Gross income is broadly defined by IRC §61(a) as "Except as otherwise provided…, gross income means all income from whatever source derived".
Income includes both taxable and nontaxable income, but not a return of capital or borrowed money. For instance, if the taxpayer buys a bond with accrued interest, then the taxpayer must pay for both the bond and the accrued interest. However, when the taxpayer receives the next interest payment from the bond, the amount paid for the accrued interest will be deductible, since that part of the interest payment is simply a return of capital; likewise, when the bondholder sells or redeems the bond, the bond purchase price can be deducted from the sale proceeds to determine either the taxable gain or deductible loss. Similarly, if a taxpayer borrows $10,000, that amount does not have to be reported since it is not income.
Gross income includes income earned in the United States and from foreign sources. Under a global system of taxation, both citizens and residents are taxed on income regardless of where it is earned. Income earned in foreign territories is usually taxed by the foreign country as well. To prevent double taxation, United States tax law allows various deductions and credits to offset taxes paid to other countries. The details of the tax treatment of foreign income usually depend on tax treaties signed by the United States and the other countries. Some countries, such as Hong Kong, tax only income earned within its borders, called a territorial system of taxation.
The general formula for determining taxable income can be presented as follows:
- − Exclusions
- = Gross Income
- − Deductions for Adjusted Gross Income
- = Adjusted Gross Income
- − Greater of total itemized deductions or the standard deduction
- − Personal and Dependency Exemptions
- = Taxable Income
Starting in 2018, under the new tax package passed by the Republicans at the end of 2017, known as the Tax Cuts and Jobs Act, the personal and dependency exemption is completely eliminated, . However, the standard deduction is nearly doubled.
Although this is the general procedure for determining taxable income as presented in tax law, Form 1040 starts with gross income. Most types of excluded income are not even listed on Form 1040, but some are, especially if it is a type of income that has both taxable and nontaxable types, such as the interest on bonds.
Deductions for Adjusted Gross Income
There are generally 2 categories of deductions: deductions for adjusted gross income (aka adjustments to gross income, above-the-line deductions), which are deductions subtracted from gross income to arrive at the adjusted gross income, and deductions from adjusted gross income, which are deductions subtracted after the adjusted gross income has been computed.
Exclusions are types of income that Congress has chosen not to tax and thus can be excluded. Common exclusions from gross income, called nontaxable income, include:
- accident insurance proceeds
- child support payments
- damages for personal injury or sickness
- gifts (tax-free to the beneficiary)
- home sale exclusion
- inheritance (tax-free to the beneficiary)
- interest from state and municipal bonds
- life insurance paid on death
- veterans benefits
- welfare payments, and
- worker's compensation benefits
There is also a limited exclusion for scholarship grants, and Social Security payments. Deductions for adjusted gross income include trade or business expenses, ½ of the self-employment tax, alimony, and tax-deductible payments made to a traditional individual retirement account or other tax-deferred retirement accounts.
The adjusted gross income (AGI) = gross income minus the adjustments to gross income. The AGI is an important intermediate quantity, in that certain personal deductions are available if they exceed a certain percentage of the AGI, establishing a floor for the deductions, such as the 10% AGI floor that applies to medical and dental expense deductions. Only the amounts of the deductions that are above the floor are deductible. Some deductions are limited by a ceiling, also equal to a certain percentage of the AGI, such as the ceiling on the charitable contribution deduction, generally about 50%, that depends on the type of property or property interest that is being donated and the type of organization receiving the property. For instance, if the taxpayer has adjusted gross income of $100,000, and deductible medical expenses of $11,000, only $1,000 of those expenses can be deducted from AGI. If the medical expenses were less than $10,000, then there would be no deduction at all. Likewise, the taxpayer cannot deduct more than $50,000 of charitable contributions, assuming that the 50% ceiling applies.
Deductions from Adjusted Gross Income
There are only 2 types of deductions that can be taken from adjusted gross income. The first type of deduction is for personal expenses, which are not normally deductible, but for which Congress has made exceptions. To take this deduction, the taxpayer has a choice of itemizing the deductions or taking the standard deduction. Because the standard deduction is so high, most taxpayers choose the standard deduction, because that gives the higher deduction. The standard deduction, which depends on filing status, was created by Congress so that poor people could keep more of their money and to lessen the burden on the IRS of auditing itemized deductions.
Itemized deductions are personal expenditures which Congress has allowed to be deducted from adjusted gross income, and generally includes medical expenses, certain taxes and interest, charitable contributions, state and local income taxes, real estate taxes, personal property taxes, home mortgage interest, investment interest, casualty and theft losses in excess of 10% of AGI plus $100, and miscellaneous other expenses, such as certain educational expenses, tax return preparer fees, and investment counseling fees.
Some itemized deductions allow for the deduction of expenses related to the production or collection of income, including the management of income-producing property. These expenses are called non-business expenses, because the taxpayers are not directly involved in operating a business. For instance, expenses related to investments are non-business expenses.
The 2nd type of deduction from adjusted gross income is the personal and dependency exemptions. Each taxpayer that provides more than ½ of his own support can claim a personal exemption. Taxpayers can also usually claim an exemption for each dependent if the taxpayer provides more than ½ of the dependent's support and the dependent is not claimed by anyone else.