The Sixteenth Amendment to the Constitution of the United States gives authority to Congress to tax income. The Internal Revenue Service defines revenue via a term ‘Gross Income’. In Chapter 26 of the Federal Code (Chapter 26 is the Internal Revenue Code) Section 61, Congress defines gross income as “… all income from whatever source derived…”. This means even the penny you pick up off the ground is considered income. However, Congress did go about specifically excluding certain items as income via Section 101 of the Code.
Caveat: Chapter 27 of the Federal Code addresses Alcohol, Tobacco, and Firearms. So there is this long standing joke among us accountants that the guy who wrote the IRS Code went onto become an alcoholic and shot himself; a little humor for an otherwise dry subject.
This article describes revenue (income) in more detail and illustrates those sources of income specifically excluded from the definition of revenue. It goes on further to cite some examples and legal cases associated with what is defined as revenue. For the purpose of this article, revenue and gross income are the same.
- 1 Federal Code Definition of Gross Income (Revenue)
- 2 Court and Legal Disagreements
- 3 Summary
Federal Code Definition of Gross Income (Revenue)
Congress decided that it is better to say all sources of revenue are income and then exclude certain items to determine gross income for tax purposes. In general, Section 61(a) includes the following list as income:
1. Compensation for services, including fees, commissions, fringe benefits, and similar items;
2. Gross income derived from business;
7. Alimony and separate maintenance payments;
9. Income from life insurance and endowment contracts;
11. Income from discharge of indebtedness;
12. Distributive share of partnership income;
13. Income in respect of decedent; and
14. Income from an interest in an estate or trust.
This list is an exact duplicate of the items in Section 61(a).
In reference to item number 7, the Code has Section 71 to specifically address this form of monetary transfer between two spouses or former spouses.
Notice how the list is almost a mirror image of the line items on page one of Form 1040.
When looking at the definition of income, Congress did decide some forms of income should be excluded because it would be detrimental to the social welfare of the citizens. So Sections 101 to 140 identify those sources of revenue specifically excluded from the definition.
The following is a short list of the more common exclusions:
Proceeds of Life Insurance Due to Death (Section 101)
Here is a perfect example of injustice if a family had to include in their taxable income a payment due to the death of a family member. Imagine the overall impact if a surviving spouse had to pay taxes on a death benefit of a life insurance contract. Congress decided to protect the financial integrity of the family unit by excluding this particular source of revenue.
Gifts and Inheritances (Section 102)
The Code allows transfers in the form of a gift up to $14,000 without taxation on the donor. However, for the donee (the individual receiving the gift) there is no inclusion in income no matter the dollar value. This is also true when an inheritance is received. The estate pays any associated tax with the transfer of the assets if a tax is applicable.
Compensation for Injuries or Sickness (Section 104)
When someone is injured, it is to the benefit of US citizens to not include in revenue for the injured any awards (damages) assigned in a court of law. In addition, any compensation afforded by the former employer and any third party payer to the injured is also excluded.
Gain from the Sale of Principal Residence (Section 121)
Any gain up to $250,000 on the sale of the primary residence of the taxpayer is excluded from income. This benefit was designed to help the retired and elderly citizens. In addition, it allows for families to upgrade their personal residence without having to pay some form a gain tax on the sale of the smaller home. This also works in reverse as a family downsizes their primary residence as the children age out of the home.
Foster Care Payments (Section 131)
Many adults volunteer to care for foster children. It is to the benefit of the nation to have as many volunteers as possible. So Congress decided to exclude foster care payments and difficulty of care payments to these adults. There are restrictions as identified in this section, however, the purpose is not hampered by the restrictions and protect the programs from fraud and abuse.
There are many others, but the above list identifies some of the more common exclusions.
Court and Legal Disagreements
Income taxation started back in 1914. Right from the start issues popped up in defining what is considered income. In one of the first Supreme Court decisions (1929) the US Supreme Court determined that income taxes paid on the behalf of an individual is considered income to that individual. The case, ‘Old Colony Trust Co. v. Commissioner’ is a situation whereby the employer paid the taxes on behalf of an employee and the court defined this payment as ‘… discharge by a third person of an obligation to him equivalent to receipt by the person taxed.’
Most of the court and legal disagreements relate to the exceptions to Section 61 of the Code. As an example, Section 102 which excludes gifts and inheritance has many cases with misunderstanding of the terminology. It is further exaggerated because of the interpretation difference between the Federal District Courts and the Tax Courts.
In ‘Carter v. Commissioner, 453 F.2d 61 (2d Cir. 1971)’, a widow received her husband’s earnings under his employment agreement. The key to this case rests in whether the payment was property as a gift to her or as a payment to Mr. Carter’s estate. Since the payments were made directly to her and not to Mr. Carter’s estate; she had never worked for the company and the company received no value in this transaction; the Court of Appeals held that the receipt of money was indeed a gift and therefore excluded as income under Section 102 of the Code.
Another area of the Code deals with defining injury. Section 104 excludes from income judicial awards (damages) “received … on account of personal physical injuries”. So what about awards associated with emotional or mental distress? Well, such a case came up in the form of ‘Murphy v. IRS 460 F. 3d 79, 2006’. Ms. Murphy was awarded damages of $70,000 for emotional distress and damage to professional reputation. Ms. Murphy sought to exclude the award because the emotional distress is indeed physical injury. The Courts concluded that the mental anguish and loss to reputation were not physical injury and therefore the damages awarded associated with them were indeed income and therefore taxable.
If you haven’t noticed yet, each of the cases border on defining the terminology used in the respective sections of the code. In ‘Gates v. Commissioner, 135 T.C.’ a husband and wife tore down the primary residence and proceeded to build a larger structure. There was a $1.1 million dollar gain on the sale of this residence. Under Code Section 121, the Gates were eligible for a $500,000 gain exclusion as a married couple filing a joint return. The Gates did not live in the house after the extensive remodeling and rebuilding of the house. The IRS argued the Gates did not satisfy the minimum two years of living in the new structure. However, the Gates did indeed live for at least 2 years in the prior structure on the same land. The Tax Court held that since the Gates did not live in the new structure for at least two years, the new physical structure does not qualify. Therefore, they were exposed to the capital gains tax on the sale of the property. This leads to many issues for future cases because if a home is burnt to the ground and rebuilt, does the new structure require at least two years of physical occupancy in order to qualify? What about additions onto the original structure?
Section 61 of the Federal Code pretty much includes all sources of revenue as income. Sections 101 through 140 provide the exceptions to the rule. Even within these exclusions there exist marginal areas of what is an exception to the exception. As the examples above illustrate, intent and terminology play a big role in the final outcome of what is includable in revenue. As a taxpayer and business owner, you should be aware of what is actual income in accordance with the Federal Code. Act on Knowledge.
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