US Income Tax/Income
The Internal Revenue Code requires three income calculations when determining income tax liability:
- Gross income, the actual income the taxpayer receives.
- Adjusted gross income (AGI), gross income reduced by "above the line" deductions such as trade and business expenses.
- Taxable income, AGI reduced by "below the line" deductions such as personal and profit-seeking expenses.
While taxable income is the only amount that matters when calculating final tax liability, the other two values have great significance in the process as well.
The definition of income
Section 61 of the Internal Revenue Code  puts it broadly: "Gross income means all income from whatever source derived." The Code supplies many examples, but provides that the list is not exhaustive. Among its enumerated types of gross income are compensation for services (i.e. wages and salaries), business income, income from dealings in property, interest, rent, royalties, dividends, alimony, annuities, life insurance income, pensions, and a number of other examples.
The simple definition of gross income has led to some questioning of what the word "income" actually means within the text of the statute. The authoritative opinion on this issue is the Supreme Court's decision in Commr. v. Glenshaw Glass Co., 348 U.S. 426 (1955), perhaps the most important case in American tax law. Glenshaw Glass established that income is:
- any undeniable accession to wealth,
- which is clearly realized by the taxpayer,
- over which the taxpayer has complete dominion.
An accession to wealth need not be in the form of money. For instance, if a farmer trades a bushel of tomatoes for an accountant's tax help, the tomatoes are an accession to wealth for the accountant. Such accessions are called receipts in kind—goods or services received in exchange for services. Contrary to popular belief, receipts in kind are considered income, and their value for tax purposes is the fair market value of the goods or services at the time of transfer.
An accession need not be in consideration for anything. "Windfalls," such as prizes and free samples, are accessions to wealth. Even an unanticipated windfall is considered income. For instance, if a taxpayer finds money hidden inside a piano, that money becomes income to them: see Cesarini v. U.S., 428 F.2d 812 (6th Cir. 1970).
Wealth is affected by assets and liabilities. Loans are usually not considered to be income because they are not true accessions to wealth: while they provide a tangible asset to the recipient, they offset this asset with an equivalent liability. But a "loan" that is not offset by an obligation to repay is income to the recipient. Moreover, if a third party pays off a taxpayer's debt, the taxpayer receives income to the extent their debt was reduced. See Old Colony Trust Co. v. Commr., 279 U.S. 716 (1929) (employer paying taxes on employee's behalf).
Realization can be thought of as an administrative rule: it serves to clarify when the taxpayer receives income. The simplest way to conceptualize realization is as the point in time when the taxpayer's property or interests are actually increased.
The Supreme Court used the theory of realization to ban income taxation of stock dividends (splits) in Eisner v. Macomber, 252 U.S. 189 (1920). Because share-for-share stock dividends do not materially affect the assets of the corporation or its shareholders, the Court reasoned that there would be no income to the shareholders in such transactions.
If a taxpayer sees a $20 bill, but does not pick it up, they have not yet realized any income, because the money is not yet theirs. Once they pick the money up and assert possession of it, the $20 is income to them: they have realized it and assumed dominion and control over it.
Consider a more complicated example: a person signs a long-term lease on a piece of property, then constructs a building on it. They fall behind on their rent and the landlord evicts them. According to Helvering v. Bruun, 309 U.S. 461 (1940), the landlord realizes income amounting to the value of the building in the year of the repossession.
Dominion over wealth is based on practical considerations rather than the considerations of property law. When an accession is legally disputed (or disputable), the claim of right doctrine comes into play. If a taxpayer receives an amount, claims it as theirs, and has no restriction on their disposition of it, that amount is considered income in the year in which they receive it. For instance, if a taxpayer receives a piece of land and someone else disputes its title, the taxpayer will have income so long as they claim that land as their own. Any income gained from illegal activities is also considered to be income whether the taxpayer's title to it is valid or not.
However, the "completeness" of dominion is compromised if the taxpayer recognizes a legal obligation to return the wealth to its previous owner. Security deposits are one example: because they must usually be paid back, they are not considered income until the recipient is legally entitled to keep them. Advance deposits, on the other hand, are income upon receipt, because they are not accompanied by an obligation to repay.
Exceptions to income
Some apparent accessions to wealth are not income because the primary purpose of the accession is to benefit the taxpayer's employer. A classic example is U.S. v. Gotcher, 401 F.2d 118 (5th Cir. 1968), in which the taxpayer went on a business trip to Germany, all expenses paid by Volkswagen and the taxpayer's employer (an auto retailer). Examining the facts of the case, the court concluded that the trip primarily benefited Volkswagen, not the taxpayer, and was therefore not income to the taxpayer. But the taxpayer's wife also had her expenses paid to come on the trip, and the court ruled that her half was income, because the benefit of her share of the trip was hers alone and not Volkswagen's.
Besides this primary purpose test, more specific rules covering many types of employment benefits appear in the Internal Revenue Code.
- No additional cost services provided by employers are not income to employees. Standby tickets for airline employees are one example. Allowing employees to fly in otherwise empty seats does not cost an airline any appreciable amount. On the other hand, providing regular "positive space" tickets to airline employees would constitute income to the employees, because the service costs the airline money if it has to deny seats to paying passengers.
- Qualified employee discounts, discounts on goods and services that are offered by the employer to its customers, are not income to employees. The Code imposes a maximum discount of the profit on goods and 20% on services: any greater employee discounts are considered income.
- Working condition fringes, services or property that would be deductible by the employee as a business expense if purchased by the employee, are not income to the employee. Examples include on-the-job training expenses, safety equipment, and travel for purely business purposes.
- De minimis fringes, benefits that are too low in value to be reasonably worth accounting for, are not income to employees. Coffee and donuts in an office are a classic example.
- Meals and lodging provided by employers follow special rules. To be excluded from income, they must be provided on business premises for a "substantial noncompensatory business reason" such as keeping the employee "on call." Note that in the case of lodging, "business premises" does not refer to location: it means that some sort of business activity must be performed at the place of lodging.
Gratuitous transfers, such as gifts and inheritances, are excluded from income by the Code. The standard for determining such a transfer is whether it was made "from a detached and disinterested generosity, out of affection, respect, admiration, charity or like impulses." If a so-called "gift" is made in consideration or anticipation of a benefit, it loses its gratuitous status and can be considered income. See Commr. v. Duberstein, 363 U.S. 278 (1960) (Cadillac given to contact who provided business leads in the past was includible in income despite being declared as a gift).
Transfers of property incidental to divorce are also treated as gifts under Section 1041 of the Code. To qualify, such transfers must either be within one year after the date of the cessation of marriage, or be "related" to the cessation if made beyond the one-year window.
Severance payments, bonuses, honorariums and other "gifts" from employers to employees are almost always considered to be income, although they may be excluded as fringe benefits as described above. Death benefits to survivors of employees have been a more difficult issue and have split the courts as to whether they should be considered as income.
Section 101 of the Code excludes life insurance payments from income, including accelerated death benefits for the terminally ill. There are several exceptions to this rule, mainly to cover obvious loopholes. Among them:
- One cannot exclude payment on a life insurance policy that was coupled with an annuity of equal value, because such an arrangement does not shift or distribute any risk.
- Creditors cannot exclude payment on life insurance policies they take out on debtors to secure repayment of their loans.
Scholarships are not income in some situations. To be exempt, they must be paid to degree candidates at an educational institution, and they are only exempt to the extent that they compensate for the cost of tuition, fees, books, supplies, and equipment. Payments for teaching, research and other services are always considered income even if they are only paid by reducing the student's tuition.
Loan forgiveness programs receive special treatment under Section 108(f). The discharge of the student's loan debt can be excluded from income, as long as the loan came from the government or an educational institution, contained a provision for forgiveness, and the forgiveness is in exchange for working in "certain professions" or for "any broad class of employers."
Sections 85 and 86 of the Code exclude social welfare payments from income. The exclusion applies to TANF, Medicare, disaster relief, replacement housing payments, and assistance to victims of crimes, among many other types of payments. But unemployment compensation is considered to be income.
An exception to the exclusion is Social Security, which follows its own complicated rules because of its dual nature as a welfare program and investment scheme.
The taxation of damages awarded in lawsuits poses complicated policy issues, but the general rules are:
- Punitive damages are always income.
- Compensatory damages may or may not be taxable depending on their nature.
- Damages that compensate for lost income, such as lost profits and back pay, are treated as income.
- Damages that compensate for lost capital, such as property, are not treated as income.
- Damages that arise due to physical injuries are not treated as income unless they are punitive. (This includes compensation to third parties, e.g. for loss of consortium.)
- Damages that compensate for emotional distress are treated as income unless they arise due to a physical injury.
Some taxpayers receive income with the condition that they must pay it to somebody else or for something else. Examples include waitresses who share tips with busboys, political candidates who receive campaign contributions, and funds paying collective expenses for multiple businesses. In most conduit situations such as these, the money "passing through" the taxpayer is not considered income to the taxpayer, but the taxpayer must be able to prove that the income was received with the condition that it be paid to someone else or for something else.
Note that many corporations are taxed on their profits even if those profits are distributed to shareholders as dividends. This is described in further detail in the Tax Liability chapter.