CHAPTER 3

GROSS INCOME: INCLUSIONS

AND EXCLUSIONS

Learning Objectives

LO 1. Describe when and how to record income for tax purposes.

LO 2. Apply the cash method of accounting to income taxes.
LO 3. Explain the taxability of components of gross income, including interest,
dividends, tax refunds, and Social Security benefits.
LO 4. Apply the rules concerning items excluded from gross income.
LO 5. Apply the rules associated with tax accounting for savings bond interest used for
education expenses, below-market interest loans, gift loans, and original issue
discount debt (Appendix).

Topics of Primary Importance

 Understanding when to include an item, such as interest, dividends, tax refunds

and social security benefits, in gross income.
 Understanding the requirements to exclude items from gross income.
 Understanding the rules and calculations for savings bond interest used for
education expenses, below-market interest loans and original-issue discount debt.

Student Confusion Areas

 Determining which items are includable and which items are excludable from
gross income.
 Determining the tax liability on a return when qualified dividends have been
received.
 Determining the computation of the taxable portion of social security benefits.
 Determining the calculations for below-market interest loans and original-issue
discount debt.

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 Notes Outline

I. LO 1 – When and How to Record Income

A. For tax purposes, income is recognized if a transaction meets all of the
following three conditions:
1. The transaction must have an economic benefit. An economic benefit
can be explained by stating that the taxpayer must be better off after the
transaction occurs.
2. The transaction must actually have reached a conclusion. This means
the transaction must occur and must be taken to completion.
3. The income cannot be tax-exempt income.

II. LO 2 – Cash Method of Accounting

A. Almost all individuals use the cash receipts and disbursements method of
accounting.

B. Under the cash method, the taxpayer reports income when received or
constructively received rather than the year in which the taxpayer earned the
income.
1. Constructive receipt means that the income is available to or in the
control of the taxpayer, regardless of whether the taxpayer chose to utilize
the income.
a. An example of constructive receipt is interest on a savings
account; it becomes income when credited to the account,
regardless of whether the taxpayer uses it.

C. Income can be realized in any form, whether in money, property, or services.

1. Receipt of property or services triggers income recognition. This is true

even for cash-basis taxpayers.
2. Income is recognized by a taxpayer even if the taxpayer receives it
indirectly.

In-class Example – A cash-basis taxpayer provided legal services to a friend in

exchange for the friend being a math tutor for the taxpayer’s daughter. Has income been
realized by anyone?
In this case, both individuals must report income based on the fair market value of the
services provided.

III. LO 3 – Taxability of Components of Gross Income

A. Interest income
1. Interest income must be included in income. Generally, it is reported on
a Form 1099-INT if the interest income is paid by a financial institution.

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 2. Interest on Series EE and Series E U.S. Savings Bonds can be reported
at maturity (or redemption date, if it occurs before the maturity date), or
the taxpayer can elect to report the annual increase in face value as interest
income every year.
a. Exception to these government bonds is the Series HH bonds
which were sold until August 2004 at face value. In this situation,
interest is paid semiannually and must be reported every year.
3. Interest can be excluded if it is tax-exempt. However, it should be
listed on the return as such.
a. Examples of tax-exempt interest are interest earned on bonds
issued by any state, any possession of the United States, any
political subdivision of either of the foregoing, or of the District of
Columbia.
b. Interest is taxable if received from state or local bonds issued
for private activities, such as convention centers or stadiums.
4. A taxpayer receiving more than $1,500 of interest income must
complete and file Schedule B.

B. Dividend income
1. Dividends are distributions by a corporation to its shareholders.
2. The Tax Cuts and Jobs Act of 2017 provides for taxability of qualified
dividends based on taxable income thresholds. In 2022, for married filing
jointly with taxable income of less than $83,350, head of household with
taxable income of less than $55,800, and married filing separately or
single with taxable income of less than $41,675, the dividends are taxed at
0%. Thereafter, dividends are taxed at 15% for income up to $517,200 for
married filing jointly, $258,600 for married filing separately, $488,500 for
head of household, and $459,750 for single taxpayers. A 20% tax rate on
dividends applies for taxable income above those amounts.
3. Stock dividends are generally not taxable, except in the following
situations:
a. Shareholders have the option to receive either stock or cash or
other property.
b. Distribution is disproportionate; some shareholders receive
property and other shareholders receive an increase in their stock
interest in the corporation.
c. Distributions of preferred stock to some common shareholders
and common stock to other common shareholders.
d. Distributions made on preferred stock.
4. A taxpayer receiving more than $1,500 of dividend income must
complete and file Schedule B.

C. State and local tax refunds received in the current year

1. If state or local taxes were deducted as an itemized deduction on
Schedule A in the prior year, the taxpayer must report the refund as
income. The taxable amount is the lesser of:

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 a. The amount received.
b. The amount deducted on Schedule A.
c. The amount by which the itemized deductions exceed the
standard deduction.

D. Unemployment compensation
1. Federal and state unemployment compensation benefits are taxable.

E. Social security benefits

1. Taxability of social security benefits depends on the provisional
income (also called modified adjusted gross income) and filing status of
the taxpayer.
2. Provisional income is computed as follows:
Adjusted gross income (before social security benefits)
Plus: Interest on U.S. savings bonds excluded for educational
purposes
Most tax-exempt interest
Employer-provided adoption benefits
Excluded foreign income
Deducted interest on educational loans
Deducted tuition and fees
50% of social security benefits
3. If provisional income exceeds certain thresholds, 50% of social
security benefits are taxable. Depending on the amount of provisional
income of the taxpayer, this taxable amount can increase to as much as
85% of the social security benefits.
a. For a married, filing jointly tax return, the lower limit of
provisional income is $32,000 and the upper limit is $44,000.
b. For a single, head of household, or qualifying widow(er), the
lower limit of provisional income is $25,000 and the upper limit is
$34,000. For the complete chart, see page 3-12 of the text.
4. Social security benefits are reported on Form SSA-1099.

In-class Example – Oscar and Olga file a joint tax return. Olga earned a salary of
$41,000 and received dividends of $1,000, taxable interest income of $500, and tax-
exempt interest of $800. Oscar received $10,000 of social security benefits. What amount
of social security benefits is taxable to Oscar and Olga?

Answer:
A portion of social security benefits may be taxable if provisional income
exceeds certain limits. The provisional income of Oscar and Olga is:

Salary…………………………………….. $ 41,000
Dividend income…………………………. 1,000
Taxable interest income…………..……… 500
Tax-exempt interest income……………… 800

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 One-half social security benefits………... 5,000
-----------
Provisional income………………. $ 48,300
=======
The amount of taxable social security benefits is equal to the lesser of (a)
85% of the benefits or (b) 85% of the excess of provisional income over
$44,000 plus the lesser of (1) $6,000 or (2) 50% of benefits.

Item (a) above is equal to $8,500. Item (b) above is equal to $3,655 (the
excess over $44,000 times 85%) plus $5,000 (the lesser of $6,000 or 50%
of benefits) for a total of $8,655. Thus, the taxable amount of social
security benefits for Oscar and Olga is $8,500.

F. Other taxable income reported on line 8 of Schedule 1

1. Jury duty pay
2. Prizes and awards
3. Forgiveness of debt
4. Certain insurance proceeds, but not applicable to life or health
insurance

IV. LO 4 – Items Excluded from Gross Income

A. Certain types of fringe benefits are tax-free to the employee and the employer
can deduct the cost of providing these benefits.
1. No-additional-cost services provided to an employee, his or her spouse,
or dependent children.
a. Examples include airline seats.
2. Discounts provided to employees for products or services normally
sold by the business.
a. Discounts on meals in restaurants or discounts on clothing at a
retail store.
b. For products, the discount cannot exceed the gross profit
percentage.
c. For services, the discount cannot exceed 20% of the normal
selling price.
3. Working condition fringe benefit.
a. Examples include professional organization dues.
4. Qualified transportation fringe benefits.
a. In 2022, parking benefits cannot exceed $280 per month, and
transit passes and vanpool benefits cannot exceed $280 per month.
5. De minimis benefits, such as holiday turkeys.
6. Additional types of excludable benefits:
a. Accident and health insurance.
b. Educational assistance up to $5,250 per year for tuition, fees,
books and supplies. Employers can contribute up to $5,250 in
payment of employee student loans under the CARES Act
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 employer student loan repayment benefit. The $5,250 cap applies
to both the new student loan repayment benefit as well as other
educational assistance.
c. Group term life insurance premiums up to $50,000 of coverage
per person.
d. Cost of employer-paid meals and lodging if these are furnished
for the convenience of the employer on the business premises.
e. Dependent care assistance up to $5,000 ($2,500 for married
filing separately) per year. In addition, the exclusion cannot
exceed the taxpayer’s earned income (earned income of the lesser
earning spouse for married filing jointly).
f. Flexible benefit plans or cafeteria plans.
i. In this type of plan, the employees can select their own
menu of benefits.

B. Other nontaxable income, not directly related to employment:

1. Scholarships and fellowships.
2. Qualified tuition program withdrawals.
3. Life insurance proceeds.
4. Gifts and inheritances.
5. Compensation for sickness or injury.
6. Child support.
7. Public assistance payments.
8. Employer-provided adoption assistance.

V. LO 5 – Tax Accounting for Complex Items

A. Interest on Series EE or Series I Savings Bonds is not taxable if the taxpayer

uses the bond proceeds to pay qualified higher education expenses for the
taxpayer, his or her spouse, or their dependents(s).
1. Qualified higher education expenses have been defined as tuition and
fees at a qualified educational institution.
2. The amount of qualified expenses must be reduced by tax-exempt
scholarships, certain educational assistance allowances, certain benefits
under a qualified state tuition program, and expenses used in determining
Hope and lifetime learning credits or a Coverdell Education Savings
Account distribution exclusion.
3. If proceeds received by the taxpayer exceed the expenses, there must
be an allocation to determine the amount that is taxable.

In-class Example – In 2022, Gabriel redeemed $4,000 (principal of $3,000 and interest
of $1,000) of Series EE Savings Bonds to pay qualified higher education expenses. His
qualified expenses for the year totaled $3,300. Gabriel may exclude interest of $825 from
income in 2022. The remainder $175 is taxable interest income.

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 $1,000 × ($3,300/$4,000) = $825.

4. The amount of excludable interest is further reduced if the modified

AGI of the taxpayer exceeds $128,650 on a joint return or $85,800 on
other returns. The formula is as follows:

Amount otherwise excludable × Modified AGI—limitation amount

$30,000 ($15,000 for single filers)

The amount of exempt interest phases out when modified AGI reaches
$158,650 for joint returns and $100,800 for other returns.

Modified AGI is computed as follows:

Adjusted Gross Income

Plus: Deduction for student loan interest
Deduction for tuition and fees
The savings bond interest exclusion itself
Excluded foreign income and allowances
Excluded adoption assistance from an employer

B. Below-market interest rate loans are required to have an imputed rate of

interest.

1. The imputed interest rules do not apply to the following:

a. Debt subject to the original issue discount rules.
b. Sales of property for $3,000 or less.
c. Certain carrying charges.
d. Sales in which all payments are due in 6 months or less.
e. In the case of sales of patents, any portion of the sales price that
is contingent on the productivity, use, or disposition of the patent.
2. Taxpayers use the accrual basis to calculate imputed interest (even if
the taxpayer reports on the cash-basis) except in the following instances,
when cash-basis reporting is permitted:
a. Sale of a personal residence.
b. Sales of farms for $1 million or less.
c. Sales in which total payments are $250,000 or less.
d. Certain land transfers between related parties.
e. Debt in which the stated principal is $2 million or less and the
lender and borrower elect to use the cash method (not applicable to
accrual method lenders or dealers.

C. Gift, shareholder, and similar loans

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 1. The concepts associated with imputed interest rules also apply to
certain low interest or interest-free loans involving related parties.
a. Gift loans over $16,000 in which interest forgone is in the form
of a gift.
b. Compensation-related loans over $10,000 between an employee
and employer or between an independent contractor and the
corporation for which he or she works or any shareholder thereof.
c. Loans over $10,000 between a corporation and any shareholder.
d. Other loans in which a principal purpose is to avoid tax.
e. Other loans in which the below-market or interest-free loan
would have a significant effect on the tax liability of the borrower
or lender.

D. Original Issue Discount (OID)

1. An original issue discount is created when someone purchases a debt
instrument from an issuer for an amount less than par. In this situation, the
initial OID is equal to the difference between the acquisition price and the
maturity value.
2. The OID is deemed to be zero if it is less than .25% of the maturity
value, multiplied by the number of complete years to maturity.
3. The holder of an OID must include part of the OID in interest income
every year, regardless of the holder’s method of accounting.
4. The method that is used to calculate the imputed interest is the effective
interest method.
5. The OID rules apply to all debt instruments with OID except for:
a. Tax-exempt debt.
b. U.S. Savings Bonds.
c. Debt with a maturity of 1 year or less on the date of issue.
d. Any obligation issued by a natural person before March 2,
1984.
e. Non-business loans of $10,000 or less between natural persons.

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