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The purpose of this Unit is to define and outline what constitutes gross income for income tax purposes. No attempt is made to exhaust the subject or to name all the various items of taxable income. It is hoped, however, that this discussion will provide a clear explanation of taxable income and that it will clearly define the various sources of income and profits.
Gross Income Defined. (a) The term "gross income" includes gains, profits, and income derived from salaries, wages, or compensation for personal service (including in the case of the President of the United States, the judges of the Supreme and inferior courts of the United States, and all other officers and employees, whether elected or appointed, of the United States, Alaska, Hawaii, or any political subdivision thereof, or the District of Columbia, the compensation received as such), of whatever kind and in whatever form paid, or from professions, vocations, trades, businesses, commerce, or sales, or dealings in property, whether real or personal, growing out of the ownership or use of or interest in such property; also from interest, rent, dividends, securities, or the transaction of any business carried on for gain or profit, or gains or profits and income derived from any source whatever.
(Section 213 -1924 Act) Income which accrued prior to March 1, 1913, but which may be realized or received in the current year need not be reported, because it does not constitute taxable income. The Sixteenth Amendment to the Constitution which granted Congress the right to enact laws taxing incomes did not become effective until February 25, 1913. As a matter of convenience, March 1, 1913, is taken as the date after which income is deemed taxable.
Compensation. All forms of compensation for personal services such as salaries, wages, bonuses, commissions, royalties, pensions, fees, percentage of profits, tips, etc., should be included in gross income. Commissions paid salesmen whether based on the sales price, profits, premiums as in the case of insurance, or on any other basis, should be included in gross income. Marriage fees, baptismal offerings, sums paid for saying masses for the dead, or any other contributions received by a clergyman, evangelist, or religious worker for services rendered should be included in gross income. Bonuses, when received as additional compensation for services actually rendered, are taxable income to the recipient provided such bonuses, when added to the stipulated salaries, do not exceed a reasonable compensation for the services rendered. Where a traveling man is given an expense allowance in addition to salary, any excess of the allowance over the actual expenses incurred must be reported as income. Pensions or retiring allowances paid by private persons or by the United States are income to the recipient. Copyright 1925, South Western Publishing Co.
Compensation may be in the form of cash or in some other form. If in some form other than cash, the fair market value, if readily realizable, of the thing taken in payment is the amount to be reported as income provided that if the services were rendered at a stipulated price, such price will be presumed to be the fair value of the compensation received. If compensation is received in the form of stock, it represents income to the extent of its fair market value. If compensation is received in the form of notes or other evidences of indebtedness, it represents income to the extent of their fair market value. A taxpayer who receives a noninterest bearing note in payment of services should treat as income the fair discounted value of the note at the time of its receipt. Premiums paid on life insurance policies on the lives of officers or employees who are themselves the beneficiaries under the policies, represent taxable income to such officers or employees. The cancellation or forgiveness of indebtedness may constitute compensation which should be included in gross income. If for example, a taxpayer performs services for a creditor, who in consideration thereof cancels a debt, income to the amount of the debt is realized by the taxpayer as compensation for his services and should be included in his gross income.
Where living quarters, board and lodging, rent or expenses are allowed employees in lieu of a salary, they must be reported as income except in the event living quarters such as camps are furnished to employees for the convenience of the employer. In this event, the ratable value need not be added to the cash compensation of the employee, hence need not be included in gross income, but where a person receives as compensation for services rendered a salary and in addition thereto living quarters, the value to such person of the quarters furnished constitutes income subject to tax. For instance, where Government employees are provided with living quarters in addition to a salary, the estimated value of such quarters should be considered income.
Income from Business or Profession. Persons engaged in business or practicing a profession of any kind must report the income received from such business or profession. This includes income derived from the following sources:
I. Sale of merchandise or products of manufacturing, mining, construction and agriculture.
2. Business service such as amusements, hotel and restaurant service, livery and garage service, laundering, storage, transportation, etc.
3. Professional service such as dentistry, law, medicine, or accountancy.
The income to be reported is the net income which is determined by deducting from the total income received from the business or profession the sum of the following items:
(a) Cost of Goods Sold
The cost of goods sold includes, in the case of a trading business, or any business in which merchandise is bought and sold, the inventory at the beginning of year plus the cost of merchandise purchased for sale during the year, minus the inventory at end of year. The cost of goods sold includes, in the case of a manufacturing business, the inventory of raw material and supplies on hand at the beginning of year plus purchases of material and supplies, and labor during year, minus the inventory of material and supplies at end of year.) In other words, the prime cost of merchandise sold during the year is the amount to be deducted under the title of "cost of goods sold".
Other business deductions include the following:
1. Salaries and wages not reported as labor in connection with cost of goods sold, provided that if any amount is included for the taxpayer's own services or the services of any dependent minor children, such amount must be included in gross income as compensation received from "salaries and wages".
2. Rent on business property in which the taxpayer has no equity. Rent paid for a dwelling occupied as a residence does not constitute a business expense, hence cannot be included as a deduction in determining the amount of net income received from a business.
3. Interest on business indebtedness to others. nterest on capital invested or advanced to the business and paid or credited to the taxpayer should not be included as a deduction in determining the net income received from the business.
4. Taxes on business and business property. Taxes assessed against local benefits of a kind tending to increase the value of the property assessed, as for paving, sewers, etc., and Federal income taxes, should not be included. These do not constitute allowable deductions in computing net income from a business.
5. Repairs, depreciation, obsolescence, depletion, and property losses. These include the following:
(a) Ordinary repairs required to keep property in useable condition.
(b) Reasonable allowance for exhaustion, wear and tear of property used in the trade or business including a reasonable allowance for obsolescence.
(c) Losses of business property by fire, storm, or other casualty, or theft, not compensated for by insurance or otherwise and not made good by repairs claimed as deductions. Do not claim any deductions for depreciation in the value of a building occupied as a dwelling or of other property held for personal use as such depreciation is not an allowable deduction.
6. Losses from bad debts arising from sales or professional services. In determining the amount to be claimed as a loss in connection with bad debts, the taxpayer may use as a basis the amount of debts definitely ascertained to be worthless and
which have been charged off within the year, or he may use such reasonable amount as has been added to a reserve for bad debts within the year. In the event a debt which has been previously charged off as bad is subsequently collected, it must be returned as income for the year in which collected.
7. All other ordinary and necessary business expenses, not classified above, such as fire insurance, heat, light and traveling expenses.
VLong-Term Contracts. For income tax purposes a longterm contract is a building, installation, or construction contract covering a period in excess of one year. Income from such contracts is taxable for the period in which the income is determined, such determination depending upon the nature and terms of the particular contract. Taxpayers whose income is derived entirely or in part from such contracts may report such income upon either of the following bases:
The gross income may be reported upon the basis of percentage of completion. Thus, if a taxpayer had contracted to construct a building for $25,000.00 and he had completed one-half the work during the taxable year for which he is filing a return, he could report one-half of the gross income to be derived from such contract whether or not he had actually collected such income during the period. If he decides to report his income on this basis, he should deduct from gross income all expenditures made during the taxable year in connection with the contract. In computing the expenditures, he should take into consideration the value of material and supplies on hand at the beginning and end of the taxable period. In other words, only the material and supplies actually consumed in construction should be charged against the gross income for that period.
Gross income may be reported in the taxable year in which the contract is completed provided such method clearly reflects the net income. If the taxpayer elects to defer the reporting of his income until the contract is completed, he should deduct from the gross income received from such contract the amount of all expenditures applicable to the contract during the life of the contract.
Under the first plan the gross income is estimated and reported as of the year in which it is earned or accrued. Under the second plan, the income is not reported until the contract is completed at which time the gross income will all be reported in the return for that year. Under either plan, all expenses and allowable deductions should be deducted from the gross income in determining the amount of the taxable income to be reported, hence it will be seen that it is really the net income derived from the contract which is to be reported as taxable income. From the standpoint of the taxpayer, it is better to apportion the profit over the period of the contract and pay the
tax on each year's proportionate earnings. For example, if a contract is completed over a period of five years with a total profit of $25,000.00, the tax on a basis of a profit of $5,000.00 a year would amount to less in the aggregate than the tax on a profit of $25,000.00 in one year.
Interest. Interest on obligations of every kind accrued since March 1, 1913, except when specifically exempted by statute, is taxable. Such interest must be reported when it becomes subject to the demands of the owner whether or not it is reduced to his possession. For instance, interest on bank deposits must be reported as income when credited to the account of the depositor although he may not withdraw it at that time. Interest accrued on bonds prior to their purchase need not be reported by the purchaser. For instance, if a bond bearing six percent interest with a par value of $100.00 is purchased for $103.00, and six months later the purchaser collects $6.00 in interest, he need report only $3.00 as income, the remaining $3.00 being considered as a return of part of the purchase price.
Bond Premium and Discount. When bonds are purchased at a premium or discount, this premium or discount need not be reported in entirety in the year when purchased, but may be amortized over the life of the bond. If a city purchases a public utility and assumes the bonds, the interest on such bonds is subject to the tax. If the city had issued the bonds originally, the interest would be exempt, but since the purchaser of the bonds at the time of their purchase anticipated a payment of the tax, its payment is not waived because the city later assumes the payment of the bonds.
Taxable Interest on Liberty Bonds. The interest received on all obligations of the United States issued previous to September 1, 1917, is exempt from taxation, hence need not be included in gross income. This includes the interest on the First Liberty Loan 374% Bonds which were issued June 15, 1917.
The interest on the Liberty Bond issues and other obligations of the United States issued since September 1, 1917, is taxable as to surtax to the extent that the taxpayer's holdings exceed the exemptions provided by the Acts under which the issues were authorized or by any subsequent Acts. This applies to all of the Liberty Bonds issued since September 1, 1917 except the Victory Liberty Loan 334% Notes which were exempt from both normal and surtaxes. However, this issue of bonds matured in 1923 and are no longer to be considered for income tax purposes.
The Victory Liberty Loan 434% Convertible Notes were subject to the surtax but these bonds also matured in 1923 and are no longer to be considered. The interest received from any of the various issues of Liberty Bonds is not subject to the normal tax. However, when the interest is subject to surtax, it is necessary to include it in gross income.