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. Disposable income is income remaining after all taxes have been taken out. It is what the taxpayer has to spend.
Internal Revenue Code §61 defines gross income as income from whatever source derived unless 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 earned or received is 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 many people in the lowest quintile of income.
All income is taxable unless it is specifically excluded in the tax code. Gross income includes:
- wages, salary, or tips
- self-employment income
- investment income
- unemployment compensation
- Social Security or Railroad retirement benefits
- taxable scholarships or grants
- bartered goods and services
- other types of income, such as gambling income
Adjusted Gross Income (AGI)
There are 2 types of adjustments to gross income, which reduces taxable income. The 1st type of deduction is an adjustment for gross income, (often simply just called adjustments to income) which is a deduction that the taxpayer can claim even if the taxpayer does not itemize deductions. These deductions are also called above-the-line deductions, because they are above the line for adjusted gross income at the bottom of the Form 1040 for tax years before 2018, 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 the old Form 1040, so they are often called 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 60% of AGI, and deductible medical expenses are subject to a 7.5% AGI floor.
Some of the most common adjustments to income include:
- contributions to Health Savings Accounts not included in payroll deductions
- contributions to traditional IRAs or other tax-deferred retirement accounts, such as 401(k)s, not included in payroll deductions
- for employees:
- pre-tax contributions to cafeteria plans, such as an HSA or FSA
- pre-tax payments for health insurance premiums
- deduction for moving expenses (limited to members of the military)
- interest deduction on student loans
- qualified tuition and related expenses
- alimony or separate maintenance payments based on a court order executed before 2020, but only if the order did not specify that the payments were not deductible
- qualified unreimbursed expenses of educators (up to $250, or $500 if married filing jointly)
- penalty for early withdrawal of savings
- certain employee business expenses for Armed Forces reservists, qualified performing artists, fee-based government officials, and employees with impairment-related work expenses
- if self-employed:
- 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
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 called 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 were listed in the Tax and Credits section of the old 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 also included personal and dependency exemptions, which are no longer available under the Tax Cuts and Jobs Act. 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|
Note: the above table is based on the Form 1040 previous to 2018. However, this form has been changed significantly by the Tax Cuts and Jobs Act, starting in 2018. For instance, the new tax law no longer allows personal or dependency exemptions. Nonetheless I have retained the table above because it still explains the difference between income, adjusted gross income, and taxable income, and it still illustrates the difference between above-the-line deductions and below-the-line deductions, a terminology still used in many tax publications.
Modified Adjusted Gross Income (MAGI)
Certain parts of the tax code refer to modified adjusted gross income (MAGI), which is adjusted gross income, but with certain tax breaks added back, most often the foreign earned income exclusion. Excluded interest on US savings bonds redeemed for higher education may also be added back.
MAGI = AGI + Certain Tax Breaks
However, the statutory definition of MAGI depends on the tax code that refers to it, so the tax breaks added back may differ. When the tax code refers to MAGI, it will also include its definition. For most taxpayers, MAGI = AGI, but if they differ, then MAGI exceeds 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 to help lower-income taxpayers.
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 lower than marginal rates. However, the 3.8% Medicare surtax is assessed on 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 = 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 limits 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 equals 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.