Written by: Steven J. Fromm, J.D., LL.M. (Taxation)
Taxable income has been defined as income from whatever source derived. This is a pretty broad definition and encompasses any income you can imagine. For example, illegal income from gambling, drug sales, illegal firearms sales are subject to taxable income. The infamous Al Capone was finally convicted and put in jail for tax evasion for his illegal income.
It is of paramount importance to understand that businesses and individual taxpayers that receive income in the form of cash must account for and pay income taxes and where applicable social security taxes on such amounts received.
It is obvious to many that amount shown on Form W-2s, Form 1099s and the like are taxable income that must be reported on Form 1040. But what about lesser encountered items of income, such as severance pay, lawsuit settlements, and disability payments, and other unusual amounts received? These and other amounts received are discussed below to give the reader an idea of whether such amounts are taxable income. They have been listed in alphebetical order to aid the reader in quickly finding items that they may have received.
Qualified scholarships and fellowships are treated as tax- free amounts if all of the following conditions are met:
- You are a candidate for a degree at an educational institution;
- Amounts you receive as a scholarship or fellowship are used for:
- Tuition and fees required for enrollment or attendance at the educational institution, or
- Books, supplies, and equipment required for courses of instruction; and
- The amounts received are not a payment for your services.
In most cases, alimony, separate maintenance, and similar payments from your spouse or former spouse are taxable to you in the year received.
Certain employers must allocate tips if the percentage of tips reported by employees falls below a required minimum percentage of gross sales. To "allocate tips" means to assign an additional amount as tips to each employee whose reported tips are below the required percentage. All tips you receive are taxable. If you do not have adequate records for your actual tips, you must include the allocated tips shown on your Form W-2 as additional tip income on your return.
Bartering occurs when you exchange goods or services without money exchanging. The goods or services exchanged have a dollar or fair market value, and this value must be included in the income of both parties.
Child Support Payments
Some types of income taxpayers receive are not taxable and child support is one of them. When you total your gross income to see if you are required to file a tax return, do not include this nontaxable income.
Gambling winnings are fully taxable and must be reported on your tax return. As an offset, gambling losses may be claimed as a miscellaneous itemized deduction only to the extent of gambling winnings.
Gifts, Bequests and Inheritances
Generally, property you receive as a gift, bequest, or inheritance is not included in your income. However, if property you receive this way later produces income such as interest, dividends, or rentals, that income is taxable to you.
If you inherited certain items called income in respect of a decedent, such amounts become taxable. For example, retirement plan distibutions from qualified plans such a 401(k), profit sharing, money purchase or pension plans as well as Individual Retirement Arrangements (IRAs) will be taxable to the recipient. Other items such as annuities and savings bonds received by a beneficiary have income tax implications.
For court awards and damages, to determine if settlement amounts you receive by compromise or judgement must be included in your income, you must consider the item that the settlement replaces.
The following law suit recoveries are taxable as ordinary income:
- Interest on any award;
- Compensation for lost wages or lost profits in most cases;
- Punitive damages;
- Amounts received in settlement of pension rights (if you did not contribute to the plan);
- Damages for certain patent/copyright infringement and breach of contract; and
- Any recovery under the Age Discrimination in Employment Act.
The following compensatory damages for the following items are not taxable income:
- Personal physical injury or physical sickness (whether received in a lump sum or installments);
- Damages to your character;
- Alienation of affection;
- Surrender of custody of a minor child.
The taxability concerning life insurance depends on various factors. Generally, life insurance proceeds are not taxable income:
- When the life insurance proceeds are paid as a result of the death of the insured unless the policy comes under the transfer for value rules ( the policy was transferred to someone else in exchange for some consideration and certain other rules apply.)
- When accelerated death benefits are paid under a life insurance contract on the life of a terminally or chronically ill individual.
Long-Term Care Insurance Contracts
Payments you receive from qualified long-term care insurance contracts are generally excluded from income as amounts received for personal injury or sickness.
Generally, you must report as income any amount you receive for your disability through an accident or health insurance plan if paid for by your employer. If both you and your employer pay for the plan, only the amount you receive for your disability that is due to your employer's payments is reported as income.
If you pay the entire cost of a health or accident insurance plan, do not include any amounts you receive for your disability as income on your tax return. If you pay the premiums of a health or accident insurance plan through a cafeteria plan, and the amount of the premium was not included as taxable income to you, the premiums are considered paid by your employer.
Prizes and Awards
If you win a prize in a lucky number drawing, television or radio quiz program, beauty contest, or other event, you must include it in your income. For example, if you win a $500 prize in a sweepstakes contest, you must report this income on your tax return in the year received.
Dividend reinvestment plans let you choose to use your dividends to buy (through an agent) more shares of stock in the corporation instead of receiving the dividends in cash. If you are a member of this type of plan and use your dividends to buy more stock at a price equal to its fair market value, you must report the dividends as income. If you are a member of a dividend reinvestment plan that lets you buy more stock at a price less than its fair market value, you must report as income the fair market value of the additional stock on the dividend payment date. Note, that this amount becomes your basis in the stock received pursuant to such reinvestment plan.
Rent Income From a Vacation Home
If you use a dwelling as a home and rent it for fewer than 15 days during the year, do not report any of the rental income and do not deduct any expenses as rental expenses. In this case, you may deduct some expenses on Schedule A (Form 1040), such as mortgage interest, property taxes, and any casualty losses.
If you receive retirement benefits in the form of pension or annuity payments, the amounts you receive may be fully taxable, or partly taxable, depending on many factors including employee contributions. If you cannot use the Simplified General Rule, you can ask the IRS to figure the tax-free part of your pension under the General Rule. If your annuity starting date is after November 18, 1996, you generally cannot use the General Rule for annuity payments from a qualified plan.
Amounts you receive as severance pay are taxable. A lump-sum payment for cancellation of your employment contract is income in the tax year you receive it and must be reported with your other salaries and wages.
Sick Pay and Short-term Disability
Amounts you receive from your employer while you are sick or injured are part of your salary or wages.
You must include in your income sick pay from any of the following:
- A welfare fund;
- A state sickness or disability fund;
- An association of employers or employees;
- An insurance company, if your employer paid for the plan.
Social Security Benefits
If your "provisional income" is above a certain base amount, a portion of your Social Security benefits (up to 85%) may be taxable. "Provisional income" is your modified adjusted gross income plus one-half of the Social Security benefits.
State Tax Refund
If you itemized deductions on your federal tax return for a prior year, and received a refund of state or local taxes in the subsequent, you may have to include all or part of the refund as income on your tax return for the year of receipt. If you did not itemize your deductions on your federal tax return for the same year as the related refund year, do not report any of the refund as income.
If you are granted a non-statutory stock option, the amount of income to include and the time to include it depend on whether the fair market value (FMV) of the option can be readily determined. If your stock option is granted under an employee stock purchase plan, you do not include any amount in your gross income as a result of the grant or exercise of your option. You report income or loss when you sell the stock that you purchased by exercising the option.
Remember that the above is just an overview and does not cover all forms of taxable and tax free income. In certain situations it may be difficult to determine whether a something is taxable income. Please consult with a tax professional to get a definitive answer.
Copyright © 2012 - Steven J. Fromm & Associates, P.C., 1420 Walnut Street, Suite 300, Philadelphia, PA 19102. All rights reserved.
If and only to the extent that this publication contains contributions from tax professionals who are subject to the rules of professional conduct set forth in Circular 230, as promulgated by the United States Department of the Treasury, the publisher, on behalf of those contributors, hereby states that any U.S. federal tax advice that is contained in such contributions was not intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose.