gains are subject to a 15 percent rate of Federal income tax. The rate is 0 percent for taxpayers with low taxable income and 20 percent for upper-income taxpayers. Distributions that are not qualified dividends are taxed at the rates that apply to ordinary income. Because the beneficial tax rate is intended to mitigate double taxation, only certain dividends are eligible for the beneficial treatment. Excluded are certain dividends from non-U.S. corporations, dividends from tax-exempt entities, and dividends that do not satisfy the holding period requirement.
Corporations that are shareholders (i.e., they own stock in another corporation) may be allowed a deduction to offset some or all of their dividend income. See text Section 12-4a.
A holding period requirement must be satisfied for the lower tax rates to apply: the stock that paid the dividend must have been held for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date.42 The purpose of this requirement is to prevent the taxpayer from buying the stock shortly before the dividend is paid, receiving the dividend, and then selling the stock at a short-term capital loss after the stock goes ex-dividend. A stock’s price often declines after the stock goes ex-dividend.
Generally, dividends are taxed to the person who is entitled to receive them—the shareholder of record as of the corporation’s record date.43 Thus, if a taxpayer sells stock after a dividend has been declared but before the record date, the dividend generally is taxed to the purchaser. If a donor makes a gift of stock to someone (e.g., a family member) after the declaration date but before the record date, the donor does not shift the dividend income to the donee. The fruit has ripened sufficiently as of the declaration date to tax the dividend income to the donor of the stock.
Example 22
On June 20, the board of directors of Black Corporation declares a $10 per share dividend. The dividend is payable on June 30 to shareholders of record on June 25. As of June 20, Maria owns 200 shares of Black stock. On June 21, Maria sells 100 of the shares to Jon for their fair market value and gives 100 of the shares to Andrew (her son). Both Jon and Andrew are shareholders of record as of June 25. Jon (the purchaser) is taxed on $1,000 because he is entitled to receive the dividend. However, Maria (the donor) is taxed on the $1,000 received by Andrew (the donee) because the gift was made after the declaration date but before the record date of the dividend.
4-4c Income Received by an Agent
Income received by the taxpayer’s agent is considered to be received by the taxpayer. Therefore, a cash basis principal recognizes the income at the time it is received by the agent.
Example 23
Longhorn, Inc., a cash basis corporation, delivers cattle to the auction barn in late December. The
auctioneer, acting as the corporation’s agent, sells the cattle and collects the proceeds in December.
The auctioneer does not pay Longhorn until the following January. Longhorn includes the sales
proceeds in its gross income in the year the auctioneer received the funds.
4-5 Specific Items Of Gross Income
The all-inclusive principles of gross income determination as applied by the IRS and the courts have, on occasion, been expanded or modified by Congress through legislation. This legislation generally provides more specific rules for determining gross income from certain sources. Most of these special rules appear in §§ 71–91 of the Code.
In addition to provisions describing how specific sources of gross income are to be taxed, several specific rules exclude items from gross income. Authority for excluding specific items is provided in §§ 101–140 and in various other provisions in the Code. Many statutory exclusions are unique to individual taxpayers (e.g., gifts and inheritances, scholarships, and a variety of fringe benefits paid to employees). These exclusions are discussed in Chapters 9 through 11. Other exclusions are broader and apply to all entities. These exclusions include interest on state and local bonds (§ 103), life insurance proceeds received by reason of death of the insured (§ 101), the fair market value of leasehold improvements received by the lessor when a lease is terminated (§ 109),48 and income from discharge of indebtedness (§ 108).
Taxpayers can recognize gross income when there is a sale or other disposition of a nonbusiness asset. These transactions are discussed in more detail in Chapters 7 and 8, but this section includes an introduction to the tax rules that apply in the most common situations. Some of the broadly applied statutory rules describing inclusions and exclusions are discussed next.
4-5a Gains and Losses from Property Transactions
When property is sold or otherwise disposed of, gain or loss may result. Such gain or loss has an effect on the gross income of the party making the sale or other disposition when the gain or loss is realized and recognized for tax purposes. The concept of realized gain or loss is expressed as follows:
Amount Realized From Sale - Adjusted Basis Of The Property = Realized Gain (Loss)
The amount realized is the selling price of the property less any costs of disposition (e.g., brokerage commissions) incurred by the seller. The adjusted basis of the property is determined as follows:
Cost (or other original basis) at date of acquisition
Add: Capital additions
Subtract: Depreciation (if appropriate) and other capital recoveries (see Chapter 5)
Equals: Adjusted basis at date of sale or other disposition
Without realized gain or loss, generally, there can be no recognized (taxable) gain or loss. All realized gains are recognized unless some specific part of the tax law provides otherwise. Realized losses may or may not be recognized (deductible) for tax purposes, depending on the circumstances involved. For example, losses realized from the disposition of personal use property (property held by individuals and not used for business or investment purposes) are not recognized.
Example 25
During the current year, Ted sells his sailboat (adjusted basis of $4,000) for $5,500. Ted also sells
one of his personal automobiles (adjusted basis of $8,000) for $5,000. Ted’s realized gain of $1,500
from the sale of the sailboat is recognized. The $3,000 realized loss on the sale of the automobile,
however, is not recognized. Thus, the gain is taxable, but the loss is not deductible.
The next step is to classifythe gain or loss as capital or ordinary. Although ordinary gain is fully taxable and ordinary loss is fully deductible, the same is not true for capital gains and capital losses.
Capital Gains and Losses
Gains and losses from the disposition of capital assets receive special tax treatment. Capital assets are defined in the Code as any property held by the taxpayer other than, among other things, inventory, accounts receivable, and depreciable property or real estate used in a business. The sale or exchange of assets in these categories usually results in ordinary income or loss treatment (see text Section 8-2). The sale of any other asset generally creates a capital gain or loss.
Computing the Net Capital Gain/Loss
To ascertain the appropriate tax treatment of capital gains and losses, a netting process first is applied.
1. Capital gains and losses are classified as:
a. short term if the sold asset was held for one year or less, or
b. long term if the sold asset was held for more than one year.
2. Capital gains and losses then are netted within these two classifications. Specifically, short-term capital losses (STCL) are offset against short-term capital gains (STCG), resulting in either a net short-term capital loss (NSTCL) or a net shortterm capital gain (NSTCG).
3. Similarly, long-term capital losses (LTCL) are offset against long-term capital gains (LTCG), resulting in either a net long-term capital gain (NLTCG) or a net longterm capital loss (NLTCL).
4. If the resulting amounts are of opposite signs (i.e., there remains a gain and a loss), those amounts are netted against each other. This produces the taxpayer’s net capital gain or loss for the tax year. It is entirely long- or short-term, as dictated by the number that was larger in steps 2 and 3.
Taxing the Net Capital Gain/Loss
Individuals and corporations are taxed differently on their net capital gains and losses. An individual’s net capital gain is subject to the following maximum tax rates. Certain upper-income taxpayers also may incur the additional Medicare tax on net investment income with respect to net capital gains. See
text Section 9-5e.
Maximum Rate
Short-term gains 37%
Long-term gains 20%
A C corporation’s net capital gain does not receive any beneficial tax treatment. It is taxed as ordinary income (at a 21 percent rate).
The net capital losses of noncorporate taxpayers can be used to offset up to $3,000 of ordinary income each year. Any remaining capital loss is carried forward indefinitely.
C corporations may deduct capital losses only to the extent of capital gains. Capital losses of C corporations in excess of capital gains may not be deducted against ordinary income. Such unused capital losses are carried back three years and then carried forward five years to offset capital gains in those years.
4-5b Interest on Certain State and Local Government Obligations
(Municipal Bond Interest)
Interest on state and local government obligations was specifically exempted from Federal income taxation. The exempt status of interest income applies solely to state and local government bonds. Thus, income received from the accrual of interest on a condemnation award or an overpayment of state tax is fully taxable. State and local governments are free to tax each other’s obligations. Thus, some states exempt the interest on the bonds they issue but tax the interest on bonds issued by other states.
(US Bonds)
The interest paid on U.S. government bonds is not excluded from the Federal income tax base. Congress has decided, however, that if the Federal government does not tax state and local bond interest, the state and local governments should not tax interest on U.S. government bonds.
4-5c Life Insurance Proceeds
Life insurance proceeds paid to the beneficiary because of the death of the insured are excluded from gross income. Congress believed that it was good tax policy to exclude life insurance proceeds from gross income for several reasons, including the following.
• For family members, life insurance proceeds serve much the same purpose as a nontaxable inheritance.
• In a business context (as well as in a family situation), life insurance proceeds replace an economic loss suffered by the business entity (i.e., from the loss of future sales or of the decedent’s professional reputation).
Example 31
Sparrow Corporation purchased an insurance policy on the life of its CEO and named itself as the
beneficiary. Sparrow paid $174,000 in premiums. When the company’s CEO died, Sparrow collected
the insurance proceeds of $600,000. The $600,000 is excluded from Sparrow’s gross income.
Exception to Exclusion Treatment
The income tax exclusion applies only when the insurance proceeds are received because of the death of the insured. If the owner cancels the policy and receives the cash surrender value, he or she must recognize gain to the extent of the excess of the amount received over the cost of the policy.
Another exception to exclusion treatment applies if the policy is transferred after the insurance company issues it. If the policy is transferred for valuable consideration, the insurance proceeds are includible in the gross income of the purchaser to the extent the proceeds received exceed the amount paid for the policy plus any subsequent premiums paid.
Example 32
Platinum Corporation pays premiums of $5,000 for an insurance policy with a face amount of $12,000
on the life of Beth, an officer of the corporation. Subsequently, Platinum sells the policy to Beth’s
husband, Jamal, for $5,500. On Beth’s death, Jamal receives the proceeds of $12,000. Jamal excludes
from gross income $5,500 plus any premiums he paid subsequent to the transfer. The remainder of
the proceeds constitutes gross income to Jamal, since he acquired the policy for cash consideration.
There are several major exceptions to the consideration rule.60 These exceptions permit exclusions from gross income for transfers to the following parties. The first three exceptions facilitate the use of insurance contracts to fund buy-sell agreements .
1. A partner of the insured.
2. A partnership in which the insured is a partner.
3. A corporation in which the insured is an officer or shareholder.
4. A transferee whose basis in the policy is determined by reference to the transferor’s basis, such as a gift or a transfer due to a divorce.
5. The insured party under the policy.
Example 33
Rick and Sita are equal partners who have a buy-sell agreement that allows either partner to purchase
the interest of a deceased partner for $500,000. Neither partner has sufficient cash to buy
the other partner’s interest, but each holds a life insurance policy on his own life in the amount of
$500,000. Rick and Sita could exchange their policies (usually at little or no taxable gain), and upon
the death of either partner, the surviving partner could collect tax-free insurance proceeds. The
proceeds then could be used to purchase the decedent’s interest in the partnership
Investment earnings arising from the reinvestment of life insurance proceeds generally are subject to income tax. For example, the beneficiary may elect to collect the insurance proceeds in installments that include taxable interest income. The interest portion of each installment is included in gross income
4-5d Income from Discharge of Indebtedness
Gross income usually is generated when a creditor cancels a borrower’s debt or accepts a payment for less than the amount owed. Foreclosure by a creditor is treated as a sale or exchange of the property and usually triggers gross income.
Example 34
Juan owed State Bank $50,000 on a note secured by some investment land. When Juan’s basis in
the land was $20,000 and the land’s fair market value was $50,000, the bank foreclosed on the loan
and took title to the land. Juan recognizes a $30,000 gain on the foreclosure, as though he had sold
the land directly to State Bank.
A creditor may cancel debt to ensure the viability of the debtor. In such cases, the debtor’s net worth is increased by the amount of debt forgiven. Generally, the debtor recognizes gross income equal to the amount of debt canceled
Example 35
Brown Corporation is unable to meet the mortgage payments on its factory building. Both the corporation and the mortgage holder are aware of the depressed market for industrial property in the
area. Foreclosure would only result in the creditor obtaining unsellable property.
To improve Brown’s financial position and thus improve its chances of obtaining the additional
credit necessary for survival from other lenders, the creditor agrees to forgive all amounts past
due and to reduce the principal amount of the mortgage. Brown’s gross income is increased by
the amount of the debt that was forgiven plus the reduction in the remaining mortgage balance.
A discharge of indebtedness generally increases the taxpayer’s gross income, but the reduction in debt is excluded in each of the following situations.
1. Discharges that occur when the debtor is insolvent.
2. Discharges under Federal bankruptcy law.
3. Discharge of the farm debt of a solvent taxpayer.
4. Discharge of qualified real property business indebtedness .
5. A seller’s cancellation of a solvent buyer’s indebtedness.
6. A shareholder’s cancellation of a corporation’s indebtedness.
7. Forgiveness of certain loans to students.
8. Discharge of acquisition indebtedness on the taxpayer’s principal residence that occurs before 2026 and is due to the financial condition of the debtor
1. Insolvency and Bankruptcy
Cancellation of indebtedness income is excluded when the debtor is insolvent (i.e., the debtor’s liabilities exceed the fair market value of the assets) or when the cancellation of debt results from a bankruptcy proceeding (situation 1 and 2). The insolvency exclusion is limited to the amount of insolvency. The law imposes a cost for the insolvency and bankruptcy exclusion. More specifically, the debtor must decrease certain tax benefits (capital loss carryforwards, net operating loss carryforwards, some tax credits, and suspended passive activity losses) by the amount of income excluded. In addition, if the amount of excluded income exceeds these tax benefits, the debtor reduces the basis in assets.
Example 38
Before any debt cancellation, Maroon Corporation holds assets with a fair market value of
$500,000 and related liabilities of $600,000. A creditor agrees to cancel $125,000 of liabilities.
Maroon excludes $100,000 of the debt cancellation income (the amount of insolvency) and is
taxed on $25,000. Maroon also reduces any tax benefits and the basis of its assets by $100,000
(the excluded income).
2. Qualified Real Property Indebtedness
Taxpayers (other than C corporations) can elect to exclude income from cancellation of indebtedness if the canceled debt is secured by real property used in a trade or business (situation 4). The debt must have been used to acquire or improve real property in a trade or business to qualify for the exclusion.
The amount of the exclusion is limited to the lesser of (1) the excess of the debt over the fair market value of the real property or (2) the adjusted basis of all depreciable real property held. In addition, the basis of all depreciable real property held by the debtor is reduced by the excluded amount.
Example 39
Blue, Inc. (an S corporation), owns a warehouse worth $5,000,000, with a $3,000,000 basis. The
warehouse is subject to a $7,000,000 mortgage that was incurred in connection with the acquisition
of the warehouse. In lieu of foreclosure, the lender decides that it will reduce the mortgage
to $4,500,000. Blue may elect to exclude $2,000,000 from gross income ($7,000,000 debt −
$5,000,000 value). If Blue makes the election, it reduces the aggregate basis of its depreciable realty
by $2,000,000.
If the basis of the warehouse had been $1,000,000 and the warehouse was the only piece of
depreciable realty that Blue owned, only $1,000,000 of the debt cancellation income would be
excluded.
3. Seller Cancellation
When a seller of property cancels debt previously incurred by a solvent buyer in a purchase transaction, the cancellation generally does not trigger gross income to the buyer (situation 5). Instead, the reduction in debt is considered to be a reduction in the purchase price of the asset. Consequently, the basis of the asset is reduced in the hands of the buyer.
Example 40
Snipe, Inc., purchases a truck from Sparrow Autos for $10,000 in cash and a $25,000 note payable.
Two days after the purchase, Sparrow announces a sale on the same model truck, with a sales price
of $28,000. Snipe contacts Sparrow and asks to be given the sales price on the truck. Sparrow complies
by canceling $7,000 of the note payable. The $7,000 is excluded from Snipe’s gross income,
and the basis of the truck to Snipe is $28,000.
4. Shareholder Cancellation
If a shareholder cancels the corporation’s indebtedness to him or her (situation 6) and receives nothing in return, the cancellation usually is considered a contribution of capital to the corporation by the shareholder. Thus, the corporation recognizes no gross income. Instead, its paid-in capital is increased, and its liabilities are decreased by the same amount.
5. Student Loans
Many states make loans to students on the condition that the loan will be forgiven if students practice a profession in the state upon completing their studies. The amount of the loan that is forgiven (situation 7) is excluded from gross income. In addition, any portion of a student loan forgiven after December 31, 2020 and before January 1, 2026 is excludible from gross income. This exclusion applies to all loans made by the Federal or state governments, as well as loans made by private lenders and educational institutions. However, the exclusion does not apply to debt forgiven in exchange for services rendered by the student to the lending organization
4-5e Tax Benefit Rule
Generally, if a taxpayer claims a deduction for an item in one year and in a later year recovers all or a portion of the prior deduction, the recovery is included in gross income in the year received.
Example 41
Accrual basis MegaCorp deducted as a loss a $1,000 receivable from a customer when it appeared
the amount would never be collected. The following year, the customer paid $800 on the receivable.
MegaCorp reports the $800 as gross income in the year it is received.
Following this logic, the tax benefit rule limits income recognition when a deduction does not yield a tax benefit in the year it is taken.
Example 42
Before deducting a $1,000 loss from an uncollectible business receivable, Tulip Company reported
taxable income of $200. The business bad debt deduction yields only a $200 tax benefit (assuming
no loss carryback is made). That is, taxable income is reduced by only $200 (to zero) as a result of
the bad debt deduction. Therefore, if the customer makes a payment on the previously deducted
receivable in the following year, only the first $200 is a taxable recovery of a prior deduction. Any
additional amount collected is nontaxable because only $200 of the loss yielded a reduction in
taxable income (i.e., a tax benefit). Note: Not stated is that $800 NOL carryforward would also have to be reduced to $0.
4-5f Imputed Interest on Below-Market Loans
An income tax can be reduced if gross income can be shifted to a taxpayer in a lower tax bracket. Lending income-producing property to another taxpayer without charging interest on the loan could allow such tax-shifting without requiring the taxpayer to give up ownership of the income-producing property.
Example 43
Brown Corporation is in the 35% tax bracket and has $400,000 in a money market account earning
5% interest. Jack is the sole shareholder of Brown. He is in the 15% tax bracket and has no investment
income. In view of the difference in tax rates, Jack believes that it would be better for him
to receive and pay tax on the earnings from Brown’s $400,000 investment. Jack does not want to
receive the $400,000 from Brown as a dividend because that would trigger a tax.
Under prior law, Jack could receive the money market account from Brown in exchange for a
$400,000 non-interest-bearing note, payable on Brown’s demand. As a result, Jack would receive
the $20,000 annual earnings on the money market account, and the combined taxes of Brown and
Jack would be decreased every year by $4,000.
Decrease in Brown’s tax (.05 × $400,000) × .35 ($7,000)
Increase in Jack’s tax (.05 × $400,000) × .15 $3,000
Overall decrease in tax liability ($4,000)
The Federal income tax law does not allow this income-shifting result. Brown Corporation in this example is deemed to have received an interest payment from Jack even though no interest was actually paid. This payment of imputed interest is taxable to Brown. Jack may be able to deduct the imaginary interest payment on his return as investment interest if he itemizes deductions. Brown then is deemed to return the interest to Jack in the form of a taxable dividend.
Imputed interest is calculated using rates that the Federal government pays on new borrowings, compounded semiannually. The Federal rates are adjusted monthly and are published by the IRS.76 Three Federal rates exist: short-term (not over three years, including demand loans), mid-term (over three years but not over nine years), and long-term (over nine years).
If interest is charged on the loan but is less than the Federal rate, the imputed interest is the difference between the amount that would have been charged at the Federal rate and the amount actually charged.
Example 44
Assume that the Federal rate applicable to the loan in the preceding example is 3.5% through
June 30 and 4% from July 1 through December 31. Brown Corporation made the loan on January 1,
and the loan is still outstanding on December 31. Brown recognizes interest income of $15,140, and
Jack reports interest expense of $15,140. Brown is deemed to have paid a $15,140 dividend to Jack.
Interest Calculations
January 1 to June 30: 3.5% × $400,000 × ½ year $7,000
July 1 to December 31: 4% × ($400,000 + $7,000) × ½ year $8,140
$15,140
If Brown had charged 3% interest under the terms of the note, compounded annually, the
deemed interest amount would have been $3,140.
Interest at the Federal rate $ 15,140
Less interest actually charged (.03 × $400,000) ($12,000)
Imputed interest $3,140
The imputed interest rules apply to the following types of below-market loans. The effects of these loans on the borrower and lender are summarized in Exhibit 4.1.
• Gift loans (loans made out of love, respect, or generosity).
• Compensation-related loans (loans made by an employer to an employee).
• Corporation-shareholder loans (loans made by a corporation to a shareholder, as in Example 43).
Exceptions and Limitations
No interest is imputed on total outstanding compensation-related loans or corporation-shareholder
loans of $10,000 or less unless the purpose of the loan is tax avoidance. Similarly, no interest is imputed on outstanding gift loans of $10,000 or less between individuals, unless the loan proceeds are used to purchase income-producing property. On loans of $100,000 or less between individuals, the imputed interest cannot exceed the borrower’s net investment income for the year (gross income from all investments less the related expenses). If the borrower’s net investment income for the year does not exceed $1,000, no interest is imputed. However, this exemption does not apply if a principal purpose of a loan is tax avoidance
Exhibit 4.1 Effect of Certain Below-Market Loans: Imputed Interest Income and Deductions
Type of Loan Lender Borrower
Gift Step 1 Interest income Interest expense
Step 2 Gift made* Gift received
Compensation related Step 1 Interest income Interest expense
Step 2 Compensation expense Compensation income
Corp. to shareholder Step 1 Interest income Interest expense
Step 2 Dividend paid Dividend income
*The gift may be subject to the Federal gift tax (refer to Chapter 1).
Exhibit 4.2 Exceptions to the Imputed Interest Rules for Below-Market Loans
De-minimis $10,000 or less
See Book
Example 46
Vicki made interest-free gift loans as follows.
Borrower’s Net
Borrower Amount Investment Income Purpose
Susan $8,000 $−0− Education
Dan $9,000 $500 Purchase of stock
Mai $25,000 $−0− Purchase of a business
Olaf $120,000 $−0− Purchase of a residence
Tax avoidance is not a principal purpose of any of the loans. The loan to Susan is not subject to
the imputed interest rules because the $10,000 exception applies. The $10,000 exception does not
apply to the loan to Dan because the proceeds were used to purchase income-producing assets.
However, under the $100,000 exception, the imputed interest is limited to Dan’s investment income
($500). Because the $1,000 exception also applies to this loan, no interest is imputed.
No interest is imputed on the loan to Mai because the $100,000 exception applies. None of the
exceptions apply to the loan to Olaf because the loan was for more than $100,000; he recognizes
imputed interest income related to his loan.
4-5g Improvements on Leased Property
When a real property lease expires, the landlord regains control of both the real property and any improvements to the property (e.g., buildings and landscaping) made by the tenant during the term of the lease. Any improvements made to the leased property are excluded from the landlord’s gross income unless the improvement is made to the property in lieu of rent.
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