What is income?  More specifically, what is income according to the Federal Income Tax laws?  The short answer is “Everything.”  The slightly longer answer is: Everything that you ever get is considered to be income unless the income tax laws tell you otherwise.

Internal Revenue Code Section 61 defines gross income as follows:

General definition:

Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items:

  1. Compensation for services, including fees, commissions, fringe benefits, and similar items;
  2. Gross income derived from business;
  3. Gains derived from dealings in property;
  4. Interest;
  5. Rents;
  6. Royalties;
  7. Dividends;
  8. Alimony and separate maintenance payments;
  9. Annuities;
  10. Income from life insurance and endowment contracts;
  11. Pensions;
  12. Income from discharge of indebtedness;
  13. Distributive share of partnership gross income;
  14. Income in respect of a decedent; and
  15. Income from an interest in an estate or trust.

Less is More:

Section 61 is a short provision that throws out a very wide net.  It is comprised of only 1 sentence, if you ignore the list of 15 examples.  The heart of the definition is only 6 words long.  Gross income means “…all income from whatever source derived…

It interesting that Congress has felt the need to enact tens of thousands of words to make up the Federal tax laws, but only 6 to define the centerpiece of the entire system. Could it be that they felt that if they said more they would only mess it up?

The words before and after this key portion are among the most common drafting terms in an attorney’s lexicon:

  1. “Except as otherwise provided in this subtitle…” (legalese for “I am about to tell you the general rule.”); and
  2. “…including (but not limited to) the following items:” (legalese for “I am about to give you a list of examples to help guide you but the fact that something is not on this list does not mean anything.”).

Interesting Income:

You do not need to read this discussion to know that something such as wages from employment are considered to be gross income.  Here are some examples of things that are included in the definition of gross income that may not be obvious:

  1. According to IRS: Crime Pays: The fruits of a crime committed by you are included in your gross income.  For example, if you steal a car worth $30,000 you are considered to have received $30,000 of gross income.  You are required to report the $30,000 on your tax return the same as if the unfortunate car owner had paid you $30,000 for your services.  If you do not report the income on your tax return, you have committed another crime, tax evasion.  Remember Al Capone?  Scarface went to jail for tax evasion, not murder. By the way, if you get caught and the car is returned to the rightful owner, you are entitled to a $30,000 itemized deduction on your tax return (a strange form of “fairness” found in the tax laws).
  2. Your Lender May Forgive You, But Not the IRS: Debts owed by you that are forgiven are included in your gross income.  For example, you owe Bank of America $40,000 but have fallen behind on your payments.  Rather than take the risk that they get nothing, Bank of America agrees to take $10,000 in a lump sum and forgive the remaining $30,000.  You are considered to have recognized $30,000 of gross income and must include it on your income tax return.  As you could imagine, this has become more common in the current economy as people renegotiate their credit card balances or walk away from their mortgages.

There are several exceptions where you may not have to recognize this type of income.  For example, if you are insolvent or the debt is discharged in bankruptcy then the $30,000 is not included in your gross income.  There are also special rules where the debt forgiven is secured by real estate.

  1. The IRS Does Not Believe In Miraculous Recoveries: If you get a tax benefit in one year for something that is later given back to you, the part that you get back must be included in your gross income A common example involves the state income taxes.  For example, in December of 2008 you mail in a check for $2,000 to the Illinois Department of Revenue as an estimated tax payment against your 2008 Illinois Income Tax. Since state income tax payments are deductible on your Federal Tax Returns, you get a $2,000 tax benefit on your 2008 Federal Return.  However, when you go on to prepare your 2008 Illinois Return it turns out that you paid in $750 more than you owe.  Because you deducted this $750 (as part of the $2,000 state tax payment) on your 2008 Federal Return, you have to report this $750 overpayment as income on your 2009 Federal Return. It does not matter whether you direct the state to refund the $750 or apply it to your 2009 Illinois tax obligation.  If this were not the case, some enterprising tax attorneys would have their clients make huge year-end payments of state income tax each year, “manufacture” a deduction and then get the money returned to them.
  2. The Grey Economy is Black and White to the IRS: Bartering creates gross income for both sides of the trade.  If you trade a good or service for some other good or service, you must report the fair market value of what you received as income on your tax return.  For example, you are a car dealer that normally sells a car for $30,000 and you meet a software designer that normally sells his software package for $30,000.  If you “trade” your car for the software package you are treated as though you sold your car for $30,000.  The software designer is also treated as though he sold their software to you for $30,000.

 

Whistling Past The Graveyard:

There are situations where you may get something of value and it is not considered to be gross income.  For this to be the case, the tax laws must specifically state that the item is not considered to be gross income.  Here are 3 common examples of things that you may get that are not considered to be income:

  1. Virgin Territory: Certain investments pay interest that is not considered to be gross income (i.e. tax exempt interest). Common examples of tax exempt income includes interest from bonds issued by states, municipalities and certain U.S. territories, such as the U.S. Virgin Islands. The Federal tax laws require that you report this income, even though it is exempt from tax. This allows the IRS to keep track and test out whether other tax laws can be used against you (e.g.  tax exempt income impacts how much of your Social Security Benefits are taxable). States, such as Illinois, generally subject all interest to state income tax even though it may be exempt from Federal tax.
  2. True Gifts: Generally, if a friend or family member gives you a gift then it is not considered to be gross income.  The question of whether it is a gift (rather than a loan or payment) is based upon the intent of the giver. The intent is generally determined by the fact and circumstances surrounding the “gift”.  While a gift does not cause an income tax, it is possible that the giver must file a Gift Tax Return and pay a Gift Tax.
  3. Patience is a Virtue: An inheritance is not considered to be gross income.  That is, if you inherit money or property from a deceased friend or family member, you are generally not required to report any of it as income.  Of course, if you inherit a Traditional IRA, all withdrawals made by you will be considered to be gross income.  Further, money earned from investing the inheritance is considered to be gross income.  For example, you inherit a $500,000 Traditional IRA from your father and withdraw $10,000 to celebrate.  The $500,000 is not gross income. However, the $10,000 withdrawal is gross income.  If you invest the $10,000 in stocks and earn $300 of dividends, the $300 is considered to be gross income.

 

Conclusion:

Gross income means: “…all income from whatever source derived…” In a way, the use of only 6 words to define the meaning of gross income reflects an understated elegance.  One could compare it to great statements such as “We the People…” or “One small step for man.” (or was that “One small step for a man.”).  However, I prefer the comparison to the great words of then U. S. Supreme Court Justice Potter Stewart when he explained what obscene “hard-core” pornography was by saying, “I shall not today attempt further to define the kinds of material I understand to be embraced…[b]ut I know it when I see it.”

 

06/2009

Copyright ©, Keith B. Baker – 2009

This article is designed to be a public resource of general information. It does not constitute “legal advice” nor does it create a “client-attorney” relationship. While the information is intended to be accurate, this cannot be guaranteed. Tax laws are complex and constantly changing as a result of new laws, regulations, court interpretations and IRS pronouncements. Often, there are also various possible interpretations.  Further, the applicable rules can be affected by the facts and circumstances of a particular situation. Because of this, some of the information may no longer be correct or may not apply to all situations. We are not responsible for any consequences or losses resulting from your reliance on such information. You are urged to consult an experienced lawyer concerning your particular factual situation and any specific legal questions you may have.

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