Most forms of gross income are taxed, but when tax liability is incurred depends on when the income was received and the accounting system used by the taxpayer. Special rules may also apply to particular types of income.
Internal Revenue Code §61 defines gross income as income from whatever source derived unless it is specifically excluded. Specifically, it includes money, property, services, or any other form of compensation. It also includes investment income and gifts, although gifts and bequests are rarely taxed since there is a large tax exemption for both, and it is taxed to the donor of the property rather than the donee.
Income that is considered earned or received is said to be realized income. Realized income is not necessarily taxable when it is realized, but when it does become taxable income, then it is said to be recognized income — it is recognized by the tax code as taxable income and must be reported as such for the tax year in which it is recognized. Another distinction of income is the difference between earned income and unearned income. Earned income is income received as compensation for the taxpayer's efforts or personal service — it is income earned from working; unearned income is all other income: either investment income or inherited income. Earned income is the most heavily taxed form of income, since it does not receive preferential tax treatment plus it is subjected to employment taxes, which, by definition, applies only to income earned from work. Earned income is the main income of working people, while unearned income is received mostly by the wealthy, which is why many wealthy people pay a lower effective tax rate than most people in the lowest quintile of income.
Adjusted Gross Income (AGI)
There are 2 types of adjustments to gross income, which reduces taxable income. The 1st type of deduction is referred to as an adjustment for gross income, which is a deduction that the taxpayer can claim even if the taxpayer does not itemize deductions. These deductions are also referred to as above-the-line deductions, because they are above the line for adjusted gross income at the bottom of Form 1040, so all the adjustments for gross income are listed on the 1st page of Form 1040. Deductions for adjusted gross income (AGI) are listed in IRC §62 and are also listed in the Adjusted Gross Income section on the 2nd page of Form 1040, U.S. Individual Income Tax Return, so they are often referred to as below-the-line deductions, since they come after AGI is calculated.
AGI is an important concept because it is widely referenced in the Internal Revenue Code, and it is important for the taxpayer because many deductions are either based on a percentage of AGI or limited by AGI. For instance, deductible charitable contributions are limited to 50% of AGI, deductible medical expenses are subject to a 10% AGI floor, and many miscellaneous expenses are subject to a 2% AGI floor. Some of the most common deductions for adjusted gross income include:
- expenses incurred in a trade or business;
- ½ of the self-employment tax paid by self-employed taxpayers;
- qualified contributions to a pension, profit-sharing, or annuity plans of self-employed taxpayers;
- health insurance premiums paid by the self-employed;
- health savings account contributions;
- contributions to a traditional IRA plan;
- expenses that are incurred as an employee but only if the expenses are reimbursed from an accountable plan;
- deduction for moving expenses;
- interest paid on student loans; and
- qualified tuition and related expenses.
Because above-the-line deductions are used to calculate AGI, their deductibility is neither modified nor limited by AGI. Moreover, all above-the-line deductions are available under the alternative minimum tax system, but few of the below-the-line deductions are available.
The 2nd type of adjustment is often referred to as an adjustment from gross income, because, unlike adjustments for gross income, these types of deductions do not change AGI. Instead, these deductions are subtracted from AGI to determine taxable income to which the marginal tax rates apply. They are listed in the Tax and Credits section of Form 1040. This is the income that is used to find the taxes owed in tax tables. The most common adjustments from gross income include itemized deductions or the standard deduction and the personal and dependency exemptions. If a deduction is not listed in §62, then it is a deduction from AGI.
Note that both adjustments for and from gross income reduce taxable income that is subject to the marginal tax rates, but neither, with the exception of business expenses for the self-employed, reduces employment taxes.
|+ Income||Page 1 of Form 1040|
|– Adjustments to Income|
|the "line" →|
|= Adjusted Gross Income (AGI)|
|– Standard Deduction or Itemized Deductions||Page 2 of Form 1040|
|– Personal and Dependency Exemptions|
|= Taxable Income|
Modified Adjusted Gross Income (MAGI)
Certain parts of the tax code refer to modified adjusted gross income (MAGI), which is generally gross income minus above-the-line deductions, but with certain tax breaks added back, most often the foreign earned income exclusion. In some cases, excluded interest on US savings bonds that were redeemed for higher education may also be added back. However, the exact definition of MAGI depends on the tax code that refers to it, since the tax breaks that are added back are different in some cases. When the tax code refers to MAGI, it will also include a definition. For most taxpayers, MAGI will closely approximate AGI, but if there is a difference, then MAGI will generally be greater than AGI. The use of MAGI is to determine a taxpayer's financial support rather than just taxable income, since MAGI is mostly used to determine the eligibility for tax credits.
For instance, MAGI, as defined under the Affordable Care Act, otherwise known as Obamacare, adds back to AGI nontaxable Social Security benefits, tax-exempt interest, and excluded foreign earned income and deducted housing expenses to determine if the taxpayer is eligible for Medicaid or tax credits for health insurance premiums for insurance bought through the new healthcare exchanges. IRC § 36B(d)(2)(B)
Ordinary Income, Capital Gains, and Recovery of Capital
The tax code also distinguishes between ordinary income and capital gains, since different tax rates apply to these forms of income. Ordinary income is generally taxed at the taxpayer's marginal rate, while capital gains have special rates that are lower than marginal rates. However, starting in 2013, a new 3.8% Medicare surtax will be applied to capital gains earned by higher income taxpayers. In some transactions, income received must be decomposed into capital gains and ordinary income. For instance, when a bond is sold between interest payment dates, then the buyer of the bond pays more because of the accrued interest, so part of the income received by the seller is accrued interest and part may be capital gains. The accrued interest must be recognized as ordinary income rather than capital gains.
When money is received in which there is an obligation to repay, such as when a landlord receives a deposit or when a borrower receives a loan, then there is no recognition of income unless the obligation to repay is terminated.
Sometimes, an assignee or agent of the taxpayer receives the income. Nonetheless, the taxpayer is still liable for the tax. An assignment of income does not shift the tax liability to the assignee – it remains with the assignor. Income received by employees working for an employer is taxable to the employer. When a child earns income for personal services, such as acting, then the amount is included in the child's gross income even if the money is paid to the parents.
Income earned from the sale of property is subject to taxation, but the amount taxed is limited by the recovery of capital doctrine — taxable income is equal to the selling price of property minus the adjusted tax basis of the property, which is often equal to the purchase price. So if the taxpayer buys $5,000 worth of stock and later sells it for $10,000, then only $5,000 of that amount is taxable, even though $10,000 was received, since the other $5,000 was simply a recovery of the invested capital. Likewise, a buyer of a bond with accrued interest must pay for that accrued interest, so the bondholder can subtract the accrued interest from her interest income for the tax year, since she did not earn the interest before the bond was bought. The tax basis of the bond is also lowered by the amount of the accrued interest, so when the bondholder sells the bond, the capital gain is increased or the capital loss is decreased by the amount of the subtracted accrued interest.
When Gross Income is Recognized
Gross income is only recognized when payment is certain. Dividends, for instance, are taxable to the owner of the stock on the date of record for the dividend payment. Otherwise, dividends do not accrue because whether dividends are paid depends on whether the corporation's board of directors approves the dividend and the taxpayer actually owns the stock on the date of record.
The tax code also allows different methods for recognizing some income. The installment method allows the income to be recognized over a period of years. By contrast, the percentage of completion method allows contractors to report income as the work is completed or they can defer all profit until the project is completed, which is known as the completed contract method. However, the completed contract method is only available in restrictive circumstances.
Income must be reported when it is constructively received. The constructive receipt doctrine stipulates that income is received when it is available to the taxpayer without limitations or restrictions. So if the taxpayer receives her check in December but she doesn't cash it until the following year, she still must report the income for the previous year. However, if her employer told her to hold off depositing the check because he had insufficient funds, then she can report the income for the following year since it was not available for certain.
Income with substantial restrictions is generally not taxable. For instance, although the cash value of ordinary life insurance increases year after year, it is not taxable to the policyholder, because the policyholder must cancel the policy to actually receive the cash surrender value — only then would the value be known for certain. Therefore, the annual increase in the cash value of the policy is not taxable to the policyholder. Likewise, if stock is issued to employees that cannot be sold until later, then the income is not taxable to the employees until the restrictions are removed.
One common exception to the constructive receipt of income is the earning of interest from original issue discount bonds. Many bonds do not pay periodic interest, but are issued at a discount to the face value of the bond. Interest is paid at maturity, which is equal to the par value paid at maturity minus the discounted price. Although the bondholder does not actually receive interest annually, he must report the interest annually, nonetheless. However, interest recognition for original issue discounted bonds does not apply to bonds with a term of one year or less from the date of issue. So if a taxpayer buys a 26-week T-bill in October, then tax liability on the interest is not incurred until the following year.
Interest on United States Savings Bonds are exempt from this interest reporting requirement, since taxes are deferred until the bondholder actually receives the interest, unless the taxpayer elects to report the accrued interest, in which case the election applies to all savings bonds that the bondholder owns and to all future purchases of government savings bonds.
Prepaid rent or interest is always taxable in the year received. The income earned from advance payments for goods can be deferred if the method of accounting for the sale is the same for tax and financial reporting purposes.
Tax credits will also affect tax liability, refunds, or the amount owed. Nonrefundable credits, such as the new Credit for Other Dependents, can reduce the tax on taxable income, but not below 0. Additionally, nonrefundable credits do not reduce other taxes, such as self-employment tax or an additional tax on qualified retirement plans, since these taxes are only added after the nonrefundable credits have been deducted. Refundable credits, such as the refundable portions of the Child Tax Credit and the American Opportunity Credit, along with payments, are applied against all taxes, so they reduce the total tax owed or increase refunds.
Here is a simplified summary of how the owed tax or refund is calculated:
- AGI = Total Income – Adjustments
- Taxable Income = AGI – Deductions
- Total Tax = Tax on Taxable Income – Nonrefundable Credits + Other Taxes
- Refund or Amount Owed = Total Tax – Refundable Credits – Payments
- Negative values are refunds.