Reporting various types of income to the IRS

Generally speaking all income, even income earned in a foreign country, should be reported the IRS.

You report your income to the IRS on form 1040.

Some income is excluded from taxation.

The IRS classifies income as either earned income, passive income or capital gains income. Earned income, passive income and short-term capital gains are taxed as “ordinary income,” long-term capital gains are taxed under another set of regulations known as capital gains tax.

Earned income is income received for your active participation. The most common example is wages earned as an employee of a business. This income is reported on form W2; the information on your W2 is also transmitted directly to the IRS.

If you are self-employed and have not incorporated, you report income to the IRS on form 1040 schedule C. It is your responsibility to maintain accurate records of revenue and expenses in order to calculate income. Payments made to you may be reported on forms 1099-Misc or 1099K; this information is also furnished to the IRS.

Form 1099-K is used by third-party processors such as PayPal, Visa, or Amazon. Form 1099-Misc is used to report payments to non-employees. It is also used to report rent, royalties, and payments to medical or legal providers.

If you have incorporated, you and your business are considered separate entities by the IRS, and each must file a tax return with the IRS. If you have incorporated as a “C” corporation, your corporation may have to pay taxes on its income. If you incorporated as an “S” corporation, the corporation does not pay taxes on its income since income and tax liability flow through to the owners. Form K1 is used to report this income.

Passive income has many forms. The most widely known would be interest and dividend income.

Interest is income received for the use of your money while dividends are corporate income distributed to the owners (shareholders). Interest income is reported to the recipient as well as the IRS on form 1099-INT, while dividend income is reported on form 1099-DIV.

Retirement income comes in several forms and is reported on form 1099-R. Pension income is generally taxable by the IRS but vary by each state. Distributions of traditional IRAs, 401(K), and 403(B) plans are taxable since the amount contributed to the plan was excluded from income the year of the contribution. Distributions from a Roth IRA are not taxable at any level since the contribution was not excluded from income and thus were taxed the year of the contribution.

Capital gains result when an asset is sold for more than was paid to obtain the asset. Common assets are stocks, bonds, vehicles, partnership shares, and homes owned as rental properties.

While the concept of selling an asset for more than you paid is fairly simple, the calculation of what you paid is more involved, the term the IRS uses is cost basis. I will briefly discuss the basis of two asset categories; stocks and bonds and real property.

The basis of stocks and bonds is fairly easy to calculate. It is the price paid for the stock plus any cost of acquisition such as commissions or transfer fees. It can be difficult determining the price paid for a stock if there have been multiple purchases over a period of time. Documentation and record keeping are essential and the brokerage houses have been doing a much better lately.

The basis of real property is somewhat more difficult to calculate. There is an income exclusion of $250,000 ($500,000 for married filing joint) on the sale of a primary residence. For other real estate the basis begins with the price paid for the property. There are then additions and subtractions to the basis. Improvements to the building will increase the basis while depreciation claimed during ownership will decrease the basis.

Paul Pahoresky