While IRC§61 generally defines income as income from whatever source derived, tax law does provide specific rules for particular types of payments. Most of these special rules are covered by IRC§71 - §90.
Gifts and Inheritances
Gifts and inheritances are not taxable to the recipient, unless they come from tax-deferred retirement accounts, such as a traditional IRA, 401(k), or a profit sharing plan. However, the donor of the gift or bequest may be required to pay a gift tax or an estate tax, if the total lifetime value of these gratuitous transfers exceeds the amount exempted from taxes for such transfers, which is more than $5,000,000 for each individual. Any payment for a service is taxed as ordinary income, even if it is characterized as a gift. However, a payment to a person who did provide services can still be tax-free if the gift or bequest was not contingent on the provided services.
If the gift is property, not cash, then the recipient also receives the cost basis of the property that the donor had, so if the recipient later sold the property for a greater value than the cost basis, then the difference is taxable as income. However, if the fair market value (FMV) is lower than the cost basis when the gift was given, then this FMV is the carryover tax basis to determine the loss if the asset was sold at a lower price than FMV. If the asset was sold at a higher price than the donor's cost basis, then the cost basis is used to determine gain. If the sale price of the asset was between the FMV and the donor's cost basis, then there is no gain or loss.
- Sale Price > Donor's Cost Basis: Taxable Gain = Sale Price – Cost Basis
- Sale Price < FMV on Gift Date: Recognized Loss = Sale Price – FMV
- FMV on Gift Date < Sale Price < Donor's Cost Basis: No Taxable Gain or Loss
So, if gifted property had a cost basis of $100 and an FMV of $50, then gain or loss would be determined as follows:
- if the property was sold for $125, then taxable gain = $125 – $100 = $25;
- if sold for $75, then there is no taxable gain or loss;
- if sold for $30, then the recognized loss = $50 – $30 = $20.
Inherited assets received a stepped-up basis, equal to the FMV of the property at the time of the donor's death. Hence, the difference between this FMV and the donor's original cost basis is tax-free to the recipient, and this FMV will be the carryover basis of the property for the donee — if the property is sold at a higher price than the carryover basis, then the difference is taxable income to the donee; likewise, the donee may be able to claim a loss if the property is sold for less than the carryover basis. An exception to this rule is for any bequests from estates in 2010, in which case, the donee's tax basis = the donor's tax basis; this exception was made to compensate for the fact that there was no estate tax in 2010.
Life Insurance and Other Insurance Proceeds
Life insurance proceeds are tax-free to the beneficiary. However, any interest earned is taxable as ordinary income. If the beneficiary receives a lump sum, then the entire amount is tax-free. If the beneficiary chooses to receive payments over a specific time period in lieu of the lump sum, then:
Tax-Free Portion = Lump Sum/Number of Years in Payout Period
Any amount over that is considered interest taxable as ordinary income. If the life insurance policy only provides for installment payments, without a lump sum option, then the present value of the installment payments is considered tax-free; the rest of each payment is taxable as ordinary income since it is considered interest.
If a taxpayer surrenders a policy for cash, then only the excess amount paid over the total premiums minus any dividends is taxable as ordinary income, even if some of the gains earned were from long-term capital gains. However, there is no tax if the policy is surrendered under an accelerated death benefit clause that is exercised by a terminally ill taxpayer to obtain cash for medical expenses. If the life insurance policy does not have an accelerated death benefit, then tax can be avoided if the policy is sold to a viatical settlement company.
A life insurance policy that was owned by the decedent does become part of the decedent's estate and may be subject to estate tax if the estate has a greater value than the decedent's remaining unified transfer tax credit for gift and estate taxes.
Proceeds for any other types of insurance policies are also generally tax-free, since the proceeds are used to compensate for losses suffered by the insured. However, if the insurance proceeds are used to replace business property for which depreciation has been claimed, then there may be a recapture of the amount depreciated, in that the amount may have to be claimed as income.
Prizes and Awards
Prizes and awards are generally taxable so, with the exception of certain scholarships, they must be included in gross income.
However, a prize or award can be excluded from income if the following conditions are satisfied:
- the prize or award is transferred to a qualified governmental unit or nonprofit organization;
- the objective is to recognize religious, scientific, educational, artistic, literary, charitable, or civic achievement, such as the Nobel Prize or the Pulitzer Prize;
- the prize recipient did not do anything to enter a contest or proceeding;
- the recipient is not required to provide future services in return for the prize or award.
Ordinarily, this transfer to a charitable organization would be an itemized deductible expense as a charitable contribution. However, transferring the prize or the award over to a charitable organization under §74(b) has certain advantages: the taxpayer does not have to itemize the deduction nor be concerned about the annual statutory ceiling on charitable contributions, and the prize or award will not increase the taxpayer's income, which could otherwise reduce deductions limited by adjusted gross income. Employee achievement awards are also exempted if the award is for less than $400 per taxable year, unless it is a qualified plan award, in which case, the exclusion is $1600.
Royalties are subject to ordinary income taxes, but they may also be subject to employment taxes. If the royalty is received for something that the taxpayer created, then the royalty will be subject to both ordinary and employment taxes. If the royalty is received from property that was purchased by the taxpayer, such as oil, gas, or mineral rights, then it will only be treated as passive income, subject to ordinary income tax. So if a writer receives royalties from the book that he wrote, then the royalties will be subject to both ordinary income tax and employment taxes. However, if the writer transfers the rights to another, then that taxpayer will only have to pay ordinary income tax on the royalties, even though the royalties are earned by the same property that the writer created. This is consistent with the major de facto tax policy objective of taxing work more heavily than investment income.
Bartering is a trade of a product or service for another product or service rather than paying for the product or service with money. The fair market value of the bartered product or service is taxable income to the recipient.
Awards for Legal Damages
Generally, awards for legal damages for losses for a physical injury or sickness that is suffered by the taxpayer are not taxable. On the other hand, most other legal awards are taxable, including those for emotional distress, unless the emotional distress was caused by a physical injury or sickness. So, for instance, damages for libel or slander, or discrimination or wrongful termination of employment are taxable. However, any expenses incurred for medical treatment of emotional distress are deductible. Awards for lost income or wages are also taxable, since they would have been taxable if they were earned.
All awarded interest is taxable, even if the interest is based on damages because of a physical injury or sickness, because the interest is earned income.
Punitive damages are usually taxable since they are awarded to punish the party causing the loss or damage rather than to compensate the party suffering the loss. However, there is an exception in those states that allow only punitive damages for wrongful death.
Holocaust restitution payments are generally excluded from gross income, which are damages paid to persons persecuted by Nazi Germany or related allies. This tax-free treatment extends to payments to heirs and estates of the persecuted people. Payments for persecution because of race, religion, sexual orientation, or physical or mental disability are also nontaxable.
Deductibility of Legal Fees
Any legal fees incurred for a tax-free legal award are never deductible. If the award is taxable, then the deduction depends on the type of award. Awards to recover business income are generally deductible as a business expense. Legal fees incurred in employment discrimination suits and certain types of other unlawful discrimination suits, as well as claims under the federal False Claims Act can be deducted as an above-the-line deduction, meaning that the legal fees can be deducted even if the taxpayer does not itemize. However, the deduction cannot be any greater than the legal award. Previous to the 2017 Tax Cuts and Jobs Act (TCJA), any other legal fees can only be deducted as a miscellaneous itemized deduction on Schedule A, Itemized Deductions, limited by the 2% AGI floor, but the TCJA eliminated this deduction.
A contingency fee, where the attorney receives a set percentage of the award, can only be deducted — it cannot be excluded from income. Thus, the taxpayer must include the entire amount as income, including any money that goes directly to the attorney.
Unemployment benefits are subject to ordinary income taxes, but not employment taxes. Unemployment benefits are reported on Form 1099-G, Certain Government Payments.
For 2020 only, the American Rescue Plan Act (ARPA) excludes up to $10,200 of unemployment compensation for each taxpayer and for each spouse, if their modified adjusted gross income (MAGI) is less than $150,000, a limit for all filing statuses. However, unemployment compensation will still count as part of MAGI when determining taxable Social Security benefits, the exclusion for employer-provided adoption benefits, and for the IRA deduction.
Example. If Mary receives $20,000 of unemployment compensation and her husband receives $8,000 of unemployment compensation and their MAGI is less than $150,000, then Mary may exclude $10,200 of her unemployment compensation from income, while her husband may exclude $8,000 of his income. The $10,200 limit applies to each spouse separately; the limits cannot be combined.
Supplemental unemployment benefits paid from company financed funds are taxed as wages, not as unemployment compensation, since these benefits are paid under guaranteed annual wage plans pursuant to agreements between the unions and employers. If the taxpayer received unemployment benefits from which he voluntarily contributed dues, then the excess of benefits over contributions is taxable.
Workers compensation is not taxable.
Before 1979, unemployment compensation (UC) was not subject to federal income tax, but the Revenue Act of 1978 made UC benefits partially taxable. In 1982, Congress lowered the AGI thresholds for taxing unemployment compensation through the ironically named Tax Equity and Fiscal Responsibility Act of 1982. Then in 1986, unemployment compensation became fully taxable by the Tax Reform Act (TRA) of 1986. According to the legislative history of the Act, unemployment benefits were made fully taxable to eliminate the work disincentive and because the government needed more revenue. Evidently, many members of Congress at that time were afraid that people might be satisfied with the low amount of unemployment compensation that they received, so they may not look for work, even though UC benefits have always been limited in duration. On the other hand, the federal government also needed revenue, even though the TRA of 1986 reduced the marginal tax rate for the wealthy from 50% to 28% and raised the bottom rate from 11% to 15%. Evidently, the additional tax revenue received by taxing unemployment compensation and by raising the tax rate on poor people was used to help compensate for the reduced revenue from the wealthy. Socialism for the rich!