As we learned in the previous chapter, gross income is income that taxpayers realize, recognize, and report on their tax returns for the year. In the previous chapter, we dis- cussed gross income in general terms. In this chapter we explain the requirements for taxpayers to recognize gross income, and we discuss the most common sources of gross income.
What Is Included in Gross Income?
The definition of gross income for tax purposes is provided in §61(a) as follows:
General Definition.—Except as otherwise provided in this subtitle, gross income means all income from whatever source derived (emphasis added).
In addition to providing this all-inclusive definition of income, §61 includes a list of examples of gross income such as compensation for services, business income, rents, royalties, interest, and dividends. However, it is clear that unless a tax provision says otherwise, gross income includes all income. Thus, gross income is broadly defined.
Reg. §1.61-(a) provides further insight into the definition of gross income as follows:
Gross income means all income from whatever source derived, unless excluded by law. Gross income includes income realized in any form, whether in money, property, or services.
Based on §61(a), Reg. §1.61-(a), and various judicial rulings, taxpayers recognize gross income when (1) they receive an economic benefit, (2) they realize the in- come, and (3) no tax provision allows them to exclude or defer the income from
LO 5-1
from Gramps’s life insurance policy. She invested part of the proceeds in an annuity contract that will pay Gram a fixed amount per year. Gram also in- vested some of the proceeds in the stock of a local corporation. She used the rest of the life insurance proceeds to purchase a certificate of deposit and start a savings account. Gram also spent some of her spare time completing sweepstakes entries. Her
a sweepstakes contest.
Until their divorce, Courtney’s husband always prepared their income tax return. Since EWD hired her, Courtney has become anxious about her income tax and whether her withholding will be sufficient to cover her tax bill. Courtney is also worried about Gram’s tax situation, because Gram did not make any tax payments this year. ■
5-2
gross income for that year.1 Let’s address each of these three requirements for recog- nizing gross income.
Economic Benefit Taxpayers must receive an economic benefit (i.e., receive an item of value) to have gross income. Common examples of economic benefit include compensation for services (compensation in the form of cash, other property, or even services received), proceeds from property sales (typically cash, property, or debt relief), and income from investments or business activities (such as business income, rents, interest, and dividends). How about when a taxpayer borrows money? Is the economic benefit criterion met? No, because when a taxpayer borrows money, the economic benefit received (the cash received) is completely offset by the liability the taxpayer is required to pay in return for borrowing the funds (the debt amount plus interest).
Realization Principle As indicated in Reg. §1.61-(a), the tax definition of income adopts the realization principle. Under this principle, income is realized when (1) a tax- payer engages in a transaction with another party, and (2) the transaction results in a measurable change in property rights. In other words, assets or services are exchanged for cash, claims to cash, or other assets with determinable value.
The concept of realization for tax purposes closely parallels the concept of realiza- tion for financial accounting purposes. Requiring a transaction to trigger realization reduces the uncertainty associated with determining the amount of income, because a change in rights can typically be traced to a specific moment in time and is generally accompanied by legal documentation.
1For tax purposes it matters not whether income is obtained through legal or illegal activities (e.g., embezzlement). See Eugene James v. U.S. (1961, S. Ct.), 7 AFTR 2d 1361.
Example 5-1
In April, Gram used part of the life insurance proceeds she received from Gramps’s death to purchase 50 shares in Acme Corporation for $30 per share. From April to the end of December, the value of the shares fluctuated between $40 and $25, but on December 31, the shares were worth $35. If Gram does not sell the shares, how much income from her stockholdings in Acme Corporation does she realize for the year?
Answer: $0. Unless Gram sells the stock, she does not enter into a transaction resulting in a measur- able change of property rights with a second party. Thus, she does not realize income even though she experienced an economic benefit from the appreciation of the stock from $30 per share to
$35 per share.
Adopting the realization principle for defining gross income provides two major ad- vantages. First, because parties to the transaction must agree to the value of the exchanged property rights, the transaction allows the income to be measured objectively. Second, the transaction often provides the taxpayer with the wherewithal to pay taxes (at least when the taxpayer receives cash in the transaction). That is, the transaction itself provides the taxpayer with the funds to pay taxes on income generated by the transaction. Thus, it reduces the possibility that the taxpayer will be required to sell other assets to pay the taxes on the income from the transaction. Note, however, that when taxpayers receive property or services in a transaction (instead of cash), realization has also occurred (despite the absence of wherewithal to pay).
Recognition Taxpayers who realize an economic benefit must include the benefit in gross income unless a specific provision of the tax code says otherwise. That is, taxpayers are generally required to recognize all realized income by reporting it as gross income on their tax returns. However, as we describe later in this chapter, through exclusions Congress allows taxpayers to permanently exclude certain types of income from gross income and through deferrals it allows taxpayers to defer certain types of income from gross income until a subsequent year. Thus, it is important to distinguish between realized and recognized income.
Other Income Concepts
The tax laws, administrative authority, and judicial rulings have established several other concepts important for determining an individual’s gross income.
Form of Receipt A common misperception is that taxpayers must receive cash to realize and recognize gross income. However, Reg. §1.61-(a) indicates that taxpayers realize income whether they receive money, property, or services in a transaction.
For example, barter clubs facilitate the exchange of rights to goods and services between members, many of whom have the mistaken belief that they need not recog- nize income on the exchanges. However, when members exchange property, they re- alize and recognize income at the market price, the amount that outsiders are willing to pay for the goods or services. Also, other taxpayers who exchange or trade goods or services with each other must recognize the value of the goods or services as in- come, even when they do not receive any cash. Indeed, taxpayers have the legal and ethical responsibility to report realized income (assuming no exclusion provision ap- plies) no matter the form of its receipt or whether the IRS knows the taxpayer received the income.
What if: Suppose during March, Gram paid no rent to her neighbor (also her landlord). Although the neighbor typically charges $350 per month for rent, he allowed Gram to live rent-free in exchange for babysitting his infant son. What income would Gram and Gram’s neighbor realize and recognize on this exchange?
Answer: $350. Gram and the neighbor each would recognize $350 of income for March. The neighbor recognizes $350 of rental receipts because this is the value of the babysitting services the neighbor re- ceived in lieu of a cash payment for rent from Gram (an economic benefit the neighbor realized through the exchange). Gram recognizes $350 of babysitting income, because this is the value of the services provided to her neighbor (an economic benefit was realized because Gram was not required to pay rent).
Example 5-2
2§1001(a).
Return of Capital Principle When taxpayers sell assets, they must determine the extent to which they include the sale proceeds in gross income. Initially, the IRS was convinced that Congress’s all-inclusive definition of income required taxpayers to include all sale proceeds in gross income. Taxpayers, on the other hand, argued that a portion of proceeds from a sale represented a return of the cost or capital investment in the underly- ing property, called tax basis. The courts determined that when receiving a payment for property, taxpayers are allowed to recover the cost of the property tax-free. Consequently, when taxpayers sell property, they are allowed to reduce the sale proceeds by their unre- covered investment in the property to determine the realized gain from the sale.2 When
the tax basis exceeds the sale proceeds, the return of capital principle generally applies to the extent of the sale proceeds. The excess of basis over sale proceeds is generally not considered to be a return of capital, but rather a loss that is deductible only if specifically authorized by the tax code. Below, we revisit the return of capital principle when we dis- cuss asset dispositions.
The return of capital principle gets complicated when taxpayers sell assets and col- lect the sale proceeds over several periods. In these cases, the principle is usually modi- fied by law to provide that the return of capital occurs pro rata as the proceeds are collected over time. We discuss this issue in more detail later in this chapter when we discuss the taxation of annuities.
Recovery of Amounts Previously Deducted A refund is not typically in- cluded in gross income because it usually represents a return of capital. For example, a refund of $1,000 on an auto purchased for $12,000 simply reduces the net cost of the vehicle to $11,000. Likewise, a $200 refund of a $700 business expense is not included in gross income but instead reduces the net expense to $500. However, if the refund is made for an expenditure deducted in a previous year, then under the tax benefit rule the refund is included in gross income to the extent that the prior deduc- tion produced a tax benefit.3 For example, suppose an individual paid a $1,000 busi- ness expense claimed as a for AGI deduction in 2017, but $250 of the expense was subsequently reimbursed in 2018. Because the $250 business deduction produced a tax benefit in 2017 (reduced taxable income), the $250 refund in 2018 would be in- cluded in income.
The application of the tax benefit rule is more complex for individuals who item- ize deductions. An itemized deduction produces a tax benefit only to the extent that total itemized deductions exceed the standard deduction. For example, suppose an individual’s total itemized deductions exceeded the standard deduction by $100. A refund of $150 of itemized deductions would cause the individual’s itemized deduc- tions to fall $50 beneath the standard deduction. If the refund occurred in the same year as the expense, the individual would have elected the standard deduction, and the refund would have caused taxable income to increase by only $100 (because of the difference between claiming the standard deduction and using the total itemized deductions that would have been claimed in the absence of any refund). If the refund occurs the year after the deduction is claimed, then only $100 of the $150 refund would be included in gross income under the tax benefit rule. The $100 is added to taxable income in the year of the refund, because this is the increment in taxable in- come that would have resulted if the refund had been issued in the year the itemized deduction was claimed.
3§111.
Example 5-3
In 2017 Courtney paid $3,500 in Ohio state income taxes, and she included this payment with her other itemized deductions when she filed her federal income tax return in March of 2018. Courtney filed her 2017 federal return as a head of household and claimed $15,600 of itemized deductions.
She also filed an Ohio state income tax return in March of 2018 and discovered she only owed
$3,080 in Ohio income tax for 2017. Hence, Courtney received a $420 refund of her Ohio income tax in June of 2018. How much of the $420 refund, if any, is Courtney required to include in her gross income in 2018? The answer depends upon the standard deduction for 2017. Help Court- ney apply the tax benefit rule (the standard deduction for head of household filing status in 2017 was $9,350).
(continued on page 5-6 )
Answer: All $420. Courtney is required to include the entire refund in her 2018 gross income be- cause her itemized deduction for the $420 of state income taxes that she overpaid last year re- duced her taxable income by $420. Accordingly, because she received a tax benefit (deduction) for the entire $420 overpayment, she must include it all in gross income in 2018. See the following for the calculation of the amount of tax benefit Courtney received from the $420 overpayment of taxes in 2017.
Deduction Amount Explanation
(1) Itemized deductions $15,600
(2) 2017 standard deduction 9,350 Head of household filing status (3) Reduction in taxable income 15,600 Greater of (1) and (2)
(4) Itemized deductions adjusted for the 15,180 (1) − $420 $420 refund
(5) Reduction in taxable income after 15,180 Greater of (2) and (4) adjustment for the $420 refund
Tax benefit due to prior deduction or $420 refund $ 420 (3) − (5)
What if: Let’s consider alternative fact patterns provided in Scenarios A and B to further illustrate the application of the tax benefit rule.
Scenario A: In 2017 Courtney’s itemized deductions, including $3,500 in state taxes, were $5,500.
Scenario B: In 2017 Courtney’s itemized deductions, including $3,500 in state taxes, were $9,550.
How much of the $420 refund would Courtney include in her 2018 gross income in Scenarios A and B?
Answer Scenario A: $0. As computed below, Courtney received $0 tax benefit from the $420 tax overpayment in 2017, so she need not include any of the refund in her gross income.
Answer Scenario B: $200. As computed below, Courtney received a $200 tax benefit (reduction in taxable income) from the $420 state tax overpayment in 2017, so she must include $200 of the refund in her 2018 gross income.
Scenario A Scenario B
Deduction Amount Amount Explanation
(1) Itemized deductions $5,500 $9,550
(2) 2017 standard deduction 9,350 9,350 Head of household filing status (3) Reduction in taxable income 9,350 9,550 Greater of (1) and (2)
(4) Itemized deductions adjusted 5,080 9,130 (1) − $420 for the $420 refund
(5) Reduction in taxable income 9,350 9,350 Greater of (2) and (4) adjusted for the $420 refund
Tax benefit due to prior deduction $ 0 $ 200 (3) − (5) of $420 refund
When Do Taxpayers Recognize Income?
Individual taxpayers generally file tax returns reporting their taxable income for a calendar- year period, whereas corporations often use a fiscal year-end. In either case, the taxpayer’s method of accounting generally determines the year in which realized income is recog- nized and included in gross income.
Accounting Methods Most large corporations use the accrual method of accounting.
Under the accrual method, income is generally recognized when earned, and expenses are generally deducted in the period when liabilities are incurred. In contrast, most indi- viduals use the cash method as their overall method of accounting.4 Under the cash method, taxpayers recognize income in the period they receive it (in the form of cash,
4Taxpayers involved in a business may use the accrual or hybrid overall method of accounting. We discuss these methods in the Business Income, Deductions, and Accounting Methods chapter.
property, or services), rather than when they actually earn it. Likewise, cash-method tax- payers claim deductions when they make expenditures, rather than when they incur liabil- ities. The cash method greatly simplifies the computation of income for the overwhelming majority of individuals, many of whom have neither the time nor the training to apply the accrual method. Another advantage of the cash method is that taxpayers may have some control over when income is received and expenses are paid. Because of this control, tax- payers can more easily use the timing tax planning strategy (described in the Tax Planning Strategies and Related Limitations chapter) to lower the present value of their tax bill.
Constructive Receipt Taxpayers using the cash method of accounting may try to shift income from the current year to the next year when they receive payments near year-end.
For instance, taxpayers may merely delay cashing a check or avoid picking up a compensa- tion payment until after year-end. The courts responded to this ploy by devising the constructive receipt doctrine.5 The constructive receipt doctrine states that a taxpayer real- izes and recognizes income when it is actually or constructively received. Constructive receipt is deemed to occur when the income has been credited to the taxpayer’s account or when the income is unconditionally available to the taxpayer, the taxpayer is aware of the income’s availability, and there are no restrictions on the taxpayer’s control over the income.
THE KEY FACTS Income Recognition
• Cash-method taxpayers recognize income when it is received.
• Income is realized regard- less of whether payments are received in money, property, or services.
• Income is taxed in the period in which a cash- method taxpayer has a right to receive payment without substantial restrictions.
Example 5-4
Courtney is a cash-method taxpayer. Based on her outstanding performance at work, Courtney earned a $4,800 year-end bonus. On December 28, Courtney’s supervisor told her that her bonus was issued as a separate check and that Courtney could pick up the check in the accounting office anytime.
Courtney did not pick up the check until January 2 of the next year, and she did not cash it until late January. When does Courtney realize and recognize the $4,800 income?
Answer: On December 28 of the tax year in question. Courtney constructively received the check that year because it was unconditionally available to her on December 28, she was aware of the check’s availability, and there were no restrictions on her control over the check. Courtney must in- clude the $4,800 bonus in gross income for that year, even though she did not actually receive the funds until late January of the next year.6
5Justice Holmes summarized this doctrine as follows: “The income that is subject to a man’s unfettered com- mand and that he is free to enjoy at his own option may be taxed to him as his income, whether he sees fit to enjoy it or not.” Corliss v. Bowers, 281 US 378 (1930).
6Note also that Courtney’s employer would include her bonus on Courtney’s W-2 for the year in which it issued the check.
7§1341 provides relief for a taxpayer who recognizes taxable income because of the claim of right doctrine and in a later year determines that she does not have a claim of right. Specifically, §1341 provides that if a taxpayer recognizes taxable income in an earlier year because she has a “claim of right” (unrestricted right) to the income received, a deduction is then allowable in a later year because she did not have an unrestricted right to the income, and if the related tax deduction exceeds $3,000, then the tax imposed in the later year is the lesser of (1) the tax for the taxable year computed with the deduction or (2) the tax for the taxable year computed without the deduction, less a tax credit for the previous tax paid on the item of income. Beginning in 2018, individuals who are required to repay compensation previously recognized in a prior year under the claim of right doctrine are not allowed a deduction for the repayment if the amount does not exceed $3,000.
Claim of Right The claim of right doctrine is another judicial doctrine created to address the timing of income recognition. Specifically, this doctrine addresses when a taxpayer receives income in one period but is required to return the payment in a subse- quent period. The claim of right doctrine states that income has been realized if a tax- payer receives income and there are no restrictions on the taxpayer’s use of the income (e.g., the taxpayer does not have an obligation to repay the amount). A common example of the claim of right doctrine is a cash bonus paid to employees based on company earn- ings. Despite potentially having to repay the bonuses (for example, in the case of a “claw- back” provision that requires repayment if the company has an earnings restatement), employees would include the bonuses in gross income in the year received because there are no restrictions on their use of the income.7