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This is the income tax formula that we introduced earlier.

In this module, I'll provide an overview of each general section of this formula.

Briefly, the income tax formula begins with income that's broadly conceived.

That is assume everything is income unless congress says it's not.

Next are exclusions.

Exclusions are income items that although it's technically income and money in

a taxpayer's pocket, Congress has, in fact, decided not to tax that income.

For example, interest earned on municipal bonds is not part of the federal

income tax base and, thus, is excluded.

That's the difference between income broadly conceived and

exclusions is gross income.

Gross income is the income subject to tax.

Next, we'll subtract various deductions or expenses.

The first set of deductions are referred to as deductions for

adjusted gross income because they're subtracted from gross income

to produce this adjusted gross income subtotal, better known as AGI.

Next the taxpayer can subtract a second set of deductions,

in fact they can select to deduct the grater of either itemized deduction,

also known as from AGI deductions.

Or the standard deduction, which is a standard amount that's allotted to each

taxpayer based on his or her filing status.

After subtracting either itemized deductions or

the standard deduction, we subtract personal and dependency exemptions.

In short, this is based on the number of people that are included

on the tax return.

Finally we get to taxable income as the difference between the AGI and

the various additional deductions and exemptions.

Recall the taxable income is the tax base in the US income tax system.

Next, to calculate the tax liability, we use our tax tables and tax rate schedules.

From the tax liability, we can subtract any income taxes that were withheld or

prepaid during the year.

As well as the various tax credits which are dollar for

dollar reductions in the tax liability.

The difference between the tax liability and the amount of prepayments and

credits claimed during the year will tell us whether or

not the tax payer needs to pay more cover the entire tax liability.

Because the prepayments or withholdings weren't enough.

Or if the taxpayer prepaid more than the tax liability during the year,

then he or she will receive a refund.

The form 1040 is the main US federal income tax return that's

filed with the IRS.

It's generally structured according to the formula on the previous slide.

It's key sections begin by asking for the taxpayer's filing status.

That is, how are you filing your tax return?

Are you filing as a single person or are you married and

filing a joint return with your spouse?

Or perhaps you fit into another category?

Maybe you're married but you're filing a separate tax return from your spouse.

Next the 1040 asks who else is being claimed on your tax return.

These are known as exemptions.

Then the 1040 goes through the tax formula essentially asking what's

the taxpayer's gross income.

Then it asks what's the adjusted gross income, the taxable income and

the tax liability and finally any additional amount owed or refunded.

During the course, we'll dive more deeply into each of these sections.

Note that although the 1040 is the main tax form,

there are a lot of supporting schedules and statements as well.

In particular, Schedule A reports itemized deductions.

Schedule B reports interests and dividends.

Schedule C reports income and

expenses from a sole proprietorship, that is a single-owner business.

Schedule D reports capital gains and losses.

Schedule E reports supplemental income and losses, including from rents and

royalties.

And Schedule F reports farm income and losses.

All of this information gets summarized on a Form 1040.

So let's start at the very beginning of the income tax return formula.

Highlighted here are gross income which includes income broadly conceived and

exclusions to that income.

IRC Section 61 explains that except as otherwise stated,

gross income is all income from whatever source derived.

So this income includes income from wages, from services, from fees, commissions,

benefits, business income.

Gains from property dealings, interests, rents,

dividends, capital gains and a lot of other items.

In fact this provision also implies that income from illegal activities is also

included in gross income.

As a something received that isn't cash but in exchange for services.

So, if my friend pays me with a new watch instead of cash for me to prepare a tax

return, I have to report the value of that watch in my gross income.

It is includible in calculating the tax base.

This gets us to the conceptualization of gross income.

The US tax laws use an all-inclusive income concept.

Within this concept,

we need to differentiate between two kinds of incomes.

Realized income and recognized income.

We can think of realized income as economic income, a very broad concept.

When did you realize economic income?

Well, you realize economic income when you have an exchange of property rights.

So for example, I own a home.

If I bought it for $250,000 and I sell it for

$300,000, I have $50,000 in realized income.

I've given up my property rights to house in this transaction and

now I know exactly the size of my income.

Generally, all realized income is included in gross income

unless it's specifically excluded or deferred.

The second type of income is recognized income.

This is the part of realized income that's actually reported on the tax return.

Again, taxpayers should assume all realized income is recognized income.

That is, it should show up on the tax return unless there's a law that says

the taxpayer doesn't have to.

However, realized income could be different from recognized income for

a couple of reasons.

First, the realized income may be excluded entirely from the tax return.

Going back to my earlier example about selling my home,

there is in fact a provision in the tax code, Section 121, that allows me to

exclude a large portion of the gains from the sale of my primary residence.

If certain rules apply.

Therefore, the $50,000 realized gain I earned in the sale of my home

will not be recognized.

So that $50,000 will not be reported on my tax return due to Section 121.

And so that income will be tax-free.

A second reason there may be a difference between realized income and

recognized income is because the income is deferred from tax.

That is maybe I realized income this year but

I don't actually have to report it on my tax return until sometime in the future.

An example here is what's known as an installment sale.

Here the tax law affords me some opportunity to spread the recognition of

my gains across several years into the future.

Here's a partial list of some other items that are included in gross income

that the taxpayer will recognize and report on the tax return.

We'll talk about some of these during the course.

For example alimony, the income element of annuities, bonuses,

business income, commissions, debt forgiveness, commissions.

And in fact we have embezzled funds.

So again, although an activity could be illegal,

it's still income from whatever source arrived, and

therefore must be included on the tax return in calculating the tax base.

Other includable income items are income from hobbies,

interest that I earn from a bank or from most bonds.

Pensions, punitive damages, rents, rewards,

salaries, tips, and even a treasure I find.

For example, if I find $20 lying in the street and I pick it up and keep it,

technically it's gross income, it must be reported on my personal income tax return.

Here's a partial list of exclusion, or

income that taxpayers do not have to include on their tax returns.

So they might be realized income but it’s not recognized income.

And we'll talk about some of these as well during the course.

Examples include accident insurance proceeds, the cost portion of annuities,

gifts and inheritances that that I've received, child support payments received.

Any damage awards received for physical injuries, interest from municipal bonds,

life insurance process received when somebody dies.

Meals and lodging if some conditions hold, scholarships some are all

social security benefits received and workers compensation benefits.

Again, we'll dig deeper into many of these gross income items and

exclusions as the course progresses.

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Gross Income

Federal Taxation I: Individuals, Employees, and Sole Proprietors

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