What is Taxable Income?
For purposes of reporting income to the Internal Revenue Service (IRS), generally, all income is taxable unless the law allows for a specific exemption. All taxable income must be reported on that respective year’s tax return and is subject to tax. Nontaxable income, on the other hand, may be reported on the tax return but is not taxable.
The most common form of income is money. However, income can also take the form of property or services. In most situations, income must be reported in the year that it was earned, even though it may not have been received by the taxpayer until the next taxable year.
Employee Compensation
There are many different types of income. The most familiar type is employee compensation in the form of wages, salaries, commissions, fees, bonuses, and tips. The taxpayer’s employer reports to the IRS all gross income earned for each employee in a respective tax year on a Form W-2. The employer provides that same W-2 statement to the employee who then in turn prepares his or her tax return using the income information on the W-2.
Back pay is salaries or wages from a prior pay period. An employee is required to report back pay as taxable wages in the same tax year the employer reported that income on the employee’s W-2.
Severance pay is a payment the employer makes to a terminated employee. The employee is required to report all severance pay and any other payments made in connection with the cancellation of the employment relationship.
Sick pay is also taxable income because it is pay that an employee receives while the employee is sick or injured.
Distinguishable from sick pay is benefits received from an accident or health plan policy. Under an accident or health plan, the employee pays a premium for insurance coverage in the event the taxpayer is injured or suffers health-related issues requiring medical care. While the actual value of the policy is not taxable, benefits derived as a pay out from the policy (in the event of an injury requiring medical care) are taxable and must be reported in the tax year they were received. Once again, the actual value of the accident or health plan policy is generally not taxable income.
An employee may exclude from taxable income amounts paid or expenses incurred by the employer for qualified adoption expenses in connection with the taxpayer’s adoption of an eligible child. Taxpayers should refer to Form 8839 “Qualified Adoption Expenses” for more information regarding the expenses that would qualify and how to claim them.
An employee may also exclude benefits received for dependent care expenses if the employer provides dependent care benefits under a qualified plan. Usually, the benefit is either 1) the amounts the employer pays to the care provider or to the employee directly for the care of the qualifying dependant, or 2) the fair market value of care in a daycare facility provided by the employer. To claim the benefit as an exclusion from taxable income, the taxpayer must file Form 2441, Part III, “Child and Dependant Care Expenses.”
The cost of up to $50,000 of group term life insurance coverage provided by the employer for an employee is not taxable income to the employee. However, the amount paid by the employer for coverage exceeding $50,000 is taxable. The taxable amount is only what the employer paysbeyond the $50,000 coverage.
A qualified transportation fringe benefit can be excluded from taxable income up to certain limits. There are three types of qualified transportation fringe benefits: 1) transportation in a commuter highway vehicle between the employee’s home and workplace, 2) a transit pass, or 3) qualified parking.
An employer’s contribution into a qualified retirement plan on behalf of an employee is not taxable at the time the employer makes the contribution. However, the employee must report the income and pay the taxes when the employee takes a distribution.
The taxable income derived from a stock option is complicated and depends largely on whether the stock option is classified as statutory or non-statutory. As such, consultation with a tax attorney to discuss the taxability of a particular stock option prior to accepting the stock option is highly recommended.
Business and Investment Income
The income earned from renting personal property is taxable and must be reported. For reporting purposes, a distinction is made based on the taxpayer’s intent in renting his or her personal property. If the taxpayer is in the business of renting personal property for profit, he or she is required to report his or her earnings on a Schedule C or Schedule C-EZ and pay the tax. A taxpayer who is not in the business of renting personal property for a profit would also be required to report his or her earnings and pay the tax; however, the taxpayer can report those earnings on his or her Form 1040. A Schedule C would not be required.
Oftentimes a taxpayer receiving a Form 1099 at the end of the year does not realize that he or she is considered a self-employed individual. A taxpayer whose income is reported on a Form 1099 is required to pay the tax obligation on a quarterly basis because the taxpayer’s employer does not deduct taxes from the taxpayer’s paycheck to remit to the IRS. The taxpayer is responsible for remitting his or her own taxes. The entire amount of all income earned on the Form 1099 is subject to tax unless the taxpayer can show and maintain records for his or her reasonable business expenses.
Income generated from copyrights, patents, and oil, gas and mineral rights is taxable as ordinary income. Royalty income is usually reported on a Schedule E “Supplemental Income and Loss,” but there may be instances where a Schedule C would be required.
The income generated in a partnership or an S-Corporation is not taxed at the partnership or corporate level. The benefit of both of these entity types is that there is no “double taxation,” meaning that the profits and losses generated by these entity types will “pass through” the entity itself to each partner or shareholder, and each will have the responsibility to report their share of respective profits and losses on their individual tax returns.
Accordingly, each partnership is required to file a partnership return (Form 1065, U.S Return of Partnership Income) that provides information about the partnership’s operations and the items “passing through” to the partners. Each partner receives a Schedule K-1 showing his share of income, deductions, credits, and tax preference items for that tax year. Each partner is then required to report partnership information on their individual tax return.
An S-Corporation is also required to file an information return (Form 1120S, U.S Income Tax Return for an S Corporation) showing its income, losses, deductions, or credits. Each shareholder will receive a Schedule K-1 showing his or her respective profits and losses based on that shareholder’s percentage ownership in the corporation. Each shareholder is required to report their share of respect profits and losses their individual tax returns.
Sickness and Injury Pay
An employee receiving disability benefits under a plan paid by the employer is taxable income to the employee and must be reported as wages on the employee’s income tax return. After retirement age (defined as when a person is eligible to receive a pension or annuity and is not disabled), a disability pension is reported and taxable as a pension or annuity and reported as such on the employee’s income tax return.
Military and government disability pensions are not taxable when a taxpayer receiving such benefits suffers from personal injuries or sickness as a result of active service or employment in or with the following military or government agencies or occupations:
1. Armed Forces of any country,
2. National Oceanic and Atmospheric Administration,
3. Public Health Service, or
4. Foreign Service.
If a taxpayer first falls into one of these categories, the taxpayer will then need to show that he or she meets the additional conditions for the exception listed below:
1. Taxpayer is entitled to receive a disability payment before September 25, 1975,
2. Taxpayer is a member of a listed government service or its reserve component, or under a binding written commitment to become a member, on September 24, 1975.
3. Taxpayer receives disability payments for combat-related injury.
Benefits paid out as workers’ compensation for an occupational sickness or injury are fully exempt if the benefits are paid under a workers’ compensation act or statute. The exemption from reporting these benefits as taxable income also applies to the survivors.
Miscellaneous Types of Income
Bartering is the exchange of property or services. The income earned is the fair market value to which the two parties to the barter agree. This income is taxable and is generally reported on a Schedule C.
Debt that is cancelled or forgiven is also taxable income. The amount to be reported as taxable income is the amount of the debt that was cancelled. However, there is no taxable income if cancellation of the debt was intended to be a gift or bequest. Normal gift tax limitations apply (e.g. a gift or forgiven debt as a gift that exceeds $13,000 is a taxable gift). However, please note that any gift tax is paid by the donee. In a forgiven debt situation, that would be the party that is forgiving debt owed to it.
Unemployment benefits are taxable income to be reported in the tax year they were received. A taxpayer receiving unemployment benefits should either make voluntary tax payments throughout the year or instruct the governmental agency paying the unemployment benefits to withhold enough for federal withholding in order to avoid incurring a large tax bill plus penalties and interest for underpaying during the year.
Alimony is taxable income and must be reported in the year it was received.
Gambling winnings must be reported in the same year they were received. The taxpayer may also deduct any gambling losses during that same year, but only to the extent of his winnings for that year.
Property acquired by gift or by inheritance is not initially taxable income. However, if the property eventually generates income (such as interest, dividends, or rents), the income generated is taxable.
Illegal activities and proceeds from bribes are taxable income. It must be reported in the year it was received.
A common misconception is that social security benefits are not taxable income. Social security benefits may be taxable depending on the amount received and the amount of other income earned or received during a particular tax year. The calculations to determine whether a taxpayer’s social security benefits are taxable income are outlined in IRS Notice 703.
When is there a filing requirement?
Taxpayers are required to report all taxable income in the year it was received unless they are not required to file a tax return. A taxpayer will not be required to file a tax return for a particular tax year if he or she did not receive enough income to trigger the tax return filing obligation. IRS Publication 17 discusses the income and other criteria needed to trigger the tax return filing obligation for each filing status. There are different taxable income levels for each status. For instance, in 2008, a single person under the age of 65 would be required to file a tax return once that person’s taxable income exceeded $8,950.00 whereas a married couple filing jointly and both over the age of 65 would not have a tax return filing requirement until their combined taxable income exceeded $20,000.00 per year.
Source: RoniDeutch.com
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