Chapter 12 Other income ey.com/EYTaxGuide
Your salary, interest you earn, dividends received, a gain from the sale of securities—all of these, of course, are taxable income.
Unfortunately, so are a lot of other things: a debt forgiven by a friend, jury pay, a free trip you receive from a travel agency for organizing a group of tourists, lottery and gambling winnings, and royalties you earn on a book.
The general rule is that anything that enriches you should be included in your gross income, unless it is specifically excluded by the tax law.
Indeed, some things are excluded from taxation. Generally, you don’t have to pay income tax on life insurance proceeds that you receive because of the death of the insured. Most gifts and inheritances are excluded from income tax. The value of the vegetables you grow in your garden and eat yourself is not taxable. This chapter tells you what kind of income is not taxable, and how you can tell the difference.
This chapter includes a discussion on passive activity losses. Passive investments include all rental activities, investments in limited partnerships, and those other businesses in which the taxpayer is not involved in the operations on a regular, continuous, and substantial basis.
You must include on your return all items of income you receive in the form of money, property, and services unless the tax law states that you do not include them. Some items, however, are only partly excluded from income. This chapter discusses many kinds of income and explains whether they are taxable or nontaxable.
Income that is taxable must be reported on your tax return and is subject to tax. Income that is nontaxable may have to be shown on your tax return but is not taxable. This chapter begins with discussions of the following income items.
Bartering. Canceled debts. Sales parties at which you are the host or hostess. Life insurance proceeds. Partnership income. S Corporation income.Recoveries (including state income tax refunds). Rents from personal property. Repayments. Royalties. Unemployment benefits. Welfare and other public assistance benefits. These discussions are followed by brief discussions of other income items.
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525 Taxable and Nontaxable Income544 Sales and Other Dispositions of Assets4681 Canceled Debts, Foreclosures, Repossessions, and Abandonments Bartering is an exchange of property or services. You must include in your income, at the time received, the fair market value of property or services you receive in bartering. If you exchange services with another person and you both have agreed ahead of time on the value of the services, that value will be accepted as fair market value unless the value can be shown to be otherwise.
Generally, you report this income on Schedule C (Form 1040), Profit or Loss From Business, or Schedule C-EZ (Form 1040), Net Profit From Business. However, if the barter involves an exchange of something other than services, such as in Example 3 below, you may have to use another form or schedule instead.
Example 1. You are a self-employed attorney who performs legal services for a client, a small corporation. The corporation gives you shares of its stock as payment for your services. You must include the fair market value of the shares in your income on Schedule C (Form 1040) or Schedule C-EZ (Form 1040) in the year you receive them.
Example 2. You are self-employed and a member of a barter club. The club uses “credit units” as a means of exchange. It adds credit units to your account for goods or services you provide to members, which you can use to purchase goods or services offered by other members of the barter club. The club subtracts credit units from your account when you receive goods or services from other members. You must include in your income the value of the credit units that are added to your account, even though you may not actually receive goods or services from other members until a later tax year.
Example 3. You own a small apartment building. In return for 6 months rent-free use of an apartment, an artist gives you a work of art she created. You must report as rental income on Schedule E (Form 1040), Supplemental Income and Loss, the fair market value of the artwork, and the artist must report as income on Schedule C (Form 1040) or Schedule C-EZ (Form 1040) the fair rental value of the apartment.
Form 1099-B from barter exchange. If you exchanged property or services through a barter exchange, Form 1099-B, Proceeds From Broker and Barter Exchange Transactions, or a similar statement from the barter exchange should be sent to you by February 17, 2015. It should show the value of cash, property, services, credits, or scrip you received from exchanges during 2014. The IRS also will receive a copy of Form 1099-B.
In most cases, if a debt you owe is canceled or forgiven, other than as a gift or bequest, you must include the canceled amount in your income. You have no income from the canceled debt if it is intended as a gift to you. A debt includes any indebtedness for which you are liable or which attaches to property you hold.
If the debt is a nonbusiness debt, report the canceled amount on Form 1040, line 21. If it is a business debt, report the amount on Schedule C (Form 1040) or Schedule C-EZ (Form 1040) (or on Schedule F (Form 1040), Profit or Loss From Farming, if the debt is farm debt and you are a farmer).
Form 1099-C. If a Federal Government agency, financial institution, or credit union cancels or forgives a debt you owe of $600 or more, you will receive a Form 1099-C, Cancellation of Debt. The amount of the canceled debt is shown in box 2.
Interest included in canceled debt. If any interest is forgiven and included in the amount of canceled debt in box 2, the amount of interest also will be shown in box 3. Whether or not you must include the interest portion of the canceled debt in your income depends on whether the interest would be deductible when you paid it. See Deductible debt Exceptions , later.
If the interest would not be deductible (such as interest on a personal loan), include in your income the amount from Form 1099-C, box 2. If the interest would be deductible (such as on a business loan), include in your income the net amount of the canceled debt (the amount shown in box 2 less the interest amount shown in box 3).
Discounted mortgage loan. If your financial institution offers a discount for the early payment of your mortgage loan, the amount of the discount is canceled debt. You must include the canceled amount in your income.
Mortgage relief upon sale or other disposition. If you are personally liable for a mortgage (recourse debt), and you are relieved of the mortgage when you dispose of the property, you may realize gain or loss up to the fair market value of the property. To the extent the mortgage discharge exceeds the fair market value of the property, it is income from discharge of indebtedness unless it qualifies for exclusion under Excluded debt
If you are not personally liable for a mortgage (nonrecourse debt), and you are relieved of the mortgage when you dispose of the property (such as through foreclosure), that relief is included in the amount you realize. You may have a taxable gain if the amount you realize exceeds your adjusted basis in the property. Report any gain on nonbusiness property as a capital gain.
See Publication 4681 for more information.
If you have gross income from the discharge of mortgage indebtedness and you are insolvent, you may be able to exclude the amount of the canceled debt in your gross income. IRS Publication 908, Bankrupcty Tax Guide, explains that a debtor is insolvent when, and to the extent, the debtor’s liabilities exceed the fair market value of his or her assets. Whether or not the debtor is insolvent is tested immediately before the cancellation of the debtor’s debt. So if the debtor is insolvent, the debtor can exclude from gross income the canceled debt, but only up the amount by which the debtor is insolvent.
If your mortgage indebtedness is discharged, it is key to establish whether and to what extent you are insolvent. It is important to keep appropriate records establishing the amount of the insolvency. The downside of claiming insolvency and choosing not to include the amount of the canceled debt in your income is that certain tax attributes are reduced by the amount the cancelled debt is not included in gross income. IRS Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, will need to be completed. Tax attributes that can be reduced include net operating losses, minimum tax credit, capital losses, basis in the debtor’s property, and passive activity losses and carryovers.
Stockholder debt. If you are a stockholder in a corporation and the corporation cancels or forgives your debt to it, the canceled debt is a constructive distribution that is generally dividend income to you. For more information, see Publication 542, Corporations.
If you are a stockholder in a corporation and you cancel a debt owed to you by the corporation, you generally do not realize income. This is because the canceled debt is considered as a contribution to the capital of the corporation equal to the amount of debt principal that you canceled.
Repayment of canceled debt. If you included a canceled amount in your income and later pay the debt, you may be able to file a claim for refund for the year the amount was included in income. You can file a claim on Form 1040X if the statute of limitations for filing a claim is still open. The statute of limitations generally does not end until 3 years after the due date of your original return.
There are several exceptions to the inclusion of canceled debt in income. These are explained next.
Student loans. Certain student loans contain a provision that all or part of the debt incurred to attend the qualified educational institution will be canceled if you work for a certain period of time in certain professions for any of a broad class of employers.
You do not have income if your student loan is canceled after you agreed to this provision and then performed the services required. To qualify, the loan must have been made by:
The Federal Government, a state or local government, or an instrumentality, agency, or subdivision thereof, A tax-exempt public benefit corporation that has assumed control of a state, county, or municipal hospital, and whose employees are considered public employees under state law, or An educational institution:Under an agreement with an entity described in (1) or (2) that provided the funds to the institution to make the loan, or As part of a program of the institution designed to encourage its students to serve in occupations with unmet needs or in areas with unmet needs and under which the services provided by the students (or former students) are for or under the direction of a governmental unit or a tax-exempt organization described in Section 501(c)(3). A loan to refinance a qualified student loan also will qualify if it was made by an educational institution or a qualified tax-exempt organization under its program designed as described in (3) (b) above.
Education loan repayment assistance. Education loan repayments made to you by the National Health Service Corps Loan Repayment Program (NHSC Loan Repayment Program), a state education loan repayment program eligible for funds under the Public Health Service Act, or any other state loan repayment or loan forgiveness program that is intended to provide for the increased availability of health services in underserved or health professional shortage areas are not taxable.
Deductible debt. You do not have income from the cancellation of a debt if your payment of the debt would be deductible. This exception applies only if you use the cash method of accounting. For more information, see chapter 5 of Publication 334, Tax Guide for Small Business.
Price reduced after purchase. In most cases, if the seller reduces the amount of debt you owe for property you purchased, you do not have income from the reduction. The reduction of the debt is treated as a purchase price adjustment and reduces your basis in the property.
Excluded debt. Do not include a canceled debt in your gross income in the following situations.
The debt is canceled in a bankruptcy case under title 11 of the U.S. Code. See Publication 908, Bankruptcy Tax Guide. The debt is canceled when you are insolvent. However, you cannot exclude any amount of canceled debt that is more than the amount by which you are insolvent. See Publication 908. The debt is qualified farm debt and is canceled by a qualified person. See chapter 3 of Publication 225, Farmer’s Tax Guide. The debt is qualified real property business debt. See chapter 5 of Publication 334. The cancellation is intended as a gift. The debt is qualified principal residence indebtedness. See Publication 525 for additional information. If you host a party or event at which sales are made, any gift or gratuity you receive for giving the event is a payment for helping a direct seller make sales. You must report this item as income at its fair market value.
Your out-of-pocket party expenses are subject to the 50% limit for meal and entertainment expenses. These expenses are deductible as miscellaneous itemized deductions subject to the 2%-of-AGI limit on Schedule A (Form 1040), but only up to the amount of income you receive for giving the party.
For more information about the 50% limit for meal and entertainment expenses, see chapter 27
Life insurance proceeds paid to you because of the death of the insured person are not taxable unless the policy was turned over to you for a price. This is true even if the proceeds were paid under an accident or health insurance policy or an endowment contract. However, interest income received as a result of life insurance proceeds may be taxable.
Proceeds not received in installments. If death benefits are paid to you in a lump sum or other than at regular intervals, include in your income only the benefits that are more than the amount payable to you at the time of the insured person’s death. If the benefit payable at death is not specified, you include in your income the benefit payments that are more than the present value of the payments at the time of death.
Proceeds received in installments. If you receive life insurance proceeds in installments, you can exclude part of each installment from your income.
To determine the excluded part, divide the amount held by the insurance company (generally the total lump sum payable at the death of the insured person) by the number of installments to be paid. Include anything over this excluded part in your income as interest.
Surviving spouse. If your spouse died before October 23, 1986, and insurance proceeds paid to you because of the death of your spouse are received in installments, you can exclude up to $1,000 a year of the interest included in the installments. If you remarry, you can continue to take the exclusion.
Surrender of policy for cash. If you surrender a life insurance policy for cash, you must include in income any proceeds that are more than the cost of the life insurance policy. In most cases, your cost (or investment in the contract) is the total of premiums that you paid for the life insurance policy, less any refunded premiums, rebates, dividends, or unrepaid loans that were not included in your income.
You should receive a Form 1099-R showing the total proceeds and the taxable part. Report these amounts on lines 16a and 16b of Form 1040 or lines 12a and 12b of Form 1040A.
More information. For more information, see Life Insurance Proceeds in Publication 525.
An endowment contract is a policy under which you are paid a specified amount of money on a certain date unless you die before that date, in which case, the money is paid to your designated beneficiary. Endowment proceeds paid in a lump sum to you at maturity are taxable only if the proceeds are more than the cost of the policy. To determine your cost, subtract any amount that you previously received under the contract and excluded from your income from the total premiums (or other consideration) paid for the contract. Include the part of the lump sum payment that is more than your cost in your income.
Endowment contracts, much like whole life insurance contracts, require you, as the owner, to pay annual premiums in return for a certain sum of cash that is paid when you reach a specified age or upon death. Unless you choose to receive the endowment proceeds in installments, the excess of the proceeds over the cost of the policy is taxable in the year of maturity, even if the proceeds are not received until a later year . The excess of the proceeds over the cost of the policy is taxed as ordinary income, not as capital gain. The cost of the endowment contract is the total amount of the premiums you paid for it, not its cash value at the time of maturity or when you surrender it.
However, if you agree to take the proceeds as an annuity within 60 days after the lump-sum payment becomes available and before you receive any cash, you are not considered to have received the lump sum for tax purposes. The lump sum is taxed as an annuity; that is, you are taxed on the amounts as you receive them each year.
For certain contracts entered into or materially changed after June 21, 1988, you may be required to treat distributions first as income and then as recovery of investment. Distributions are defined for this purpose to include a loan. In certain circumstances, an additional 10% tax will be imposed on the amount that is includible in gross income. Consult your tax advisor to determine if you are subject to this provision.
Certain amounts paid as accelerated death benefits under a life insurance contract or viatical settlement before the insured’s death are excluded from income if the insured is terminally or chronically ill.
Viatical settlement. This is the sale or assignment of any part of the death benefit under a life insurance contract to a viatical settlement provider. A viatical settlement provider is a person who regularly engages in the business of buying or taking assignment of life insurance contracts on the lives of insured individuals who are terminally or chronically ill and who meets the requirements of Section 101(g)(2)(B) of the Internal Revenue Code.
Exclusion for terminal illness. Accelerated death benefits are fully excludable if the insured is a terminally ill individual. This is a person who has been certified by a physician as having an illness or physical condition that can reasonably be expected to result in death within 24 months from the date of the certification.
Exclusion for chronic illness. If the insured is a chronically ill individual who is not terminally ill, accelerated death benefits paid on the basis of costs incurred for qualified long-term care services are fully excludable. Accelerated death benefits paid on a per diem or other periodic basis are excludable up to a limit. This limit applies to the total of the accelerated death benefits and any periodic payments received from long-term care insurance contracts. For information on the limit and the definitions of chronically ill individual, qualified long-term care services, and long-term care insurance contracts, see Long-Term Care Insurance Contracts under Sickness and Injury Benefits in Publication 525.
Exception. The exclusion does not apply to any amount paid to a person (other than the insured) who has an insurable interest in the life of the insured because the insured:
Is a director, officer, or employee of the person, or Has a financial interest in the person’s business. Form 8853. To claim an exclusion for accelerated death benefits made on a per diem or other periodic basis, you must file Form 8853, Archer MSAs and Long-Term Care Insurance Contracts, with your return. You do not have to file Form 8853 to exclude accelerated death benefits paid on the basis of actual expenses incurred.
If you are a survivor of a public safety officer who was killed in the line of duty, you may be able to exclude from income certain amounts you receive.
For this purpose, the term public safety officer includes law enforcement officers, firefighters, chaplains, and rescue squad and ambulance crew members. For more information, see Publication 559, Survivors, Executors, and Administrators.
A partnership generally is not a taxable entity. The income, gains, losses, deductions, and credits of a partnership are passed through to the partners based on each partner’s distributive share of these items.
Schedule K-1 (Form 1065). Although a partnership generally pays no tax, it must file an information return on Form 1065, U.S. Return of Partnership Income, and send Schedule K-1 (Form 1065) to each partner. In addition, the partnership will send each partner a copy of the Partner’s Instructions for Schedule K-1 (Form 1065) to help each partner report his or her share of the partnership’s income, deductions, credits, and tax preference items.
For more information on partnerships, see Publication 541, Partnerships.
General. A partnership includes a group, pool, joint venture, or other unincorporated organization that carries on a business or financial operation. Most entities that qualify for partnership treatment can elect out of partnership treatment under the “check-the-box” regulations. See your tax advisor for more information.
Limited liability companies. All states permit the formation of limited liability companies (LLCs). In an LLC, members and designated managers are not personally liable for any debts of the company. Absent an election to the contrary the entity will generally be treated as a partnership and, as a result, enjoy the same federal income tax benefits that apply to partnerships. If the entity is appropriately established, LLCs combine the benefits of corporate limited liability with the advantages of partnership taxation. In addition to LLCs, one may consider the formation of a limited liability partnership (LLP). Consult your tax advisor or attorney to find out if these are options for your business in the state you live in.
Reporting income. Because a partnership is not a taxable entity, all tax items are passed through to the partners. A partnership is required to give you a Schedule K-1, Partner’s Share of Income, Credits, Deductions, etc. A Schedule K-1 will list your distributive share of income, gains, losses, deductions, and credits that is required to be included in your individual tax return. If, for example, the Schedule K-1 indicates interest income of $100, you will need to include $100 as interest income on your Schedule B, Form 1040 or 1040A. (See chapter 7 Interest income .)
Basis. Because the partnership’s income and losses flow directly through to you, that income or loss will affect your tax basis in the partnership. It is important that you maintain and update this tax-basis calculation every year for two reasons. First, your distributive share of the partnership losses is limited to the adjusted basis of your interest in the partnership at the end of the partnership year in which the losses took place. Second, in the year you sell your partnership interest, you will need to know your tax basis in order to calculate your gain or loss. To determine the adjusted basis of your interest in the partnership, begin with your initial investment and your initial share of the partnership’s liabilities and make the following adjustments.
Additions to basis
Your distributive share of the partnership’s taxable income Your share of any tax-exempt income earned by the partnership Your share of the excess of partnership deductions for depletion over the basis of partnership property subject to depletion Any additional capital you contribute Your share of any increase in partnership liabilities Subtractions from basis
Any cash distributions you receive The basis that you take in any property distributed to you by the partnership Your share of oil and gas depletion claimed by the partnership Your distributive share of partnership deductions, losses, and certain credits Your share of nondeductible, noncapital expenditures made by the partnership Your share of any decrease in partnership liabilities The partnership agreement usually covers the distribution of profits, losses, and other items. However, if there is no agreement for sharing a specific item of gain or loss, generally, each partner’s distributive share is figured according to the partner’s interest in the partnership.
In addition, special “at-risk” rules apply to a partnership engaged in any activity.
You may deduct your share of a partnership loss from any activity only up to the total amount that you are at risk in the activity at the end of the partnership’s tax year.
The amount you are at risk in an activity is the cash and the adjusted basis of other property you contributed to the activity. Also, you are at risk for any amounts borrowed for use in the activity for which you either are personally liable or have pledged property, except property used in the activity, as security.
Generally, you are not at risk for:
Any nonrecourse loans used to finance the activity, to acquire property used in the activity, or to acquire your interest in the activity, unless they are secured by property not used in the activity; Amounts for which you are protected against loss by guarantees, stop-loss agreements, or other similar arrangements; or Amounts borrowed from interested or related parties if your partnership is engaged in certain activities. For more information on the at-risk rules, see Publication 925, Passive Activity and At-Risk Rules .
In addition to the factors discussed above, your amount at risk is affected by the operating results of the activity itself. Income from the activity increases the amount you are at risk. Losses from the activity decrease the amount you are at risk. The at-risk amount is determined at the end of each tax year. Any loss in excess of that amount is disallowed for that year. It may, however, be carried over to future years, and to the extent that you subsequently have amounts at risk, it may be deducted in those years.
Under prior law, a partnership engaged in real estate activity was not subject to the at-risk rules. The Tax Reform Act of 1986 extended the at-risk rules to include real estate activities placed in service after December 31, 1986, but made exceptions for third-party nonrecourse debt from commercial lenders and certain other parties.
In addition to the at-risk rules, the income from real estate partnerships is also subject to the passive activity rules. See Passive Activity Limitations and At-Risk Limitations
When to report partnership income. Generally, you must include your distributive share of partnership items on your return for the tax year in which the last day of the partnership year falls. (See chapter 43 Decedents: Dealing with the death of a family member , for exceptions relating to partnership interests held by a decedent.) If you receive income from a partnership other than in your capacity as a partner, however, you must report the income in the year in which it was received. For instance, if you sell property to your partnership at a gain, the gain is generally included in income when you receive the sales proceeds, regardless of when your partnership’s tax year ends.
Estimated tax payments. A partner must take into account his or her share of the partnership’s income or deductions to date at each estimated tax payment date. Often, this information is not readily available. If you are a member of a partnership you may protect yourself from underpayment penalties by basing your payments on one of the exceptions described in chapter 4 Tax withholding and estimated tax .
However, additional issues arise if an individual’s residence changes during the year. An individual’s resident state income tax return generally must include all the income the individual recognized during the year. A part-year resident would include all income recognized during the period of residency, as well as income sourced to that state during the period of nonresidency. The state tax treatment of flow-through entity income for a part-year resident varies from state to state. You should review the rules for the state(s) in which you reside for guidance.
Sale of partnership interest. If you have a gain or a loss from the sale or exchange of a partnership interest, it is treated as a gain or a loss from the sale of a capital asset. The gain or loss is the difference between the amount you receive and the adjusted basis of your interest in the partnership. If you are relieved of any debts of the partnership, you must include these debts in the amount you receive.
However, you may have ordinary income as well as capital gain or loss on the sale of your partnership interest if the sale involves uncollected accounts receivable or inventory items that have increased in value. Consult your tax advisor for further help.
Qualified joint venture. If you and your spouse each materially participate as the only members of a jointly owned and operated business, and you file a joint return for the tax year, you can make a joint election to be treated as a qualified joint venture instead of a partnership. To make this election, you must divide all items of income, gain, loss, deduction, and credit attributable to the business between you and your spouse in accordance with your respective interests in the venture. For further information on how to make the election and which schedule(s) to file, see the instructions for your individual tax return.
In most cases, an S corporation does not pay tax on its income. Instead, the income, losses, deductions, and credits of the corporation are passed through to the shareholders based on each shareholder’s pro rata share.
Schedule K-1 (Form 1120S). An S corporation must file a return on Form 1120S, U.S. Income Tax Return for an S Corporation, and send Schedule K-1 (Form 1120S) to each shareholder. In addition, the S corporation will send each shareholder a copy of the Shareholder’s Instructions for Schedule K-1 (Form 1120S) to help each shareholder report his or her share of the S corporation’s income, losses, credits, and deductions.
For more information on S corporations and their shareholders, see the Instructions for Form 1120S.
Shareholder’s return. Generally, S corporation distributions are considered a nontaxable return of your basis in the corporation’s stock. However, in certain cases, part of the distributions may be taxable as a dividend or as a long-term or short-term capital gain, or as both. The corporation’s distributions may be in the form of cash or property.
All current-year income or loss and other tax items are taxed to you at the corporation’s year-end. Generally, the items that are passed through to you as a shareholder will increase or decrease the basis of your S corporation stock as appropriate. Dividends are paid only from prior-year earnings (generally retained earnings from years prior to becoming an S corporation). Generally, property (including cash) distributions, except dividend distributions, are considered a return of capital to the extent of your basis in the stock of the corporation. Distributions in excess of basis are treated as a gain from the sale or exchange of property.
You should receive from the S corporation in which you are a shareholder a copy of the Shareholder’s Instructions for Schedule K-1 (Form 1120S), together with a copy of Schedule K-1 (Form 1120S), showing your share of the income, credits, and deductions of the S corporation for the tax year. Your distributive share of the items of income, gain, loss, deduction, or credit of the S corporation must be shown separately on your Form 1040 or 1040A. The tax treatment of these items generally is the same as if you had realized or incurred them personally.
Individuals form an S corporation to get the legal benefits of a corporation, such as limited liability, while retaining the tax benefits of an individual. Usually, an S corporation does not pay federal income tax. One exception is a tax on net passive investment income that is paid by the S corporation, but normally, the individual owners of the corporation pay tax or accrue tax benefits on their personal returns based on the corporation’s profits and losses. Income from an S corporation is included in an individual’s return as if the S corporation did not exist. Dividends that the S corporation receives are included as dividends on your return on Schedule B (Form 1040). Capital gains are included on Schedule D (Form 1040). Items of income from an S corporation that are not separately stated on an individual’s return, such as interest, dividends, and capital gains/losses, are combined and included on Schedule E (Form 1040). If you have losses from an S corporation when you are not an active participant in the corporation’s business activities, your losses will be subject to the passive activity loss limitations. See the section on Passive Activity Losses
Estimated tax payments. A shareholder must take into account his or her share of the S corporation’s income or deductions to date at each estimated tax payment date. Often, this information is not readily available. If you are a member of an S corporation, you may protect yourself from underpayment penalties by basing your payments on one of the exceptions described in chapter 4 Tax withholding and estimated tax .
Generally, an S corporation must have its tax year-end on December 31. However, under certain circumstances, an S corporation may operate on a fiscal year; that is, its tax year may end on a date other than December 31. Your return should include all S corporation income for its operating year that ends within your tax year.
If your S corporation’s year ends on October 31, your return for 2014 will include the income items for the corporation’s entire year that ended October 31, 2014, even though that means including 2 months of 2013.
Deducting losses. You may deduct any losses of the S corporation for the year up to the amount of your basis.
Basis in an S corporation. Your basis in an S corporation at the end of a year is your investment (basis of stock owned plus loans made directly by you to the S corporation), with the following adjustments:
Additions to basis
Your distributive share of the S corporation’s separately and non-separately stated taxable income Your share of tax-exempt income earned by the S corporation Any additional capital that you contribute Deductions for depletion in excess of the basis of the property A loan to the corporation directly from the shareholder; however, a guarantee of a third-party loan by a shareholder does not qualify as an addition to basis Subtractions from basis
Generally, any cash distributed and the fair market value of property distributed (other than taxable dividends), but not below zero Your distributive share of the S corporation’s separately and non-separately stated items of loss, deductions, and certain credits. Your share of nondeductible, noncapital expenditures made by the S corporation Your share of the deductions for depletion for any oil and gas property held by the S corporation to the extent that the deduction does not exceed the proportionate share of the property’s adjusted basis allocated to you Your basis in an S corporation is $20,000. The corporation makes a distribution to you of $30,000 in cash or property. You would have to recognize income of $10,000 due to a distribution in excess of basis.
Your basis in an S corporation is $20,000. If it reports losses of $30,000, you may deduct only $20,000 for the year. The other $10,000 of losses is carried over to subsequent tax years and deducted in the year you have more basis.
All you need to prepare your individual tax return is the Form K-1 provided by the S corporation. It tells you what the numbers are and where to put them on your Form 1040.
An S corporation is just one of several alternatives to consider as a vehicle to conduct business activities, but it does offer some of the best features of a regular corporation, a partnership, and a sole proprietorship.
As in a regular corporation, the stockholders of an S corporation are normally immune from liabilities in excess of their investment. Like a regular corporation, the S corporation structure is convenient for transferring equity to heirs as part of your estate planning and the gradual transition of management and control to your heirs or successors (see chapter 44 ,Estate and gift tax planning , for further information). As shareholders, the heirs then report their proportionate share of S corporation income and losses on their respective tax returns. Like a partnership or sole proprietorship, the S corporation permits the investors to deduct operating losses. Just as important, profits are not taxed twice, as they are in a regular corporation. A regular corporation itself pays taxes, and so do the individuals who receive a share of those profits when dividends are paid. An S corporation is, except in certain circumstances, exempt from taxes—at least at the federal level.
A recovery is a return of an amount you deducted or took a credit for in an earlier year. The most common recoveries are refunds, reimbursements, and rebates of deductions itemized on Schedule A (Form 1040). You also may have recoveries of non-itemized deductions (such as payments on previously deducted bad debts) and recoveries of items for which you previously claimed a tax credit.
Tax benefit rule. You must include a recovery in your income in the year you receive it up to the amount by which the deduction or credit you took for the recovered amount reduced your tax in the earlier year. For this purpose, any increase to an amount carried over to the current year that resulted from the deduction or credit is considered to have reduced your tax in the earlier year. For more information, see Publication 525.
Federal income tax refund. Refunds of federal income taxes are not included in your income because they are never allowed as a deduction from income.
State tax refund. If you received a state or local income tax refund (or credit or offset) in 2014, you generally must include it in income if you deducted the tax in an earlier year. The payer should send Form 1099-G, Certain Government Payments, to you by January 31, 2015. The IRS also will receive a copy of the Form 1099-G. If you file Form 1040, use the State and Local Income Tax Refund Worksheet in the 2014 Form 1040 instructions for line 10 to figure the amount (if any) to include in your income. See Publication 525 for when you must use another worksheet.
If you could choose to deduct for a tax year either:
State and local income taxes, or State and local general sales taxes, then the maximum refund that you may have to include in income is limited to the excess of the tax you chose to deduct for that year over the tax you did not choose to deduct for that year. For examples, see Publication 525.
Mortgage interest refund. If you received a refund or credit in 2014 of mortgage interest paid in an earlier year, the amount should be shown in box 3 of your Form 1098, Mortgage Interest Statement. Do not subtract the refund amount from the interest you paid in 2014. You may have to include it in your income under the rules explained in the following discussions.
Interest on recovery. Interest on any of the amounts you recover must be reported as interest income in the year received. For example, report any interest you received on state or local income tax refunds on Form 1040, line 8a.
Recovery and expense in same year. If the refund or other recovery and the expense occur in the same year, the recovery reduces the deduction or credit and is not reported as income.
Recovery for 2 or more years. If you receive a refund or other recovery that is for amounts you paid in 2 or more separate years, you must allocate, on a pro rata basis, the recovered amount between the years in which you paid it. This allocation is necessary to determine the amount of recovery from any earlier years and to determine the amount, if any, of your allowable deduction for this item for the current year. For information on how to compute the allocation, see Recoveries in Publication 525.
Itemized Deduction Recoveries If you recover any amount that you deducted in an earlier year on Schedule A (Form 1040), you generally must include the full amount of the recovery in your income in the year you receive it.
Where to report. Enter your state or local income tax refund on Form 1040, line 10, and the total of all other recoveries as other income on Form 1040, line 21. You cannot use Form 1040A or Form 1040EZ.
Standard deduction limit. You generally are allowed to claim the standard deduction if you do not itemize your deductions. Only your itemized deductions that are more than your standard deduction are subject to the recovery rule (unless you are required to itemize your deductions). If your total deductions on the earlier year return were not more than your income for that year, include in your income this year the lesser of:
Your recoveries, or The amount by which your itemized deductions exceeded the standard deduction. Example. For 2013, you filed a joint return. Your taxable income was $60,000 and you were not entitled to any tax credits. Your standard deduction was $12,200, and you had itemized deductions of $14,300. In 2014, you received the following recoveries for amounts deducted on your 2013 return:
Medical expenses $200
Total recoveries $925
None of the recoveries were more than the deductions taken for 2013. The difference between the state and local income tax you deducted and your local general sales tax was more than $400.
Your total recoveries are less than the amount by which your itemized deductions exceeded the standard deduction ($14,300 − 12,200 = $2,100), so you must include your total recoveries in your income for 2014. Report the state and local income tax refund of $400 on Form 1040, line 10, and the balance of your recoveries, $525, on Form 1040, line 21.
Standard deduction for earlier years. To determine if amounts recovered in 2014 must be included in your income, you must know the standard deduction for your filing status for the year the deduction was claimed. Look in the instructions for your tax return from prior years to locate the standard deduction for the filing status for that prior year.
525 Taxable and Nontaxable Income
544 Sales and Other Dispositions of Assets
4681 Canceled Debts, Foreclosures, Repossessions, and Abandonments