assignment of income and gifts

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Hoensheid: assignment of income and gift substantiation.

It is fairly common to make charitable gifts of property prior to a sale transaction. Often, those gifts are of real property or closely-held business interests. This is for good reason. Structured properly, not only do donors generally receive a charitable income tax deduction equal to the fair market value of the donated property, they also avoid any capital gains on the sale of that property. [1] The double benefit of both avoiding capital gain and receiving a full fair market value deduction can be quite powerful. [2]

As stated above, however, the gift must be structured properly in order to obtain these benefits. Two of the important areas in this regard are: (1) avoidance of an assignment of income; and (2) proper gift substantiation. We have previously written about cases where these issues have arisen. [3]   A recent Tax Court opinion once again addresses these issues, [4] this time possibly contradicting IRS guidance [5] and a previous binding opinion of the full Tax Court. [6]

Commercial Steel Treating Corp. (“CTSC”) was owned by three brothers. After one of the brothers announced his plans to retire in the Fall of 2014, the three brothers decided to solicit bids for a sale of the company. In so doing, they engaged a financial advisory firm which began the process in early 2015.

Once that process started, the following sequence of events unfolded:

• April 1, 2015: HCI Equity Partners (“HCI”) submitted a draft Letter of Intent (“LOI”) to acquire CTSC.
• Mid April 2015: Mr. Hoensheid, one of the owner/brothers and the taxpayer in this case, begins discussing the possibility of establishing a donor advised fund (“DAF”) to make a charitable contribution of CTSC stock prior to the anticipated sale to take advantage of the type of planning described above (i.e. double benefit of fair market value charitable deduction and avoidance of capital gains on the donated shares).
• April 16, 2015: Mr. Hoensheid’s attorney emailed that “the transfer would have to take place before there is a definitive agreement in place.” [7]
• April 23, 2015: LOI between HCI and CTSC was executed.
• May 22, 2015: CTSC executed an Affidavit of Acquired Person for the Federal Trade Commission representing that CTSC had “a good faith intention of completing the transaction.”
• Valuation date of CTSC submitted in substantiation of charitable deduction.
• Hoensheid emailed his attorney that “I do not want to transfer the stock until we are 99% sure we are closing.”
• Shareholders and Directors meetings ratifying sale of all stock of CTSC to HCI.
• CTSC submitted to the Michigan Department of Licensing and Regulatory Affairs an amendment to its Articles of Incorporation per request from HCI.
• Stock Purchase Agreement submitted by Mr. Hoensheid’s attorney to Fidelity Charitable for execution (dated effective June 15, 2015).
• Shareholders approve Mr. Hoensheid’s transfer of an unspecified number of CTSC shares to Fidelity.
• June 12, 2015: HCI’s investment committee and managing partners approved acquisition of CTSC.
• HCI formed a new Delaware corporation to serve as the acquirer of CTSC.
• Hoensheid sends an email that he is “not totally sure of the shares being transferred to the charitable fund yet.”
• July 7: CTSC determined to distribute payments to employees pursuant to a Change of Control Bonus Plan and almost all remaining cash to its shareholders.
• Email from Mr. Hoensheid’s financial advisor that “it looks like Scott has arrived at 1380 shares.”
• Hoensheid delivered the stock certificate transferring shares in CTSC to his attorney.
• Revised draft Stock Purchase Agreement circulated with missing date upon which Mr. Hoensheid transferred shares to Fidelity Charitable.
• CTSC paid bonuses to employees under Change of Control Bonus plan.
• Redline draft of Stock Purchase Agreement circulated indicating acceptance of all substantive changes.
• Printout list of CTSC shareholders indicating gift to Fidelity Charitable from Mr. Hoensheid on July 10, 2015.
• PDF stock certificate submitted by email to Fidelity Charitable showing the stock transfer from Mr. Hoensheid to Fidelity Charitable.
• July 14: CTSC distributed almost all remaining cash to its shareholders.
• July 15, 2015: Transaction closing and funding.

There was some dispute between the taxpayers and the IRS about the date of the charitable gift. The taxpayers argued the stock was gifted on July 10, 2015, the date upon which Mr. Hoensheid decided to transfer 1380 shares of CTSC to Fidelity Charitable, executed a stock certificate to that effect, and delivered the stock certificate to his attorney. However, the IRS argued, and the Tax Court agreed, that the transfer did not occur until July 13, 2015. The reason was that, citing to Michigan law [8] , there was no deliver of the gift to the charity until the PDF stock certificate was sent [9] and no acceptance of the gift until Fidelity Charitable’s email on July 13, 2015, acknowledging same. [10] As a result, for purposes of the tax dispute, July 13, 2015, was the date of the charitable donation.

Assignment of Income

The assignment of income doctrine recognizes income as taxed “to those who earn or otherwise create the right to receive it.” [11] Particularly in the charitable donation context, a donor will be deemed “to have effectively realized income and then assigned that income to another when the donor has an already fixed or vested right to the unpaid income.” [12] This analysis looks “to the realities and substance of the underlying transaction, rather than to formalities or hypothetical possibilities.” [13] The form of a charitable donation will not be respected if the donor does not: (1) give the appreciated property away absolutely and divest of title (2) before the property gives rise to income by way of a sale. [14]

Before analyzing Mr. Hoensheid’s donation through the relevant tests for assignment of income, the Tax Court addressed arguments raised by Mr. Hoensheid regarding existing guidance. In addition to other sources, this is particularly important in citing to Rev. Rul. 78-197 and Rauenhorst [15] . In Rev. Rul. 78-197 the IRS acquiesced in the Palmer [16] decision where a donor transferred shares in a closely-held corporation he controlled to a private foundation he also controlled, followed by a redemption of those shares by the corporation. The IRS argued the substance of the transaction was a redemption followed by a cash contribution since the taxpayer had a “prearranged plan” of redeeming the shares at the time of the contribution. After the Tax Court ruled in favor of the taxpayer, the IRS issued Rev. Rul. 78-197 stating that “the Service will treat the proceeds of a redemption of stock under facts similar to those in Palmer as income to the donor only if the donee is legally bound, or can be compelled by the corporation to surrender the shares for redemption ” (emphasis added). Certainly, regardless of any other facts, there was nothing to legally compel a closing of the sale of CTSC stock to HCI, or otherwise compel such closing, at the date of Mr. Hoensheid’s charitable gift.

In Palmer , the Tax Court held that certain charitable gifts made after a redemption of stock was “imminent” did not constitute an assignment of income. In Rauenhorst , the Tax Court noted that the IRS attempted to “devise a ‘bright-line’ test which focuses on the donee’s control over the disposition of the appreciated property” by adopting Rev. Rul. 78-197. Although Revenue Rulings do not bind the Tax Court, they do bind the IRS. When there was an LOI, but no binding obligation to sell, therefore, the IRS was precluded in Rauenhorst from arguing there as an assignment of income when the facts in the case were not distinguishable from those in Rev. Rul. 78-197. The facts in Rauenhorst bear similarities to those in Hoensheid . In Rauenhorst , there was a signed LOI, a resolution authorizing executing an agreement of sale, and a valuation report indicating there was little chance the transaction would not close.

However, in Rauenhorst , and cited in Hoensheid , the Tax Court noted “we have indicated our reluctance to elevate the question of donee control to a talisman for resolving anticipatory assignment of income” and that the donee’s power to reverse the transaction is “only one factor to be considered in ascertaining the ‘realities and substance’ of the transaction.” In Rauenhorst and Hoensheid , the Tax Court stated that “the ultimate question is whether the transferor, considering the reality and substance of all the circumstances, had a fixed right to income in property at the time of the transfer.” [17] As such, notwithstanding that the Tax Court in Rauenhorst held the IRS to its position in Rev. Rul. 78-197, the court stated that “in the appropriate case we could disregard a ruling or rulings as inconsistent with our interpretation of the law.” As such, while Hoensheid could be seen as inconsistent with Rauenhorst , it also could be seen as consistent insofar as the Tax Court kept the door open for the Hoensheid result in the opinion it issued in Rauenhorst . [18]

In making that determination the Tax Court in Hoensheid looked at factors including: (1) “any legal obligation to sell by the donee”, (2) “the actions already taken by the parties to effect the transaction”, (3) “the remaining unresolved transactional contingencies”, and (4) “the status of the corporate formalities required to finalize the transaction.”

Applying these factors, while conceding that there was no obligation of Fidelity Charitable to sell shares at the time of contribution, the Tax Court found there to be an assignment of income. The court cited to the number of acts which had taken place at the time of the donation which rendered the transaction a “foregone conclusion.” Relevant facts included that, on the date of the charitable donation, corporate formalities of approving the transaction had occurred, bonuses payable to employees resulting from the transaction had been paid, dividends had been paid to such an extent that CTSC no longer remained a viable going concern, and all substantive terms of the transaction had been fully negotiated. Ultimately, the court stated that, by July 13, 2015, “the transaction had simply ‘proceeded too far down the road to enable petitioners to escape taxation on the gain attributable to the donated shares.’”

Substantiation

Although the scope of this writing is to address the concept of anticipatory assignment of income and the Hoensheid opinion, particularly as it relates to prior authorities and guidance, it is important to note the substantiation issues which ultimately cost the taxpayers any charitable deduction. Even finding an assignment of income, the taxpayers would be entitled to charitable donation equal to the fair market value of the shares gifted. They merely would be forced to recognized their share of gain from the sale transaction. However, having failed to satisfy the charitable donation substantiation requirements, the taxpayers lost the deduction in full.

Relevant in Hoensheid , gifts of property of more than $500,000 require taxpayers to obtain a qualified appraisal from a qualified appraiser to attach to the taxpayer’s income tax return for the year of the gift. [19] Although the scope of what constitutes a “qualified appraisal” from a “qualified appraiser” is beyond the scope of this writing, in Hoensheid , the taxpayer failed primarily as a result of obtaining an appraisal from someone unqualified to render valuations for purposes of substantiating charitable gifts.

The Tax Court notes that the requirement for the appraiser to be qualified is “the most important requirement” of the regulations. [20] The appraiser in Hoensheid only infrequently performed valuations, did not hold himself out as an appraiser, and held no certifications from any professional appraiser organization. Based on these and other factors, it was clear that the appraiser in Hoensheid was not a “qualified appraiser” as contemplated by the applicable statute and regulations. By all accounts, he was used because he charged no fee for the valuation, instead offering to perform the valuation under the fees paid to the financial advisory firm handling the sale transaction which is where he was employed. In addition to the appraiser lacking the proper qualifications, the valuation report contained a number of deficiencies which rendered it not to constitute a “qualified appraisal” either. One of such problems was using a June 1, 2015, valuation date when intervening events between that date and the date of the gift, including the substantial bonus and dividend distributions, should have caused the value of CSTC to materially change.

Although “substantial compliance” can be sufficient in satisfying regulatory substantiation requirements [21] , the Tax Court found that Mr. Hoensheid failed to substantially comply due to his failure to engage a qualified professional to complete the valuation along with the numerous errors could not be concluded to satisfy the requirements of substantial compliance. However, as a silver lining, in avoiding a 20% underpayment penalty [22] , Mr. Hoensheid was held to have reasonably relied on his attorney’s advice that the deadline for the charitable donation was the date a definitive agreement is executed.

Here, Mr. Hoensheid made a couple of fatal choices. First, he chose to wait until the transaction was 99% sure to close before making the charitable gift. Second, he cut corners by using a free and unqualified appraiser rather than simply paying for a qualified valuation professional. Sure, Mr. Hoensheid’s professional advisors led him to believe he may have had until the closing (the date the purchase agreement would be signed) in order to make the gift. Further, his attorney may have been justified in believing that to constitute the law given Rauenhorst and Rev. Rul. 78-197. However, his own attorney said “any tax lawyer worth [her] fees would not have recommended that a donor make a gift of appreciated stock” so close to the closing.

It is understandable that taxpayers desire to wait until they are confident a sale will close before donating equity interests. We encounter that frequently. There is no clear, bright-line date on which the tests as discussed in Hoensheid may apply (as opposed to Rauenhorst and Rev. Rul. 78-197). As such, taxpayers and their planners should look to the timeline in this case and the Tax Court’s discussion in determining when to make charitable gifts in anticipation of a sale. In many cases, closing and purchase agreement execution occur simultaneously as opposed to transactions where a purchase agreement is signed with a number of contingencies and before much of the due diligence or other pre-closing details have been finalized. Extra care is likely needed when there is a contemporaneous execution and closing, as in  Hoensheid . While no legally binding document may have been executed, the deal may be a “foregone conclusion” at some point along the spectrum.

Of course, beyond the assignment of income issues, we continue to see taxpayers trip up on charitable gift substantiation. [23] Sometimes it is a mere mistake; other times taxpayers try to cut corners and/or save money by not engaging the proper professionals. When large gifts are being made, real value is being donated. The donor will never get those funds back and the costs of complying with the substantiation requirements is typically much less than the value of the deduction, especially when gifts are made in advance of a liquidity event.

[1] This presumes a donation of long-term capital gain property to a public charity, generally subject to a limitation on the deduction of 30% of the donor’s adjusted gross income. IRC § 170(b)(1)(C).

[2] As an example, a top bracket taxpayer (37% ordinary income tax bracket and 20% capital gains bracket) who donates a $1 million asset with a $200,000 cost basis stands to obtain both an $1M income tax deduction for a benefit of $370,000 and also avoid $800,000 of capital gains for a benefit of $160,000, yielding a combined tax benefit of $530,000. This means the true cost of the $1 million charitable gift was only $470,000. The savings may be more to the extent the net investment income tax and/or state income tax applies.

[3] Allen, Charles J., “IRS Continues Aggressive Stance on Charitable Contributions,” Oct. 23, 2018, https://esapllc.com/chrem-case/ ; and Sage, Joshua W., “Gifting Appreciated Stock Before Redemption – Dickinson,” Oct. 6, 2020, https://www.esapllc.com/dickinson-redemption2020/ .

[4] Estate of Scott Hoensheid, et ux. v. Commissioner , T.C. Memo 2023-34.

[5] Rev. Rul. 78-197.

[6] Rauenhorst v. Commissioner , 119 T.C. 157 (2002).

[7] These statements were repeated in an email from the taxpayer’s financial advisor on April 20, 2015, and the taxpayer’s attorney on April 21, 2015.

[8] Michigan law requires a showing of: (1) donor intent to make a gift; (2) actual or constructive delivery of the subject matter of the gift; and (3) donee acceptance. See Davidson v. Bugbee , 575 N.W.2d 574, 576 (Mich. Ct. App. 1997).

[9] Although the stock ledger showing an earlier transfer date could have possibly substantiated delivery, that printout was dated July 13, 2015, meaning the Tax Court could not determine an earlier date upon which CTSC acknowledged the transfer.

[10] Again, here, there were communications with Fidelity Charitable showing a July 11, 2015, transfer date but the documentary proof provided to the Tax Court by the taxpayers bore a July 15, 2015, date rather than a production of the earlier original. As such, absent proper proof, the Tax Court could not conclude a July 11, 2015, acceptance date occurred.

[11] Helvering v. Horst , 311 U.C. 112, 119 (1940).

[12] Cold Metal Process Co. v. Commissioner , 247 F.2d 864, 872-73 (6th Cir. 1957).

[13] Jones v. U.S. , 531 F.2d 1343, 1345 (6th Cir. 1976); and Allen v. Commissioner , 66 T.C. 340, 346 (1976).

[14] Humacid Co. v. Commissioner , 42 T.C. 894, 913 (1964).

[15] See supra Note 6.

[16] Palmer v. Commissioner , 62 T.C. 684 (1974),

[17] Citing Ferguson v. Commissioner , 108 T.C. 244 (1997).

[18] Note also the Ninth Circuit’s opinion in Ferguson v. Commissioner , 174 F.3d 997 (9th Cir. 1999), whereby assignment of income was found where a threshold of a tender of 85% of corporate shares was required prior to any binding obligations to sell when only more than 50% had been transferred at the time of the gift, the court finding there was enough “momentum” to the transaction to make the merger “most unlikely” to fail. This extension of the assignment of income doctrine was specifically refused to be followed by the U.S. District Court in Keefer v. U.S. , 2022 WL 2473369, particularly given that the case was appealable to the Fifth Circuit Court of Appeals.

[19] IRC §170(f)(11)(D) and (E), and Treas. Reg. § 1.170A-13.

[20] Citing Mohamed v. Commissioner , T.C. Memo 2012-152.

[21] We have discussed substantial compliance in other writings including, Gray Edmondson, “RERI Revisited on Appeal, $33M Deduction Denial Upheld,” June 5, 2019, https://esapllc.com/reri-appeal/ ; and Devin Mills, “Private Jet Deduction Fails for Lack of Substantiation,” July 26, 2022, https://esapllc.com/izen-jet-2022/ .

[22] IRC § 6662 based on any underpayment of tax required to be shown on a return that is attributable to negligence, disregard of rules or regulations, or a substantial understatement of income tax.

[23] For a recent article discussing charitable gift substantiation, including substantial compliance, see Sholk, Steven H., “A Guide to the Substantiation Rules for Deductible Charitable Contributions,” 137 J. Tax’n 03 (Dec. 2022).

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What is “Assignment of Income” Under the Tax Law?

Gross income is taxed to the individual who earns it or to owner of property that generates the income. Under the so-called “assignment of income doctrine,” a taxpayer may not avoid tax by assigning the right to income to another.

Specifically, the assignment of income doctrine holds that a taxpayer who earns income from services that the taxpayer performs or property that the taxpayer owns generally cannot avoid liability for tax on that income by assigning it to another person or entity. The doctrine is frequently applied to assignments to creditors, controlled entities, family trusts and charities.

A taxpayer cannot, for tax purposes, assign income that has already accrued from property the taxpayer owns. This aspect of the assignment of income doctrine is often applied to interest, dividends, rents, royalties, and trust income. And, under the same rationale, an assignment of an interest in a lottery ticket is effective only if it occurs before the ticket is ascertained to be a winning ticket.

However, a taxpayer can shift liability for capital gains on property not yet sold by making a bona fide gift of the underlying property. In that case, the donee of a gift of securities takes the “carryover” basis of the donor.  

For example, shares now valued at $50 gifted to a donee in which the donor has a tax basis of $10, would yield a taxable gain to the donee of its eventual sale price less the $10 carryover basis. The donor escapes income tax on any of the appreciation.

For guidance on this issue, please contact our professionals at 315.242.1120 or [email protected] .

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• Frost Brown Todd

Section 1202 Planning: When Might the Assignment of Income Doctrine Apply to a Gift of QSBS?

Jan 26, 2022

Categories:

Blogs Qualified Small Business Stock (QSBS) Tax Law Defined™ Blog

Scott W. Dolson

Section 1202 allows taxpayers to exclude gain on the sale of QSBS if all eligibility requirements are met.  Section 1202 also places a cap on the amount of gain that a stockholder is entitled to exclude with respect to a single issuer’s stock. [i]   A taxpayer has at least a $10 million per-issuer gain exclusion, but some taxpayer’s expected gain exceeds that cap.  In our article Maximizing the Section 1202 Gain Exclusion Amount , we discussed planning techniques for increasing, and in some cases multiplying, the $10 million gain exclusion cap through gifting QSBS to other taxpayers. [ii]  Increased awareness of this planning technique has contributed to a flurry of stockholders seeking last-minute tax planning help.  This article looks at whether you can “multiply” Section 1202’s gain exclusion by gifting qualified small business stock (QSBS) when a sale transaction is imminent.

This is one in a series of articles and blogs addressing planning issues relating to QSBS and the workings of Sections 1202 and 1045.  During the past several years, there has been an increase in the use of C corporations as the start-up entity of choice.  Much of this interest can be attributed to the reduction in the corporate rate from 35% to 21%, but savvy founders and investors have also focused on qualifying for Section 1202’s generous gain exclusion.  Recently proposed tax legislation sought to curb Section 1202’s benefits, but that legislation, along with the balance of President Biden’s Build Back Better bill, is currently stalled in Congress.

The Benefits of Gifting QSBS

Section 1202(h)(1) provides that if a stockholder gifts QSBS, the recipient of the gift is treated as “(A) having acquired such stock in the same manner as the transferor, and (B) having held such stock during any continuous period immediately preceding the transfer during which it was held (or treated as held under this subsection by the transferor.”  This statute literally allows a holder of $100 million of QSBS to gift $10 million worth to each of nine friends, with the result that the holder and his nine friends each having the right to claim a separate $10 million gain exclusion.  Under Section 1202, a taxpayer with $20 million in expected gain upon the sale of founder QSBS can increase the overall tax savings from approximately $2.4 million (based on no Federal income tax on $10 million of QSBS gain) to $4.8 million (based on no Federal income tax on $20 million of QSBS gain) by gifting $10 million worth of QSBS to friends and family. [iii]

A reasonable question to ask is whether it is ever too late to make a gift of QSBS for wealth transfer or Section 1202 gain exclusion cap planning?  What about when a sale process is looming but hasn’t yet commenced?  Is it too late to make a gift when a nonbinding letter of intent to sell the company has been signed?   What about the situation where a binding agreement has been signed but there are various closing conditions remaining to be satisfied, perhaps including shareholder approval?  Finally, is it too late to make a gift when a definitive agreement has been signed and all material conditions to closing have been satisfied?

Although neither Section 1202 nor any other tax authorities interpreting Section 1202 address whether there are any exceptions to Section 1202’s favorable treatment of gifts based on the timing of the gift, the IRS is not without potential weapons in its arsenal.

Application of the Assignment of Income Doctrine

If QSBS is gifted in close proximity to a sale, the IRS might claim that the donor stockholder was making an anticipatory assignment of income. [iv]

As first enunciated by the Supreme Court in 1930, the anticipatory assignment of income doctrine holds that income is taxable to the person who earns it, and that such taxes cannot be avoided through “arrangement[s] by which the fruits are attributed to a different tree from that on which they grew.” [v]   Many assignment of income cases involve stock gifted to charities immediately before a prearranged stock sale, coupled with the donor claiming a charitable deduction for full fair market value of the gifted stock.

In Revenue Ruling 78-197, the IRS concluded in the context of a charitable contribution coupled with a prearranged redemption that the assignment of income doctrine would apply only if the donee is legally bound, or can be compelled by the corporation, to surrender shares for redemption. [vi]  In the aftermath of this ruling, the Tax Court has refused to adopt a bright line test but has generally followed the ruling’s reasoning.  For example, in Estate of Applestein v. Commissioner , the taxpayer gifted to custodial accounts for his children stock in a corporation that had entered into a merger agreement with another corporation. Prior to the gift, the merger agreement was approved by the stockholders of both corporations.  Although the gift occurred before the closing of the merger transaction, the Tax Court held that the “right to the merger proceeds had virtually ripened prior to the transfer and that the transfer of the stock constituted a transfer of the merger proceeds rather than an interest in a viable corporation.” [vii]   In contrast, in Rauenhorst v. Commissioner , the Tax Court concluded that a nonbinding letter of intent would not support the IRS’ assignment of income argument because the stockholder at the time of making the gift was not legally bound nor compelled to sell his equity. [viii]

In Ferguson v. Commissioner , the Tax Court focused on whether the percentage of shares tendered pursuant to a tender offer was the functional equivalent of stockholder approval of a merger transaction, which the court viewed as converting an interest in a viable corporation to the right to receive cash before the gifting of stock to charities. [ix]   The Tax Court concluded that there was an anticipatory assignment of income in spite of the fact that there remained certain contingencies before the sale would be finalized.  The Tax Court rejected the taxpayer’s argument that the application of the assignment of income doctrine should be conditioned on the occurrence of a formal stockholder vote, noting that the reality and substance of the particular events under consideration should determine tax consequences.

Guidelines for Last-Minute Gifts

Based on the guidelines established by Revenue Ruling 78-197 and the cases discussed above, the IRS should be unsuccessful if it asserts an assignment of income argument in a situation where the gift of QSBS is made prior to the signing of a definitive sale agreement, even if the company has entered into a nonbinding letter of intent.  The IRS’ position should further weakened with the passage of time between the making of a gift and the entering into of a definitive sale agreement.  In contrast, the IRS should have a stronger argument if the gift is made after the company enters into a binding sale agreement.  And the IRS’ position should be stronger still if the gift of QSBS is made after satisfaction of most or all material closing conditions, and in particular after stockholder approval.  Stockholders should be mindful of Tax Court’s comment that the reality and substance of events determines tax consequences, and that it will often be a nuanced set of facts that ultimately determines whether the IRS would be successful arguing for application of the assignment of income doctrine.

Transfers of QSBS Incident to Divorce

The general guidelines discussed above may not apply to transfers of QSBS between former spouses “incident to divorce” that are governed by Section 1041.  Section 1041(b)(1) confirms that a transfer incident to divorce will be treated as a gift for Section 1202 purposes.  Private Letter Ruling 9046004 addressed the situation where stock was transferred incident to a divorce and the corporation immediately redeemed the stock.  In that ruling, the IRS commented that “under section 1041, Congress gave taxpayers a mechanism for determining which of the two spouses will pay the tax upon the ultimate disposition of the asset.  The spouses are thus free to negotiate between themselves whether the ‘owner’ spouse will first sell the asset, recognize the gain or loss, and then transfer to the transferee spouse the proceeds from the sale, or whether the owner spouse will first transfer the asset to the transferee spouse who will then recognize gain or loss upon its subsequent sale.”  Thus, while there are some tax cases where the assignment of income doctrine has been successfully asserted by the IRS in connection with transfers between spouses incident to divorce, Section 1041 and tax authorities interpreting its application do provide divorcing taxpayers an additional argument against application of the doctrine, perhaps even where the end result might be a multiplication of Section 1202’s gain exclusion.

More Resources 

In spite of the potential for extraordinary tax savings, many experienced tax advisors are not familiar with QSBS planning. Venture capitalists, founders and investors who want to learn more about QSBS planning opportunities are directed to several articles on the Frost Brown Todd website:

• Planning for the Potential Reduction in Section 1202’s Gain Exclusion
• Section 1202 Qualification Checklist and Planning Pointers
• A Roadmap for Obtaining (and not Losing) the Benefits of Section 1202 Stock
• Maximizing the Section 1202 Gain Exclusion Amount
• Advanced Section 1045 Planning
• Recapitalizations Involving Qualified Small Business Stock
• Section 1202 and S Corporations
• The 21% Corporate Rate Breathes New Life into IRC § 1202
• View all QSBS Resources

Contact  Scott Dolson  or  Melanie McCoy  (QSBS estate and trust planning) if you want to discuss any QSBS issues by telephone or video conference.

[i] References to “Section” are to sections of the Internal Revenue Code.

[ii] The planning technique of gifting QSBS recently came under heavy criticism in an article written by two investigative reporters.  See Jesse Drucker and Maureen Farrell, The Peanut Butter Secret: A Lavish Tax Dodge for the Ultrawealthy.  New York Times , December 28, 2021.

[iii] But in our opinion, in order to avoid a definite grey area in Section 1202 law, the donee should not be the stockholder’s spouse.  The universe of donees includes nongrantor trusts, including Delaware and Nevada asset protection trusts.

[iv] This article assumes that the holder of the stock doesn’t have sufficient tax basis in the QSBS to take advantage of the 10X gain exclusion cap – for example, the stock might be founder shares with a basis of .0001 per share.

[v]   Lucas v. Earl , 281 U.S. 111 (1930).  The US Supreme Court later summarized the assignment of income doctrine as follows:  “A person cannot escape taxation by anticipatory assignments, however skillfully devised, where the right to receive income has vested.”  Harrison v. Schaffner , 312 U.S. 579, 582 (1941).

[vi] Revenue Ruling 78-197, 1978-1 CB 83.

[vii] Estate of Applestein v. Commissioner , 80 T.C. 331, 346 (1983).

[viii] Gerald A. Rauenhorst v. Commissioner , 119 T.C. 157 (2002).

[ix] Ferguson v. Commissioner , 108 T.C. 244 (1997).

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• TAX MATTERS

Appreciated stock donation not treated as a taxable redemption

The tax court holds that taxpayers made an absolute gift..

• Individual Income Taxation

The Tax Court granted summary judgment to a married couple, ruling that the IRS improperly recharacterized their charitable donations of stock as taxable redemptions. The court held the couple made an absolute gift in each tax year at issue, and although the charity soon after redeemed the stock, the court respected the form of the transaction.

Facts:  Jon and Helen Dickinson claimed a charitable contribution deduction on their joint federal income tax returns for 2013 through 2015, due to a contribution each year by Jon Dickinson of appreciated stock in his employer, Geosyntec Consultants Inc. (GCI), a privately held company, to Fidelity Investments Charitable Gift Fund, a Sec. 501(c)(3) tax-exempt organization. Dickinson was GCI’s CFO.

GCI’s board of directors authorized shareholders to donate GCI shares to Fidelity in written consent actions in 2013 and 2014, stating that Fidelity’s donor-advised fund program required Fidelity “to immediately liquidate the donated stock” and that the charity “promptly tenders the donated stock to the issuer for cash.” The board also authorized donations in 2015.

GCI confirmed in letters to Fidelity the recording of Fidelity’s new ownership of the shares. Dickinson signed a letter of understanding to Fidelity regarding each stock donation, stating that the stock was “exclusively owned and controlled by Fidelity.” Fidelity sent confirmation letters stating that it had “exclusive legal control over the contributed asset.” Fidelity redeemed the GCI shares for cash shortly after each donation.

The IRS issued a notice of deficiency, asserting that the Dickinsons were liable for tax on the redemption of the donated GCI shares and a penalty under Sec. 6662(a) for each year. The Service contended the donations should be treated in substance as taxable redemptions of the shares for cash by Dickinson, followed by donations of the cash to Fidelity.

The Dickinsons petitioned the Tax Court for a redetermination of the deficiencies and penalties and moved for summary judgment.

Issue:  Generally, pursuant to Sec. 170 and Regs. Sec. 1.170A-1(c)(1), a taxpayer may deduct the fair market value of appreciated property donated to a qualified charity without recognizing the gain in the property.

In  Humacid Co. , 42 T.C. 894, 913 (1964), the Tax Court stated: “The law with respect to gifts of appreciated property is well established. A gift of appreciated property does not result in income to the donor so long as [1] he gives the property away absolutely and parts with title thereto [2] before the property gives rise to income by way of a sale.” 

The issue before the court was whether the form of Dickinson’s donations of GCI stock should be respected as meeting the requirements in  Humacid Co. , or recharacterized as taxable redemptions resulting in income to the Dickinsons.

Holding:  The Tax Court held that the form of the stock donations should be respected, as both prongs of  Humacid Co.  were satisfied, and granted the taxpayers summary judgment.

Regarding the first prong, the court held that Dickinson transferred all his rights in the shares to Fidelity, based on GCI’s letters to Fidelity confirming the transfer of ownership in the shares, Fidelity’s letters to the Dickinsons stating it had “exclusive legal control” over the donated stock, and the letters of understanding. Thus, Dickinson made an absolute gift.

The Tax Court analyzed the second prong under the assignment-of-income doctrine. This provides that a taxpayer cannot avoid taxation by assigning a right to income to another. The court stated: “Where a donee redeems shares shortly after a donation, the assignment of income doctrine applies only if the redemption was practically certain to occur at the time of the gift, and would have occurred whether the shareholder made the gift or not.”

The Tax Court noted that in  Palmer , 62 T.C. 684 (1974), it held there was no assignment of income where there was not yet a vote for a redemption at the time of a stock donation, even though the vote was anticipated. Similarly, the court reasoned that “the redemption in this case was not a fait accompli at the time of the gift” and held Dickinson did not avoid income due to the redemption by donating the GCI shares. Thus, the court respected the form of the transaction.

The Tax Court did not apply Rev. Rul. 78-197, in which the IRS ruled that it “will treat the proceeds as income to the donor under facts similar to those in the  Palmer  decision only if the donee is legally bound, or can be compelled by the [issuing] corporation, to surrender the shares for redemption.” The court noted that it has not adopted the revenue ruling, and furthermore, the IRS did not allege that Dickinson had a fixed right to redemption income at the time of the donation.

• Dickinson , T.C. Memo. 2020-128

—  By Mark Aquilio, CPA, J.D., LL.M. , professor of accounting and taxation, St. John’s University, Queens, N.Y.

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Recognizing when the IRS can reallocate income

• C Corporation Income Taxation
• IRS Practice & Procedure

Transactions between related parties come under close scrutiny by the IRS because they are not always conducted at arm's length. If the amounts involved in the transaction do not represent fair market values, the IRS can change the characteristics of the transaction to reflect its actual nature.

The IRS may attempt to reallocate income between a closely held corporation and its shareholders based on several sets of rules, including the following:

• Assignment-of-income rules that have been developed through the courts;
• The allocation-of-income theory of Sec. 482; and
• The rules for allocation of income between a personal service corporation and its employee-owners of Sec. 269A.

Income reallocation under the assignment - of - income doctrine is dependent on determining who earns or controls the income. Justice Oliver Wendell Holmes made the classic statement of the assignment - of - income doctrine when he stated that the Supreme Court would not recognize for income tax purposes an "arrangement by which the fruits are attributed to a different tree from that on which they grew" ( Lucas v. Earl , 281 U.S. 111, 115 (1930)).

Reallocation under Sec. 482 is used to prevent tax evasion or to more clearly reflect income when two or more entities are controlled by the same interests. Note the use of the word "or" in the preceding sentence. The Code empowers the IRS to allocate income even if tax evasion is not present if the allocation will more clearly reflect the income of the controlled interests. The intent of these provisions is to place the controlled entity in the same position as if it were not controlled so that the income of the controlled entity is clearly reflected (Regs. Sec. 1. 482 - 1 (a)) .

Example 1. Performing services for another group member:   Corporations P and S are members of the same controlled group. S asks P to have its financial staff perform an analysis to determine S' s borrowing needs. P does not charge S for this service. Under Sec. 482, the IRS could adjust each corporation's taxable income to reflect an arm's - length charge by P for the services it provided to S .

Under Sec. 269A(a), the IRS has the authority to allocate income, deductions, credits, exclusions, and other items between a personal service corporation (PSC) and its employee - owners if:

• The PSC performs substantially all of its services for or on behalf of another corporation, partnership, or other entity; and
• The PSC was formed or used for the principal purpose of avoiding or evading federal income tax by reducing the income or securing the benefit of any expense, deduction, credit, exclusion, or other item for any employee-owner that would not otherwise be available.

A PSC will not be considered to have been formed or availed of for the principal purpose of avoiding or evading federal income taxes if a safe harbor is met. The safe harbor applies if the employee - owner's federal income tax liability is not reduced by more than the lesser of (1) $2,500 or (2) 10% of the federal income tax liability of the employee - owner that would have resulted if the employee - owner personally performed the services (Prop. Regs. Sec. 1. 269A - 1 (c)).

For purposes of this rule, a PSC is a corporation, the principal activity of which is the performance of personal services when those services are substantially performed by employee - owners (Sec. 269A(b)(1)). An employee - owner is any employee who owns on any day during the tax year more than 10% of the PSC's outstanding stock. As with many related - party provisions, the Sec. 318 stock attribution rules (with modifications) apply in determining stock ownership (Sec. 269A(b)(2)).

Example 2. Reallocation of income: H forms M Corp., which is a PSC. A few months later, he transfers shares of stock of an unrelated corporation to M . The following year, M receives dividends from the unrelated corporation and claims the Sec. 243(a) 50% dividend exclusion. The IRS may reallocate the dividend income from M to H if the principal purpose of the transfer of the unrelated stock to M was to use the 50% dividend exclusion under Sec. 243. However, the amounts to reallocate to H must exceed the safe - harbor amounts.

These rules usually apply when an individual performs personal services for an employer that does not offer tax - advantaged employee benefits (such as a qualified retirement plan and other employee fringe benefits). In those situations, the individual may set up a 100%- owned C corporation that contracts with the employer. The employer then pays the corporation. The individual functions as the employee of the corporation, and the corporation sets up tax - advantaged fringe benefit programs. The individual generally is able to "zero out" the income of the corporation with payments for salary and fringe benefits.

Despite the significant authority that Sec. 269A grants to the IRS, there is little evidence of the IRS or the courts using this statute. In a 1987 private letter ruling, the IRS held that a one - owner , one - employee medical corporation did not violate the statute, even though it retained only nominal amounts of taxable income, and the corporate structure allowed the individual to achieve a significant pension plan deduction. These facts were not sufficient to establish a principal purpose of tax avoidance (IRS Letter Ruling 8737001). In Sargent , 929 F.2d 1252 (8th Cir. 1991), the Eighth Circuit indicated a lack of interest in applying Sec. 269A because, in that case, the court felt the PSC had been set up for other legitimate reasons.    

This case study has been adapted from PPC's Tax Planning Guide — Closely Held Corporations , 31st Edition (March 2018), by Albert L. Grasso, R. Barry Johnson, and Lewis A. Siegel. Published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2018 (800-431-9025; tax.thomsonreuters.com ).

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A recent taxpayer victory in the Tax Court in the case of Jon Dickinson, et ux. v. Commissioner, TC Memo 2020‑128 (Sept. 3, 2020), is an important reminder to donors and potential charitable donees to be well informed of the law when donating, or soliciting donations of, appreciated closely held business interests.

Benefits of Donating Appreciated Interests Ahead of Sales

Wise taxpayers, frequently on the advice of their knowledgeable tax advisors, know that when making a charitable gift, it is typically most beneficial to make a donation to a public charity of an appreciated asset in order to obtain a charitable deduction, rather than donating cash, or even worse, the after-tax proceeds of the sale of the appreciated asset. The benefits, of course, are that the taxpayer will both receive a tax deduction equal to the fair market value of the asset and will not incur tax (i.e., capital gains) on the transaction. This benefit is illustrated in the below example:

 Donating appreciated business interests in situations where the business may be sold, or the business owner may otherwise be preparing to divest herself or himself of part of their ownership interest, may be particularly appealing to a philanthropic business owner. As the example illustrates, pre-transaction planning can maximize the amount ultimately available for philanthropic endeavors at the lowest cost to the donor. Savvy gift officers and charities will often suggest this strategy to donors as a way for both the donor and the charity to “win.”

Assignment of Income Doctrine

Donors should be cautious about making a gift of an interest in anticipation of a sale or other liquidation event for a variety of reasons. For example, if the expected transaction does not occur, it may not be advisable for the charity to own an interest in the company (and the company may not be too happy about it either). Under those circumstances a charity is not permitted to “re-gift” the interest back to the donor. In even the best of situations, reversing such a transaction would be become complex, and in fact, in most cases it is usually not possible.

Because of the risk associated with a deal not closing, donors often seek to wait until there is some certainty that a transaction will in fact close. However, the longer a donor waits, the greater the risk that the intended result – a donation of property subject to an unrealized gain (i.e., untaxed) – will not be achieved because of the assignment of income doctrine. 

The assignment of income doctrine is one of a handful of judicial doctrines developed by United States courts to try to limit tax evasion. A key principal is that a donor cannot avoid taxation on property by merely making a gift of the property. If the substance of the transaction is to avoid income that is otherwise already subject to taxation, such gift may be disregarded. 1 This boils down to a facts-and-circumstances timing question.

Generally, the assignment of income doctrine provides that gain is realized by the owner of property when all events have occurred such that the final resulting transaction is all but assured. In reality, the interest has “ripened” into a fixed right to receive income. 2 Said yet another way, the question is often whether subsequent to the gift there are independent event(s) of significance to conclude that all substantive events related to the transaction have not yet occurred. The charity receiving the donation cannot simply function as a conduit for a transaction that has progressed to the point where it is almost certainly taking place. Whether a particular transaction or series of transactions have, when considering the reality and substance of the circumstances, proceeded to such a point is a fact-specific determination.

The Tax Court Emphasizes Form of Gift of Appreciated Stock

In the Dickinson case decided earlier this month, Mr. Dickinson had acquired shares over time in a large privately held engineering and consulting firm. He, along with other shareholders, were authorized by the company’s Board of Directors to donate shares to Fidelity Investments Charitable Gift Fund, the donor advised fund, in the years 2013 and 2014. Fidelity Charitable’s policy, known to the firm and its shareholders, was to immediately liquidate donated stock and it did so with Mr. Dickinson’s donated shares by selling them back to the company.

On audit, the IRS determined that Mr. Dickinson did not donate appreciated stock, rather he donated cash because, in substance, the company first redeemed the shares and he then donated the cash to fund a donor advised fund account at Fidelity Charitable. The Tax Court rejected that characterization, however, choosing instead to focus on the form of the transaction, namely that (1) Mr. Dickinson fully transferred his rights to and legal control of the shares to Fidelity Charitable, and (2) he did so before the shares gave rise to income by way of a sale or redemption. Preexisting knowledge of Fidelity Charitable’s policy to immediately dispose of donated stock did not, in and of itself, convert the donation of stock into a pre-donation redemption; Fidelity Charitable received the stock and it had the right to do with it what it pleased. At the time of the donation, it could not have been definitively said that a redemption of the shares, regardless of who the owner was, would have occurred.

While the IRS attempted to base its conclusion on the theory that there was a pre-arranged plan for the redemption of the stock, the Tax Court rejected that argument. The Court found that even if that was the case, that does not mean that had the donor retained the stock it would similarly have been redeemed. Citing its 1974 Palmer decision, the Tax Court stated, “[t]he ultimate question, as noted in Palmer, is whether the redemption and the shareholder’s corresponding right to income had already crystallized at the time of the gift.” 3

Planning Pointers for Donors and Charities

The Dickinson case is a good reminder that the IRS will seek to challenge gifts of appreciated business interests. With such an emphasis by the Tax Court on the proper form of such gifts, donors should be mindful to make the donation sufficiently before the time when the “all events” test has been met, especially in the case of a proposed or impending transaction, or before “the shareholder’s corresponding right to income…[has] already crystallized.” While the taxpayer succeeded in the Dickinson case, the facts-and-circumstances nature of the assignment of income doctrine can make decision-making tricky when donors hope to make donations of appreciated interests in advance of transactions. Taxpayers should seek legal counsel in such cases.

Charities should also take heed. While many charities have wisely begun to focus on soliciting non-cash charitable gifts, such as appreciated stock, charities should become familiar with the legal principles, such as the assignment of income doctrine, which can impact these gifts. Charities should consider their policies and practices with respect to soliciting and accepting such gifts, both in form and in practice. Not all donors will be fully aware of these principles and may be sorely surprised after making a gift if audited. It may behoove a charity to help educate donors so that a gift is successfully completed. Unhappy donors are not typically repeat donors.

1 See Palmer v. Commissioner, 62 T.C. 684, 692 (1974), affd. on other grounds 523 F.2d 1308 [36 AFTR 2d 75-5942] (8th Cir. 1975), acq. 1978-1 CB 2.

2 See Ferguson v. Commissioner, 174 F.3d 997 (9th Cir. 1999).

3 See Palmer v. Commissioner, 62 T.C. at 694-695

Christina Cahill, Nicole Riberio & Erica Seaborne also contributed to this article. 

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For the latest information about developments related to Pub. 525, such as legislation enacted after it was published, go to IRS.gov/Pub525 .

Deferred compensation contribution limit increased. If you participate in a 401(k), 403(b), or the federal government's Thrift Savings Plan (TSP), the total annual amount you can contribute is increased to $22,500 ($30,000 if age 50 or older). This also applies to most 457 plans.

Health flexible spending arrangements (health FSAs) under cafeteria plans. For tax years beginning in 2023, the dollar limitation under section 125(i) on voluntary employee salary reductions for contributions to health FSAs is $3,050.

Temporary allowance of 100% business meal deduction has expired. The temporary allowance of a 100% business meal deduction for food or beverages provided by a restaurant and paid or incurred after December 31, 2020, and before January 1, 2023, has expired. Taxpayers may continue to deduct 50% of the cost of business meals if the taxpayer (or an employee of the taxpayer) is present and the food or beverages aren’t considered lavish or extravagant.

Contributions to simplified employee pension plan (SEP) and savings incentive match plan for employees (SIMPLE) Roth IRAs. Section 601 of the SECURE 2.0 Act of 2022 provided that your employer may provide for contributions to a Roth IRA under a SEP or SIMPLE IRA plan.

Designated Roth nonelective contributions and designated Roth matching contributions. Section 604 of the SECURE 2.0 Act of 2022 permits certain nonelective contributions and matching contributions that are made after December 29, 2022, to be designated as Roth contributions.

De minimis financial incentives. Section 113 of the SECURE 2.0 Act of 2022 provided that employers can offer their employees de minimis financial incentives to make elective deferrals. These incentives may not exceed $250 in value, and, in general, are includible in employees’ income.

Paycheck Protection Program loan forgiveness. Gross income doesn’t include any amount arising from the forgiveness of a Paycheck Protection Program (PPP) loan, effective for taxable years ending after March 27, 2020. (See P.L. 116-136.) Likewise, gross income does not include any amount arising from the forgiveness of Second Draw PPP loans, effective December 27, 2020. (See P.L. 116-260.) When a taxpayer who does not factually satisfy the conditions for a qualifying forgiveness causes its lender to forgive the PPP loan by inaccurately representing that the taxpayer satisfies them, the taxpayer may not exclude the amount of the forgiven loan from gross income under 15 U.S.C. section 636m(i) or section 276(b)(1) of the COVID-related Tax Relief Act of 2020. For more information, see Forgiveness of Paycheck Protection Program (PPP) Loans .

Emergency financial aid grants. Certain emergency financial aid grants under the CARES Act are excluded from the income of college and university students, effective for grants made after March 26, 2020. (See P.L. 116-136 and P.L. 116-260.)

Other loan forgiveness under the CARES Act. Gross income does not include any amount arising from the forgiveness of certain loans, emergency Economic Injury Disaster Loan (EIDL) grants, and certain loan repayment assistance, each as provided by the CARES Act, effective for tax years ending after March 27, 2020. (See P.L. 116-136 and P.L. 116-260.)

Exclusion of income for volunteer firefighters and emergency medical responders. If you are a volunteer firefighter or emergency medical responder, you may be able to exclude from gross income certain rebates or reductions of state or local property or income taxes and up to $50 per month provided by a state or local government. For more information, see Volunteer firefighters and emergency medical responders .

Repeal of deduction for alimony payments and corresponding inclusion in gross income. Alimony received under a divorce or separation instrument executed after 2018 won't be includible in your income. The same is true of alimony received under a divorce or separation instrument executed before 2019 and modified after 2018, if the modification expressly states that the alimony isn't deductible to the payer or includible in your income. For more information, see Pub. 504.

Forms 1040A and 1040EZ no longer available. Forms 1040A and 1040EZ aren't available to file your 2023 taxes. If you used one of these forms in the past, you’ll now file Form 1040 or 1040-SR.

Qualified equity grants. For tax years beginning after 2017, certain qualified employees can make a new election to defer income taxation for up to 5 years for the qualified stocks received. See Qualified Equity Grants under Employee Compensation , later.

Suspension of qualified bicycle commuting reimbursement exclusion. For tax years beginning after 2017, reimbursement you receive from your employer for the purchase, repair, or storage of a bicycle you regularly use for travel between your residence and place of employment must be included in your gross income.

Unemployment compensation. If you received unemployment compensation but did not receive Form 1099-G, Certain Government Payments, through the mail, you may need to access your information through your state’s website to get your electronic Form 1099-G.

Achieving a Better Life Experience (ABLE) account. This is a type of savings account for individuals with disabilities and their families. Distributions are tax free if used to pay the beneficiary's qualified disability expenses. See Pub. 907 for more information.

Certain amounts received by wrongfully incarcerated individuals. Certain amounts you receive due to a wrongful incarceration may be excluded from gross income. See IRS.gov/Newsroom/IRS-Updates-Frequently-Asked-Questions-Related-to-Wrongful-Incarceration for more information.

Foreign income. If you're a U.S. citizen or resident alien, you must report income from sources outside the United States (foreign income) on your tax return unless it’s exempt by U.S. law. This is true whether you reside inside or outside the United States and whether or not you receive a Form W-2, Wage and Tax Statement, or Form 1099 from the foreign payer. This applies to earned income (such as wages and tips) as well as unearned income (such as interest, dividends, capital gains, pensions, rents, and royalties). If you reside outside the United States, you may be able to exclude part or all of your foreign source earned income. For details, see Pub. 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad.

Olympic and Paralympic medals and United States Olympic Committee (USOC) prize money. If you receive Olympic and Paralympic medals and USOC prize money, the value of the medals and the amount of the prize money may be nontaxable. See the Instructions for Schedule 1 (Form 1040), line 8m, at IRS.gov/Form1040 for more information.

Public safety officers. A spouse, former spouse, and child of a public safety officer killed in the line of duty can exclude from gross income survivor benefits received from a governmental section 401(a) plan attributable to the officer's service. See section 101(h).A public safety officer that's permanently and totally disabled or killed in the line of duty and a surviving spouse or child can exclude from income death or disability benefits received from the federal Bureau of Justice Assistance or death benefits paid by a state program. See section 104(a)(6).

Qualified Medicaid waiver payments. Certain payments you receive for providing care to an eligible individual in your home under a state's Medicaid waiver program may be excluded from your income under Notice 2014-7. See also Instructions for Schedule 1 (Form 1040), line 8s.

Qualified settlement income. If you're a qualified taxpayer, you can contribute all or part of your qualified settlement income, up to $100,000, to an eligible retirement plan, including an IRA. Contributions to eligible retirement plans, other than a Roth IRA or a designated Roth contribution, reduce the qualified settlement income that you must include in income. See Exxon Valdez settlement income under Other Income , later. Also, see Pub. 590-A for more information.

Taxpayer identification number (TIN). A TIN is your social security number (SSN), individual taxpayer identification number (ITIN), adoption taxpayer identification number (ATIN), or employer identification number (EIN).

Terrorist attacks. You can exclude from income certain disaster assistance, disability, and death payments received as a result of a terrorist or military action. For more information, see Sickness and Injury Benefits , later; Pub. 3920, Tax Relief for Victims of Terrorist Attacks; and Pub. 907, Tax Highlights for Persons With Disabilities.

Photographs of missing children. The Internal Revenue Service is a proud partner with the National Center for Missing & Exploited Children® (NCMEC) . Photographs of missing children selected by the Center may appear in this publication on pages that would otherwise be blank. You can help bring these children home by looking at the photographs and calling 800-THE-LOST (800-843-5678) if you recognize a child.

Introduction

You can receive income in the form of money, property, or services. This publication discusses many kinds of income and explains whether they are taxable or nontaxable. It includes discussions on employee wages and fringe benefits, and income from bartering, partnerships, S corporations, and royalties. It also includes information on disability pensions, life insurance proceeds, and welfare and other public assistance benefits. Check the index for the location of a specific subject.

In most cases, an amount included in your income is taxable unless it is specifically exempted by law. Income that is taxable must be reported on your return and is subject to tax. Income that is nontaxable may have to be shown on your tax return but isn’t taxable.

If you are a cash method taxpayer, you are generally taxed on income that is available to you, regardless of whether it is actually in your possession.

A valid check that you received or that was made available to you before the end of the tax year is considered income constructively received in that year, even if you don’t cash the check or deposit it to your account until the next year. For example, if the postal service tries to deliver a check to you on the last day of the tax year but you aren’t at home to receive it, you must include the amount in your income for that tax year. If the check was mailed so that it couldn’t possibly reach you until after the end of the tax year, and you otherwise couldn’t get the funds before the end of the year, you include the amount in your income for the next tax year.

Income received by an agent for you is income you constructively received in the year the agent received it. If you agree by contract that a third party is to receive income for you, you must include the amount in your income when the third party receives it.

You and your employer agree that part of your salary is to be paid directly to one of your creditors. You must include that amount in your income when your creditor receives it.

Generally, you report an advance payment for goods, services, or other items as income in the year you receive the payment. However, if you use an accrual method of accounting and are otherwise eligible, you can elect to postpone including the advance payment in income until the next year. See Pub. 538 for more information.

We welcome your comments about this publication and suggestions for future editions.

You can send us comments through IRS.gov/FormComments . Or, you can write to the Internal Revenue Service, Tax Forms and Publications, 1111 Constitution Ave. NW, IR-6526, Washington, DC 20224.

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Useful Items

Publication

334 Tax Guide for Small Business

523 Selling Your Home

527 Residential Rental Property

541 Partnerships

544 Sales and Other Dispositions of Assets

550 Investment Income and Expenses

554 Tax Guide for Seniors

559 Survivors, Executors, and Administrators

575 Pension and Annuity Income

907 Tax Highlights for Persons With Disabilities

915 Social Security and Equivalent Railroad Retirement Benefits

970 Tax Benefits for Education

4681 Canceled Debts, Foreclosures, Repossessions, and Abandonments

Form (and Instructions)

1040 U.S. Individual Income Tax Return

1040-NR U.S. Nonresident Alien Income Tax Return

1040-SR U.S. Tax Return for Seniors

1099-R Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.

W-2 Wage and Tax Statement

See How To Get Tax Help at the end of this publication for information about getting these publications.

Publication 525 - Main Contents

Employee compensation.

In most cases, you must include in gross income everything you receive in payment for personal services. In addition to wages, salaries, commissions, fees, and tips, this includes other forms of compensation such as fringe benefits and stock options.

You should receive a Form W-2 from your employer or former employer showing the pay you received for your services. Include all your pay on Form 1040 or 1040-SR, line 1a, even if you don’t receive Form W-2, or you receive a Form W-2 that doesn’t include all pay that should be included on the Form W-2.

If you performed services, other than as an independent contractor, and your employer didn’t withhold social security and Medicare taxes from your pay, you must file Form 8919 with your Form 1040 or 1040-SR. These wages must be included on Form 1040 or 1040-SR, line 1g. See Form 8919 for more information.

The FMV of an item of property is the price at which the item would change hands between a willing buyer and a willing seller, neither being required to buy or sell and both having reasonable knowledge of the relevant facts.

If you provide childcare, either in the child's home or in your home or other place of business, the pay you receive must be included in your income. If you're not an employee, you're probably self-employed and must include payments for your services on Schedule C (Form 1040), Profit or Loss From Business. You generally aren’t an employee unless you're subject to the will and control of the person who employs you as to what you're to do, and how you're to do it.

If you babysit for relatives or neighborhood children, whether on a regular basis or only periodically, the rules for childcare providers apply to you.

Whether you're an employee or self-employed person, your income could be subject to self-employment tax. See the Instructions for Schedule C (Form 1040) and the Instructions for Schedule SE (Form 1040) if you're self-employed. Also see Pub. 926 for more information.

If you filed for bankruptcy under chapter 11 of the Bankruptcy Code, you must allocate your wages and withheld income tax. Your Form W-2 will show your total wages and withheld income tax for the year. On your tax return, you report the wages and withheld income tax for the period before you filed for bankruptcy. Your bankruptcy estate reports the wages and withheld income tax for the period after you filed for bankruptcy. If you receive other information returns (such as Form 1099-DIV or Form 1099-INT) that report gross income to you, rather than to the bankruptcy estate, you must allocate that income.

The only exception is for purposes of figuring your self-employment tax if you're self-employed. For that purpose, you must take into account all your self-employment income for the year from services performed both before and after the beginning of the case.

You must file a statement with your income tax return stating you filed a chapter 11 bankruptcy case. The statement must show the allocation and describe the method used to make the allocation. For a sample of this statement and other information, see Notice 2006-83, 2006-40 I.R.B. 596, available at IRS.gov/irb/2006-40_IRB#NOT-2006-83 .

Miscellaneous Compensation

This section discusses many types of employee compensation. The subjects are arranged in alphabetical order.

If you receive advance commissions or other amounts for services to be performed in the future and you're a cash-method taxpayer, you must include these amounts in your income in the year you receive them.

If you repay unearned commissions or other amounts in the same year you receive them, reduce the amount of unearned commissions included in your income by the repayment. If you repay them in a later tax year, you can deduct the repayment as an itemized deduction on your Schedule A (Form 1040), Other Itemized Deductions, line 16, or you may be able to take a credit for that year. See Repayments , later.

If you receive travel, transportation, or other business expense allowances or reimbursements from your employer, see Pub. 463.

Include in income amounts you're awarded in a settlement or judgment for back pay. These include payments made to you for damages, unpaid life insurance premiums, and unpaid health insurance premiums. They should be reported to you by your employer on Form W-2.

Bonuses or awards you receive for outstanding work are included in your income and should be shown on your Form W-2. These include prizes such as vacation trips for meeting sales goals. If the prize or award you receive is goods or services, you must include the FMV of the goods or services in your income. However, if your employer merely promises to pay you a bonus or award at some future time, it isn’t taxable until you receive it or it’s made available to you.

If you receive tangible personal property (other than cash, a gift certificate, or an equivalent item) as an award for length of service or safety achievement, you must generally exclude its value from your income. However, the amount you can exclude is limited to your employer's cost and can’t be more than $1,600 ($400 for awards that aren’t qualified plan awards) for all such awards you receive during the year. Your employer can tell you whether your award is a qualified plan award. Your employer must make the award as part of a meaningful presentation, under conditions and circumstances that don’t create a significant likelihood of it being disguised pay.

However, the exclusion doesn’t apply to the following awards.

A length-of-service award if you received it for less than 5 years of service or if you received another length-of-service award during the year or the previous 4 years.

A safety achievement award if you're a manager, administrator, clerical employee, or other professional employee or if more than 10% of eligible employees previously received safety achievement awards during the year.

You received three employee achievement awards during the year: a nonqualified plan award of a watch valued at $250, and two qualified plan awards of a stereo valued at $1,000 and a set of golf clubs valued at $500. Assuming that the requirements for qualified plan awards are otherwise satisfied, each award by itself would be excluded from income. However, because the $1,750 total value of the awards is more than $1,600, you must include $150 ($1,750 − $1,600) in your income.

This is any payment made by an employer to an individual for any period during which the individual is, for a period of more than 30 days, an active duty member of the uniformed services and represents all or a portion of the wages the individual would have received from the employer for that period. These payments are treated as wages and are subject to income tax withholding, but not FICA or FUTA taxes. The payments are reported as wages on Form W-2.

Most payments received by U.S. Government civilian employees for working abroad are taxable. However, certain cost-of-living allowances are tax free. Pub. 516 explains the tax treatment of allowances, differentials, and other special pay you receive for employment abroad.

Your employer will report to you the total amount of deferrals for the year under a nonqualified deferred compensation plan. This amount is shown in Form W-2, box 12, using code Y. This amount isn’t included in your income.

However, if at any time during the tax year, the plan fails to meet certain requirements, or isn’t operated under those requirements, all amounts deferred under the plan for the tax year and all preceding tax years are included in your income for the current year. This amount is included in your wages shown in Form W-2, box 1. It’s also shown in Form W-2, box 12, using code Z.

In most cases, any compensation deferred under a nonqualified deferred compensation plan of a nonqualified entity is included in gross income when there is no substantial risk of forfeiture of the rights to such compensation. For this purpose, a nonqualified entity is one of the following.

A foreign corporation, unless substantially all of its income is:

Effectively connected with the conduct of a trade or business in the United States, or

Subject to a comprehensive foreign income tax.

A partnership, unless substantially all of its income is allocated to persons other than:

Foreign persons for whom the income isn’t subject to a comprehensive foreign income tax, and

Tax-exempt organizations.

If your employer gives you a secured note as payment for your services, you must include the FMV (usually the discount value) of the note in your income for the year you receive it. When you later receive payments on the note, a proportionate part of each payment is the recovery of the FMV that you previously included in your income. Don’t include that part again in your income. Include the rest of the payment in your income in the year of payment.

If your employer gives you a nonnegotiable unsecured note as payment for your services, payments on the note that are credited toward the principal amount of the note are compensation income when you receive them.

You must include in income amounts you receive as severance pay and any payment for the cancellation of your employment contract.

Severance payments are wages subject to social security and Medicare taxes. As noted in section 15 of Pub. 15, Special Rules for Various Types of Services and Payments , severance payments are also subject to income tax withholding and FUTA tax.

If you're a federal employee and receive a lump-sum payment for accrued annual leave when you retire or resign, this amount will be included as wages on your Form W-2.

If you resign from one agency and are reemployed by another agency, you may have to repay part of your lump-sum annual leave payment to the second agency. You can reduce gross wages by the amount you repaid in the same tax year in which you received it. Attach to your tax return a copy of the receipt or statement given to you by the agency you repaid to explain the difference between the wages on your return and the wages on your Forms W-2.

If you choose to accept a reduced amount of severance pay so that you can receive outplacement services (such as training in résumé writing and interview techniques), you must include the unreduced amount of the severance pay in income.

Pay you receive from your employer while you're sick or injured is part of your salary or wages. In addition, you must include in your income sick pay benefits received from any of the following payers.

A welfare fund.

A state sickness or disability fund.

An association of employers or employees.

An insurance company, if your employer paid for the plan.

If you and your employer have an agreement that your employer pays your social security and Medicare taxes without deducting them from your gross wages, you must report the amount of tax paid for you as taxable wages on your tax return. The payment is also treated as wages for figuring your social security and Medicare taxes and your social security and Medicare benefits. However, these payments aren’t treated as social security and Medicare wages if you're a household worker or a farm worker.

Don’t include a stock appreciation right granted by your employer in income until you exercise (use) the right. When you use the right, you're entitled to a cash payment equal to the FMV of the corporation's stock on the date of use minus the FMV on the date the right was granted. You include the cash payment in income in the year you use the right.

If your employer gives you digital assets (such as Bitcoin) as payment for your services, you must include the FMV of the digital assets as of the date(s) of receipt in your income. The FMV of digital assets paid as wages is subject to federal income tax withholding, Federal Insurance Contribution Act (FICA) tax, and Federal Unemployment Tax Act (FUTA) tax and must be reported on Form W-2. Notice 2014-21, 2014-16 I.R.B. 938, describes how digital assets are treated for federal tax purposes and is available at IRS.gov/irb/2014-16_IRB#NOT-2014-21 . For further information, see IRS.gov/DigitalAssets .

Fringe Benefits

Fringe benefits received in connection with the performance of your services are included in your income as compensation unless you pay FMV for them or they’re specifically excluded by law. Refraining from the performance of services (for example, under a covenant not to compete) is treated as the performance of services for purposes of these rules.

See Valuation of Fringe Benefits , later in this discussion, for information on how to determine the amount to include in income.

You're the recipient of a fringe benefit if you perform the services for which the fringe benefit is provided. You're considered to be the recipient even if it’s given to another person, such as a member of your family. An example is a car your employer gives to your spouse for services you perform. The car is considered to have been provided to you and not to your spouse.

You don’t have to be an employee of the provider to be a recipient of a fringe benefit. If you're a partner, a director, or an independent contractor, you can also be the recipient of a fringe benefit.

Your employer or another person for whom you perform services is the provider of a fringe benefit regardless of whether that person actually provides the fringe benefit to you. The provider can be a client or customer of an independent contractor.

You must use the same accounting period your employer uses to report your taxable noncash fringe benefits. Your employer has the option to report taxable noncash fringe benefits by using either of the following rules.

The general rule: benefits are reported for a full calendar year (January 1–December 31).

The special accounting period rule: benefits provided during the last 2 months of the calendar year (or any shorter period) are treated as paid during the following calendar year. For example, each year your employer reports the value of benefits provided during the last 2 months of the prior year and the first 10 months of the current year.

You must use the same accounting period that you use to report the benefit to claim an employee business deduction (for example, use of a car).

Your employer must include all taxable fringe benefits in Form W-2, box 1, as wages, tips, and other compensation, and, if applicable, in boxes 3 and 5 as social security and Medicare wages. Although not required, your employer may include the total value of fringe benefits in box 14 (or on a separate statement). However, if your employer provided you with a vehicle and included 100% of its annual lease value in your income, the employer must separately report this value to you in box 14 (or on a separate statement).

Accident or Health Plan

In most cases, the value of accident or health plan coverage provided to you by your employer isn’t included in your income. Benefits you receive from the plan may be taxable, as explained under Sickness and Injury Benefits , later.

For information on the items covered in this section, other than Long-term care coverage , see Pub. 969.

Contributions by your employer to provide coverage for long-term care services generally aren’t included in your income. However, contributions made through a flexible spending or similar arrangement (such as a cafeteria plan) must be included in your income. This amount will be reported as wages in Form W-2, box 1.

Contributions by your employer to your Archer MSA generally aren’t included in your income. Their total will be reported in Form W-2, box 12, with code R. You must report this amount on Form 8853, Archer MSAs and Long-Term Care Insurance Contracts. File the form with your return.

If your employer provides a health FSA that qualifies as an accident or health plan, the amount of your salary reduction, and reimbursements of your medical care expenses, in most cases aren’t included in your income.

For 2023, health FSAs are subject to a $3,050 limit on salary reduction contributions.

If your employer offers an HRA that qualifies as an accident or health plan, your coverage under the HRA and reimbursements of your medical care expenses from the HRA generally aren’t included in your income.

If you’re an eligible individual, you and any other person, including your employer or a family member, can make contributions to your HSA. Contributions, other than employer contributions, are deductible on your return whether or not you itemize deductions. Contributions made by your employer aren’t included in your income. Distributions from your HSA that are used to pay qualified medical expenses aren’t included in your income. Distributions not used for qualified medical expenses are included in your income. See Pub. 969 for the requirements of an HSA.

Contributions by a partnership to a bona fide partner's HSA aren’t contributions by an employer. The contributions are treated as a distribution of money and aren’t included in the partner's gross income. Contributions by a partnership to a partner's HSA for services rendered are treated as guaranteed payments that are includible in the partner's gross income. In both situations, the partner can deduct the contribution made to the partner's HSA.

Contributions by an S corporation to a 2%-shareholder-employee's HSA for services rendered are treated as guaranteed payments and are includible in the shareholder-employee's gross income. The shareholder-employee can deduct the contribution made to the shareholder-employee's HSA.

You can make a one-time distribution from your individual retirement arrangement (IRA) to an HSA and you generally won’t include any of the distribution in your income. See Pub. 590-B for the requirements for these qualified HSA funding distributions.

You may be able to exclude from your income amounts paid or expenses incurred by your employer for qualified adoption expenses in connection with your adoption of an eligible child. See the Instructions for Form 8839 for more information.

Adoption benefits are reported by your employer in Form W-2, box 12, with code T. They are also included as social security and Medicare wages in boxes 3 and 5. However, they aren’t included as wages in box 1. To determine the taxable and nontaxable amounts, you must complete Part III of Form 8839. File the form with your return.

If your employer provides you with the free or low-cost use of an employer-operated gym or other athletic club on your employer's premises, the value isn’t included in your compensation. The gym must be used primarily by employees, their spouses, and their dependent children.

If your employer pays for a fitness program provided to you at an off-site resort hotel or athletic club, the value of the program is included in your compensation.

De Minimis (Minimal) Benefits

If your employer provides you with a product or service and the cost of it is so small that it would be unreasonable for the employer to account for it, the value isn’t included in your income. In most cases, the value of benefits such as discounts at company cafeterias, cab fares home when working overtime, occasional personal use of an employer’s copying machine (where at least 85% of the use of the machine is for business), and company picnics aren’t included in your income. Also, see Employee Discounts , later.

If your employer gives you a turkey, ham, or other item of nominal value at Christmas or other holidays, don’t include the value of the gift in your income. However, if your employer gives you cash, a gift certificate, or a similar item that you can easily exchange for cash, you include the value of that gift as extra salary or wages regardless of the amount involved.

If your employer provides dependent care benefits under a dependent care assistance plan, you may be able to exclude these benefits from your income. Dependent care benefits include:

Amounts your employer pays directly to either you or your care provider for the care of your qualifying person while you work,

The FMV of care in a daycare facility provided or sponsored by your employer, and

Pre-tax contributions you made under a dependent care FSA.

The amount you can exclude is limited to the lesser of:

The total amount of dependent care benefits you received during the year,

The total amount of qualified expenses you incurred during the year,

Your earned income,

Your spouse's earned income, or

$5,000 ($2,500 if married filing separately).

Your employer must show the total amount of dependent care benefits provided to you during the year under a dependent care assistance plan in Form W-2, box 10. Any amount over your employer’s plan limit is also included in box 1. See Form 2441.

To claim the exclusion, you must complete Part III of Form 2441. See the Instructions for Form 2441 for more information.

You can exclude from your income up to $5,250 of qualified employer-provided educational assistance. For more information, see Pub. 970.

If your employer sells you property or services at a discount, you may be able to exclude the amount of the discount from your income. The exclusion applies to discounts on property or services offered to customers in the ordinary course of the line of business in which you work. However, it doesn’t apply to discounts on real property or property commonly held for investment (such as stocks or bonds).

The exclusion is limited to the price charged nonemployee customers multiplied by the following percentage.

For a discount on property, your employer's gross profit percentage (gross profit divided by gross sales) on all property sold during the employer's previous tax year. (Ask your employer for this percentage.)

For a discount on services, 20% (0.20).

Financial counseling fees paid for you by your employer are included in your income and must be reported as part of wages. Fees for tax or investment counseling are miscellaneous itemized deductions and are no longer deductible.

Qualified retirement planning services paid for you by your employer may be excluded from your income. For more information, see Retirement Planning Services , later.

Employer-Provided Group-Term Life Insurance

In most cases, the cost of up to $50,000 of group-term life insurance coverage provided to you by your employer (or former employer) isn’t included in your income. However, you must include in income the cost of employer-provided insurance that is more than the cost of $50,000 of coverage reduced by any amount you pay toward the purchase of the insurance.

For exceptions to this rule, see Entire cost excluded and Entire cost taxed , later.

If your employer provided more than $50,000 of coverage, the amount included in your income is reported as part of your wages in Form W-2, box 1. Also, it's shown separately in box 12 with code C.

This insurance is term life insurance protection (insurance for a fixed period of time) that:

Provides a general death benefit,

Is provided to a group of employees,

Is provided under a policy carried by the employer, and

Provides an amount of insurance to each employee based on a formula that prevents individual selection.

If your group-term life insurance policy includes permanent benefits, such as a paid-up or cash surrender value, you must include in your income, as wages, the cost of the permanent benefits minus the amount you pay for them. Your employer should be able to tell you the amount to include in your income.

Insurance that provides accidental or other death benefits but doesn't provide general death benefits (for example, travel insurance) isn’t group-term life insurance.

If your former employer provided more than $50,000 of group-term life insurance coverage during the year, the amount included in your income is reported as wages in Form W-2, box 1. Also, it's shown separately in box 12 with code C. Box 12 will also show the amount of uncollected social security and Medicare taxes on the excess coverage, with codes M and N. You must pay these taxes with your income tax return. Include them on Schedule 2 (Form 1040), line 13. For more information, see the Instructions for Forms 1040 and 1040-SR.

Your exclusion for employer-provided group-term life insurance coverage can’t exceed the cost of $50,000 of coverage, whether the insurance is provided by a single employer or multiple employers. If two or more employers provide insurance coverage that totals more than $50,000, the amounts reported as wages on your Forms W-2 won’t be correct. You must figure how much to include in your income. Reduce the amount you figure by any amount reported in Form W-2, box 12, with code C, add the result to the wages reported in box 1, and report the total on your return.

Use the following worksheet to figure the amount to include in your income.

If you pay any part of the cost of the insurance, your entire payment reduces, dollar for dollar, the amount you would otherwise include in your income. However, you can’t reduce the amount to include in your income by:

Payments for coverage in a different tax year;

Payments for coverage through a cafeteria plan, unless the payments are after-tax contributions; or

Payments for coverage not taxed to you because of the exceptions discussed later under Entire cost excluded .

Worksheet 1. Figuring the Cost of Group-Term Life Insurance To Include in Income

Table 1. Cost of $1,000 of Group-Term Life Insurance for 1 Month

You're 51 years old and work for employers A and B. Both employers provide group-term life insurance coverage for you for the entire year. Your coverage is $35,000 with employer A and $45,000 with employer B. You pay premiums of $4.15 a month under the employer B group plan. You figure the amount to include in your income as follows.

Worksheet 1. Figuring the Cost of Group-Term Life Insurance To Include in Income—Illustrated

The total amount to include in income for the cost of excess group-term life insurance is $33. Neither employer provided over $50,000 insurance coverage, so the wages shown on your Forms W-2 don't include any part of that $33. You must add it to the wages shown on your Forms W-2 and include the total on your return.

You aren't taxed on the cost of group-term life insurance if any of the following circumstances apply.

You’re permanently and totally disabled and have ended your employment.

Your employer is the beneficiary of the policy for the entire period the insurance is in force during the tax year.

A charitable organization to which contributions are deductible is the only beneficiary of the policy for the entire period the insurance is in force during the tax year. (You aren’t entitled to a deduction for a charitable contribution for naming a charitable organization as the beneficiary of your policy.)

The plan existed on January 1, 1984, and:

You retired before January 2, 1984, and were covered by the plan when you retired; or

You reached age 55 before January 2, 1984, and were employed by the employer or its predecessor in 1983.

You’re taxed on the entire cost of group-term life insurance if either of the following circumstances applies.

The insurance is provided by your employer through a qualified employees' trust, such as a pension trust or a qualified annuity plan.

You’re a key employee and your employer's plan discriminates in favor of key employees.

Meals and Lodging

You don't include in your income the value of meals and lodging provided to you and your family by your employer at no charge if the following conditions are met.

The meals are:

Furnished on the business premises of your employer, and

Furnished for the convenience of your employer.

The lodging is:

Furnished on the business premises of your employer,

Furnished for the convenience of your employer, and

A condition of your employment. (You must accept it in order to be able to properly perform your duties.)

You also don't include in your income the value of meals or meal money that qualifies as a minimal fringe benefit. See De Minimis (Minimal) Benefits , earlier.

If you're an employee of an educational institution or an academic health center and you're provided with lodging that doesn't meet the three conditions given earlier, you may still not have to include the value of the lodging in income. However, the lodging must be qualified campus lodging, and you must pay an Adequate rent .

This is an organization that meets the following conditions.

Its principal purpose or function is to provide medical or hospital care or medical education or research.

It receives payments for graduate medical education under the Social Security Act.

One of its principal purposes or functions is to provide and teach basic and clinical medical science and research using its own faculty.

Qualified campus lodging is lodging furnished to you, your spouse, or any of your dependents by, or on behalf of, the institution or center for use as a home. The lodging must be located on or near a campus of the educational institution or academic health center.

The amount of rent you pay for the year for qualified campus lodging is considered adequate if it's at least equal to the lesser of:

5% of the appraised value of the lodging, or

The average of rentals paid by individuals (other than employees or students) for comparable lodging held for rent by the educational institution.

The lodging must be appraised by an independent appraiser and the appraisal must be reviewed on an annual basis.

You are a sociology professor for State University and rent a home from the university that is qualified campus lodging. The house is appraised at $200,000. The average rent paid for comparable university lodging by persons other than employees or students is $14,000 a year. You pay an annual rent of $11,000. You don’t include in your income any rental value because the rent you pay equals at least 5% of the appraised value of the house (5% × $200,000 = $10,000). If you paid annual rent of only $8,000, you would have to include $2,000 in your income ($10,000 − $8,000).

For tax years 2018 through 2025, reimbursements for certain moving expenses are no longer excluded from the gross income of nonmilitary taxpayers.

The value of services you receive from your employer for free, at cost, or for a reduced price isn't included in your income if your employer:

Offers the same service for sale to customers in the ordinary course of the line of business in which you work, and

Doesn’t have a substantial additional cost (including any sales income given up) to provide you with the service (regardless of what you paid for the service).

In most cases, no-additional-cost services are excess capacity services, such as airline, bus, or train tickets; hotel rooms; and telephone services.

You're employed as a flight attendant for a company that owns both an airline and a hotel chain. Your employer allows you to take personal flights (if there is an unoccupied seat) and stay in any one of their hotels (if there is an unoccupied room) at no cost to you. The value of the personal flight isn't included in your income. However, the value of the hotel room is included in your income because you don't work in the hotel business.

If your employer has a qualified retirement plan, qualified retirement planning services provided to you (and your spouse) by your employer aren't included in your income. Qualified services include retirement planning advice, information about your employer's retirement plan, and information about how the plan may fit into your overall individual retirement income plan. You can't exclude the value of any tax preparation, accounting, legal, or brokerage services provided by your employer. Also, see Financial Counseling Fees , earlier.

Transportation

If your employer provides you with a qualified transportation fringe benefit, it can be excluded from your income, up to certain limits. A qualified transportation fringe benefit is:

Transportation in a commuter highway vehicle (such as a van) between your home and work place,

A transit pass, or

Cash reimbursement by your employer for these expenses under a bona fide reimbursement arrangement is also excludable. However, cash reimbursement for a transit pass is excludable only if a voucher or similar item that can be exchanged only for a transit pass isn't readily available for direct distribution to you.

The exclusion for commuter vehicle transportation and transit pass fringe benefits can't be more than $300 a month.

The exclusion for the qualified parking fringe benefit can't be more than $300 a month.

If the benefits have a value that is more than these limits, the excess must be included in your income.

This is a highway vehicle that seats at least six adults (not including the driver). At least 80% of the vehicle's mileage must reasonably be expected to be:

For transporting employees between their homes and workplace, and

On trips during which employees occupy at least half of the vehicle's adult seating capacity (not including the driver).

This is any pass, token, farecard, voucher, or similar item entitling a person to ride mass transit (whether public or private) free or at a reduced rate or to ride in a commuter highway vehicle operated by a person in the business of transporting persons for compensation.

This is parking provided to an employee at or near the employer's place of business. It also includes parking provided on or near a location from which the employee commutes to work by mass transit, in a commuter highway vehicle, or by car pool. It doesn't include parking at or near the employee's home.

You can exclude a qualified tuition reduction from your income. This is the amount of a reduction in tuition:

For education (below graduate level) furnished by an educational institution to an employee, former employee who retired or became disabled, or his or her spouse and dependent children;

For education furnished to a graduate student at an educational institution if the graduate student is engaged in teaching or research activities for that institution; or

Representing payment for teaching, research, or other services if you receive the amount under the National Health Service Corps Scholarship Program or the Armed Forces Health Professions Scholarship and Financial Assistance program.

If your employer provides you with a product or service and the cost of it would have been allowable as a business or depreciation deduction if you paid for it yourself, the cost isn't included in your income.

You work as an engineer and your employer provides you with a subscription to an engineering trade magazine. The cost of the subscription isn't included in your income because the cost would have been allowable to you as a business deduction if you had paid for the subscription yourself.

Valuation of Fringe Benefits

If a fringe benefit is included in your income, the amount included is generally its value determined under the general valuation rule or under the special valuation rules. For an exception, see Employer-Provided Group-Term Life Insurance , earlier.

You must include in your income the amount by which the FMV of the fringe benefit is more than the sum of:

The amount, if any, you paid for the benefit, plus

The amount, if any, specifically excluded from your income by law.

The FMV of a fringe benefit is determined by all the facts and circumstances. It’s the amount you would have to pay a third party to buy or lease the benefit. This is determined without regard to:

Your perceived value of the benefit, or

The amount your employer paid for the benefit.

If your employer provides a car (or other highway motor vehicle) to you, your personal use of the car is usually a taxable noncash fringe benefit.

Under the general valuation rules, the value of an employer-provided vehicle is the amount you would have to pay a third party to lease the same or a similar vehicle on the same or comparable terms in the same geographic area where you use the vehicle. An example of a comparable lease term is the amount of time the vehicle is available for your use, such as a 1-year period. The value can't be determined by multiplying a cents-per-mile rate times the number of miles driven unless you prove the vehicle could have been leased on a cents-per-mile basis. See Notice 2021-7 for more information on temporary relief for employers and employees using the automobile lease valuation rule to determine the value of an employer-provided vehicle in 2020 or 2021. The special valuation rule used for 2021 under the Notice must continue to be used by the employer and the employee for all subsequent years, except to the extent the employer uses the commuting valuation rule. See Special valuation rules below.

Under the general valuation rules, if your flight on an employer-provided piloted aircraft is primarily personal and you control the use of the aircraft for the flight, the value is the amount it would cost to charter the flight from a third party.

If there is more than one employee on the flight, the cost to charter the aircraft must be divided among those employees. The division must be based on all the facts, including which employee or employees control the use of the aircraft.

Generally, you can use a special valuation rule for a fringe benefit only if your employer uses the rule. If your employer uses a special valuation rule, you can't use a different special rule to value that benefit. You can always use the general valuation rule discussed earlier, based on facts and circumstances, even if your employer uses a special rule.

If you and your employer use a special valuation rule, you must include in your income the amount your employer determines under the special rule minus the sum of:

Any amount you repaid your employer, plus

Any amount specifically excluded from income by law.

The automobile lease rule.

The vehicle cents-per-mile rule.

The commuting rule.

The unsafe conditions commuting rule.

The employer-operated eating-facility rule.

For more information on these rules, see Pub. 15-B.

For information on the noncommercial flight and commercial flight valuation rules, see sections 1.61-21(g) and 1.61-21(h) of the regulations.

Retirement Plan Contributions

Except for Roth contributions, your employer's contributions to a qualified retirement plan for you aren’t included in income at the time contributed. (Your employer can tell you whether your retirement plan is qualified.) However, the cost of life insurance coverage included in the plan may have to be included.

If your employer pays into a nonqualified plan for you, you must generally include the contributions in your income as wages for the tax year in which the contributions are made. However, if your interest in the plan isn't transferable or is subject to a substantial risk of forfeiture (you have a good chance of losing it) at the time of the contribution, you don't have to include the value of your interest in your income until it's transferable or is no longer subject to a substantial risk of forfeiture.

Elective Deferrals

If you’re covered by certain kinds of retirement plans, you can choose to have part of your compensation contributed by your employer to a retirement fund, rather than have it paid to you. The amount you set aside (called an “elective deferral”) is treated as an employer contribution to a qualified plan. An elective deferral, other than a designated Roth contribution (discussed later), isn't included in wages subject to income tax at the time contributed. However, it’s included in wages subject to social security and Medicare taxes.

Elective deferrals include elective contributions to the following retirement plans.

Cash or deferred arrangements (section 401(k) plans).

The TSP for federal employees.

Salary reduction simplified employee pension plans (SARSEP plans).

Savings incentive match plans for employees (SIMPLE plans).

Tax-sheltered annuity plans (section 403(b) plans).

Section 501(c)(18)(D) plans. (But see Reporting by employer , later.)

Section 457 plans.

Under a qualified automatic contribution arrangement, your employer can treat you as having elected to have a part of your compensation contributed to a section 401(k) plan. You’re to receive written notice of your rights and obligations under the qualified automatic contribution arrangement. The notice must explain:

Your rights to elect not to have elective contributions made, or to have contributions made at a different percentage; and

How contributions made will be invested in the absence of any investment decision by you.

You must be given a reasonable period of time after receipt of the notice and before the first elective contribution is made to make an election with respect to the contributions.

For 2023, you shouldn't have deferred more than a total of $22,500 of contributions to the plans listed in (1) through (3), earlier, unless you are 50 or older. The specific plan limits for the plans listed in (4) through (7), earlier, are discussed later. Amounts deferred under specific plan limits are part of the overall limit on deferrals.

Your employer or plan administrator should apply the proper annual limit when figuring your plan contributions. However, you’re responsible for monitoring the total you defer to ensure that the deferrals aren't more than the overall limit.

You may be allowed catch-up contributions (additional elective deferrals) if you're age 50 or older by the end of your tax year. For 2023, the catch-up limit for section 401(k) and 403(b) plans, the TSP, SARSEP plans, and governmental section 457 plans is $7,500. For SIMPLE plans, it’s $3,500.

For more information about catch-up contributions to:

Section 401(k) plans, see Elective Deferrals in chapter 4 of Pub. 560;

SARSEPs, see Salary Reduction Simplified Employee Pensions in chapter 2 of Pub. 560;

SIMPLE plans, see SIMPLE Plans in chapter 3 of Pub. 560; and

Section 457 plans, see Limit for deferrals under section 457 plans , later.

If you're a participant in a SIMPLE plan, you generally shouldn't have deferred more than $15,500 in 2023. Amounts you defer under a SIMPLE plan count toward the overall limit ($22,500 for 2023) and may affect the amount you can defer under other elective deferral plans.

If you're a participant in a tax-sheltered annuity plan (section 403(b) plan), the limit on elective deferrals for 2023 is generally $22,500. However, if you have at least 15 years of service with a public school system, a hospital, a home health service agency, a health and welfare service agency, a church, or a convention or association of churches (or associated organization), the limit on elective deferrals is increased by the least of the following amounts.

$15,000, reduced by the sum of:

The additional pre-tax elective deferrals made in earlier years because of this rule, plus

The aggregate amount of designated Roth contributions permitted for prior tax years because of this rule.

$5,000 times the number of your years of service for the organization, minus the total elective deferrals made by your employer on your behalf for earlier years.

If you qualify for the 15-year rule, your elective deferrals under this limit can be as high as $25,500 for 2023.

For more information, see Pub. 571.

If you're a participant in a section 501(c)(18) plan (a trust created before June 25, 1959, funded only by employee contributions), you should have deferred no more than the lesser of $7,000 or 25% of your compensation. Amounts you defer under a section 501(c)(18) plan count toward the overall limit ($22,500 in 2023) and may affect the amount you can defer under other elective deferral plans.

If you're a participant in a section 457 plan (a deferred compensation plan for employees of state or local governments or tax-exempt organizations), you should have deferred no more than the lesser of your includible compensation or $22,500 in 2023. However, if you're within 3 years of normal retirement age, you may be allowed an increased limit if the plan allows it. See Increased limit , later.

Generally, this is your Form W-2 wages plus elective deferrals. In most cases, it includes all the following payments.

Wages and salaries.

Fees for professional services.

The value of any employer-provided qualified transportation fringe benefit (defined under Transportation , earlier) that isn't included in your income.

Other amounts received (cash or noncash) for personal services you performed, including, but not limited to, the following items.

Commissions and tips.

Fringe benefits.

De minimis financial incentives to make elective deferrals to a qualified cash or deferred arrangement.

Employer contributions (elective deferrals) to the following.

The section 457 plan.

Section 401(k) plans that aren't included in your income.

A SARSEP plan.

A tax-sheltered annuity (section 403(b) plan).

A SIMPLE plan.

A section 125 cafeteria plan.

Instead of using the amounts listed earlier to determine your includible compensation, your employer can use any of the following amounts.

Your wages as defined for income tax withholding purposes.

Your wages as reported in Form W-2, box 1.

Your wages that are subject to social security withholding (including elective deferrals).

During any, or all, of the last 3 years ending before you reach normal retirement age under the plan, your plan may provide that your limit is the lesser of:

Twice the annual limit ($45,000 for 2023), or

The basic annual limit plus the amount of the basic limit not used in prior years (only allowed if not using age 50-or-over catch-up contributions).

You can generally have additional elective deferrals made to your governmental section 457 plan if:

You reached age 50 by the end of the year, and

No other elective deferrals can be made for you to the plan for the year because of limits or restrictions.

Employers with section 401(k) plans, section 403(b) plans, and governmental section 457 plans can create qualified Roth contribution programs so that you may elect to have part or all of your elective deferrals to the plan designated as after-tax Roth contributions. Designated Roth contributions are treated as elective deferrals, except that they're included in income. Your retirement plan must maintain separate accounts and recordkeeping for the designated Roth contributions. In addition, your retirement plan may allow you to designate certain nonelective contributions or matching contributions as Roth contributions. These Roth contributions are also included in income.

Qualified distributions from a Roth account aren't included in income. A distribution made before the end of the 5-tax-year period beginning with the first tax year for which you made a Roth contribution to the account isn't a qualified distribution.

Your employer generally shouldn't include elective deferrals in your wages in Form W-2, box 1. Instead, your employer should mark the Retirement plan checkbox in box 13 and show the total amount deferred in box 12.

Wages shown in Form W-2, box 1, shouldn't have been reduced for contributions you made to a section 501(c)(18)(D) plan. The amount you contributed should be identified with code H in box 12. You may deduct the amount deferred subject to the limits that apply. Include your deduction in the total on Schedule 1 (Form 1040), line 24f.

These contributions are elective deferrals but are included in your wages in Form W-2, box 1. Designated Roth contributions to a section 401(k) plan are reported using code AA in box 12, or, for section 403(b) plans, code BB in box 12. Designated Roth contributions to a governmental section 457 plan are reported using code EE in box 12.

These contributions are reported on Form 1099-R for the year in which the contributions are allocated to your account. The total amount of designated Roth nonelective contributions and designated Roth matching contributions that are allocated to your account in the year is reported in box 1 and in box 2a. These contributions are reported using code G in box 7.

If your deferrals exceed the limit, you must notify your plan by the date required by the plan. If the plan permits, the excess amount will be distributed to you. If you participate in more than one plan, you can have the excess paid out of any of the plans that permit these distributions. You must notify each plan by the date required by that plan of the amount to be paid from that particular plan. The plan must then pay you the amount of the excess, along with any income earned on that amount, by April 15 of the following year.

You must include the excess deferral in your income for the year of the deferral. File Form 1040 or 1040-SR to add the excess deferral amount to earned income on line 1h.

If you don't take out the excess amount, you can't include it in the cost of the contract even though you included it in your income. Therefore, you're taxed twice on the excess deferral left in the plan—once when you contribute it, and again when you receive it as a distribution (unless the excess deferral was a designated Roth contribution).

If you take out the excess after the year of the deferral and you receive the corrective distribution by April 15 of the following year, don't include it in income again in the year you receive it. If you receive it later, you must include it in income in both the year of the deferral and the year you receive it (unless the excess deferral was a designated Roth contribution). Any income on the excess deferral taken out is taxable in the tax year in which you take it out. If you take out part of the excess deferral and the income on it, allocate the distribution proportionately between the excess deferral and the income.

You should receive a Form 1099-R for the year in which the excess deferral is distributed to you. Use the following rules to report a corrective distribution shown on Form 1099-R for 2023.

If the distribution was for a 2023 excess deferral, your Form 1099-R should have code 8 in box 7. Add the excess deferral amount to your wages on your 2023 tax return.

If the distribution was for a 2023 excess deferral to a designated Roth account, your Form 1099-R should have codes B and 8 in box 7. Don’t add this amount to your wages on your 2023 return.

If the distribution was for a 2022 excess deferral, your Form 1099-R should have code P in box 7. If you didn't add the excess deferral amount to your wages on your 2022 tax return, you must file an amended return on Form 1040-X. If you didn't receive the distribution by April 15, 2023, you must also add it to your wages on your 2023 tax return.

If the distribution was for the income earned on an excess deferral, your Form 1099-R should have code 8 in box 7. Add the income amount to your wages on your 2023 income tax return, regardless of when the excess deferral was made.

If you're a highly compensated employee, the total of your elective deferrals made for you for any year under a section 401(k) plan or SARSEP plan may be limited by the average deferrals, as a percentage of pay, made by all eligible non-highly compensated employees.

If you contributed more to the plan than allowed, the excess contributions may be distributed to you. You must include the distribution in your income on Form 1040 or 1040-SR, line 1h.

If you receive a corrective distribution of excess contributions (and allocable income), it's included in your income in the year of the distribution. The allocable income is the amount of gain or loss through the end of the plan year for which the contribution was made that is allocable to the excess contributions. You should receive a Form 1099-R for the year the excess contributions are distributed to you. Add the distribution to your wages for that year.

The amount contributed in 2023 to a defined contribution plan is generally limited to the lesser of 100% of your compensation or $66,000. Under certain circumstances, contributions that exceed these limits (excess annual additions) may be corrected by a distribution of your elective deferrals or a return of your after-tax contributions and earnings from these contributions.

A corrective payment of excess annual additions consisting of elective deferrals or earnings from your after-tax contributions is fully taxable in the year paid. A corrective payment consisting of your after-tax contributions isn't taxable.

If you received a corrective payment of excess annual additions, you should receive a separate Form 1099-R for the year of the payment with code E in box 7. Report the total payment shown in Form 1099-R, box 1, on Form 1040 or 1040-SR, line 5a. Report the taxable amount shown in Form 1099-R, box 2a, on Form 1040 or 1040-SR, line 5b.

Stock Options

In Wisconsin Central Ltd. v. United States , 138 S. Ct. 2067, the U.S. Supreme Court ruled that “money remuneration” is “currency issued by a recognized authority as a medium of exchange,” and that employee stock options aren’t “money remuneration” subject to the Railroad Retirement Tax Act (RRTA). Tier 1 and Tier 2 taxes aren’t withheld when employees covered by the RRTA exercise stock options. Federal income tax must still be withheld on taxable compensation from railroad employees exercising their options. If you receive an option to buy or sell stock or other property as payment for your services, you may have income when you receive the option (the grant), when you exercise the option (use it to buy or sell the stock or other property), or when you sell or otherwise dispose of the option or property acquired through exercise of the option. The timing, type, and amount of income inclusion depend on whether you receive a nonstatutory stock option or a statutory stock option. Your employer can tell you which kind of option you hold.

Nonstatutory Stock Options

If you're granted a nonstatutory stock option, you may have income when you receive the option. The amount of income to include and the time to include it depend on whether the FMV of the option can be readily determined. The FMV of an option can be readily determined if it’s actively traded on an established market.

The FMV of an option that isn't traded on an established market can be readily determined only if all of the following conditions exist.

You can transfer the option.

You can exercise the option immediately in full.

The option or the property subject to the option isn't subject to any condition or restriction (other than a condition to secure payment of the purchase price) that has a significant effect on the FMV of the option.

The FMV of the option privilege can be readily determined.

If you receive a nonstatutory stock option that has a readily determinable FMV at the time it's granted to you, the option is treated like other property received as compensation. See Restricted Property , later, for rules on how much income to include and when to include it. However, the rule described in that discussion for choosing to include the value of property in your income for the year of the transfer doesn't apply to a nonstatutory option.

If the FMV of the option isn't readily determinable at the time it's granted to you (even if it's determined later), you don't have income until you exercise or transfer the option.

When you exercise a nonstatutory stock option, the amount to include in your income depends on whether the option had a readily determinable value.

When you exercise a nonstatutory stock option that had a readily determinable value at the time the option was granted, you don't have to include any amount in income.

When you exercise a nonstatutory stock option that didn't have a readily determinable value at the time the option was granted, the restricted property rules apply to the property received. The amount to include in your income is the difference between the amount you pay for the property and its FMV when it becomes substantially vested. If it isn't substantially vested at the time you exercise this nonstatutory stock option (so that you may have to give the stock back), you don't have to include any amount in income. You include the difference in income when the option becomes substantially vested. For more information on restricted property, see Restricted Property , later.

If you transfer a nonstatutory stock option without a readily determinable value in an arm's-length transaction to an unrelated person, you must include in your income the money or other property you received for the transfer as if you had exercised the option.

If you transfer a nonstatutory stock option without a readily determinable value in a non-arm's-length transaction (for example, a gift), the option isn't treated as exercised or closed at that time. You must include in your income, as compensation, any money or property received. When the transferee exercises the option, you must include in your income, as compensation, the excess of the FMV of the stock acquired by the transferee over the sum of the exercise price paid and any amount you included in income at the time you transferred the option. At the time of the exercise, the transferee recognizes no income and has a basis in the stock acquired equal to the FMV of the stock.

Any transfer of this kind of option to a related person is treated as a non-arm's-length transaction. See Regulations section 1.83-7 for the definition of a related person.

If you're an employee, and you issue a recourse note to your employer in satisfaction of the exercise price of an option to acquire your employer's stock, and your employer and you subsequently agree to reduce the stated principal amount of the note, you generally recognize compensation income at the time and in the amount of the reduction.

If you have income from the exercise of nonstatutory stock options, your employer should report the amount to you in Form W-2, box 12, with code V. The employer should show the spread (that is, the FMV of stock over the exercise price of options granted to you for that stock) from your exercise of the nonstatutory stock options. Your employer should include this amount in boxes 1, 3 (up to the social security wage base), and 5. Your employer should include this amount in box 14 if it's a railroad employer.

If you're a nonemployee spouse and you exercise nonstatutory stock options you received incident to a divorce, the income is reported to you in box 3 of Form 1099-MISC.

There are no special income rules for the sale of stock acquired through the exercise of a nonstatutory stock option. Report the sale as explained in the Instructions for Schedule D (Form 1040) for the year of the sale. You may receive a Form 1099-B reporting the sales proceeds.

Your basis in the property you acquire under the option is the amount you pay for it plus any amount you included in income upon grant or exercise of the option.

Your holding period begins as of the date you acquired the option, if it had a readily determinable value, or as of the date you exercised or transferred the option if it had no readily determinable value.

For options granted on or after January 1, 2014, the basis information reported to you on Form 1099-B won't reflect any amount you included in income upon grant or exercise of the option. For options granted before January 1, 2014, any basis information reported to you on Form 1099-B may or may not reflect any amount you included in income upon grant or exercise; therefore, the basis may need to be adjusted.

Statutory Stock Options

There are two kinds of statutory stock options.

Incentive stock options (ISOs) .

Options granted under employee stock purchase plans.

For either kind of option, you must be an employee of the company granting the option, or a related company, at all times during the period beginning on the date the option is granted and ending 3 months before the date you exercise the option (for an ISO, 1 year before if you're disabled). Also, the option must be nontransferable except at death.

If you don't meet the employment requirements, or you receive a transferable option, your option is a nonstatutory stock option.

If you receive a statutory stock option, don't include any amount in your income when the option is granted.

If you exercise a statutory stock option, don't include any amount in income when you exercise the option.

For the AMT, you must treat stock acquired through the exercise of an ISO as if no special treatment applied. This means that, when your rights in the stock are transferable or no longer subject to a substantial risk of forfeiture, you must include as an adjustment in figuring alternative minimum taxable income the amount by which the FMV of the stock exceeds the option price. Enter this adjustment on Form 6251, line 2i. Increase your AMT basis in any stock you acquire by exercising the ISO by the amount of the adjustment. However, no adjustment is required if you dispose of the stock in the same year you exercise the option.

See Restricted Property , later, for more information.

Your employer, Elm Company, granted you an ISO on April 8, 2022, to buy 100 shares of Elm Company at $9 a share, its FMV at the time. You exercised the option on January 7, 2023, when the stock was selling on the open market for $14 a share. On January 27, 2023, when the stock was selling on the open market for $16 a share, your rights to the stock first became transferable. You include $700 ($1,600 value when your rights first became transferable minus $900 option price) as an adjustment on Form 6251, line 2i.

You have taxable income or a deductible loss when you sell the stock that you bought by exercising the option. Your income or loss is the difference between the amount you paid for the stock (the option price) and the amount you receive when you sell it. You generally treat this amount as capital gain or loss and report it as explained in the Instructions for Schedule D (Form 1040) for the year of the sale.

However, you may have ordinary income for the year that you sell or otherwise dispose of the stock in either of the following situations.

You don't satisfy the holding period requirement.

You satisfy the conditions described under Option granted at a discount under Employee stock purchase plan , later.

You satisfy the holding period requirement if you don't sell the stock until the end of the later of the 1-year period after the stock was transferred to you or the 2-year period after the option was granted. However, you're considered to satisfy the holding period requirement if you sold the stock to comply with conflict-of-interest requirements.

Your holding period for the property you acquire when you exercise an option begins on the day after you exercise the option.

If you sell stock acquired by exercising an ISO, you need to determine if you satisfied the holding period requirement.

If you sell stock acquired by exercising an ISO and satisfy the holding period requirement, your gain or loss from the sale is capital gain or loss. Report the sale as explained in the Instructions for Schedule D (Form 1040). The basis of your stock is the amount you paid for the stock.

If you sell stock acquired by exercising an ISO, don't satisfy the holding period requirement, and have a gain from the sale, the gain is ordinary income up to the amount by which the stock's FMV when you exercised the option exceeded the option price. Any excess gain is capital gain. If you have a loss from the sale, it's a capital loss and you don't have any ordinary income.

Your employer or former employer should report the ordinary income to you as wages in Form W-2, box 1, and you must report this ordinary income amount on Form 1040 or 1040-SR, line 1a. If your employer or former employer doesn't provide you with a Form W-2, or if the Form W-2 doesn't include the ordinary income in box 1, you must report the ordinary income as wages on Schedule 1 (Form 1040), line 8k, for the year of the sale or other disposition of the stock. Report the capital gain or loss as explained in the Instructions for Schedule D (Form 1040). In determining capital gain or loss, your basis is the amount you paid when you exercised the option plus the amount reported as wages.

Your employer, Oak Corporation, granted you an ISO on March 12, 2021, to buy 100 shares of Oak Corporation stock at $10 a share, its FMV at the time. You exercised the option on January 7, 2022, when the stock was selling on the open market for $12 a share. On January 27, 2023, you sold the stock for $15 a share. Although you held the stock for more than a year, less than 2 years had passed from the time you were granted the option. In 2023, you must report the difference between the option price ($10) and the value of the stock when you exercised the option ($12) as wages. The rest of your gain is capital gain, figured as follows.

If you sold stock acquired by exercising an option granted under an employee stock purchase plan, you need to determine if you satisfied the holding period requirement.

If you sold stock acquired by exercising an option granted under an employee stock purchase plan, and you satisfy the holding period requirement, determine your ordinary income as follows.

Your basis is equal to the option price at the time you exercised your option and acquired the stock. The timing and amount of pay period deductions don't affect your basis.

Pine Company has an employee stock purchase plan. The option price is the lower of the stock price at the time the option is granted or at the time the option is exercised. The value of the stock when the option was granted was $25. Pine Company deducts $5 from Adrian's pay every week for 48 weeks (total = $240 ($5 × 48)). The value of the stock when the option is exercised is $20. Adrian receives 12 shares of Pine Company’s stock ($240 ÷ $20). Adrian's holding period for all 12 shares begins the day after the option is exercised, even though the money used to purchase the shares was deducted from Adrian's pay on 48 separate days. Adrian's basis in each share is $20.

If, at the time the option was granted, the option price per share was less than 100% (but not less than 85%) of the FMV of the share, and you dispose of the share after meeting the holding period requirement, or you die while owning the share, you must include in your income as compensation the lesser of:

The excess of the FMV of the share at the time the option was granted over the option price, or

The excess of the FMV of the share at the time of the disposition or death over the amount paid for the share under the option.

Any excess gain is capital gain. If you have a loss from the sale, it's a capital loss, and you don't have any ordinary income.

Example 10.

Your employer, Willow Corporation, granted you an option under its employee stock purchase plan to buy 100 shares of stock of Willow Corporation for $20 a share at a time when the stock had a value of $22 a share. Eighteen months later, when the value of the stock was $23 a share, you exercised the option, and 14 months after that you sold your stock for $30 a share. In the year of sale, you must report as wages the difference between the option price ($20) and the value at the time the option was granted ($22). The rest of your gain ($8 per share) is capital gain, figured as follows.

If you don't satisfy the holding period requirement, your ordinary income is the amount by which the stock's FMV when you exercised the option exceeded the option price. This ordinary income isn't limited to your gain from the sale of the stock. Increase your basis in the stock by the amount of this ordinary income. The difference between your increased basis and the selling price of the stock is a capital gain or loss.

Example 11.

The facts are the same as in Example 10 , except that you sold the stock only 6 months after you exercised the option. You didn't satisfy the holding period requirement, so you must report $300 as wages and $700 as capital gain, figured as follows.

P.L. 115-97 made a change in the law that allows a new election for “qualified employees” of private corporations to elect to defer income taxation for up to 5 years from the date of vesting on “qualified stock” granted in connection with broad-based compensatory stock option and restricted stock unit (RSU) programs. This election is available for stock attributable to options exercised or RSUs settled after 2017. The corporation must have a written plan providing RSU or option to at least 80% of U.S. employees. The recipients must have the same rights and privileges under RSU or option plan.

The term “qualified employee” doesn’t include:

1% owner of corporation (current or any point during prior 10 calendar years),

Current or former CEO or CFO (current or any point previously),

Family of previously mentioned individuals, or

One of the four highest compensated officers (current or any point during prior 10 calendar years).

The term “qualified stock” means any stock in a corporation that is the employer of the employee if:

Stock is received relating to the exercise of an option, or

Stock is received in settlement of an RSU, and

Option or RSU was granted by the corporation.

The term “qualified stock” can’t include stock from stock-settled stock appreciation rights or restricted stock awards (restricted property). It won’t include any stock if the employee may receive cash instead of stock. The election is made in a manner similar to the election described under Choosing to include in income for year of transfer , later, under Restricted Property , even though the “qualified stock” isn't restricted property. The election must be made no later than 30 days after the first date the rights of the employee in such stock are transferable or aren’t subject to a substantial risk of forfeiture, whichever occurs earlier. See Restricted Property , later, for how to make the choice.

If an employee elects to defer income inclusion under the provision, the income must be included in the employee's income for the year that includes the earliest of (1) the first date the qualified stock becomes transferable, (2) the date the employee first becomes an excluded employee (as excluded from “qualified employee”), (3) the first date on which any stock of the employer becomes readily tradable on an established securities market, (4) the date 5 years after the first date the employee's right to the stock becomes substantially vested, or (5) the date on which the employee revokes his or her inclusion deferral election.

The employer corporation is required to provide notification of rights to employees covered under a qualified program or face penalties. There will be withholding at the highest marginal rate.

Restricted Property

In most cases, if you receive property for your services, you must include its FMV in your income in the year you receive the property. However, if you receive stock or other property that has certain restrictions that affect its value, you don't include the value of the property in your income until it has been substantially vested. (You can choose to include the value of the property in your income in the year it's transferred to you, as discussed later, rather than the year it's substantially vested.)

Until the property becomes substantially vested, it's owned by the person who makes the transfer to you, usually your employer. However, any income from the property, or the right to use the property, is included in your income as additional compensation in the year you receive the income or have the right to use the property.

When the property becomes substantially vested, you must include its FMV, minus any amount you paid for it, in your income for that year. Your holding period for this property begins when the property becomes substantially vested.

Example 12.

Your employer, the Holly Corporation, sells you 100 shares of its stock at $10 a share. At the time of the sale, the FMV of the stock is $100 a share. Under the terms of the sale, the stock is under a substantial risk of forfeiture (you have a good chance of losing it) for a 5-year period. Your stock isn't substantially vested when it's transferred, so you don't include any amount in your income in the year you buy it. At the end of the 5-year period, the FMV of the stock is $200 a share. You must include $19,000 in your income [100 shares × ($200 FMV − $10 you paid)]. Dividends paid by the Holly Corporation on your 100 shares of stock are taxable to you as additional compensation during the period the stock can be forfeited.

Property is substantially vested when:

It’s transferable, or

It isn't subject to a substantial risk of forfeiture. (You don't have a good chance of losing it.)

Property is transferable if you can sell, assign, or pledge your interest in the property to any person (other than the transferor), and if the person receiving your interest in the property isn't required to give up the property, or its value, if the substantial risk of forfeiture occurs.

Generally, a substantial risk of forfeiture exists only if rights in property that are transferred are conditioned, directly or indirectly, on the future performance (or refraining from performance) of substantial services by any person, or on the occurrence of a condition related to a purpose of the transfer if the possibility of forfeiture is substantial.

Example 13.

The Redwood Corporation transfers to you as compensation for services 100 shares of its corporate stock for $100 a share. Under the terms of the transfer, you must resell the stock to the corporation at $100 a share if you leave your job for any reason within 3 years from the date of transfer. You must perform substantial services over a period of time, and you must resell the stock to the corporation at $100 a share (regardless of its value) if you don't perform the services; so, your rights to the stock are subject to a substantial risk of forfeiture.

You can choose to include the value of restricted property at the time of transfer (minus any amount you paid for the property) in your income for the year it's transferred. If you make this choice, the substantial vesting rules don't apply and, generally, any later appreciation in value isn't included in your compensation when the property becomes substantially vested. Your basis for figuring gain or loss when you sell the property is the amount you paid for it plus the amount you included in income as compensation.

If you forfeit the property after you have included its value in income, your loss is the amount you paid for the property minus any amount you realized on the forfeiture.

You make the choice by filing a written statement with the Internal Revenue Service Center where you file your return. You must file this statement no later than 30 days after the date the property was transferred. Mail your statement to the address listed for your state under “Are requesting a refund or aren’t enclosing a check or money order...” given in Where Do You File in the Instructions for Forms 1040 and 1040-SR. You must give a copy of this statement to the person for whom you performed the services and, if someone other than you received the property, to that person.

You must sign the statement and indicate on it that you're making the choice under section 83(b) of the Internal Revenue Code. The statement must contain all of the following information.

Your name, address, and TIN.

A description of each property for which you're making the choice.

The date or dates on which the property was transferred and the tax year for which you're making the choice.

The nature of any restrictions on the property.

The FMV at the time of transfer (ignoring restrictions except those that will never lapse) of each property for which you're making the choice.

Any amount that you paid for the property.

A statement that you have provided copies to the appropriate persons.

Dividends you receive on restricted stock are treated as compensation and not as dividend income. Your employer should include these payments on your Form W-2. If they are also reported on a Form 1099-DIV, you should list them on Schedule B (Form 1040), with a statement that you have included them as wages. Don’t include them in the total dividends received.

Dividends you receive on restricted stock you chose to include in your income in the year transferred are treated the same as any other dividends. You should receive a Form 1099-DIV showing these dividends. Don’t include the dividends in your wages on your return. Report them as dividends.

These rules apply to the sale or other disposition of property that you didn't choose to include in your income in the year transferred and that isn't substantially vested.

If you sell or otherwise dispose of the property in an arm's-length transaction, include in your income as compensation for the year of sale the amount realized minus the amount you paid for the property. If you exchange the property in an arm's-length transaction for other property that isn't substantially vested, treat the new property as if it were substituted for the exchanged property.

The sale or other disposition of a nonstatutory stock option to a related person isn't considered an arm's-length transaction. See Regulations section 1.83-7 for the definition of a “related person.”

If you sell the property in a transaction that isn't at arm's length, include in your income as compensation for the year of sale the total of any money you received and the FMV of any substantially vested property you received on the sale. In addition, you'll have to report income when the original property becomes substantially vested, as if you still held it. Report as compensation its FMV minus the total of the amount you paid for the property and the amount included in your income from the earlier sale.

Example 14.

In 2020, you paid your employer $50 for a share of stock that had an FMV of $100 and was subject to forfeiture until 2023. In 2022, you sold the stock to your spouse for $10 in a transaction not at arm's length. You had compensation of $10 from this transaction. In 2023, when the stock had an FMV of $120, it became substantially vested. For 2022, you must report additional compensation of $60, figured as follows.

If you inherit property not substantially vested at the time of the decedent's death, any income you receive from the property is considered income in respect of a decedent and is taxed according to the rules for restricted property received for services. For information about income in respect of a decedent, see Pub. 559.

Special Rules for Certain Employees

This part of the publication deals with special rules for people in certain types of employment: members of the clergy, members of religious orders, people working for foreign employers, military personnel, and volunteers.

If you’re a member of the clergy, you must include in your income offerings and fees you receive for marriages, baptisms, funerals, masses, etc., in addition to your salary. If the offering is made to the religious institution, it isn't taxable to you.

If you’re a member of a religious organization and you give your outside earnings to the organization, you must still include the earnings in your income. However, you may be entitled to a charitable contribution deduction for the amount paid to the organization. See Pub. 526. Also, see Members of Religious Orders , later.

A pension or retirement pay for a member of the clergy is usually treated as any other pension or annuity. It must be reported on lines 5a and 5b of Form 1040 or 1040-SR.

Special rules for housing apply to members of the clergy. Under these rules, you don't include in your income the rental value of a home (including utilities) or a designated housing allowance provided to you as part of your pay. However, the exclusion can't be more than the reasonable pay for your service. If you pay for the utilities, you can exclude any allowance designated for utility cost, up to your actual cost. The home or allowance must be provided as compensation for your services as an ordained, licensed, or commissioned minister. However, you must include the rental value of the home or the housing allowance as earnings from self-employment on Schedule SE (Form 1040) if you’re subject to the self-employment tax. For more information, see Pub. 517.

Members of Religious Orders

If you're a member of a religious order who has taken a vow of poverty, how you treat earnings that you renounce and turn over to the order depends on whether your services are performed for the order.

If you're performing the services as an agent of the order in the exercise of duties required by the order, don't include in your income the amounts turned over to the order.

If your order directs you to perform services for another agency of the supervising church or an associated institution, you're considered to be performing the services as an agent of the order. Any wages you earn as an agent of an order that you turn over to the order aren't included in your income.

Example 15.

You're a member of a church order and have taken a vow of poverty. You renounce any claims to your earnings and turn over to the order any salaries or wages you earn. You're a registered nurse, so your order assigns you to work in a hospital that is an associated institution of the church. However, you remain under the general direction and control of the order. You're considered to be an agent of the order and any wages you earn at the hospital that you turn over to your order aren't included in your income.

If you're directed to work outside the order, your services aren't an exercise of duties required by the order unless they meet both of the following requirements.

They're the kind of services that are ordinarily the duties of members of the order.

They're part of the duties that you must exercise for, or on behalf of, the religious order as its agent.

Example 16.

You are a member of a religious order and have taken a vow of poverty. You renounce all claims to your earnings and turn over your earnings to the order.

You are a schoolteacher. You were instructed by the superiors of the order to get a job with a private tax-exempt school. You became an employee of the school, and, at your request, the school made the salary payments directly to the order.

Because you are an employee of the school, you’re performing services for the school rather than as an agent of the order. The wages you earn working for the school are included in your income.

Example 17.

You are a member of a religious order who, as a condition of membership, have taken vows of poverty and obedience. All claims to your earnings are renounced. You received permission from the order to establish a private practice as a psychologist and counsel members of religious orders as well as nonmembers. Although the order reviews your budget annually, you control not only the details of your practice but also the means by which your work as a psychologist is accomplished.

Your private practice as a psychologist doesn't make you an agent of the religious order. The psychological services you provide aren't the type of services that are provided by the order. The income you earn as a psychologist is earned in your individual capacity. You must include in your income the earnings from your private practice.

Foreign Employer

Special rules apply if you work for a foreign employer.

If you're a U.S. citizen who works in the United States for a foreign government, an international organization, a foreign embassy, or any foreign employer, you must include your salary in your income.

You're exempt from social security and Medicare employee taxes if you're employed in the United States by an international organization or a foreign government. However, you must pay self-employment tax on your earnings from services performed in the United States, even though you aren't self-employed. This rule also applies if you're an employee of a qualifying wholly owned instrumentality of a foreign government.

Your compensation for official services to an international organization is exempt from federal income tax if you aren't a citizen of the United States or you're a citizen of the Philippines (whether or not you're a citizen of the United States).

Your compensation for official services to a foreign government is exempt from federal income tax if all of the following are true.

You aren't a citizen of the United States or you're a citizen of the Philippines (whether or not you're a citizen of the United States).

Your work is like the work done by employees of the United States in foreign countries.

The foreign government gives an equal exemption to employees of the United States in its country.

If you're an alien who works for a foreign government or international organization and you file a waiver under section 247(b) of the Immigration and Nationality Act to keep your immigrant status, any salary you receive after the date you file the waiver isn't exempt under this rule. However, it may be exempt under a treaty or agreement. See Pub. 519, U.S. Tax Guide for Aliens, for more information about treaties.

This exemption applies only to employees' wages, salaries, and fees. Pensions and other income, such as investment income, don't qualify for this exemption.

For information on the tax treatment of income earned abroad, see Pub. 54.

Payments you receive as a member of a military service are generally taxed as wages except for retirement pay, which is taxed as a pension. Allowances generally aren't taxed. For more information on the tax treatment of military allowances and benefits, see Pub. 3.

Any payments made to you by an employer during the time you're performing service in the uniformed services are treated as compensation. These wages are subject to income tax withholding and are reported on Form W-2. See the discussion under Miscellaneous Compensation , earlier.

If your retirement pay is based on age or length of service, it’s taxable and must be included in your income as a pension on lines 5a and 5b of Form 1040 or 1040-SR. Don’t include in your income the amount of any reduction in retirement or retainer pay to provide a survivor annuity for your spouse or children under the Retired Serviceman's Family Protection Plan or the Survivor Benefit Plan.

For a more detailed discussion of survivor annuities, see Pub. 575.

If you're retired on disability, see Military and Government Disability Pensions under Sickness and Injury Benefits , later.

If you received a QRD of all or part of the balance in your health FSA because you're a reservist and you have been ordered or called to active duty for a period of 180 days or more, the QRD is treated as wages and is reportable on Form W-2.

Don’t include in your income any veterans' benefits paid under any law, regulation, or administrative practice administered by the Department of Veterans Affairs (VA). The following amounts paid to veterans or their families aren't taxable.

Education, training, and subsistence allowances.

Disability compensation and pension payments for disabilities paid either to veterans or their families.

Grants for homes designed for wheelchair living.

Grants for motor vehicles for veterans who lost their sight or the use of their limbs.

Veterans' insurance proceeds and dividends paid either to veterans or their beneficiaries, including the proceeds of a veteran's endowment policy paid before death.

Interest on insurance dividends left on deposit with the VA.

Benefits under a dependent-care assistance program.

The death gratuity paid to a survivor of a member of the U.S. Armed Forces who died after September 10, 2001.

Payments made under the compensated work therapy program.

Any bonus payment by a state or political subdivision because of service in a combat zone.

If, in a previous year, you received a bonus payment by a state or political subdivision because of service in a combat zone that you included in your income, you can file a claim for refund of the taxes on that income. Use Form 1040-X to file the claim. File a separate form for each tax year involved. In most cases, you must file your claim within 3 years after the date you filed your original return or within 2 years after the date you paid the tax, whichever is later. See the Instructions for Form 1040-X for information on filing that form.

The tax treatment of amounts you receive as a volunteer is covered in the following discussions.

Living allowances you receive as a Peace Corps volunteer or volunteer leader for housing, utilities, household supplies, food, and clothing are exempt from tax.

The following allowances must be included in your income and reported as wages.

Allowances paid to your spouse and minor children while you're a volunteer leader training in the United States.

Living allowances designated by the Director of the Peace Corps as basic compensation. These are allowances for personal items such as domestic help, laundry and clothing maintenance, entertainment and recreation, transportation, and other miscellaneous expenses.

Leave allowances.

Readjustment allowances or termination payments. These are considered received by you when credited to your account.

Example 18.

You are a Peace Corps volunteer and get $175 a month as a readjustment allowance during your period of service, to be paid to you in a lump sum at the end of your tour of duty. Although the allowance isn't available to you until the end of your service, you must include it in your income on a monthly basis as it’s credited to your account.

If you're a VISTA volunteer, you must include meal and lodging allowances paid to you in your income as wages.

Don’t include in your income amounts you receive for supportive services or reimbursements for out-of-pocket expenses from the following programs.

Retired Senior Volunteer Program (RSVP).

Foster Grandparent Program.

Senior Companion Program.

If you receive amounts for supportive services or reimbursements for out-of-pocket expenses from SCORE, don't include these amounts in gross income.

Don’t include in your income any reimbursements you receive for transportation, meals, and other expenses you have in training for, or actually providing, volunteer federal income tax counseling for the elderly (TCE).

You can deduct as a charitable contribution your unreimbursed out-of-pocket expenses in taking part in the volunteer income tax assistance (VITA) program.

If you are a volunteer firefighter or emergency medical responder, do not include in your income the following benefits you receive from a state or local government.

Rebates or reductions of property or income taxes you receive because of services you performed as a volunteer firefighter or emergency medical responder.

Payments you receive because of services you performed as a volunteer firefighter or emergency medical responder, up to $50 for each month you provided services.

The excluded income reduces any related tax or contribution deduction.

Business and Investment Income

This section provides information on the treatment of income from certain rents and royalties, and from interests in partnerships and S corporations.

You may be subject to the Net Investment Income Tax (NIIT). The NIIT is a 3.8% tax on the lesser of net investment income or the excess of your modified adjusted gross income (MAGI) over a threshold amount. For details, see Form 8960 and its instructions.

Rents From Personal Property

If you rent out personal property, such as equipment or vehicles, how you report your income and expenses is in most cases determined by:

Whether or not the rental activity is a business, and

Whether or not the rental activity is conducted for profit.

If you're in the business of renting personal property, report your income and expenses on Schedule C (Form 1040). The form instructions have information on how to complete them.

If you aren't in the business of renting personal property, report your rental income on Schedule 1 (Form 1040), line 8l.

If you rent personal property for profit, include your rental expenses in the total amount you enter on Schedule 1 (Form 1040), line 24b.

If you don't rent personal property for profit, your deductions are limited and you can't report a loss to offset other income. See Activity not for profit under Other Income , later.

Royalties from copyrights; patents; and oil, gas, and mineral properties are taxable as ordinary income.

In most cases, you report royalties on Schedule E (Form 1040). However, if you hold an operating oil, gas, or mineral interest or are in business as a self-employed writer, inventor, artist, etc., report your income and expenses on Schedule C (Form 1040).

Royalties from copyrights on literary, musical, or artistic works, and similar property, or from patents on inventions, are amounts paid to you for the right to use your work over a specified period of time. Royalties are generally based on the number of units sold, such as the number of books, tickets to a performance, or machines sold.

Royalty income from oil, gas, and mineral properties is the amount you receive when natural resources are extracted from your property. The royalties are generally based on production or revenue and are paid to you by a person or company who leases the property from you.

If you're the owner of an economic interest in mineral deposits or oil and gas wells, you can recover your investment through the depletion allowance.

Under certain circumstances, you can treat amounts you receive from the disposal of coal and iron ore as payments from the sale of a capital asset, rather than as royalty income. For information about gain or loss from the sale of coal and iron ore, see chapter 2 of Pub. 544.

If you sell your complete interest in oil, gas, or mineral rights, the amount you receive is considered payment for the sale of section 1231 property, not royalty income. Under certain circumstances, the sale is subject to capital gain or loss treatment as explained in the Instructions for Schedule D (Form 1040). For more information on selling section 1231 property, see chapter 3 of Pub. 544.

If you retain a royalty, an overriding royalty, or a net profit interest in a mineral property for the life of the property, you have made a lease or a sublease, and any cash you receive for the assignment of other interests in the property is ordinary income subject to a depletion allowance.

If you own mineral property but sell part of the future production, in most cases you treat the money you receive from the buyer at the time of the sale as a loan from the buyer. Don’t include it in your income or take depletion based on it.

When production begins, you include all the proceeds in your income, deduct all the production expenses, and deduct depletion from that amount to arrive at your taxable income from the property.

Partnership Income

A partnership generally isn't 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. For more information, see Pub. 541.

Your distributive share of partnership income, gains, losses, deductions, or credits is generally based on the partnership agreement. You must report your distributive share of these items on your return whether or not they are actually distributed to you. However, your distributive share of the partnership losses is limited to the adjusted basis of your partnership interest at the end of the partnership year in which the losses took place.

The partnership agreement usually covers the distribution of profits, losses, and other items. However, if the agreement doesn't state how a specific item of gain or loss will be shared, or the allocation stated in the agreement doesn't have substantial economic effect, your distributive share is figured according to your interest in the partnership.

Although a partnership generally pays no tax, it must file an information return on Form 1065. This shows the result of the partnership's operations for its tax year and the items that must be passed through to the partners.

You should receive from each partnership in which you're a member a copy of Schedule K-1 (Form 1065) showing your share of income, deductions, credits, and tax preference items of the partnership for the tax year. Keep Schedule K-1 for your records. Don’t attach it to your Form 1040 or 1040-SR, unless you're specifically required to do so.

You must generally report partnership items on your individual return the same way as they're reported on the partnership return. That is, if the partnership had a capital gain, you report your share as explained in the Instructions for Schedule D (Form 1040). You report your share of partnership ordinary income on Schedule E (Form 1040).

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.

S Corporation Income

In most cases, an S corporation doesn't 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. You must report your share of these items on your return. In most cases, the items passed through to you will increase or decrease the basis of your S corporation stock as appropriate.

An S corporation must file a return on Form 1120-S. This shows the results of the corporation's operations for its tax year and the items of income, losses, deductions, or credits that affect the shareholders' individual income tax returns.

You should receive a copy of Schedule K-1 (Form 1120-S) from any S corporation in which you're a shareholder. Schedule K-1 (Form 1120-S) shows your share of income, losses, deductions, and credits for the tax year. Keep Schedule K-1 (Form 1120-S) for your records. Don’t attach it to your Form 1040 or 1040-SR, unless you're specifically required to do so.

Your distributive share of the items of income, losses, deductions, or credits of the S corporation must be shown separately on your Form 1040 or 1040-SR. The character of these items is generally the same as if you had realized or incurred them personally.

In most cases, S corporation distributions are a nontaxable return of your basis in the corporation 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.

For more information, see the Instructions for Form 1120-S.

Sickness and Injury Benefits

In most cases, you must report as income any amount you receive for personal injury or sickness through an accident or health plan that is paid for by your employer. If both you and your employer pay for the plan, only the amount you receive that is due to your employer's payments is reported as income. However, certain payments may not be taxable to you. For information on nontaxable payments, see Military and Government Disability Pensions and Other Sickness and Injury Benefits , later in this discussion.

If you pay the entire cost of an accident or health plan, don't include any amounts you receive from the plan for personal injury or sickness as income on your tax return. If your plan reimbursed you for medical expenses you deducted in an earlier year, you may have to include some, or all, of the reimbursement in your income. See Recoveries under Miscellaneous Income , later.

In most cases, if you're covered by an accident or health insurance plan through a cafeteria plan, and the amount of the insurance premiums wasn't included in your income, you aren't considered to have paid the premiums and you must include any benefits you receive in your income. If the amount of the premiums was included in your income, you're considered to have paid the premiums and any benefits you receive aren't taxable.

Disability Pensions

If you retired on disability, you must include in income any disability pension you receive under a plan that is paid for by your employer. You must report your taxable disability payments on line 1h of Form 1040 or 1040-SR until you reach minimum retirement age. Minimum retirement age is generally the age at which you can first receive a pension or annuity if you aren't disabled.

Beginning on the day after you reach minimum retirement age, payments you receive are taxable as a pension or annuity. Report the payments on lines 5a and 5b of Form 1040 or 1040-SR. For more information on pensions and annuities, see Pub. 575.

Don’t include in your income disability payments you receive for injuries incurred as a direct result of terrorist attacks or military action directed against the United States (or its allies), whether outside or within the United States. In the case of the September 11 attacks, injuries eligible for coverage by the September 11 Victim Compensation Fund are treated as incurred as a direct result of the attack. However, you must include in your income any amounts that you received that you would have received in retirement had you not become disabled as a result of a terrorist attack or military action. Accordingly, you must include in your income any payments you receive from a 401(k), pension, or other retirement plan to the extent that you would have received the amount at the same or later time regardless of whether you had become disabled. See Pub. 907.

A terrorist action is one that is directed against the United States or any of its allies (including a multinational force in which the United States is participating). A military action is one that involves the U.S. Armed Forces and is a result of actual or threatened violence or aggression against the United States or any of its allies, but doesn't include training exercises.

Disability payments you receive for injuries not incurred as a direct result of a terrorist attack or military action or for illnesses or diseases not resulting from an injury incurred as a direct result of a terrorist attack or military action can't be excluded from your income under this provision but may be excludable for other reasons. See Pub. 907.

If you receive payments from a retirement or profit-sharing plan that doesn't provide for disability retirement, don't treat the payments as a disability pension. The payments must be reported as a pension or annuity.

If you retire on disability, any lump-sum payment you receive for accrued annual leave is a salary payment. The payment isn't a disability payment. Include it in your income in the tax year you receive it.

Military and Government Disability Pensions

Certain military and government disability pensions aren't taxable.

You may be able to exclude from income amounts you receive as a pension, annuity, or similar allowance for personal injury or sickness resulting from active service in one of the following government services.

The armed forces of any country.

The National Oceanic and Atmospheric Administration.

The Public Health Service.

The Foreign Service.

Don’t include the disability payments in your income if any of the following conditions apply.

You were entitled to receive a disability payment before September 25, 1975.

You were a member of a listed government service or its reserve component, or were under a binding written commitment to become a member, on September 24, 1975.

You receive the disability payments for a combat-related injury. This is a personal injury or sickness that:

Results directly from armed conflict;

Takes place while you're engaged in extra-hazardous service;

Takes place under conditions simulating war, including training exercises such as maneuvers; or

Is caused by an instrumentality of war.

You would be entitled to receive disability compensation from the VA if you filed an application for it. Your exclusion under this condition is equal to the amount you would be entitled to receive from the VA.

If you receive a disability pension based on years of service, in most cases, you must include it in your income. However, if the pension qualifies for the exclusion for a service-connected disability (discussed earlier), don't include in income the part of your pension that you would have received if the pension had been based on a percentage of disability. You must include the rest of your pension in your income.

If you retire from the U.S. Armed Forces based on years of service and are later given a retroactive service-connected disability rating by the VA, your retirement pay for the retroactive period is excluded from income up to the amount of VA disability benefits you would have been entitled to receive. You can claim a refund of any tax paid on the excludable amount (subject to the statute of limitations) by filing an amended return on Form 1040-X for each previous year during the retroactive period. You must include with each Form 1040-X a copy of the official VA determination letter granting the retroactive benefit. The letter must show the amount withheld and the effective date of the benefit.

Generally, the VA determination letter will contain a table with five headings. The table on the letter must cover the same dates for the tax year reported on the Form 1040-X. To calculate the correct tax reduction, multiply the Effective Months by the Amount Withheld for the tax year. For example, Form 1040-X filed for tax year 2020. The table shows the Amount Withheld effective December 2019 is $320.00. To calculate the amount for the tax reduction, multiply the 2020 Effective Months by the Amount Withheld. In this case, January–December (2020) is 12 months x $320.00 (Amount Withheld) = $3,840.00; this amount should be the amount claimed as a reduction on Line 1 Adjusted Gross Income (AGI), Column B, of the 2020 Form 1040-X.

If you receive a lump-sum disability severance payment and are later awarded VA disability benefits, exclude 100% of the severance benefit from your income. However, you must include in your income any lump-sum readjustment or other nondisability severance payment you received on release from active duty, even if you're later given a retroactive disability rating by the VA.

In most cases, under the statute of limitations a claim for credit or refund must be filed within 3 years from the time a return was filed. However, if you receive a retroactive service-connected disability rating determination, the statute of limitations is extended by a 1-year period beginning on the date of the determination. This 1-year extended period applies to claims for credit or refund filed after June 17, 2008, and doesn't apply to any tax year that began more than 5 years before the date of the determination.

Example 19.

You retired in 2017 and receive a pension based on your years of service. On August 3, 2023, you receive a determination of service-connected disability retroactive to 2017. Generally, you could claim a refund for the taxes paid on your pension for 2020, 2021, and 2022. However, under the special limitation period, you can also file a claim for 2019 as long as you file the claim by August 3, 2024. You can't file a claim for 2017 and 2018 because those tax years began more than 5 years before the determination.

Combat-related special compensation, as described under 10 U.S.C. section 1413a, is a specific entitlement payable to only retirees of the Uniformed Services. If you are in receipt of combat-related special compensation, you may exclude the amount of your combat-related special compensation from your income. Other portions of your military or disability retirement pay may still be included in your income.

Don’t include in your income disability payments you receive for injuries resulting directly from a terrorist or military action. In the case of the September 11 attacks, injuries eligible for coverage by the September 11 Victim Compensation Fund are treated as incurred as a direct result of the attack. However, you must include in your income any amounts that you received that you would have received in retirement had you not become disabled as a result of a terrorist or military action. Accordingly, you must include in your income any payments you receive from a 401(k), pension, or other retirement plan to the extent that you would have received the amount at the same or later time regardless of whether you had become disabled. Disability payments you receive for injuries not incurred as a direct result of a terrorist or military action or for illnesses or diseases not resulting from an injury incurred as a direct result of a terrorist or military action may be excludable from income for other reasons. See Pub. 907.

Long-Term Care Insurance Contracts

In most cases, long-term care insurance contracts are treated as accident and health insurance contracts. Amounts you receive from them (other than policyholder dividends or premium refunds) are excludable in most cases from income as amounts received for personal injury or sickness. To claim an exclusion for payments made on a per diem or other periodic basis under a long-term care insurance contract, you must file Form 8853 with your return.

A long-term care insurance contract is an insurance contract that only provides coverage for qualified long-term care services. The contract must:

Be guaranteed renewable;

Not provide for a cash surrender value or other money that can be paid, assigned, pledged, or borrowed;

Provide that refunds, other than refunds on the death of the insured or complete surrender or cancellation of the contract, and dividends under the contract may be used only to reduce future premiums or increase future benefits; and

In most cases, not pay or reimburse expenses incurred for services or items that would be reimbursed under Medicare, except where Medicare is a secondary payer or the contract makes per diem or other periodic payments without regard to expenses.

Qualified long-term care services are:

Necessary diagnostic, preventive, therapeutic, curing, treating, mitigating, rehabilitative services, and maintenance and personal care services; and

Required by a chronically ill individual and provided pursuant to a plan of care prescribed by a licensed health care practitioner.

A chronically ill individual is one who has been certified by a licensed health care practitioner within the previous 12 months as one of the following.

An individual who, for at least 90 days, is unable to perform at least two activities of daily living without substantial assistance due to a loss of functional capacity. Activities of daily living are eating, toileting, transferring, bathing, dressing, and continence.

An individual who requires substantial supervision to be protected from threats to health and safety due to severe cognitive impairment.

The exclusion for payments made on a per diem or other periodic basis under a long-term care insurance contract is subject to a limit. The limit applies to the total of these payments and any accelerated death benefits made on a per diem or other periodic basis under a life insurance contract because the insured is chronically ill. (For more information on accelerated death benefits, see Life Insurance Proceeds under Miscellaneous Income , later.)

Under this limit, the excludable amount for any period is figured by subtracting any reimbursement received (through insurance or otherwise) for the cost of qualified long-term care services during the period from the larger of the following amounts.

The cost of qualified long-term care services during the period.

The dollar amount for the period ($420 per day for any period in 2023).

Workers' Compensation

Amounts you receive as workers' compensation for an occupational sickness or injury are fully exempt from tax if they're paid under a workers' compensation act or a statute in the nature of a workers' compensation act. The exemption also applies to your survivors. The exemption, however, doesn't apply to retirement plan benefits you receive based on your age, length of service, or prior contributions to the plan, even if you retired because of an occupational sickness or injury.

If you return to work after qualifying for workers' compensation, salary payments you receive for performing light duties are taxable as wages.

If your disability pension is paid under a statute that provides benefits only to employees with service-connected disabilities, part of it may be workers' compensation. That part is exempt from tax. The rest of your pension, based on years of service, is taxable as pension or annuity income. If you die, the part of your survivors' benefit that is a continuation of the workers' compensation is exempt from tax.

Other Sickness and Injury Benefits

In addition to disability pensions and annuities, you may receive other payments for sickness or injury.

Payments you receive as sick pay under the Railroad Unemployment Insurance Act are taxable and you must include them in your income. However, don't include them in your income if they're for an on-the-job injury.

These payments are similar to workers' compensation and aren't taxable in most cases.

Payments received under FECA for personal injury or sickness, including payments to beneficiaries in case of death, aren't taxable. However, you're taxed on amounts you receive under FECA as continuation of pay for up to 45 days while a claim is being decided. Report this income on line 1a of Form 1040 or 1040-SR. Also, pay for sick leave while a claim is being processed is taxable and must be included in your income as wages.

For benefits and coverage provided after March 23, 2010, the value of any qualified Indian health care benefit isn't taxable. These benefits include any health service or benefits provided by the Indian Health Service, amounts to reimburse medical care expenses provided by an Indian tribe, coverage under accident or health insurance, and any other medical care provided by an Indian tribe.

Many other amounts you receive as compensation for sickness or injury aren't taxable. These include the following amounts.

Compensatory damages you receive for physical injury or physical sickness, whether paid in a lump sum or in periodic payments. See Court awards and damages under Other Income , later.

Benefits you receive under an accident or health insurance policy on which either you paid the premiums or your employer paid the premiums but you had to include them in your income.

Disability benefits you receive for loss of income or earning capacity as a result of injuries under a no-fault car insurance policy.

Compensation you receive for permanent loss or loss of use of a part or function of your body, or for your permanent disfigurement. This compensation must be based only on the injury and not on the period of your absence from work. These benefits aren't taxable even if your employer pays for the accident and health plan that provides these benefits.

A reimbursement for medical care is generally not taxable. However, it may reduce your medical expense deduction. If you receive reimbursement for an expense you deducted in an earlier year, see Recoveries , later.

If you receive an advance reimbursement or loan for future medical expenses from your employer without regard to whether you suffered a personal injury or sickness or incurred medical expenses, that amount is included in your income, whether or not you incur uninsured medical expenses during the year.

Reimbursements received under your employer's plan for expenses incurred before the plan was established are included in income.

Amounts you receive under a reimbursement plan that provides for the payment of unused reimbursement amounts in cash or other benefits are included in your income. For details, see Pub. 969.

Miscellaneous Income

This section discusses various types of income. You may have taxable income from certain transactions even if no money changes hands. For example, you may have taxable income if you lend money at a below-market interest rate or have a debt you owe canceled.

Bartering is an exchange of property or services. You must include in your income, at the time received, the FMV 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 FMV unless the value can be shown to be otherwise.

Generally, you report this income on Schedule C (Form 1040). However, if the barter involves an exchange of something other than services, such as in Example 23 , later, you may have to use another form or schedule instead.

Example 20.

You're 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 FMV of the shares in your income on Schedule C (Form 1040) in the year you receive them.

Example 21.

You're a self-employed accountant. You and a house painter are members of a barter club. Members contact each other directly and bargain for the value of the services to be performed. In return for accounting services you provided, the house painter painted your home. You must report as your income on Schedule C (Form 1040) the FMV of the house painting services you received. The house painter must include in income the FMV of the accounting services you provided.

Example 22.

You're 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 23.

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) the FMV of the artwork, and the artist must report as income on Schedule C (Form 1040) the fair rental value of the apartment.

If you exchanged property or services through a barter exchange, Form 1099-B or a similar statement from the barter exchange should be sent to you by February 15, 2024. It should show the value of cash, property, services, credits, or scrip you received from exchanges during 2023. The IRS will also receive a copy of Form 1099-B.

In most cases, the income you receive from bartering isn't subject to regular income tax withholding. However, backup withholding will apply in certain circumstances to ensure that income tax is collected on this income.

Under backup withholding, the barter exchange must withhold, as income tax, 24% of the income if:

You don't give the barter exchange your TIN, or

The IRS notifies the barter exchange that you gave it an incorrect TIN.

Canceled Debts

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's intended as a gift to you. A debt includes any indebtedness for which you're liable or which attaches to property you hold.

If the debt is a nonbusiness debt, report the canceled amount on Schedule 1 (Form 1040), line 8c. If it's a business debt, report the amount on Schedule C (Form 1040) or on Schedule F (Form 1040) if the debt is farm debt and you're a farmer.

Starting in 2014, you must include the income you elected to defer in 2009 or 2010 from a cancellation, reacquisition, or modification of a business debt. For information on this election, see Revenue Procedure 2009-37, available at IRS.gov/irb/2009-36_IRB#RP-2009-37 .

If a federal government agency, financial institution, or credit union cancels or forgives a debt you owe of $600 or more, you may receive a Form 1099-C. Form 1099-C, box 2, shows the amount of debt either actually or deemed discharged. If you don't agree with the amount reported in box 2, contact your creditor.

If any interest is forgiven and included in the amount of canceled debt in box 2, the amount of interest will also 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 if you paid it. See Deductible debt under Exceptions , later.

If the interest would not be deductible (such as interest on a personal loan), include in your income the amount from box 2 of Form 1099-C. 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).

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.

If you're personally liable for a mortgage (recourse debt), and you're relieved of the mortgage when you dispose of the property, you may realize gain or loss up to the FMV of the property. To the extent the mortgage discharge exceeds the FMV of the property, it's income from discharge of indebtedness unless it qualifies for exclusion under Excluded debt , later. Report any income from discharge of indebtedness on nonbusiness debt that doesn't qualify for exclusion as other income on Schedule 1 (Form 1040), line 8c.

If you aren't personally liable for a mortgage (nonrecourse debt), and you're 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 Pub. 4681 for more information.

If you're 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 Pub. 542.

If you're a stockholder in a corporation and you cancel a debt owed to you by the corporation, you generally don't 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.

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 1040-X if the statute of limitations for filing a claim is still open. The statute of limitations generally doesn't 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.

Generally, if you are responsible for making loan payments, and the loan is canceled or repaid by someone else, you must include the amount that was canceled or paid on your behalf in your gross income for tax purposes. However, in certain circumstances, you may be able to exclude amounts from gross income as a result of the cancellation or repayment of certain student loans. These exclusions are for:

Student loan cancellation due to meeting certain work requirements;

Cancellation of certain loans after December 31, 2020, and before January 1, 2026 (see Special rule for student loan discharges for 2021 through 2025 ); or

Certain student loan repayment assistance programs.

If your student loan is canceled in part or in whole in 2023 due to meeting certain work requirements, you may not have to include the canceled debt in your income. To qualify for this work-related exclusion, your loan must have been made by a qualified lender to assist you in attending an eligible educational organization described in section 170(b)(1)(A)(ii). In addition, the cancellation must be pursuant to a provision in the student loan that all or part of the debt will be canceled if you work:

For a certain period of time,

In certain professions, and

For any of a broad class of employers.

This is an educational organization that maintains a regular faculty and curriculum and normally has a regularly enrolled body of students in attendance at the place where it carries on its educational activities.

These include the following.

The United States, or an instrumentality or agency thereof.

A state or territory of the United States; or the District of Columbia; or any political subdivision thereof.

A public benefit corporation that is tax-exempt under section 501(c)(3); and that has assumed control of a state, county, or municipal hospital; and whose employees are considered public employees under state law.

An educational organization described in section 170(b)(1)(A)(ii), if the loan is made:

As part of an agreement with an entity described in (1), (2), or (3) under which the funds to make the loan were provided to the educational organization; or

Under a program of the educational organization that is designed to encourage its students to serve in occupations with unmet needs or in areas with unmet needs where services provided by the students (or former students) are for or under the direction of a governmental unit or a tax-exempt section 501(c)(3) organization.

The American Rescue Plan Act of 2021 modified the treatment of student loan forgiveness for discharges in 2021 through 2025. Generally, if you are responsible for making loan payments, and the loan is canceled or repaid by someone else, you must include the amount that was canceled or paid on your behalf in your gross income for tax purposes. However, in certain circumstances you may be able to exclude this amount from gross income if the loan was one of the following.

A loan for postsecondary educational expenses.

A private education loan.

A loan from an educational organization described in section 170(b)(1)(A)(ii).

A loan from an organization exempt from tax under section 501(a) to refinance a student loan.

This is any loan provided expressly for postsecondary education, regardless of whether provided through the educational organization or directly to the borrower, if such loan was made, insured, or guaranteed by one of the following.

An eligible educational organization.

An eligible educational organization is generally any accredited public, nonprofit, or proprietary (privately owned profit-making) college, university, vocational school, or other postsecondary educational organization. Also, the organization must be eligible to participate in a student aid program administered by the U.S. Department of Education.

An eligible educational organization also includes certain educational organizations located outside the United States that are eligible to participate in a student aid program administered by the U.S. Department of Education.

A private education loan is a loan provided by a private educational lender that:

Is not made, insured, or guaranteed under Title IV of the Higher Education Act of 1965; and

Is issued expressly for postsecondary educational expenses to a borrower, regardless of whether the loan is provided through the educational organization that the student attends or directly to the borrower from the private educational lender. A private education loan does not include an extension of credit under an open end consumer credit plan, a reverse mortgage transaction, a residential mortgage transaction, or any other loan that is secured by real property or a dwelling.

A private educational lender is one of the following.

A financial institution that solicits, makes, or extends private education loans.

A federal credit union that solicits, makes, or extends private education loans.

Any other person engaged in the business of soliciting, making, or extending private education loans.

This is any loan made by the organization if the loan is made:

As part of an agreement with an entity described earlier under which the funds to make the loan were provided to the educational organization; or

Under a program of the educational organization that is designed to encourage its students to serve in occupations with unmet needs or in areas with unmet needs where the services provided by the students (or former students) are for or under the direction of a governmental unit or a tax-exempt section 501(c)(3) organization.

This is any corporation, community chest, fund, or foundation organized and operated exclusively for one or more of the following purposes.

Charitable.

Educational.

Scientific.

Testing for public safety.

Fostering national or international amateur sports competition (but only if none of its activities involve providing athletic facilities or equipment).

The prevention of cruelty to children or animals.

In most cases, the cancellation of a student loan made by an educational organization because of services you performed for that organization or another organization that provided the funds for the loan must be included in gross income on your tax return.

If you refinanced a student loan with another loan from an eligible educational organization or a tax-exempt organization, that loan may also be considered as made by a qualified lender. The refinanced loan is considered made by a qualified lender if it’s made under a program of the refinancing organization that is designed to encourage students to serve in occupations with unmet needs or in areas with unmet needs where the services required of the students are for or under the direction of a governmental unit or a tax-exempt section 501(c)(3) organization.

Student loan repayments made to you are tax free if you received them for any of the following.

The National Health Service Corps (NHSC) Loan Repayment Program.

A state education loan repayment program eligible for funds under the Public Health Service Act.

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 (as determined by such state).

You don't 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 Pub. 334.

In most cases, if the seller reduces the amount of debt you owe for property you purchased, you don't have income from the reduction. The reduction of the debt is treated as a purchase price adjustment and reduces your basis in the property.

Don’t 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 Pub. 908.

The debt is canceled when you're insolvent. However, you can't exclude any amount of canceled debt that is more than the amount by which you're insolvent. See Pub. 908.

The debt is qualified farm debt and is canceled by a qualified person. See chapter 3 of Pub. 225.

The debt is qualified real property business debt. See chapter 5 of Pub. 334.

The cancellation is intended as a gift.

The debt is qualified principal residence indebtedness, discussed next.

This is debt secured by your principal residence that you took out to buy, build, or substantially improve your principal residence. QPRI can't be more than the cost of your principal residence plus improvements.

You must reduce the basis of your principal residence by the amount excluded from gross income. To claim the exclusion, you must file Form 982 with your tax return.

Your principal residence is the home where you ordinarily live most of the time. You can have only one principal residence at any one time.

The exclusion applies only to debt discharged after 2006 and in most cases before 2026. The maximum amount you can treat as QPRI is $750,000 ($375,000 if married filing separately). You can't exclude debt canceled because of services performed for the lender or on account of any other factor not directly related to a decline in the value of your residence or to your financial condition.

If only part of a loan is QPRI, the exclusion applies only to the extent the canceled amount is more than the amount of the loan immediately before the cancellation that isn't QPRI.

Example 24.

You file a joint return. Your principal residence is secured by a debt of $900,000, of which $700,000 is QPRI. Your residence is sold for $600,000 and $300,000 of debt is canceled. Only $100,000 of the canceled debt may be excluded from income (the $300,000 that was discharged minus the $200,000 of nonqualified debt).

The forgiveness of a PPP loan creates tax-exempt income, so although you don't need to report the income from the forgiveness of your PPP loan on Form 1040 or 1040-SR, you do need to report certain information related to your PPP loan.

Rev. Proc. 2021-48, 2021-49 I.R.B. 835, permits taxpayers to treat tax-exempt income resulting from the forgiveness of a PPP loan as received or accrued: (1) as, and to the extent that, eligible expenses are paid or incurred; (2) when you apply for forgiveness of the PPP loan; or (3) when forgiveness of the PPP loan is granted. If you have tax-exempt income resulting from the forgiveness of a PPP loan, attach a statement to your return reporting each taxable year for which you are applying Rev. Proc. 2021-48, and which section of Rev. Proc. 2021-48 you are applying—either section 3.01(1), (2), or (3). Any statement should include the following information for each PPP loan.

Your name, address, and ITIN or SSN;

A statement that you are applying or applied section 3.01(1), (2), or (3) of Rev. Proc. 2021-48, and for what taxable year;

The amount of tax-exempt income from forgiveness of the PPP loan that you are treating as received or accrued and for what taxable year; and

Whether forgiveness of the PPP loan has been granted as of the date you file your return.

Write “RP 2021-48” at the top of your attached statement.

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 FMV.

Your out-of-pocket party expenses are subject to the 50% limit for meal expenses. For tax years beginning after 2017, no deduction is allowed for any expenses related to activities generally considered entertainment, amusement, or recreation. Taxpayers may continue to deduct 50% of the cost of business meals if the taxpayer (or an employee of the taxpayer) is present and the food or beverages aren’t considered lavish or extravagant. The meals may be provided to a current or potential business customer, client, consultant, or similar business contact. Food and beverages that are provided during entertainment events won’t be considered entertainment if purchased separately from the event.

For more information about the limit for meal expenses, see 50% Limit in Pub. 463.

Life Insurance Proceeds

Life insurance proceeds paid to you because of the death of the insured person aren't 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 issued on or before December 31, 1984. However, interest income received as a result of life insurance proceeds may be taxable.

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 isn't specified, you include in your income the benefit payments that are more than the present value of the payments at the time of death.

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.

Example 25.

The face amount of the policy is $75,000 and, as beneficiary, you choose to receive 120 monthly installments of $1,000 each. The excluded part of each installment is $625 ($75,000 ÷ 120), or $7,500 for an entire year. The rest of each payment, $375 a month (or $4,500 for an entire year), is interest income to you.

If, as the beneficiary under an insurance contract, you're entitled to receive the proceeds in installments for the rest of your life without a refund or period-certain guarantee, you figure the excluded part of each installment by dividing the amount held by the insurance company by your life expectancy. If there is a refund or period-certain guarantee, the amount held by the insurance company for this purpose is reduced by the actuarial value of the guarantee.

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.

If you're the policyholder of an employer-owned life insurance contract, you must include in income any life insurance proceeds received that are more than the premiums and any other amounts you paid on the policy. You're subject to this rule if you have a trade or business, you own a life insurance contract on the life of your employee, and you (or a related person) are a beneficiary under the contract.

However, you may exclude the full amount of the life insurance proceeds if the following apply.

Before the policy is issued, you provide written notice about the insurance to the employee and the employee provides written consent to be insured.

The employee was your employee within the 12-month period before death, or, at the time the contract was issued, was a director or highly compensated employee; or

The amount is paid to the family or designated beneficiary of the employee.

If an insurance company pays you interest only on proceeds from life insurance left on deposit, the interest you're paid is taxable.

If your spouse died before October 23, 1986, and you chose to receive only the interest from your insurance proceeds, the $1,000 interest exclusion for a surviving spouse doesn't apply. If you later decide to receive the proceeds from the policy in installments, you can take the interest exclusion from the time you begin to receive the installments.

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 weren’t included in your income.

You should receive a Form 1099-R showing the total proceeds and the taxable part. Report these amounts on lines 5a and 5b of Form 1040 or 1040-SR.

In most cases, a split-dollar life insurance arrangement is an arrangement between an owner and a nonowner of a life insurance contract under which either party to the arrangement pays all or part of the premiums, and one of the parties paying the premiums is entitled to recover all or part of those premiums from the proceeds of the contract. There are two mutually exclusive rules to tax split-dollar life insurance arrangements.

Under the economic benefit rule, the owner of the life insurance contract is treated as providing current life insurance protection and other taxable economic benefits to the nonowner of the contract.

Under the loan rule, the nonowner of the life insurance contract is treated as loaning premium payments to the owner of the contract.

An endowment contract is a policy under which you're 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 (investment in the contract) 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 payment that is more than your cost in your income.

Endowment proceeds that you choose to receive in installments instead of a lump sum payment at the maturity of the policy are taxed as an annuity. This is explained in Pub. 575. For this treatment to apply, you must choose to receive the proceeds in installments before receiving any part of the lump sum. This election must be made within 60 days after the lump-sum payment first becomes payable to you.

Accelerated Death Benefits

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.

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.

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.

If the insured is a chronically ill individual who isn't 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. For 2023, this limit is $420. It 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 , earlier.

The exclusion doesn't 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.

To claim an exclusion for accelerated death benefits made on a per diem or other periodic basis, you must file Form 8853 with your return. You don't have to file Form 8853 to exclude accelerated death benefits paid on the basis of actual expenses incurred.

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 itemized deductions. You may also have recoveries of nonitemized deductions (such as payments on previously deducted bad debts) and recoveries of items for which you previously claimed a tax credit.

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.

Refunds of federal income taxes aren't included in your income because they're never allowed as a deduction from income.

If you received a state or local income tax refund (or credit or offset) in 2023, you must generally include it in income if you deducted the tax in an earlier year. The payer should send Form 1099-G to you by January 31, 2024. The IRS will also receive a copy of the Form 1099-G. If you file Form 1040 or 1040-SR, use the worksheet in the 2023 Instructions for Schedule 1 (Form 1040) to figure the amount (if any) to include in your income. See Itemized Deduction Recoveries , later, for when you must use Worksheet 2 , later in this publication.

If you could choose to deduct for a tax year either:

State and local income taxes, or

State and local general sales taxes, then

For 2022, you can choose a $10,000 state income tax deduction or a $9,000 state general sales tax deduction. You choose to deduct the state income tax. In 2023, you receive a $2,500 state income tax refund. The maximum refund that you may have to include in income is $1,000, because you could have deducted $9,000 in state general sales tax.

For 2022, you can choose a $9,500 state general sales tax deduction based on actual expenses or a $9,200 state income tax deduction. You choose to deduct the general sales tax deduction. In 2023, you return an item you had purchased and receive a $500 sales tax refund. In 2023, you also receive a $1,500 state income tax refund. The maximum refund that you may have to include in income is $500, because it's less than the excess of the tax deducted ($9,500) over the tax you didn't choose to deduct ($9,200 − $1,500 = $7,700). Because you didn't choose to deduct the state income tax, you don't include the state income tax refund in income.

If you received a refund or credit in 2023 of mortgage interest paid in an earlier year, the amount should be shown in Form 1098, box 4. Don’t subtract the refund amount from the interest you paid in 2023. You may have to include it in your income under the rules explained in the following discussions.

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, 1040-SR, or 1040-NR, line 2b.

If the refund or other recovery and the expense occur in the same year, the recovery reduces the deduction or credit and isn't reported as income.

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.

Example 28.

You paid 2022 estimated state income tax of $4,000 in four equal payments. You made your fourth payment in January 2023. You had no state income tax withheld during 2022. In 2023, you received a $400 tax refund based on your 2022 state income tax return. You claimed itemized deductions each year on Schedule A (Form 1040).

You must allocate the $400 refund between 2022 and 2023, the years in which you paid the tax on which the refund is based. You paid 75% ($3,000 ÷ $4,000) of the estimated tax in 2022, so 75% of the $400 refund, or $300, is for amounts you paid in 2022 and is a recovery item. If all of the $300 is a taxable recovery item, you'll include $300 on Schedule 1 (Form 1040), line 1, for 2023, and attach a copy of your calculation showing why that amount is less than the amount shown on the Form 1099-G you received from the state.

The balance ($100) of the $400 refund is for your January 2023 estimated tax payment. When you figure your deduction for state and local income taxes paid during 2023, you'll reduce the $1,000 paid in January by $100. Your deduction for state and local income taxes paid during 2023 will include the January net amount of $900 ($1,000 − $100), plus any estimated state income taxes paid in 2023 for 2023, and any state income tax withheld during 2023.

If you filed a joint state or local income tax return in an earlier year and you aren't filing a joint Form 1040 or 1040-SR with the same person for 2023, any refund of a deduction claimed on that state or local income tax return must be allocated to the person that paid the expense. If both persons paid a portion of the expense, allocate the refund based on your individual portion. For example, if you paid 25% of the expense, then you would use 25% of the refund to figure if you must include any portion of the refund in your income.

For the rules that apply to RDPs who are domiciled in community property states, see Pub. 555 and Form 8958.

If you didn't itemize deductions for the year for which you received the recovery of an expense that was deductible only if you itemized, don't include any of the recovery amount in your income.

Example 29.

You claimed the standard deduction on your 2022 federal income tax return. In 2023, you received a refund of your 2022 state income tax. Don’t report any of the refund as income because you didn't itemize deductions for 2022.

Itemized Deduction Recoveries

The following discussion explains how to determine the amount to include in your income from a recovery of an amount deducted in an earlier year as an itemized deduction. However, you generally don't need to use this discussion if you file Form 1040 or 1040-SR and the recovery is for state or local income taxes paid in 2022. Instead, use the State and Local Income Tax Refund Worksheet—Schedule 1, Line 1, in the 2023 Instructions for Schedule 1 (Form 1040) for line 1 to figure the amount (if any) to include in your income. See the Instructions for Forms 1040 and 1040-SR.

You can't use the State and Local Income Tax Refund Worksheet—Schedule 1, Line 1, and must use this discussion if you're a nonresident alien (discussed later) or any of the following statements are true.

You received a refund in 2023 that is for a tax year other than 2022.

You received a refund other than an income tax refund, such as a general sales tax or real property tax refund, in 2023 of an amount deducted or credit claimed in an earlier year.

The amount on your 2022 Form 1040, line 13, was more than the amount on your 2022 Form 1040, line 11 minus line 12.

You had taxable income on your 2022 Form 1040, line 15, but no tax on your Form 1040, line 16, because of the 0% tax rate on net capital gains and qualified dividends in certain situations. See Capital gains , later.

Your 2022 state and local income tax refund is more than your 2022 state and local income tax deduction minus the amount you could have deducted as your 2022 state and local general sales taxes.

You made your last payment of 2022 estimated state or local income tax in 2023.

You owed AMT in 2022.

You couldn't use the full amount of credits you were entitled to in 2022 because the total credits were more than the amount shown on your 2022 Form 1040, line 18.

You could be claimed as a dependent by someone else in 2022.

You received a refund because of a jointly filed state or local income tax return, but you aren't filing a joint 2023 Form 1040 or 1040-SR with the same person.

If you're a nonresident alien and file Form 1040-NR, you can't claim the standard deduction. If you recover an itemized deduction that you claimed in an earlier year, you must generally include the full amount of the recovery in your income in the year you receive it. However, if you had no taxable income in that earlier year (see Negative taxable income , later), you should complete Worksheet 2 to determine the amount you must include in income. If any other statement under Total recovery included in income isn't true, see the discussion referenced in the statement to determine the amount to include in income.

If you determined your tax in the earlier year by using the Schedule D Tax Worksheet, or the Qualified Dividends and Capital Gain Tax Worksheet, and you receive a refund in 2023 of a deduction claimed in that year, you'll have to refigure your tax for the earlier year to determine if the recovery must be included in your income. If inclusion of the recovery doesn't change your total tax, you don't include the recovery in income. However, if your total tax increases by any amount, you must include the recovery in your income up to the amount of the deduction that reduced your tax in the earlier year.

If you recover any itemized deduction that you claimed in an earlier year, you must generally include the full amount of the recovery in your income in the year you receive it. This rule applies if, for the earlier year, all of the following statements are true.

Your itemized deductions exceeded the standard deduction by at least the amount of the recovery. (If your itemized deductions didn't exceed the standard deduction by at least the amount of the recovery, see Standard deduction limit , later.)

You had taxable income. (If you had no taxable income, see Negative taxable income , later.)

Your deduction for the item recovered equals or exceeds the amount recovered. (If your deduction was less than the amount recovered, see Recovery limited to deduction , later.)

You had no unused tax credits. (If you had unused tax credits, see Unused tax credits , later.)

You weren’t subject to AMT. (If you were subject to AMT, see Subject to AMT , later.)

If any of the earlier statements aren’t true, see Total recovery not included in income , later.

In addition to the previous five items, you must include in your income the full amount of a refund of state or local income tax or general sales tax if the excess of the tax you deducted over the tax you didn't deduct is more than the refund of the tax deducted.

If the refund is more than the excess, see Total recovery not included in income , later.

Enter your state or local income tax refund on Schedule 1 (Form 1040), line 1, and the total of all other recoveries as other income on Schedule 1 (Form 1040), line 8z.

Example 30.

For 2022, you filed a joint return on Form 1040. Your taxable income was $60,000 and you weren’t entitled to any tax credits. Your standard deduction was $25,900, and you had itemized deductions of $27,400. In 2023, you received the following recoveries for amounts deducted on your 2022 return.

None of the recoveries were more than the deductions taken for 2022. The difference between the state and local income tax you deducted and your local general sales tax you could have deducted was more than $400.

Your total recoveries are less than the amount by which your itemized deductions exceeded the standard deduction ($27,400 − $25,900 = $1,500), so you must include your total recoveries in your income for 2023. Report the state and local income tax refund of $400 on Schedule 1 (Form 1040), line 1, and the balance of your recoveries, $525, on Schedule 1 (Form 1040), line 8z.

If one or more of the five statements listed earlier under Total recovery included in income isn't true, you may be able to exclude at least part of the recovery from your income. See the discussion referenced in the statement. You may be able to use Worksheet 2 to determine the part of your recovery to include in your income. You can also use Worksheet 2 to determine the part of a state tax refund (discussed earlier) to include in income.

If you aren't required to include all of your recoveries in your income, and you have both a state income tax refund and other itemized deduction recoveries, you must allocate the taxable recoveries between the state income tax refund you report on Schedule 1 (Form 1040 or 1040-NR), line 1, and the amount you report as other income on Schedule 1 (Form 1040 or 1040-NR), line 8z. If you don't use Worksheet 2 , make the allocation as follows.

Divide your state income tax refund by the total of all your itemized deduction recoveries.

Multiply the amount of taxable recoveries by the percentage in (1). This is the amount you report as a state income tax refund.

Subtract the result in (2) above from the amount of taxable recoveries. This is the amount you report as other income.

Example 31.

In 2023, you recovered $2,500 of your 2022 itemized deductions claimed on Schedule A (Form 1040), but the recoveries you must include in your 2023 income are only $1,500. Of the $2,500 you recovered, $500 was due to your state income tax refund. Your state income tax was more than your state general sales tax by $600. The amount you report as a state tax refund on Schedule 1 (Form 1040), line 1, is $300 [($500 ÷ $2,500) × $1,500]. The balance of the taxable recoveries, $1,200, is reported as other income on Schedule 1 (Form 1040), line 8z.

You are generally allowed to claim the standard deduction if you don't itemize your deductions. Only your itemized deductions that are more than your standard deduction are subject to the recovery rule (unless you're required to itemize your deductions). If your total deductions on the earlier year return weren’t 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.

To determine if amounts recovered in the current year 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. If you filed Form 1040-NR, you couldn't claim the standard deduction except for certain nonresident aliens from India (see Pub. 519).

Example 32.

You filed a joint return on Form 1040 for 2022 with taxable income of $45,000. Your itemized deductions were $26,150. The standard deduction that you could have claimed was $25,900. In 2023, you recovered $2,100 of your 2022 itemized deductions. None of the recoveries were more than the actual deductions for 2022. Include $250 of the recoveries in your 2023 income. This is the smaller of your recoveries ($2,100) or the amount by which your itemized deductions were more than the standard deduction ($26,150 − $25,900 = $250).

If your taxable income for the prior year ( Worksheet 2 , line 10) was a negative amount, the recovery you must include in income is reduced by that amount. You have a negative taxable income for 2022 if your:

Form 1040, the sum of lines 12 and 13, was more than line 11; or

Form 1040-NR, line 14, was more than line 11.

Example 33.

The facts are the same as in Example 32 , except line 14 was $200 more than line 11 on your 2022 Form 1040, giving you a negative taxable income of $200. You must include $50 in your 2023 income, rather than $250.

You don't include in your income any amount of your recovery that is more than the amount you deducted in the earlier year. The amount you include in your income is limited to the smaller of:

The amount deducted, or

The amount recovered.

Example 34.

For 2022, you paid $1,700 for medical expenses. Because of the limit on deducting medical expenses, you deducted only $200 as an itemized deduction. In 2023, you received a $500 reimbursement from your medical insurance for your 2022 expenses. The only amount of the $500 reimbursement that must be included in your income for 2023 is $200, the amount actually deducted.

Overall limitation on itemized deductions no longer applies.

For tax years beginning after 2017, there is no limitation on itemized deductions based on your AGI.

To determine the part of the recovery you must include in income, follow the two steps below.

Figure the greater of:

The standard deduction for the earlier year, or

The amount of itemized deductions you would have been allowed for the earlier year if you had figured them using only the net amount of the recovery item. The net amount is the amount you actually paid reduced by the recovery amount.

Note. If you were required to itemize your deductions in the earlier year, use step 1b and not step 1a.

Subtract the amount in step 1 from the amount of itemized deductions actually allowed in the earlier year after applying the limit on itemized deductions.

If you had unused tax credits in the earlier year, see Unused tax credits , later.

For more information on this calculation, see Revenue Ruling 93-75. This ruling is in Cumulative Bulletin 1993-2.

If you recover an item deducted in an earlier year in which you had unused tax credits, you must refigure the earlier year's tax to determine if you must include the recovery in your income. To do this, add the amount of the recovery to your earlier year's taxable income and refigure the tax and the credits on the refigured amount. If the refigured tax, after application of the credits, is more than the actual tax in the earlier year, include the recovery in your income up to the amount of the deduction that reduced the tax in the earlier year. For this purpose, any increase to a credit carried over to the current year that resulted from deducting the recovered amount in the earlier year is considered to have reduced your tax in the earlier year. If the recovery is for an itemized deduction claimed in a year in which the deductions were limited, see Itemized deductions limited , earlier.

If your tax, after application of the credits, doesn't change, you didn't have a tax benefit from the deduction. Don’t include the recovery in your income.

Example 35.

In 2022, you filed as head of household and itemized your deductions on Schedule A (Form 1040). Your taxable income was $5,260 and your tax was $528. You claimed a child care credit of $1,200. The credit reduced your tax to zero, and you had an unused tax credit of $672 ($1,200 − $528). In 2023, you recovered $1,000 of your itemized deductions. You reduce your 2022 itemized deductions by $1,000 and refigure that year's tax on taxable income of $6,260. However, the child care credit exceeds the refigured tax of $628. Your tax liability for 2022 isn't changed by reducing your deductions by the recovery. You didn't have a tax benefit from the recovered deduction and don’t include any of the recovery in your income for 2023.

If you were subject to the AMT in the year of the deduction, you'll have to refigure your tax for the earlier year to determine if the recovery must be included in your income. This will require a refiguring of your regular tax, as shown in Example 35 , and a refiguring of your AMT. If inclusion of the recovery doesn't change your total tax, you don't include the recovery in your income. However, if your total tax increases by any amount, you received a tax benefit from the deduction and you must include the recovery in your income up to the amount of the deduction that reduced your tax in the earlier year.

Nonitemized Deduction Recoveries

This section discusses recovery of deductions other than itemized deductions.

If you recover an amount that you deducted in an earlier year when you were figuring your AGI, you must generally include the full amount of the recovery in your income in the year received.

If any part of the deduction you took for the recovered amount didn't reduce your tax, you may be able to exclude at least part of the recovery from your income. You must include the recovery in your income only up to the amount of the deduction that reduced your tax in the year of the deduction. (See Tax benefit rule , earlier.)

If your taxable income for the prior year was a negative amount, the recovery you must include in income is reduced by that amount. You have a negative taxable income for 2022 if your:

If you recover an item deducted in an earlier year in which you had unused tax credits, you must refigure the earlier year's tax to determine if you must include the recovery in your income. To do this, add the amount of the recovery to your earlier year's taxable income and refigure the tax and the credits on the refigured amount. If the refigured tax, after application of the credits, is more than the actual tax in the earlier year, include the recovery in your income up to the amount of the deduction that reduced the tax in the earlier year. For this purpose, any increase to a credit carried over to the current year that resulted from deducting the recovered amount in the earlier year is considered to have reduced your tax in the earlier year.

If you received a recovery in 2023 for an item for which you claimed a tax credit in an earlier year, you must increase your 2022 tax by the amount of the recovery, up to the amount by which the credit reduced your tax in the earlier year. You had a recovery if there was a downward price adjustment or similar adjustment on the item for which you claimed a credit.

This rule doesn't apply to the investment credit or the foreign tax credit. Recoveries of these credits are covered by other provisions of the law. See Pub. 514 or Form 4255 for details.

A sharing economy is one in which assets are shared between individuals for a fee, usually through the internet. For example, you rent out your car when you don’t need it, or you share your wi-fi account for a fee.

A gig economy is one in which a short-term contract or freelance work is the norm, as opposed to a permanent job. For example, you drive for a ride-sharing service, or work as a fitness trainer, babysitter, or tutor.

Generally, if you have income from sharing economy transactions, or you did gig work, you must include all income received whether you received a Form 1099-K, Payment Card and Third Party Network Transactions, or not. See the Instructions for Schedule C (Form 1040) and the Instructions for Schedule SE (Form 1040).

Survivor Benefits

In most cases, payments made by or for an employer because of an employee's death must be included in income. The following discussions explain the tax treatment of certain payments made to survivors. For additional information, see Pub. 559.

Lump-sum payments you receive from a decedent's employer as the surviving spouse or beneficiary may be accrued salary payments; distributions from employee profit-sharing, pension, annuity, or stock bonus plans; or other items that should be treated separately for tax purposes. The tax treatment of these lump-sum payments depends on the type of payment.

Salary or wages received after the death of the employee are usually ordinary income to you.

Lump-sum distributions from qualified employee retirement plans are subject to special tax treatment. For information on these distributions, see Pub. 575 (or Pub. 721 if you're the survivor of a federal employee or retiree).

If you're a survivor of a public safety officer who was killed in the line of duty, you can exclude from income any amount received as a survivor annuity on account of the death of a public safety officer killed in the line of duty.

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 Pub. 559.

Unemployment Benefits

The tax treatment of unemployment benefits you receive depends on the type of program paying the benefits.

Generally, you must include in income all unemployment compensation you receive. You should receive a Form 1099-G showing in box 1 the total unemployment compensation paid to you. In most cases, you enter unemployment compensation on Schedule 1 (Form 1040), line 7.

Unemployment compensation generally includes any amount received under an unemployment compensation law of the United States or of a state. It includes the following benefits.

Benefits paid by a state or the District of Columbia from the Federal Unemployment Trust Fund.

State unemployment insurance benefits.

Railroad unemployment compensation benefits.

Disability payments from a government program paid as a substitute for unemployment compensation. (Amounts received as workers' compensation for injuries or illness aren't unemployment compensation. See Workers' Compensation under Sickness and Injury Benefits , earlier.)

Trade readjustment allowances under the Trade Act of 1974.

Unemployment assistance under the Disaster Relief and Emergency Assistance Act of 1974.

Unemployment assistance under the Airline Deregulation Act of 1978 Program.

If you contribute to a governmental unemployment compensation program and your contributions aren't deductible, amounts you receive under the program aren't included as unemployment compensation until you recover your contributions. If you deducted all of your contributions to the program, the entire amount you receive under the program is included in your income.

If you repaid in 2023 unemployment compensation you received in 2023, subtract the amount you repaid from the total amount you received and enter the difference on Schedule 1 (Form 1040), line 7. On the dotted line next to your entry, enter “Repaid” and the amount you repaid. If you repaid unemployment compensation in 2023 that you included in your income in an earlier year and the amount is more than $3,000, you can deduct the amount repaid on Schedule A (Form 1040), line 16, if you itemize deductions or you can take a credit against your tax on Schedule 3 (Form 1040), line 13b. See Repayments , later.

You can choose to have federal income tax withheld from your unemployment compensation. To make this choice, complete Form W-4V and give it to the paying office. Tax will be withheld at 10% of your payment.

Benefits received from an employer-financed fund (to which the employees didn't contribute) aren't unemployment compensation. They're taxable as wages and are subject to withholding for income tax. They may be subject to social security and Medicare taxes. For more information, see Supplemental Unemployment Benefits in section 5 of Pub. 15-A. Report these payments on line 1a of Form 1040 or 1040-SR.

You may have to repay some of your supplemental unemployment benefits to qualify for trade readjustment allowances under the Trade Act of 1974. If you repay supplemental unemployment benefits in the same year you receive them, reduce the total benefits by the amount you repay. If you repay the benefits in a later year, you must include the full amount of the benefits in your income for the year you received them.

Deduct the repayment in the later year as an adjustment to gross income on Form 1040 or 1040-SR. Include the repayment on Schedule 1 (Form 1040), line 24e. If the amount you repay in a later year is more than $3,000, you may be able to take a credit against your tax for the later year instead of deducting the amount repaid. For information on this, see Repayments , later.

Unemployment benefit payments from a private (nonunion) fund to which you voluntarily contribute are taxable only if the amounts you receive are more than your total payments into the fund. Report the taxable amount on Schedule 1 (Form 1040), line 8z.

Benefits paid to you as an unemployed member of a union from regular union dues are included in your income on Schedule 1 (Form 1040), line 8z. However, if you contribute to a special union fund and your payments to the fund aren't deductible, the unemployment benefits you receive from the fund are includible in your income only to the extent they're more than your contributions.

Payments you receive from your employer during periods of unemployment, under a union agreement that guarantees you full pay during the year, are taxable as wages. Include them on line 1a of Form 1040 or 1040-SR.

Payments similar to a state's unemployment compensation may be made by the state to its employees who aren't covered by the state's unemployment compensation law. Although the payments are fully taxable, don't report them as unemployment compensation. Report these payments on Schedule 1 (Form 1040), line 8z.

Welfare and Other Public Assistance Benefits

Don’t include in your income governmental benefit payments from a public welfare fund based upon need, such as payments due to blindness. Payments from a state fund for the victims of crime shouldn't be included in the victims' incomes if they're in the nature of welfare payments. Don’t deduct medical expenses that are reimbursed by such a fund. You must include in your income any welfare payments that are compensation for services or that are obtained fraudulently.

Payments you receive from a state welfare agency for taking part in a work-training program aren't included in your income, as long as the payments (exclusive of extra allowances for transportation or other costs) don't total more than the public welfare benefits you would have received otherwise. If the payments are more than the welfare benefits you would have received, the entire amount must be included in your income as wages.

Payments you receive from a state agency under the RTAA must be included in your income. The state must send you Form 1099-G to advise you of the amount you should include in income. The amount should be reported on Schedule 1 (Form 1040), line 8z.

If you have a disability, you must include in income compensation you receive for services you perform unless the compensation is otherwise excluded. However, you don't include in income the value of goods, services, and cash that you receive, not in return for your services, but for your training and rehabilitation because you have a disability. Excludable amounts include payments for transportation and attendant care, such as interpreter services for the deaf, reader services for the blind, and services to help individuals with an intellectual disability do their work.

Don’t include post-disaster grants received under the Disaster Relief and Emergency Assistance Act in your income if the grant payments are made to help you meet necessary expenses or serious needs for medical, dental, housing, personal property, transportation, or funeral expenses. Don’t deduct casualty losses or medical expenses that are specifically reimbursed by these disaster relief grants. If you have deducted a casualty loss for the loss of your personal residence and you later receive a disaster relief grant for the loss of the same residence, you may have to include part or all of the grant in your taxable income. See Recoveries , earlier. Unemployment assistance payments under the Act are taxable unemployment compensation. See Unemployment compensation under Unemployment Benefits , earlier.

You can exclude from income any amount you receive that is a qualified disaster relief payment. A qualified disaster relief payment is an amount paid to you:

To reimburse or pay reasonable and necessary personal, family, living, or funeral expenses that result from a qualified disaster;

To reimburse or pay reasonable and necessary expenses incurred for the repair or rehabilitation of your home or repair or replacement of its contents to the extent it’s due to a qualified disaster;

By a person engaged in the furnishing or sale of transportation as a common carrier because of the death or personal physical injuries incurred as a result of a qualified disaster; or

By a federal, state, or local government, or agency or instrumentality in connection with a qualified disaster in order to promote the general welfare.

A qualified disaster is:

A disaster that results from a terrorist or military action;

A federally declared disaster; or

A disaster that results from an accident involving a common carrier, or from any other event, which is determined to be catastrophic by the Secretary of the Treasury or his or her delegate.

For amounts paid under item 4, a disaster is qualified if it's determined by an applicable federal, state, or local authority to warrant assistance from the federal, state, or local government, agency, or instrumentality.

You can also exclude from income any amount you receive that is a qualified disaster mitigation payment. Qualified disaster mitigation payments are commonly paid to you in the period immediately following damage to property as a result of a natural disaster. However, disaster mitigation payments are used to mitigate (reduce the severity of) potential damage from future natural disasters. They're paid to you through state and local governments based on the provisions of the Robert T. Stafford Disaster Relief and Emergency Assistance Act or the National Flood Insurance Act.

You can't increase the basis or adjusted basis of your property for improvements made with nontaxable disaster mitigation payments.

If you benefit from Pay-for-Performance Success Payments under HAMP, the payments aren't taxable.

If you receive or benefit from payments made under:

A State Housing Finance agency (State HFA) Hardest Hit Fund program in which program payments can be used to pay mortgage interest, or

An Emergency Homeowners' Loan Program (EHLP) administered by the Department of Housing and Urban Development (HUD) or a state,

The Homeowner Assistance Fund (HAF) program in which program payments are used to provide financial assistance to eligible homeowners for purposes of paying certain expenses related to their principal residence to prevent mortgage delinquencies, defaults, foreclosures, loss of utilities or home energy services, and also displacements of homeowners experiencing financial hardship after January 21, 2020,

For more details about the HAF program, go to Home.Treasury.gov/Policy-Issues/Coronavirus/Assistance-for-State-Local-and-Tribal-Governments/Homeowner-Assistance-Fund .

If you are a tribal member and wish more details about the HAF program, go to IRS.gov/Newsroom/FAQs-for-Payments-by-Indian-Tribal-Governments-and-Alaska-Native-Corporations-to-Individuals-Under-Covid-Relief-Legislation .

Payments made under section 235 of the National Housing Act for mortgage assistance aren't included in the homeowner's income. Interest paid for the homeowner under the mortgage assistance program can't be deducted.

Replacement housing payments made under the Uniform Relocation Assistance and Real Property Acquisition Policies Act for Federal and Federally Assisted Programs aren't includible in gross income, but are includible in the basis of the newly acquired property.

A relocation payment under section 105(a)(11) of the Housing and Community Development Act made by a local jurisdiction to a displaced individual moving from a flood-damaged residence to another residence isn't includible in gross income. Home rehabilitation grants received by low-income homeowners in a defined area under the same Act are also not includible in gross income.

Nonreimbursable grants under title IV of the Indian Financing Act of 1974 to Indians to expand profit-making Indian-owned economic enterprises on or near reservations aren't includible in gross income.

Gross income doesn't include the value of any Indian general welfare benefit. “Indian general welfare benefit” includes any payment made or services provided to or on behalf of a member (or any spouse or dependent of that member) of an Indian tribe or Alaska Native Corporation under an Indian tribal government program, but only if:

The program is administered under specified guidelines and doesn't discriminate in favor of members of the governing body of the Indian tribe or Alaska Native Corporation; and

The benefits provided under the program (a) are available to any tribal member who meets guidelines, (b) are for the promotion of general welfare, (c) aren't lavish or extravagant, and (d) aren't compensation for services.

Generally, any items of cultural significance, reimbursement of costs, or cash honorarium for participation in cultural or ceremonial activities for the transmission of tribal culture aren't treated as compensation for services.

The above exclusion was enacted by the Tribal General Welfare Exclusion Act of 2014, September 26, 2014. The exclusion applies to tax years for which the period of limitation on refund or credit under section 6511 has not expired (generally, within 3 years from the time the return was filed or 2 years from the time the tax was paid, whichever expires later). Additionally, a claim for the above exclusion will be allowed if made within 1 year of the enactment of the exclusion.

The enactment of the above exclusion generally codifies the exclusion afforded under Revenue Procedure 2014-35, June 4, 2014. See Revenue Procedure 2014-35 for more details.

Medicare benefits received under title XVIII of the Social Security Act aren't includible in the gross income of the individuals for whom they're paid. This includes basic (Part A (Hospital Insurance Benefits for the Aged)) and supplementary (Part B (Supplementary Medical Insurance Benefits for the Aged)).

The Social Security Administration (SSA) provides benefits such as old-age benefits, benefits to disabled workers, and benefits to spouses and dependents. These benefits may be subject to federal income tax depending on your filing status and other income. See Pub. 915 for more information. An individual originally denied benefits, but later approved, may receive a lump-sum payment for the period when benefits were denied (which may be prior years). See Pub. 915 for information on how to make a lump-sum election, which may reduce your tax liability. There are also other types of benefits paid by the SSA. However, SSI benefits and lump-sum death benefits (one-time payment to spouse and children of deceased) aren't subject to federal income tax. For more information on these benefits, go to SSA.gov .

If you received social security benefits during the year, you'll receive Form SSA-1099, Social Security Benefit Statement. An IRS Notice 703 will be enclosed with your Form SSA-1099. This notice includes a worksheet you can use to figure whether any of your benefits are taxable.

For an explanation of the information found on your Form SSA-1099, see Pub. 915.

If you received equivalent railroad retirement or special guaranty benefits during the year, you'll receive Form RRB-1099, Payments by the Railroad Retirement Board.

For an explanation of the information found on your Form RRB-1099, see Pub. 915.

If you're married and file a joint return, you and your spouse must combine your incomes and your social security and equivalent railroad retirement benefits when figuring whether any of your combined benefits are taxable. Even if your spouse didn't receive any benefits, you must add your spouse's income to yours when figuring if any of your benefits are taxable.

Use the worksheet in the Forms 1040 and 1040-SR instruction package to determine the amount of your benefits to include in your income. Pub. 915 also has worksheets you can use. However, you must use the worksheets in Pub. 915 if any of the following situations apply.

You received a lump-sum benefit payment during the year that is for one or more earlier years.

You exclude employer-provided adoption benefits or interest from qualified U.S. savings bonds.

You take the foreign earned income exclusion, the foreign housing exclusion or deduction, the exclusion of income from American Samoa, or the exclusion of income from Puerto Rico by bona fide residents of Puerto Rico.

You must use the special worksheets in Appendix B of Pub. 590-A to figure your taxable benefits and your IRA deduction if all of the following conditions apply.

You receive social security or equivalent railroad retirement benefits.

You have taxable compensation.

You contribute to your IRA.

You or your spouse is covered by a retirement plan at work.

If any of your benefits are taxable, you must use Form 1040 or 1040-SR to report the taxable part. Report your net benefits (as shown on your Forms SSA-1099 and RRB-1099) on line 6a of Form 1040 or 1040-SR. Report the taxable part on line 6b of Form 1040 or 1040-SR. If you elect to use the lump-sum election method, check the box on line 6c of Form 1040 or 1040-SR and see the instructions.

Food benefits you receive under the Nutrition Program for the Elderly aren't taxable. If you prepare and serve free meals for the program, include in your income as wages the cash pay you receive, even if you're also eligible for food benefits.

Payments made by a state to qualified people to reduce their cost of winter energy use aren't taxable.

Other Income

The following brief discussions are arranged in alphabetical order. Other income items briefly discussed below are referenced to publications that provide more information.

You must include on your return income from an activity from which you don't expect to make a profit. An example of this type of activity is a hobby or a farm you operate mostly for recreation and pleasure. Enter this income on Schedule 1 (Form 1040), line 8j. Deductions for expenses related to the activity are limited. They can't total more than the income you report and can be taken only if you itemize deductions on Schedule A (Form 1040).

If you received a payment from Alaska's mineral income fund (Alaska Permanent Fund dividend), report it as income on Schedule 1 (Form 1040), line 8g. The state of Alaska sends each recipient a document that shows the amount of the payment with the check. The amount is also reported to the IRS.

Include in your income on Schedule 1 (Form 1040), line 2a, any taxable alimony payments you receive. Amounts you receive for child support aren't income to you. For complete information, see Pub. 504 and the Instructions for Forms 1040 and 1040-SR.

A below-market loan is a loan on which no interest is charged or on which the interest is charged at a rate below the applicable federal rate. If you make a below-market gift or demand loan, you must include the forgone interest (at the federal rate) as interest income on your return. These loans are considered a transaction in which you, the lender, are treated as having made:

A loan to the borrower in exchange for a note that requires the payment of interest at the applicable federal rate; and

An additional payment to the borrower, which the borrower transfers back to you as interest.

Contribution to capital,

Payment of compensation, or

Another type of payment.

For more information on below-market loans, see chapter 1 of Pub. 550.

If you receive a bribe, include it in your income.

These contributions aren't income to a candidate unless they're diverted to the candidate’s personal use. To be exempt from tax, the contributions must be spent for campaign purposes or kept in a fund for use in future campaigns. However, interest earned on bank deposits, dividends received on contributed securities, and net gains realized on sales of contributed securities are taxable and must be reported on Form 1120-POL. Excess campaign funds transferred to an office account must be included in the officeholder's income on Schedule 1 (Form 1040), line 8z, in the year transferred.

If you sell property (such as land or a residence) under a contract, but the contract is canceled and you return the buyer's money in the same tax year as the original sale, you have no income from the sale. If the contract is canceled and you return the buyer's money in a later tax year, you must include your gain in your income for the year of the sale. When you return the money and take back the property in the later year, you treat the transaction as a purchase that gives you a new basis in the property equal to the funds you return to the buyer.

Special rules apply to the reacquisition of real property where a secured indebtedness (mortgage) to the original seller is involved. For further information, see Repossession in Pub. 537.

Don’t include in your income amounts you receive from the passengers for driving a car in a carpool to and from work. These amounts are considered reimbursement for your expenses. However, this rule doesn't apply if you have developed carpool arrangements into a profit-making business of transporting workers for hire.

A cash rebate you receive from a dealer or manufacturer of an item you buy isn't income, but you must reduce your basis by the amount of the rebate.

Example 36.

You buy a new car for $24,000 cash and receive a $2,000 rebate check from the manufacturer. The $2,000 isn't income to you. Your basis in the car is $22,000. This is the basis on which you figure gain or loss if you sell the car, and figure depreciation if you use it for business.

You generally shouldn't report these reimbursements on your return unless you're figuring gain or loss from the casualty or theft. See Pub. 547.

If you're the beneficiary of a charitable gift annuity, you must include the yearly annuity or fixed percentage payment in your income.

The payer will report the types of income you received on Form 1099-R. Report the gross distribution from box 1 on Form 1040 or 1040-SR, line 5a, and the part taxed as ordinary income (box 2a minus box 3) on Form 1040 or 1040-SR, line 5b. Report the portion taxed as capital gain as explained in the Instructions for Schedule D (Form 1040).

You shouldn't report these payments on your return. See Pub. 504 for more information.

To determine if settlement amounts you receive by compromise or judgment must be included in your income, you must consider the item that the settlement replaces. The character of the income as ordinary income or capital gain depends on the nature of the underlying claim. Include the following as ordinary income.

Interest on any award.

Compensation for lost wages or lost profits in most cases.

Punitive damages in most cases. It doesn't matter if they relate to a physical injury or physical sickness.

Amounts received in settlement of pension rights (if you didn't contribute to the plan).

Damages for:

Patent or copyright infringement,

Breach of contract, or

Interference with business operations.

Back pay and damages for emotional distress received to satisfy a claim under title VII of the Civil Rights Act of 1964.

Attorney fees and costs (including contingent fees) where the underlying recovery is included in gross income.

Attorney fees and costs relating to whistleblower awards where the underlying recovery is included in gross income.

Don’t include in your income compensatory damages for personal physical injury or physical sickness (whether received in a lump sum or installments).

Emotional distress itself isn't a physical injury or physical sickness, but damages you receive for emotional distress due to a physical injury or sickness are treated as received for the physical injury or sickness. Don’t include them in your income.

If the emotional distress is due to a personal injury that isn't due to a physical injury or sickness (for example, unlawful discrimination or injury to reputation), you must include the damages in your income, except for any damages you receive for medical care due to that emotional distress. Emotional distress includes physical symptoms that result from emotional distress, such as headaches, insomnia, and stomach disorders.

You may be able to deduct attorney fees and court costs paid to recover a judgment or settlement for a claim of unlawful discrimination under various provisions of federal, state, and local law listed in section 62(e), a claim against the U.S. Government, or a claim under section 1862(b)(3)(A) of the Social Security Act. You can claim this deduction as an adjustment to income on Schedule 1 (Form 1040), line 24h. The following rules apply.

The attorney fees and court costs may be paid by you or on your behalf in connection with the claim for unlawful discrimination, the claim against the U.S. Government, or the claim under section 1862(b)(3)(A) of the Social Security Act.

The deduction you're claiming can't be more than the amount of the judgment or settlement you're including in income for the tax year.

The judgment or settlement to which your attorney fees and court costs apply must occur after October 22, 2004.

If you receive damages under a written binding agreement, court decree, or mediation award that was in effect (or issued on or before) September 13, 1995, don't include in income any of those damages received on account of personal injuries or sickness.

In most cases, if you receive benefits under a credit card disability or unemployment insurance plan, the benefits are taxable to you. These plans make the minimum monthly payment on your credit card account if you can't make the payment due to injury, illness, disability, or unemployment. Report on Schedule 1 (Form 1040), line 8z, the amount of benefits you received during the year that is more than the amount of the premiums you paid during the year.

If you purchase a home and receive assistance from a nonprofit corporation to make the down payment, that assistance isn't included in your income. If the corporation qualifies as a tax-exempt charitable organization, the assistance is treated as a gift and is included in your basis of the house. If the corporation doesn't qualify, the assistance is treated as a rebate or reduction of the purchase price and isn't included in your basis.

If you get a job through an employment agency, and the fee is paid by your employer, the fee isn't includible in your income if you aren't liable for it. However, if you pay it and your employer reimburses you for it, it’s includible in your income.

You can exclude from gross income any subsidy provided, either directly or indirectly, by public utilities for the purchase or installation of an energy conservation measure for a dwelling unit.

This includes installations or modifications that are primarily designed to reduce consumption of electricity or natural gas, or improve the management of energy demand.

This includes a house, apartment, condominium, mobile home, boat, or similar property. If a building or structure contains both dwelling and other units, any subsidy must be properly allocated.

An estate or trust, unlike a partnership, may have to pay federal income tax. If you're a beneficiary of an estate or trust, you may be taxed on your share of its income distributed or required to be distributed to you. However, there is never a double tax. Estates and trusts file their returns on Form 1041, and your share of the income is reported to you on Schedule K-1 (Form 1041).

If you're the beneficiary of an estate or trust that must distribute all of its current income, you must report your share of the distributable net income, whether or not you actually received it.

If you're the beneficiary of an estate or trust and the fiduciary has the choice of whether to distribute all or part of the current income, you must report all income that is required to be distributed to you, whether or not it's actually distributed, plus all other amounts actually paid or credited to you, up to the amount of your share of distributable net income.

Treat each item of income the same way that the estate or trust would treat it. For example, if a trust's dividend income is distributed to you, you report the distribution as dividend income on your return. The same rule applies to distributions of tax-exempt interest and capital gains.

The fiduciary of the estate or trust must tell you the type of items making up your share of the estate or trust income and any credits you're allowed on your individual income tax return.

Losses of estates and trusts generally aren't deductible by the beneficiaries.

Income earned by a grantor trust is taxable to the grantor, not the beneficiary, if the grantor keeps certain control over the trust. (The grantor is the one who transferred property to the trust.) This rule applies if the property (or income from the property) put into the trust will or may revert (be returned) to the grantor or the grantor's spouse.

Generally, a trust is a grantor trust if the grantor has a reversionary interest valued (at the date of transfer) at more than 5% of the value of the transferred property, or has certain other powers.

If your personal expenses are paid for by another person, such as a corporation, the payment may be taxable to you depending upon your relationship with that person and the nature of the payment. But if the payment makes up for a loss caused by that person, and only restores you to the position you were in before the loss, the payment isn't includible in your income.

Include in your income on Schedule 1 (Form 1040), line 8z, any qualified settlement income you receive as a qualified taxpayer. See Statement , later. Qualified settlement income is any interest and punitive damage awards that are:

Otherwise includible in taxable income, and

Received in connection with the civil action In re Exxon Valdez , No. 89-095-CV (HRH) (Consolidated) (D. Alaska).

You're a qualified taxpayer if you were a plaintiff in the civil action mentioned earlier or you were a beneficiary of the estate of your spouse or a close relative who was such a plaintiff and from whom you acquired the right to receive qualified settlement income.

The income can be received as a lump sum or as periodic payments. You'll receive a Form 1099-MISC showing the gross amount of the settlement income paid to you in the tax year.

If you're a qualified taxpayer, you can contribute all or part of your qualified settlement income, up to $100,000, to an eligible retirement plan, including an IRA. Contributions to eligible retirement plans, other than a Roth IRA or a designated Roth account, reduce the qualified settlement income that you must include in income. See Statement , later. For more information on these contributions, see Pubs. 575 and 590-A.

For tax years after 2017, you can no longer deduct legal expenses that were subject to the 2%-of-adjusted-gross-income floor. If the qualified settlement income was received in connection with your trade or business (other than as an employee), you can reduce the taxable amount of qualified settlement income by these expenses.

If you report on Schedule 1 (Form 1040), line 8z, qualified settlement income that is less than the gross amount shown on Form 1099-MISC, you must attach a statement to your tax return. The statement must identify and show the gross amount of the qualified settlement income, the reductions for the amount contributed to an eligible retirement plan, and the net amount.

For purposes of the income averaging rules that apply to an individual engaged in a farming or fishing business, qualified settlement income is treated as attributable to a fishing business for the tax year in which it's received. See Schedule J (Form 1040) and its instructions for more information.

Include all fees for your services in your income. Examples of these fees are amounts you receive for services you perform as:

A corporate director;

An executor, administrator, or personal representative of an estate;

A manager of a trade or business you operated before declaring chapter 11 bankruptcy;

A notary public; or

An election precinct official.

Corporate director fees are self-employment income. Report these payments on Schedule C (Form 1040).

All personal representatives must include in their gross income fees paid to them from an estate. If you aren't in the trade or business of being an executor (for instance, you're the executor of a friend's or relative's estate), report these fees on Schedule 1 (Form 1040), line 8z. If you're in the trade or business of being an executor, report these fees as self-employment income on Schedule C (Form 1040). The fee isn't includible in income if it's waived.

Include in your income all payments received from your bankruptcy estate for managing or operating a trade or business that you operated before you filed for bankruptcy. Report this income on Schedule 1 (Form 1040), line 8z.

Report payments for these services on Schedule C (Form 1040). These payments aren't subject to self-employment tax. See the separate Instructions for Schedule SE (Form 1040) for details.

You should receive a Form W-2 showing payments for services performed as an election official or election worker. Report these payments on line 1a of Form 1040 or 1040-SR.

If you operate a daycare service and receive payments under the Child and Adult Care Food Program administered by the Department of Agriculture that aren't for your services, the payments aren't included in your income in most cases. However, you must include in your income any part of the payments you don't use to provide food to individuals eligible for help under the program.

If you have a gain on a personal foreign currency transaction because of changes in exchange rates, you don't have to include that gain in your income unless it's more than $200. If the gain is more than $200, report it as a capital gain.

Generally, payment you receive from a state, political subdivision, or a qualified foster care placement agency for caring for a qualified foster individual in your home is excluded from your income. However, you must include in your income payment to the extent it's received for the care of more than 5 qualified foster individuals age 19 years or older.

A qualified foster individual is a person who:

Is living in a foster family home; and

Was placed there by:

An agency of a state or one of its political subdivisions, or

A qualified foster care placement agency.

These are payments that are designated by the payer as compensation for providing the additional care that is required for physically, mentally, or emotionally handicapped qualified foster individuals. A state must determine that the additional compensation is needed, and the care for which the payments are made must be provided in the foster care provider's home in which the qualified foster individual was placed.

Certain Medicaid waiver payments are treated as difficulty-of-care payments when received by an individual care provider for caring for an eligible individual (whether related or unrelated) living in the provider's home. See Notice 2014-7, available at IRS.gov/irb/2014-4_IRB#NOT-2014-7 , and related questions and answers, available at IRS.gov/Individuals/Certain-Medicaid-Waiver-Payments-May-Be-Excludable-From-Income , for more information.

You must include in your income difficulty-of-care payments to the extent they're received for more than:

10 qualified foster individuals under age 19, or

Five qualified foster individuals age 19 or older.

If you're paid to maintain space in your home for emergency foster care, you must include the payment in your income.

If you receive payments that you must include in your income and you're in business as a foster care provider, report the payments on Schedule C (Form 1040). See Pub. 587 to help you determine the amount you can deduct for the use of your home.

If you find and keep property that doesn't belong to you that has been lost or abandoned (treasure trove), it's taxable to you at its FMV in the first year it's your undisputed possession.

If you received a free tour from a travel agency for organizing a group of tourists, you must include its value in your income. Report the FMV of the tour on Schedule 1 (Form 1040), line 8z, if you aren't in the trade or business of organizing tours. You can't deduct your expenses in serving as the voluntary leader of the group at the group's request. If you organize tours as a trade or business, report the tour's value on Schedule C (Form 1040).

You must include your gambling winnings in your income on Schedule 1 (Form 1040), line 8b. Winnings from fantasy sports leagues are gambling winnings. If you itemize your deductions on Schedule A (Form 1040), you can deduct gambling losses you had during the year, but only up to the amount of your winnings. If you're in the trade or business of gambling, use Schedule C (Form 1040). For tax years 2018 through 2025, professional gambling losses and expenses are limited to the amount of your winnings.

Winnings from lotteries and raffles are gambling winnings. In addition to cash winnings, you must include in your income the FMV of bonds, cars, houses, and other noncash prizes. However, the difference between the FMV and the cost of an oil and gas lease obtained from the government through a lottery isn't includible in income.

Generally, if you win a state lottery prize payable in installments, you must include in your gross income the annual payments and any amounts you receive designated as interest on the unpaid installments. If you sell future lottery payments for a lump sum, you must report the amount you receive from the sale as ordinary income (on Schedule 1 (Form 1040), line 8b) in the year you receive it.

You may have received a Form W-2G showing the amount of your gambling winnings and any tax taken out of them. Include the amount from box 1 on Schedule 1 (Form 1040), line 8b. Include the amount shown in box 4 on Form 1040 or 1040-SR, line 25c, as federal income tax withheld.

In most cases, property you receive as a gift, bequest, or inheritance isn't included in your income. However, if property you receive this way later produces income such as interest, dividends, or rents, that income is taxable to you. If property is given to a trust and the income from it is paid, credited, or distributed to you, that income is also taxable to you. If the gift, bequest, or inheritance is the income from the property, that income is taxable to you.

If you inherited a pension or an IRA, you may have to include part of the inherited amount in your income. See Survivors and Beneficiaries in Pub. 575 if you inherited a pension. See What if You Inherit an IRA? in Pubs. 590-A and 590-B if you inherited an IRA.

If you sell an interest in an expected inheritance from a living person, include the entire amount you receive in gross income on Schedule 1 (Form 1040), line 8z.

If you receive cash or other property as a bequest for services you performed while the decedent was alive, the value is taxable compensation.

If you received payments for lost wages or income, property damage, or physical injury due to the Gulf oil spill, the payment may be taxable.

Payments you received for lost wages, lost business income, or lost profits are taxable.

Payments you received for property damage aren't taxable if the payments aren't more than your adjusted basis in the property. If the payments are more than your adjusted basis, you'll realize a gain. If the damage was due to an involuntary conversion, you may defer the tax on the gain if you purchase qualified replacement property. See Pub. 544.

If the payments (including insurance proceeds) you received, or expect to receive, are less than your adjusted basis, you may be able to claim a casualty deduction. See Pub. 547.

Payments you received for personal physical injuries or physical sickness aren't taxable. This includes payments for emotional distress that is attributable to personal physical injuries or physical sickness. Payments for emotional distress that aren't attributable to personal physical injuries or physical sickness are taxable.

For the most recent guidance, go to IRS.gov and enter “Gulf Oil Spill” in the search box.

Don’t include in your income any payment you receive under the National Historic Preservation Act to preserve a historically significant property.

Losses from a hobby aren't deductible from other income. A hobby is an activity from which you don't expect to make a profit. See Activity not for profit , earlier, under Other Income.

Restitution payments you receive as a Holocaust victim (or the heir of a Holocaust victim) and interest earned on the payments aren't taxable. Excludable interest is earned by escrow accounts or settlement funds established for holding funds prior to the settlement. You also don't include the restitution payments and interest the funds earned prior to disbursement in any calculation in which you ordinarily would add excludable income to your AGI, such as the calculation to determine the taxable part of social security benefits. If the payments are made in property, your basis in the property is its FMV when you receive it.

Excludable restitution payments are payments or distributions made by any country or any other entity because of persecution of an individual on the basis of race, religion, physical or mental disability, or sexual orientation by Nazi Germany, any other Axis regime, or any other Nazi-controlled or Nazi-allied country, whether the payments are made under a law or as a result of a legal action. They include compensation or reparation for property losses resulting from Nazi persecution, including proceeds under insurance policies issued before and during World War II by European insurance companies.

Income from illegal activities, such as money from dealing illegal drugs, must be included in your income on Schedule 1 (Form 1040), line 8z, or on Schedule C (Form 1040) if from your self-employment activity.

If you're a member of a qualified Indian tribe that has fishing rights secured by treaty, executive order, or an Act of Congress as of March 17, 1988, don't include in your income amounts you receive from activities related to those fishing rights. The income isn't subject to income tax, self-employment tax, or employment taxes.

Amounts received by an individual Indian as a lump sum or periodic payment pursuant to the Class Action Settlement Agreement dated December 7, 2009, aren't included in gross income. This amount won't be used to figure AGI or MAGI in applying any Internal Revenue Code provision that takes into account excludable income.

In general, you exclude from your income the amount of interest earned on a frozen deposit. A deposit is frozen if, at the end of the calendar year, you can't withdraw any part of the deposit because:

The financial institution is bankrupt or insolvent, or

The state where the institution is located has placed limits on withdrawals because other financial institutions in the state are bankrupt or insolvent.

The amount of interest you exclude from income for the year is the interest that was credited on the frozen deposit for that tax year minus the sum of:

The net amount withdrawn from the deposit during that year, and

The amount that could have been withdrawn at the end of that tax year (not reduced by any penalty for premature withdrawals of a time deposit).

You may be able to exclude from income the interest from qualified U.S. savings bonds you redeem if you pay qualified higher education expenses in the same year. Qualified higher education expenses are those you pay for tuition and required fees at an eligible educational institution for you, your spouse, or your dependent. A qualified U.S. savings bond is a series EE bond issued after 1989 or a series I bond. The bond must have been issued to you when you were 24 years of age or older. For more information on this exclusion, see Education Savings Bond Program in chapter 1 of Pub. 550 and in chapter 10 of Pub. 970.

This interest is usually exempt from federal tax. However, you must show the amount of any tax-exempt interest on your federal income tax return. For more information, see State or Local Government Obligations in chapter 1 of Pub. 550.

If a prospective employer asks you to appear for an interview and either pays you an allowance or reimburses you for your transportation and other travel expenses, the amount you receive isn't taxable in most cases. You include in income only the amount you receive that is more than your actual expenses.

Jury duty pay you receive must be included in your income on Schedule 1 (Form 1040), line 8h. If you must give the pay to your employer because your employer continues to pay your salary while you serve on the jury, you can deduct the amount turned over to your employer as an adjustment to income. Enter the amount you repay your employer on Schedule 1 (Form 1040), line 24a.

You must include kickbacks, side commissions, push money, or similar payments you receive in your income on Schedule 1 (Form 1040), line 8z, or on Schedule C (Form 1040) if from your self-employment activity.

Example 37.

You sell cars and help arrange car insurance for buyers. Insurance brokers pay back part of their commissions to you for referring customers to them. You must include the kickbacks in your income.

You must include as other income on Schedule 1 (Form 1040), line 8z (or Schedule C (Form 1040) if you're self-employed), incentive payments from a manufacturer that you receive as a salesperson. This is true whether you receive the payment directly from the manufacturer or through your employer.

Example 38.

You sell cars for an automobile dealership and receive incentive payments from the automobile manufacturer every time you sell a particular model of car. You report the incentive payments on Schedule 1 (Form 1040), line 8z.

In most cases, you don't include in income amounts you withdraw from your Archer MSA or Medicare Advantage MSA if you use the money to pay for qualified medical expenses. Generally, qualified medical expenses are those you can deduct on Schedule A (Form 1040). For more information about Archer MSAs or Medicare Advantage MSAs, see Pub. 969.

For tax years beginning after 2017, reimbursements for certain moving expenses are no longer excluded from the gross income of nonmilitary taxpayers.

If you win a prize in a lucky number drawing, television or radio quiz program, beauty contest, or other event, you must include it in your income. For example, if you win a $50 prize in a photography contest, you must report this income on Schedule 1 (Form 1040), line 8i. If you refuse to accept a prize, don't include its value in your income.

Prizes and awards in goods or services must be included in your income at their FMV.

Cash awards or bonuses given to you by your employer for good work or suggestions must generally be included in your income as wages. However, certain noncash employee achievement awards can be excluded from income. See Bonuses and awards under Miscellaneous Compensation , earlier.

If you're a salesperson and receive prize points redeemable for merchandise that are awarded by a distributor or manufacturer to employees of dealers, you must include their FMV in your income. The prize points are taxable in the year they're paid or made available to you, rather than in the year you redeem them for merchandise.

If you were awarded a prize in recognition of accomplishments in religious, charitable, scientific, artistic, educational, literary, or civic fields, you must generally include the value of the prize in your income. However, you don't include this prize in your income if you meet all of the following requirements.

You were selected without any action on your part to enter the contest or proceeding.

You aren't required to perform substantial future services as a condition for receiving the prize or award.

The prize or award is transferred by the payer directly to a governmental unit or tax-exempt charitable organization as designated by you. The following conditions apply to the transfer.

You can't use the prize or award before it's transferred.

You should provide the designation before the prize or award is presented to prevent a disqualifying use. The designation should contain:

The purpose of the designation by making a reference to section 74(b)(3);

A description of the prize or award;

The name and address of the organization to receive the prize or award;

Your name, address, and TIN; and

Your signature and the date signed.

In the case of an unexpected presentation, you must return the prize or award before using it (or spending, depositing, or investing it, etc., in the case of money) and then prepare the statement as described in (b) above.

After the transfer, you should receive from the payer a written response stating when and to whom the designated amounts were transferred.

These rules don't apply to scholarship or fellowship awards. See Scholarships and fellowships , later.

Effective December 22, 2017, section 1400Z-2 provides a temporary deferral of inclusion in gross income for eligible gains invested in QOFs, and a stepped-up basis to fair market value of the investment in the QOF at time of sale or exchange, if the investment is held for at least 10 years. See the Form 8949 instructions on how to report your election to defer eligible gains invested in a QOF. See Form 8997, Initial and Annual Statement of Qualified Opportunity Fund (QOF) Investments, and its instructions for reporting information. For additional information, see Opportunity Zones Frequently Asked Questions, available at IRS.gov/Newsroom/Opportunity-Zones-Frequently-Asked-Questions .

A QTP (also known as a 529 program) is a program set up to allow you to either prepay or contribute to an account established for paying a student's qualified higher education expenses at an eligible educational institution. A program can be established and maintained by a state, an agency or instrumentality of a state, or an eligible educational institution.

The part of a distribution representing the amount paid or contributed to a QTP isn't included in income. This is a return of the investment in the program.

In most cases, the beneficiary doesn't include in income any earnings distributed from a QTP if the total distribution is less than or equal to adjusted qualified higher education expenses. See Pub. 970 for more information.

The following types of payments are treated as pension or annuity income and are taxable under the rules explained in Pub. 575.

Tier 1 railroad retirement benefits that are more than the social security equivalent benefit.

Tier 2 benefits.

Vested dual benefits.

If you receive a reward for providing information, include it in your income.

You may be able to exclude from income all or part of any gain from the sale or exchange of your main home. See Pub. 523.

If you sold an item you owned for personal use, such as a car, refrigerator, furniture, stereo, jewelry, or silverware, your gain is taxable as a capital gain. Report it as explained in the Instructions for Schedule D (Form 1040). You can't deduct a loss.

However, if you sold an item you held for investment, such as gold or silver bullion, coins, or gems, any gain is taxable as a capital gain and any loss is deductible as a capital loss.

You sold a painting on an online auction website for $100. You bought the painting for $20 at a garage sale years ago. Report your $80 gain as a capital gain as explained in the Instructions for Schedule D (Form 1040).

A candidate for a degree can exclude amounts received as a qualified scholarship or fellowship. A qualified scholarship or fellowship is any amount you receive that is for:

Tuition and fees required to enroll at or attend an eligible educational institution; or

Course-related expenses, such as fees, books, and equipment that are required for courses at the eligible educational institution. These items must be required of all students in your course of instruction.

Generally, you can't exclude from your gross income the part of any scholarship or fellowship that represents payment for teaching, research, or other services required as a condition for receiving the scholarship. This applies even if all candidates for a degree must perform the services to receive the degree.

You don't have to include in income the part of any scholarship or fellowship that represents payment for teaching, research, or other services if you receive the amount under:

The National Health Services Corps Scholarship Program,

The Armed Forces Health Professions Scholarship and Financial Assistance Program, or

A comprehensive student work-learning-service program (as defined in section 448(e) of the Higher Education Act of 1965) operated by a work college (as defined in that section).

For information about the rules that apply to a tax-free qualified tuition reduction provided to employees and their families by an educational institution, see Pub. 970.

Allowances paid by the VA for education, training, or subsistence under any law administered by the Department of Veterans Affairs, aren't included in your income. These allowances aren't considered scholarship or fellowship grants.

Scholarship prizes won in a contest aren't scholarships or fellowships if you don't have to use the prizes for educational purposes. You must include these amounts in your income on Schedule 1 (Form 1040), line 8i, whether or not you use the amounts for educational purposes.

If you're an eligible individual who receives benefits under the Smallpox Emergency Personnel Protection Act of 2003 for a covered injury resulting from a covered countermeasure, you can exclude the payment from your income (to the extent it isn't allowed as a medical and dental expense deduction on Schedule A (Form 1040)). Eligible individuals include health care workers, emergency personnel, and first responders in a smallpox emergency who have received a smallpox vaccination.

Do not include payments on your tax return made by states under legislatively provided social benefit programs for the promotion of the general welfare. To qualify for the general welfare exclusion, state payments must be paid from a governmental fund, be for the promotion of general welfare (that is, based on the need of the individual or family receiving such payments), and not represent compensation for services.

In 2022, some states implemented programs to provide state payments to certain individuals residing in their states. Many of these programs were related to the various consequences of the COVID-19 pandemic. Some of those 2022 programs provided for payments to be made in early 2023. For special tax refunds or payments that were excluded from federal income in 2022, the same tax treatment applies to the special tax refund or payments received in 2023. This means taxpayers who didn’t get a payment under the program during 2022 may exclude from federal income a state payment provided under the 2022 program even if they actually received the payment in 2023. See IRS News Release IR-2023-158 at IRS.gov/Newsroom/IRS-Issues-Guidance-on-State-Tax-Payments for more information.

If you steal property, you must report its FMV in your income in the year you steal it, unless in the same year you return it to its rightful owner.

Don’t include in your income a school board mileage allowance for taking children to and from school if you aren't in the business of taking children to school. You can't deduct expenses for providing this transportation.

Amounts deducted from your pay for union dues, assessments, contributions, or other payments to a union can't be excluded from your income.

For tax years beginning after 2017, you can no longer deduct job-related expenses or other miscellaneous itemized deductions subject to the 2%-of-adjusted-gross-income floor.

Benefits paid to you by a union as strike or lockout benefits, including both cash and the FMV of other property, are usually included in your income as compensation. You can exclude these benefits from your income only when the facts clearly show that the union intended them as gifts to you.

If you're a delegate of your local union chapter and you attend the annual convention of the international union, don't include in your income amounts you receive from the international union to reimburse you for expenses of traveling away from home to attend the convention. You can't deduct the reimbursed expenses, even if you're reimbursed in a later year. If you're reimbursed for lost salary, you must include that reimbursement in your income.

If you're a customer of an electric utility company and you participate in the utility's energy conservation program, you may receive on your monthly electric bill either:

A reduction in the purchase price of electricity furnished to you (rate reduction), or

A nonrefundable credit against the purchase price of the electricity.

If you receive a whistleblower's award from the IRS, you must include it in your income. Any deduction allowed for attorney fees and court costs paid by you, or on your behalf, in connection with the award are deducted as an adjustment to income, but can't be more than the amount included in income for the tax year.

If you had to repay an amount that you included in your income in an earlier year, you may be able to deduct the amount repaid from your income for the year in which you repaid it. Or, if the amount you repaid is more than $3,000, you may be able to take a credit against your tax for the year in which you repaid it. In most cases, you can claim a deduction or credit only if the repayment qualifies as an expense or loss incurred in your trade or business or in a for-profit transaction.

The type of deduction you're allowed in the year of repayment depends on the type of income you included in the earlier year. In most cases, you deduct the repayment on the same form or schedule on which you previously reported it as income. For example, if you reported it as self-employment income, deduct it as a business expense on Schedule C (Form 1040) or Schedule F (Form 1040). If you reported it as a capital gain, deduct it as a capital loss as explained in the Instructions for Schedule D (Form 1040). If you reported it as wages, unemployment compensation, or other nonbusiness income, you may be able to deduct it as an other itemized deduction if the amount repaid is over $3,000.

If you repaid social security or equivalent railroad retirement benefits, see Pub. 915.

If the amount you repaid was more than $3,000, you can deduct the repayment as an other itemized deduction on Schedule A (Form 1040), line 16, if you included the income under a claim of right. This means that at the time you included the income, it appeared that you had an unrestricted right to it. However, you can choose to take a credit for the year of repayment. Figure your tax under both methods and compare the results. Use the method (deduction or credit) that results in less tax.

Figure your tax for the year of repayment claiming a deduction for the repaid amount.

Figure your tax for the year of repayment claiming a credit for the repaid amount. Follow these steps.

Figure your tax for the year of repayment without deducting the repaid amount.

Refigure your tax from the earlier year without including in income the amount you repaid in the year of repayment.

Subtract the tax in (2) from the tax shown on your return for the earlier year. This is the credit.

Subtract the answer in (3) from the tax for the year of repayment figured without the deduction (step 1).

If method 1 results in less tax, deduct the amount repaid. If method 2 results in less tax, claim the credit figured in (3) above on Form 1040 or 1040-SR. (If the year of repayment is 2022, and you're taking the credit, enter the credit on Schedule 3 (Form 1040), line 13b, and see the instructions for it.)

Example 40.

For 2022, you filed a return and reported your income on the cash method. In 2023, you repaid $5,000 included in your 2022 income under a claim of right. Your filing status in 2023 and 2022 is single. Your income and tax for both years are as follows.

Your tax under method 1 is $5,197. Your tax under method 2 is $6,297, figured as follows.

If you had to repay an amount that you included in your wages or compensation in an earlier year on which social security, Medicare, or tier 1 RRTA taxes were paid, ask your employer to refund the excess amount to you. If the employer refuses to refund the taxes, ask for a statement indicating the amount of the overcollection to support your claim. File a claim for refund using Form 843.

Employers can't make an adjustment or file a claim for refund for Additional Medicare Tax withholding when there is a repayment of wages received by an employee in a prior year because the employee determines liability for Additional Medicare Tax on the employee's income tax return for the prior year. If you had to repay an amount that you included in your wages or compensation in an earlier year, and on which Additional Medicare Tax was paid, you may be able to recover the Additional Medicare Tax paid on the amount. To recover Additional Medicare Tax on the repaid wages or compensation, you must file Form 1040-X for the prior year in which the wages or compensation were originally received. See the Instructions for Form 1040-X.

This discussion doesn't apply to:

Deductions for bad debts;

Deductions for theft losses due to criminal fraud or embezzlement in a transaction entered into for profit;

Deductions from sales to customers, such as returns and allowances, and similar items; or

Deductions for legal and other expenses of contesting the repayment.

If you use the cash method, you can take the deduction (or credit, if applicable) for the tax year in which you actually make the repayment. If you use any other accounting method, you can deduct the repayment or claim a credit for it only for the tax year in which it’s a proper deduction under your accounting method. For example, if you use an accrual method, you're entitled to the deduction or credit in the tax year in which the obligation for the repayment accrues.

How To Get Tax Help

If you have questions about a tax issue; need help preparing your tax return; or want to download free publications, forms, or instructions, go to IRS.gov to find resources that can help you right away.

After receiving all your wage and earnings statements (Forms W-2, W-2G, 1099-R, 1099-MISC, 1099-NEC, etc.); unemployment compensation statements (by mail or in a digital format) or other government payment statements (Form 1099-G); and interest, dividend, and retirement statements from banks and investment firms (Forms 1099), you have several options to choose from to prepare and file your tax return. You can prepare the tax return yourself, see if you qualify for free tax preparation, or hire a tax professional to prepare your return.

Your options for preparing and filing your return online or in your local community, if you qualify, include the following.

Free File. This program lets you prepare and file your federal individual income tax return for free using software or Free File Fillable Forms. However, state tax preparation may not be available through Free File. Go to IRS.gov/FreeFile to see if you qualify for free online federal tax preparation, e-filing, and direct deposit or payment options.

VITA. The Volunteer Income Tax Assistance (VITA) program offers free tax help to people with low-to-moderate incomes, persons with disabilities, and limited-English-speaking taxpayers who need help preparing their own tax returns. Go to IRS.gov/VITA , download the free IRS2Go app, or call 800-906-9887 for information on free tax return preparation.

TCE. The Tax Counseling for the Elderly (TCE) program offers free tax help for all taxpayers, particularly those who are 60 years of age and older. TCE volunteers specialize in answering questions about pensions and retirement-related issues unique to seniors. Go to IRS.gov/TCE or download the free IRS2Go app for information on free tax return preparation.

MilTax. Members of the U.S. Armed Forces and qualified veterans may use MilTax, a free tax service offered by the Department of Defense through Military OneSource. For more information, go to MilitaryOneSource ( MilitaryOneSource.mil/MilTax ).

Also, the IRS offers Free Fillable Forms, which can be completed online and then e-filed regardless of income.

Go to IRS.gov/Tools for the following.

The Earned Income Tax Credit Assistant ( IRS.gov/EITCAssistant ) determines if you’re eligible for the earned income credit (EIC).

The Online EIN Application ( IRS.gov/EIN ) helps you get an employer identification number (EIN) at no cost.

The Tax Withholding Estimator ( IRS.gov/W4App ) makes it easier for you to estimate the federal income tax you want your employer to withhold from your paycheck. This is tax withholding. See how your withholding affects your refund, take-home pay, or tax due.

The First-Time Homebuyer Credit Account Look-up ( IRS.gov/HomeBuyer ) tool provides information on your repayments and account balance.

The Sales Tax Deduction Calculator ( IRS.gov/SalesTax ) figures the amount you can claim if you itemize deductions on Schedule A (Form 1040).

IRS.gov/Help : A variety of tools to help you get answers to some of the most common tax questions.

IRS.gov/ITA : The Interactive Tax Assistant, a tool that will ask you questions and, based on your input, provide answers on a number of tax topics.

IRS.gov/Forms : Find forms, instructions, and publications. You will find details on the most recent tax changes and interactive links to help you find answers to your questions.

You may also be able to access tax information in your e-filing software.

There are various types of tax return preparers, including enrolled agents, certified public accountants (CPAs), accountants, and many others who don’t have professional credentials. If you choose to have someone prepare your tax return, choose that preparer wisely. A paid tax preparer is:

Primarily responsible for the overall substantive accuracy of your return,

Required to sign the return, and

Required to include their preparer tax identification number (PTIN).

The Social Security Administration (SSA) offers online service at SSA.gov/employer for fast, free, and secure W-2 filing options to CPAs, accountants, enrolled agents, and individuals who process Form W-2, Wage and Tax Statement, and Form W-2c, Corrected Wage and Tax Statement.

Go to IRS.gov/SocialMedia to see the various social media tools the IRS uses to share the latest information on tax changes, scam alerts, initiatives, products, and services. At the IRS, privacy and security are our highest priority. We use these tools to share public information with you. Don’t post your social security number (SSN) or other confidential information on social media sites. Always protect your identity when using any social networking site.

The following IRS YouTube channels provide short, informative videos on various tax-related topics in English, Spanish, and ASL.

Youtube.com/irsvideos .

Youtube.com/irsvideosmultilingua .

Youtube.com/irsvideosASL .

The IRS Video portal ( IRSVideos.gov ) contains video and audio presentations for individuals, small businesses, and tax professionals.

You can find information on IRS.gov/MyLanguage if English isn’t your native language.

The IRS is committed to serving taxpayers with limited-English proficiency (LEP) by offering OPI services. The OPI Service is a federally funded program and is available at Taxpayer Assistance Centers (TACs), most IRS offices, and every VITA/TCE tax return site. The OPI Service is accessible in more than 350 languages.

Taxpayers who need information about accessibility services can call 833-690-0598. The Accessibility Helpline can answer questions related to current and future accessibility products and services available in alternative media formats (for example, braille, large print, audio, etc.). The Accessibility Helpline does not have access to your IRS account. For help with tax law, refunds, or account-related issues, go to IRS.gov/LetUsHelp .

Form 9000, Alternative Media Preference, or Form 9000(SP) allows you to elect to receive certain types of written correspondence in the following formats.

Standard Print.

Large Print.

Audio (MP3).

Plain Text File (TXT).

Braille Ready File (BRF).

Go to IRS.gov/DisasterRelief to review the available disaster tax relief.

Go to IRS.gov/Forms to view, download, or print all the forms, instructions, and publications you may need. Or, you can go to IRS.gov/OrderForms to place an order.

Download and view most tax publications and instructions (including the Instructions for Form 1040) on mobile devices as eBooks at IRS.gov/eBooks .

IRS eBooks have been tested using Apple's iBooks for iPad. Our eBooks haven’t been tested on other dedicated eBook readers, and eBook functionality may not operate as intended.

Go to IRS.gov/Account to securely access information about your federal tax account.

View the amount you owe and a breakdown by tax year.

See payment plan details or apply for a new payment plan.

Make a payment or view 5 years of payment history and any pending or scheduled payments.

Access your tax records, including key data from your most recent tax return, and transcripts.

View digital copies of select notices from the IRS.

Approve or reject authorization requests from tax professionals.

View your address on file or manage your communication preferences.

With an online account, you can access a variety of information to help you during the filing season. You can get a transcript, review your most recently filed tax return, and get your adjusted gross income. Create or access your online account at IRS.gov/Account .

This tool lets your tax professional submit an authorization request to access your individual taxpayer IRS online account. For more information, go to IRS.gov/TaxProAccount .

The safest and easiest way to receive a tax refund is to e-file and choose direct deposit, which securely and electronically transfers your refund directly into your financial account. Direct deposit also avoids the possibility that your check could be lost, stolen, destroyed, or returned undeliverable to the IRS. Eight in 10 taxpayers use direct deposit to receive their refunds. If you don’t have a bank account, go to IRS.gov/DirectDeposit for more information on where to find a bank or credit union that can open an account online.

Tax-related identity theft happens when someone steals your personal information to commit tax fraud. Your taxes can be affected if your SSN is used to file a fraudulent return or to claim a refund or credit.

The IRS doesn’t initiate contact with taxpayers by email, text messages (including shortened links), telephone calls, or social media channels to request or verify personal or financial information. This includes requests for personal identification numbers (PINs), passwords, or similar information for credit cards, banks, or other financial accounts.

Go to IRS.gov/IdentityTheft , the IRS Identity Theft Central webpage, for information on identity theft and data security protection for taxpayers, tax professionals, and businesses. If your SSN has been lost or stolen or you suspect you’re a victim of tax-related identity theft, you can learn what steps you should take.

Get an Identity Protection PIN (IP PIN). IP PINs are six-digit numbers assigned to taxpayers to help prevent the misuse of their SSNs on fraudulent federal income tax returns. When you have an IP PIN, it prevents someone else from filing a tax return with your SSN. To learn more, go to IRS.gov/IPPIN .

Go to IRS.gov/Refunds .

Download the official IRS2Go app to your mobile device to check your refund status.

Call the automated refund hotline at 800-829-1954.

Payments of U.S. tax must be remitted to the IRS in U.S. dollars. Digital assets are not accepted. Go to IRS.gov/Payments for information on how to make a payment using any of the following options.

IRS Direct Pay : Pay your individual tax bill or estimated tax payment directly from your checking or savings account at no cost to you.

Debit Card, Credit Card, or Digital Wallet : Choose an approved payment processor to pay online or by phone.

Electronic Funds Withdrawal : Schedule a payment when filing your federal taxes using tax return preparation software or through a tax professional.

Electronic Federal Tax Payment System : Best option for businesses. Enrollment is required.

Check or Money Order : Mail your payment to the address listed on the notice or instructions.

Cash : You may be able to pay your taxes with cash at a participating retail store.

Same-Day Wire : You may be able to do same-day wire from your financial institution. Contact your financial institution for availability, cost, and time frames.

The IRS uses the latest encryption technology to ensure that the electronic payments you make online, by phone, or from a mobile device using the IRS2Go app are safe and secure. Paying electronically is quick, easy, and faster than mailing in a check or money order.

Go to IRS.gov/Payments for more information about your options.

Apply for an online payment agreement ( IRS.gov/OPA ) to meet your tax obligation in monthly installments if you can’t pay your taxes in full today. Once you complete the online process, you will receive immediate notification of whether your agreement has been approved.

Use the Offer in Compromise Pre-Qualifier to see if you can settle your tax debt for less than the full amount you owe. For more information on the Offer in Compromise program, go to IRS.gov/OIC .

Go to IRS.gov/Form1040X for information and updates.

Go to IRS.gov/WMAR to track the status of Form 1040-X amended returns.

Go to IRS.gov/Notices to find additional information about responding to an IRS notice or letter.

You can now upload responses to all notices and letters using the Document Upload Tool. For notices that require additional action, taxpayers will be redirected appropriately on IRS.gov to take further action. To learn more about the tool, go to IRS.gov/Upload .

You can use Schedule LEP (Form 1040), Request for Change in Language Preference, to state a preference to receive notices, letters, or other written communications from the IRS in an alternative language. You may not immediately receive written communications in the requested language. The IRS’s commitment to LEP taxpayers is part of a multi-year timeline that began providing translations in 2023. You will continue to receive communications, including notices and letters, in English until they are translated to your preferred language.

Keep in mind, many questions can be answered on IRS.gov without visiting a TAC. Go to IRS.gov/LetUsHelp for the topics people ask about most. If you still need help, TACs provide tax help when a tax issue can’t be handled online or by phone. All TACs now provide service by appointment, so you’ll know in advance that you can get the service you need without long wait times. Before you visit, go to IRS.gov/TACLocator to find the nearest TAC and to check hours, available services, and appointment options. Or, on the IRS2Go app, under the Stay Connected tab, choose the Contact Us option and click on “Local Offices.”

The Taxpayer Advocate Service (TAS) Is Here To Help You

TAS is an independent organization within the IRS that helps taxpayers and protects taxpayer rights. TAS strives to ensure that every taxpayer is treated fairly and that you know and understand your rights under the Taxpayer Bill of Rights .

The Taxpayer Bill of Rights describes 10 basic rights that all taxpayers have when dealing with the IRS. Go to TaxpayerAdvocate.IRS.gov to help you understand what these rights mean to you and how they apply. These are your rights. Know them. Use them.

TAS can help you resolve problems that you can’t resolve with the IRS. And their service is free. If you qualify for their assistance, you will be assigned to one advocate who will work with you throughout the process and will do everything possible to resolve your issue. TAS can help you if:

Your problem is causing financial difficulty for you, your family, or your business;

You face (or your business is facing) an immediate threat of adverse action; or

You’ve tried repeatedly to contact the IRS but no one has responded, or the IRS hasn’t responded by the date promised.

TAS has offices in every state, the District of Columbia, and Puerto Rico . To find your advocate’s number:

Go to TaxpayerAdvocate.IRS.gov/Contact-Us ;

Download Pub. 1546, The Taxpayer Advocate Service Is Your Voice at the IRS, available at IRS.gov/pub/irs-pdf/p1546.pdf ;

Call the IRS toll free at 800-TAX-FORM (800-829-3676) to order a copy of Pub. 1546;

Check your local directory; or

Call TAS toll free at 877-777-4778.

TAS works to resolve large-scale problems that affect many taxpayers. If you know of one of these broad issues, report it to TAS at IRS.gov/SAMS . Be sure to not include any personal taxpayer information.

LITCs are independent from the IRS and TAS. LITCs represent individuals whose income is below a certain level and who need to resolve tax problems with the IRS. LITCs can represent taxpayers in audits, appeals, and tax collection disputes before the IRS and in court. In addition, LITCs can provide information about taxpayer rights and responsibilities in different languages for individuals who speak English as a second language. Services are offered for free or a small fee. For more information or to find an LITC near you, go to the LITC page at TaxpayerAdvocate.IRS.gov/LITC or see IRS Pub. 4134, Low Income Taxpayer Clinic List , at IRS.gov/pub/irs-pdf/p4134.pdf .

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Tax Alert | Tax Court Guidance on Charitable Contributions and Assignment of Income

February 26, 2024

Tax Court Guidance on Charitable Contributions and Assignment of Income

Today is the first of two alerts dealing with the Estate of Hoensheid v. Commissioner of Internal Revenue, T.C. Memo 2023-34 (2023). In this, the first, the standard for determining whether a taxpayer has made an anticipatory assignment of income is discussed. The judicially created  anticipatory assignment of income doctrine recognizes that income is taxed to those who earn or otherwise create the right to receive it and that it cannot be assigned or gifted away.

Hoensheid involves a common fact pattern. The taxpayer was one of three owners of a closely held business, wishing to both sell and to contribute part or all of the proceeds to a tax exempt charity or donor advised fund, the assignee. If properly structured, the owner receives a charitable deduction equal to the fair market value of the contributed property and the built in gain on the investment is taxed to the charity. In order to do so, the owner must contribute the ownership interest (in this case 1380 shares of stock) to the charity, but when?  Like most owners, the taxpayer in Hoensheid wanted to wait as long as possible before making the actual contribution. During the course of the negotiations concerning the sale, the taxpayer was advised that the contribution had to be completed before any purchase agreement was executed. This is referred to the binding agreement test and has its origin in Rev. Rul. 78-197. If you contribute before the purchase agreement is signed, no anticipatory assignment. If you contribute after the purchase agreement is signed, anticipatory assignment. It provides a bright line for taxpayers. But is it that simple? The Tax Court first analyzed the requirements under state law to determine when the gift was completed. It concluded the gift took place on July 13, 2015 two days before the signing of the SPA on July 15, 2015 seemingly within the bright line test of Rev. Rul. 78-197. The Tax Court agreed that the gift occurred before the sale and that the charity was not obligated to sell at the time of the gift, but that although the donee’s legal obligation to sell is significant to the assignment of income analysis, it was only one factor.

In short, there is no bright line but there are multiple factors in an assignment of income analysis of a fact pattern. Instead, the ultimate question is whether  the transferor, considering the reality and substance of all the circumstances, had a fixed right to income in the property at the time of transfer. If the sale was virtually certain to occur, the anticipatory assignment of income doctrine is satisfied and the taxpayer, not the charity, is taxed on the sales proceeds from the charities sale.

In this case, the relevant factors in determining whether the sale of shares were virtually certain to occur include (1) any legal obligation to sell by the donee, (2) the actions already taken by the parties to effect the transaction, (3) the remaining unresolved transactional contingencies, and (4) the status of the corporate formalities required to finalize the transactions.

With regard to the first factor, the Tax Court held that there was no proof of any obligation of the charity to sell the shares either formal or informal. This was a favorable factor for the taxpayer.

With regard to the second factor, the Tax Court found that their were bonus and shareholder distributions made before the SPA was executed. This factor indicates that the income was earned at an earlier point in time.

With regard to the third factor, the Tax Court found that there were major transactional contingencies (environmental obligations) but that they had been resolved before the SPA was executed. This factor indicates that the income was earned at an earlier point in time.

With regard to the fourth factor, the Tax Court found that after the SPA was executed there were only ministerial actions remaining. This factor indicates that the income was earned at an earlier point in time.

The tax court, based on the various factors mentioned above that the income or gain from the sale was earned at an earlier point in time, resulting in the taxpayer being treated as the seller of the shares of stock purportedly gifted to the charity.

In summary, as the Tax Court found, to avoid an anticipatory assignment of income on the contribution of appreciated shares of stock followed by a sale of the donee, a donor must bear at least some risk at the time of contribution that the sale will not close. The bright line of Rev. Rul. 78-187 was a factor but compliance with that alone did not provide a safe harbor. Other factors needed to be considered to determine if the gain was earned before the sale and taxable to the donor.

If you are the owner of a closely held business and are contemplating a charitable gift of a portion of your ownership interest do not hesitate to contact either David Ritter, Stuart Gladstone, Bob Kosicki or Cheryl Ritter for guidance in dealing with the multiple factors set forth in the anticipatory assignment of income doctrine.

For more information or assistance, please contact: 

David J. Ritter, Esq. , Member and Chair, Tax Practice , at  [email protected] or 973-403-3117

Stuart M. Gladstone, Esq. , Member,  Tax Practice , at  [email protected]  or 973-403-3109

Robert A. Kosicki, Esq. , Counsel, Tax Practice , at  [email protected] or 973-403-3122

Cheryl L. Ritter, Esq. , Counsel, Tax Practice , at  [email protected] or 973-364-8307

About Brach Eichler LLC

Brach Eichler LLC, is a full-service law firm based in Roseland, NJ. With over 80 attorneys, the firm is focused in the following practice areas: Healthcare Law; Real Estate; Litigation; Trusts and Estates; Corporate Transactions & Financial Services; Personal Injury; Criminal Defense and Government Investigations; Labor and Employment; Environmental and Land Use; Family Law Services; Patent, Intellectual Property & Information Technology; Real Estate Tax Appeals; Tax; and Cannabis Law. Brach Eichler attorneys have been recognized by clients and peers alike in The Best Lawyers in America©, Chambers USA, and New Jersey Super Lawyers. For more information, visit www.bracheichler.com .

This alert is intended for informational and discussion purposes only. The information contained in this alert is not intended to provide, and does not constitute legal advice or establish the attorney/client relationship by way of any information contained herein. Brach Eichler LLC does not guarantee the accuracy, completeness, usefulness or adequacy of any information contained herein. Readers are advised to consult with a qualified attorney concerning the specifics of a particular situation.

Related Practices:   Tax

Related Attorney:   Cheryl L. Ritter , David J. Ritter , Stuart M. Gladstone , Robert A. Kosicki

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Assignment of Income Lawyers

(This may not be the same place you live)

  What Happens if you Assign your Income?

There are some instances when a person may choose to assign a portion of their income to another individual. You may be able to do this by asking your employer to send your paycheck directly to a third party.

It should be noted, however, that if you choose to assign your income to a third party, then this does not mean that you will be able to avoid paying taxes on that income. In other words, you will still be responsible for paying taxes on that income regardless of whether you decide to assign your income to a third party or not. This guideline is known as the “assignment of income doctrine.”

The primary purpose of the “assignment of income doctrine” is to ensure that a person does not simply assign their income to a third party to avoid having to pay taxes. If they do, then they can be charged and convicted of committing tax evasion .

One other important thing to bear in mind about income assignments is that they are often confused with the concept of wage garnishments. However, income or wage assignments are different from wage garnishments. In a situation that involves wage garnishment, a person’s paycheck is involuntarily withheld from them to pay off a debt like outstanding child support payments and is typically ordered by a court.

In contrast, an income or wage assignment is when a person voluntarily agrees to assign their income to someone else through a contract or a similar type of agreement.

How is Assigned Income Taxed?

Are there any exceptions, should i consult with an attorney.

As previously discussed, a taxpayer will still be required to pay taxes on any income that is assigned to a third party. The person who earns the income is the one who will be responsible for paying taxes on the income, not the person to whom it is assigned. The same rule applies to income that a person receives from property or assets.

For example, if a person earns money through a source of what is considered to be a passive stream of income, such as from stock dividends, the person who owns these assets will be the one responsible for paying taxes on the income they receive from it. The reason for this is because income is generally taxed to the person who owns any income-generating property under the law.

If a person chooses to give away their income-generating property and/or assets as a gift to a family member, then they will no longer be taxed on any income that is earned from those property or assets. This rule will be triggered the moment that the owner has given up their complete control and rights over the property in question.

In order to demonstrate how this might work, consider the following example:

• Instead, the person to whom the apartment building was transferred will now be liable for paying taxes on any income they receive from tenants paying rent to live in the building since they are the new owner.

There is one exception to the rule provided by the assignment of income doctrine and that is when income is assigned in a scenario that involves a principal-agent relationship . For example, if an agent receives income from a third-party that is intended to be paid to the principal, then this income is usually not taxable to the agent. Instead, it will be taxable to the principal in this relationship.

Briefly, an agent is a person who acts on behalf of another (i.e., the principal) in certain situations or in regard to specific transactions. On the other hand, a principal is someone who authorizes another person (i.e., the agent) to act on their behalf and represent their interests under particular circumstances.

For example, imagine a sales representative that is employed by a large corporation. When the sales representative sells the corporation’s product or service to a customer, they will receive money from the customer in exchange for that service or product. Although the sales representative is the one being paid in the transaction, the money actually belongs to the corporation. Thus, it is the corporation who would be liable for paying taxes on the income.

In other words, despite the fact that this income may appear to have been earned by the corporation’s agent (i.e., the sales representation in this scenario), the corporation (i.e., the principal) will still be taxed on the income since the sales representative is acting on behalf of the corporation to generate income for them.

One other exception that may apply here is known as a “kiddie tax.” A kiddie tax is unearned or investment-related income that belongs to a child, but must be paid by the earning child’s parent and at the tax rate assigned to adults (as opposed to children). This is also to help prevent parents from abusing the tax system by using their child’s lower tax rate to shift over assets or earned income and take advantage of their child’s lower tax bracket rate.

So, even though a parent has assigned money or assets to a child that could be considered their earned income, the money will still have to be paid by the parent and taxed at a rate that is reserved for adults. The child will not need to pay any taxes on this earned income until it reaches a certain amount.

In general, the tax rules that exist under the assignment of income doctrine can be confusing. There are several exceptions to these rules and many of them require knowing how to properly apply them to the specific facts of each individual case.

Therefore, if you have any questions about taxable income streams or are involved in a dispute over taxable income with the IRS, then it may be in your best interest to contact an accountant or a local tax attorney to provide further guidance on the matter. An experienced tax attorney can help you to avoid incurring extra tax penalties and can assist you in resolving your income tax issue in an efficient manner.

Your attorney will also be able to explain the situation and can recommend various options to settle the assignment of income issue or any related concerns. In addition, your attorney will be able to communicate with the IRS on your behalf and can provide legal representation if you need to appear in court.

Lastly, if you think you are not liable for paying taxes on income that has been assigned to you by someone else, then your lawyer can review the facts of your claim and can find out whether you may be able to avoid having to pay taxes on that income.

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Charitable Gifts of Stock: Timing and Documentation Continue to be Critical When Selling a Business

A recent Tax Court case affirms the importance of timing and documentation when planning a charitable stock donation before a business sale.

Prior to selling a business, small business owners often consider donating their company stock to charity. If executed correctly, donating stock prior to a business sale may reduce capital gains while allowing owners a charitable contribution deduction.

In Estate of Hoensheid et al. v. Commissioner , (No. 18606-19; T.C. Memo. 2023-34) the Court determined the timeline of events associated with the transfer of stock and subsequent sale of the business resulted in the petitioner significantly underreporting capital gains.

The Court held that by delaying the gift until the transaction was essentially finalized, the petitioner avoided recognition of realized income under the anticipatory assignment of income doctrine. The Court’s decision also highlighted the petitioner’s failure to secure a qualified appraisal given that the stock gift exceeded $500,000.

The Timeline of the Case

In 2014, the petitioner (now deceased) and his two brothers equally owned all the outstanding shares of Commercial Steel Treating Corporation (CSTC). The brothers were grandchildren of the founder. In the fall of 2014, the brothers began to explore a potential sale of CSTC and established a target sale price. On April 1, 2015, a private equity firm submitted a letter of intent to acquire CSTC for a price more than the original target price. On April 23, the brothers signed a nonbinding letter of intent with the buyer. The next month, on May 22, the brothers signed an affidavit indicating their intent to complete the transaction and sell CSTC.

During negotiations, in mid-April, the petitioner expressed to his financial advisors his intent to donate a portion of his CSTC stock to Fidelity Charitable Gift Fund, a tax-exempt, charitable organization with a donor-advised fund program. On June 1, after the terms of the CSTC sale were negotiated and agreed upon, an advisor to the petitioner emailed Fidelity Charitable a letter of understanding describing the planned stock donation. The petitioner sent a donation letter to Fidelity Charitable, which the tax-exempt entity confirmed on June 11. However, the petitioner did not send Fidelity Charitable the CSTC stock certificate at this time.

Over the next month, the terms of the sale were finalized, and the petitioner delivered the CSTC stock certificate to Fidelity Charitable on July 13. The sale of CSTC closed on July 15, 2015.

On his 2015 return, the petitioner reduced the amount of his recognized gain to reflect the stock transfer and took a charitable contribution deduction. The return included a completed Form 8283, Noncash Charitable Contributions, with an attachment titled “CSTC Fidelity Gift Fund Valuation.” The form reported the donation date as June 11, 2015.

Anticipatory Assignment of Income

The anticipatory assignment of income doctrine prevents taxpayers from transferring, or assigning, realized income to another taxpayer before actual receipt to avoid income recognition. The Court determined the petitioner effectively realized income from the CSTC sale before the July 15 closing date because of evidence (including a fixed sales price) supporting that the CSTC sale transaction was virtually certain.

Based on Michigan state law, the petitioner’s resident state, determining the validity of a gift requires three steps:

• donor intent to make the gift
• actual or constructive delivery of the subject matter of the gift
• donee acceptance

The Court concluded that although a valid gift was executed on July 13, 2015, the terms of the CSTC sale were fixed before the stock delivery resulting in an unreported gain on sale of CSTC.

Qualified Appraisal

The Court acknowledged the validity of the gift on July 13, 2015, but denied the charitable contribution deduction. Among other requirements, contributions of property exceeding $500,000 require a qualified appraisal to substantiate the deduction. The petitioner’s gift of CSTC shares was valued at over $3 million dollars in June 2015.

An appraiser signed the completed Form 8283; however, the Court determined the appraisal did not meet the requirements of Internal Revenue Code Section 170(f)(11)(D). Specifically, the Court cited the following: the valuation was not completed for federal income tax purposes; the appraisal included an incorrect date of transfer; the appraisal date was considered premature; the appraisal did not sufficiently describe the method for the valuation; it was not signed by the appraiser; it did not include the appraiser’s qualifications; the appraisal did not describe the property in sufficient detail; and the appraisal did not include an explanation of the specific basis for the valuation.

Important Reminders

This case provides two important reminders. First, the importance of completing charitable gifts of stock prior to selling a business. In this case, the Court determined that the stock transfer (two days before the business sale closing) was made after the sale transaction was agreed upon, essentially eliminating all the petitioner’s risk.

No bright-line rule exists, but donations must occur before finalizing the terms of the business sale, including, for example, signing a letter of intent or other sales contract.

Second, make sure the appraisal conforms to the applicable rules. A review of the rules compared to the components of the appraisal prior to filing the return can save a valuation deduction. There are other important rules to follow as well, including the necessary components of the Form 8283.

Stay up-to-date on the latest tax news and views.

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Tax Court in Brief | Estate of Hoenshied v. Commissioner | Anticipatory Assignment of Income, Charitable Contribution Deduction, and Qualified Appraisals

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The Tax Court in Brief – April 3rd – April 7th, 2023

Freeman Law ’s “ The Tax Court in Brief ” covers every substantive Tax Court opinion, providing a weekly brief of its decisions in clear, concise prose.

For a link to our podcast covering the Tax Court in Brief, download  here  or check out other episodes of  The Freeman Law Project .

Tax Litigation:  The Week of April 3rd, 2022, through April 7th, 2023

Estate of Hoenshied v. Comm’r, T.C. Memo. 2023-34 | March 15, 2023 | Nega, J. | Dkt. No. 18606-19

Summary: In this 49-page opinion the Tax Court addresses a deficiency arising from the charitable contribution of appreciated shares of stock in a closely held corporation to a charitable organization that administers donor-advised funds for tax-exempt purposes under section 501(c)(3). The contribution in issue was made near contemporaneously with the selling of those shares to a third party. The timeline (truncated heavily for this blog) is as follows:

On June 11, 2015, the shareholders of the corporation in issue unanimously ratified the sale of all outstanding stock of the corporation. Immediately following the shareholder meeting, the corporation’s board of directors unanimously approved Petitioner’s request to be able to transfer a portion of his shares to Fidelity Charitable Gift Fund, a tax-exempt charitable organization under section 501(c)(3). Thereafter, the corporation and the purchaser of shares continued drafting and revising the Contribution and Stock Purchase Agreement.

On July 13, 2015, Fidelity Charitable first received a stock certificate from Petitioner.

On July 14, 2015, the Contribution and Stock Purchase Agreement was revised to specify that Petitioner contributed shares to Fidelity Charitable on July 10, 2015, and on July 15, 2015, the Contribution and Stock Purchase Agreement was signed and the transaction was funded.

Fidelity Charitable, having provided an Irrevocable Stock Power as part of the transaction, received $2,941,966 in cash proceeds from the sale, which was deposited in Petitioner’s donor-advised fund giving account.

On November 18, 2015, Fidelity Charitable sent Petitioner a contribution confirmation letter acknowledging a charitable contribution of the corporate shares and indicating that Fidelity Charitable received the shares on June 11, 2015.

In its 2015 tax return, Petitioner did not report any capital gains on the shares contributed to Fidelity Charitable but claimed a noncash charitable contribution deduction of $3,282,511. In support of the claimed deduction, a Form 8283 was attached to the return.

Petitioner’s 2015 tax return was selected for examination. The IRS issued to Petitioners a notice of deficiency, determining a deficiency of $647,489, resulting from the disallowance of the claimed charitable contribution deduction, and a penalty of $129,498 under section 6662(a).

Key Issues:

• Whether and when Petitioners made a valid contribution of the shares of stock?
• Whether Petitioners had unreported capital gain income due to their right to proceeds from the sale of those shares becoming fixed before the gift?
• Whether Petitioners are entitled to a charitable contribution deduction?
• Whether Petitioners are liable for an accuracy-related penalty under section 6662(a) with respect to an underpayment of tax?

Primary Holdings:

(1) Petitioners failed to establish that any of the elements of a valid gift was present on June 11, 2015. No evidence was presented to credibly identify a specific action taken on June 11 that placed the shares within Fidelity Charitable’s dominion and control. Instead, the valid gift of shares was made by effecting delivery of a PDF of the certificate to Fidelity Charitable on July 13.

(2) Yes. None of the unresolved contingencies remaining on July 13, 2015 were substantial enough to have posed even a small risk of the overall transaction’s failing to close. Thus, Petitioners, through the doctrine of anticipatory assignment of income, had capital gains on the sale of the 1,380 appreciated shares of stock, even though Fidelity Charitable received the proceeds from that sale.

(3) No, Petitioners failed to show that the charitable contribution met the qualified appraisal requirements of section 170. The appraiser was not shown to be qualified, per regulations, at trial or in the appraisal itself, and the appraisal did not substantially comply with the regulatory requirements. “The failure to include a description of such experience in the appraisal was a substantive defect. . . . Petitioners’ failure to satisfy multiple substantive requirements of the regulations, paired with the appraisal’s other more minor defects, precludes them from establishing substantial compliance.” In addition, Petitioners failed to establish reasonable cause for failing to comply with the appraisal requirements “because petitioner knew or should have known that the date of contribution (and thus the date of valuation) was incorrect.” Thus, the IRS’s determination to disallow the charitable contribution deduction is sustained.

(4) No. While Petitioners did not have reasonable cause for their failure to comply with the qualified appraisal requirement, their liability for an accuracy-related penalty was a separate analysis, and the IRS did not carry the burden of proof. Petitioners did not follow their professional’s advice to have the paperwork for the contribution ready to go “well before the signing of the definitive purchase agreement.” But, Petitioners adhered to the literal thrust of the advice given: that “execution of the definitive purchase agreement” was the firm deadline to contribute the shares and avoid capital gains (even if that proved to be incorrect advice under the circumstances).

Key Points of Law:

Gross Income. Gross income means “all income from whatever source derived,” including “[g]ains derived from dealings in property.” 26 U.S.C. § 61(a)(3). In general, a taxpayer must realize and recognize gains on a sale or other disposition of appreciated property. See id. at § 1001(a)–(c). However, a taxpayer typically does not recognize gain when disposing of appreciated property via gift or charitable contribution. See Taft v. Bowers , 278 U.S. 470, 482 (1929); see also 26 U.S.C. § 1015(a) (providing for carryover basis of gifts). A taxpayer may also generally deduct the fair market value of property contributed to a qualified charitable organization. See 26 U.S.C. § 170(a)(1); Treas. Reg. 16 § 1.170A-1(c)(1). Contributions of appreciated property are thus tax advantaged compared to cash contributions; when a contribution of property is structured properly, a taxpayer can both avoid paying tax on the unrealized appreciation in the property and deduct the property’s fair market value. See, e.g. , Dickinson v. Commissioner , T.C. Memo. 2020-128, at *5.

Donor-Advised Fund. The use of a donor-advised fund further optimizes a contribution by allowing a donor “to get an immediate tax deduction but defer the actual donation of the funds to individual charities until later.” Fairbairn v. Fid. Invs. Charitable Gift Fund , No. 18-cv-04881, 2021 WL 754534, at *2 (N.D. Cal. Feb. 26, 2021).

Two-Part Test to Determine Charitable Contribution of Appreciated Property Followed by Sale by Donee. The donor must (1) give the appreciated property away absolutely and divest of title (2) “before the property gives rise to income by way of a sale.” Humacid Co. v. Commissioner , 42 T.C. 894, 913 (1964).

Valid Gift of Shares of Stock. “Ordinarily, a contribution is made at the time delivery is effected.” Treas. Reg. § 1.170A-1(b). “If a taxpayer unconditionally delivers or mails a properly endorsed stock certificate to a charitable donee or the donee’s agent, the gift is completed on the date of delivery.” Id. However, the regulations do not define what constitutes delivery, and the Tax Court evaluates applicable state law for the threshold determination of whether donors have divested themselves of their property rights via gift. See, e.g. , United States v. Nat’l Bank of Com. , 472 U.S. 713, 722 (1985). In determining the validity of a gift, Michigan law, for example (and as applied in Estate of Hoensheid ), requires a showing of (1) donor intent to make a gift; (2) actual or constructive delivery of the subject matter of the gift; and (3) donee acceptance. See Davidson v. Bugbee , 575 N.W.2d 574, 576 (Mich. Ct. App. 1997).

Present Intent. The determination of a party’s subjective intent is necessarily a highly fact-bound issue. When deciding such an issue, the Tax Court must determine “whether a witness’s testimony is credible based on objective facts, the reasonableness of the testimony, the consistency of statements made by the witness, and the demeanor of the witness.” Ebert v. Commissioner , T.C. Memo. 2015-5, at *5–6. If contradicted by the objective facts in the record, the Tax Court will not “accept the self-serving testimony of [the taxpayer] . . . as gospel.” Tokarski v. Commissioner , 87 T.C. 74, 77 (1986).

Delivery. Under Michigan law, the delivery requirement generally contemplates an “open and visible change of possession” of the donated property. Shepard v. Shepard , 129 N.W. 201, 208 (Mich. 1910). Manually providing tangible property to the donee is the classic form of delivery. Manually providing to the donee a stock certificate that represents intangible shares of stock is traditionally sufficient delivery. The determination of what constitutes delivery is context-specific and depends upon the “nature of the subject-matter of the gift” and the “situation and circumstances of the parties.” Shepard , 129 N.W. at 208. Constructive delivery may be effected where property is delivered into the possession of another on behalf of the donee. See, e.g. , In re Van Wormer’s Estate , 238 N.W. 210, 212 (Mich. 1931). Whether constructive or actual, delivery “must be unconditional and must place the property within the dominion and control of the donee” and “beyond the power of recall by the donor.” In re Casey Estate , 856 N.W.2d 556, 563 (Mich. Ct. App. 2014). If constructive or actual delivery of the gift property occurs, its later retention by the donor is not sufficient to defeat the gift. See Estate of Morris v. Morris , No. 336304, 2018 WL 2024582, at *5 (Mich. Ct. App. May 1, 2018).

Delivery of Shares. Retention of stock certificates by donor’s attorney may preclude a valid gift. Also, a determination of no valid gift may occur where the taxpayer instructs a custodian of corporate books to prepare stock certificates but remained undecided about ultimate gift. In some jurisdictions, transfer of shares on the books of the corporation can, in certain circumstances, constitute delivery of an inter vivos gift of shares. See, e.g. , Wilmington Tr. Co. v. Gen. Motors Corp. , 51 A.2d 584, 594 (Del. Ch. 1947); Chi. Title & Tr. Co. v. Ward , 163 N.E. 319, 322 (Ill. 1928); Brewster v. Brewster , 114 A.2d 53, 57 (Md. 1955). The U.S. Court of Appeals for the Sixth Circuit has stated that transfer on the books of a corporation constitutes delivery of shares of stock, apparently as a matter of federal common law. See Lawton v. Commissioner , 164 F.2d 380, 384 (6th Cir. 1947), rev’g 6 T.C. 1093 (1946); Bardach v. Commissioner , 90 F.2d 323, 326 (6th Cir. 1937), rev’g 32 B.T.A. 517 (1935); Marshall v. Commissioner , 57 F.2d 633, 634 (6th Cir. 1932), aff’g in part, rev’g in part 19 B.T.A. 1260 (1930). The transfers on the books of the corporation were bolstered by other objective actions that evidenced a change in possession and thus a gift. See Jolly’s Motor Livery Co. v. Commissioner , T.C. Memo. 1957-231, 16 T.C.M. (CCH) 1048, 1073.

Acceptance. Donee acceptance of a gift is generally “presumed if the gift is beneficial to the donee.” Davidson , 575 N.W.2d at 576.

Anticipatory Assignment of Income. The anticipatory assignment of income doctrine is a longstanding “first principle of income taxation.” Commissioner v. Banks , 543 U.S. 426, 434 (2005). The doctrine recognizes that income is taxed “to those who earn or otherwise create the right to receive it,” Helvering v. Horst , 311 U.S. 112, 119 (1940), and that tax cannot be avoided “by anticipatory arrangements and contracts however skillfully devised,” Lucas v. Earl , 281 U.S. 111, 115 (1930). A person with a fixed right to receive income from property thus cannot avoid taxation by arranging for another to gratuitously take title before the income is received. See Helvering , 311 U.S. at 115–17; Ferguson , 108 T.C. at 259. This principle is applicable, for instance, where a taxpayer gratuitously assigns wage income that the taxpayer has earned but not yet received, or gratuitously transfers a debt instrument carrying accrued but unpaid interest. A donor will be deemed to have effectively realized income and then assigned that income to another when the donor has an already fixed or vested right to the unpaid income. See Cold Metal Process Co. v. Commissioner , 247 F.2d 864, 872–73 (6th Cir. 1957), rev’g 25 T.C. 1333 (1956). The same principle is often applicable where a taxpayer gratuitously transfers shares of stock that are subject to a pending, prenegotiated transaction and thus carry a fixed right to proceeds of the transaction. See Rollins v. United States , 302 F. Supp. 812, 817–18 (W.D. Tex. 1969).

Determining Anticipatory Assignment of Income. In determining whether an anticipatory assignment of income has occurred with respect to a gift of shares of stock, the Tax Court looks to the realities and substance of the underlying transaction, rather than to formalities or hypothetical possibilities. See Jones v. United States , 531 F.2d 1343, 1345 (6th Cir. 1976) (en banc); Allen v. Commissioner , 66 T.C. 340, 346 (1976). In general, a donor’s right to income from shares of stock is fixed if a transaction involving those shares has become “practically certain to occur” by the time of the gift, “despite the remote and hypothetical possibility of abandonment.” Jones , 531 F.2d at 1346. The mere anticipation or expectation of income at the time of the gift does not establish that a donor’s right to income is fixed. The Tax Court looks to several other factors that bear upon whether the sale of shares was virtually certain to occur at the time of a purported gift as part of the same transaction. Relevant factors may include (1) any legal obligation to sell by the donee, (2) the actions already taken by the parties to effect the transaction, (3) the remaining unresolved transactional contingencies, and (4) the status of the corporate formalities required to finalize the transaction.

Corporate Formalities. Also relevant is the status of the corporate formalities necessary for effecting the transaction. See Estate of Applestein , 80 T.C. at 345–46 (finding that taxpayer’s right to sale proceeds from shares had “virtually ripened” upon shareholders’ approval of proposed merger agreement). Under Michigan law, a proposed plan to exchange shares must generally be approved by a majority of the corporation’s shareholders. Formal shareholder approval of a transaction has often proven to be sufficient to demonstrate that a right to income from shares was fixed before a subsequent transfer. However, such approval is not necessary for a right to income to be fixed, when other actions taken establish that a transaction was virtually certain to occur. See Ferguson , 104 T.C. at 262–63.

Charitable Contribution Deduction. Section 170(a)(1) allows as a deduction any charitable contribution (as defined) payment of which is made within the taxable year. “A charitable contribution is a gift of property to a charitable organization made with charitable intent and without the receipt or expectation of receipt of adequate consideration.” Palmolive Bldg. Invs., LLC v. Commissioner , 149 T.C. 380, 389 (2017). Section 170(f)(8)(A) provides that “[n]o deduction shall be allowed . . . for any contribution of $250 or more unless the taxpayer substantiates the contribution by a contemporaneous written acknowledgement of the contribution by the donee organization that meets the requirements of subparagraph (B).” For contributions of property in excess of $500,000, the taxpayer must also attach to the return a “qualified appraisal” prepared in accordance with generally accepted appraisal standards. 26 U.S.C. § 170(f)(11)(D) and (E).

Contemporaneous Written Acknowledgement (“CWA”). A CWA must include, among other things, the amount of cash and a description of any property contributed. 26 U.S.C. § 170(f)(8)(B). A CWA is contemporaneous if obtained by the taxpayer before the earlier of either (1) the date the relevant tax return was filed or (2) the due date of the relevant tax return. Id. at § 170(f)(8)(C). For donor-advised funds, the CWA must include a statement that the donee “has exclusive legal control over the assets contributed.” 26 U.S.C. § 170(f)(18)(B). These requirements are construed strictly and do not apply the doctrine of substantial compliance to excuse defects in a CWA.

Qualified Appraisal for Certain Charitable Contributions. Section 170(f)(11)(A)(i) provides that “no deduction shall be allowed . . . for any contribution of property for which a deduction of more than $500 is claimed unless such person meets the requirements of subparagraphs (B), (C), and (D), as the case may be.” Subparagraph (D) requires that, for contributions for which a deduction in excess of $500,000 is claimed, the taxpayer attach a qualified appraisal to the return. Section 170(f)(11)(E)(i) provides that a qualified appraisal means, with respect to any property, an appraisal of such property which—(I) is treated for purposes of this paragraph as a qualified appraisal under regulations or other guidance prescribed by the Secretary, and (II) is conducted by a qualified appraiser in accordance with generally accepted appraisal standards and any regulations or other guidance prescribed under subclause (I). The regulations provide that a qualified appraisal is an appraisal document that, inter alia, (1) “[r]elates to an appraisal that is made” no earlier than 60 days before the date of contribution and (2) is “prepared, signed, and dated by a qualified appraiser.” Treas. Reg. § 1.170A-13(c)(3)(i).

Qualified Appraisal Must Include: Treasury Regulation § 1.170A-13(c)(3)(ii) requires that a qualified appraisal itself include, inter alia:

(1) “[a] description of the property in sufficient detail for a person who is not generally familiar with the type of property to ascertain that the property that was appraised is the property that was (or will be) contributed;”

(2) “[t]he date (or expected date) of contribution to the donee;”

(3) “[t]he name, address, and . . . identifying number of the qualified appraiser;”

(4) “[t]he qualifications of the qualified appraiser;”

(5) “a statement that the appraisal was prepared for income tax purposes;”

(6) “[t]he date (or dates) on which the property was appraised;”

(7) “[t]he appraised fair market value . . . of the property on the date (or expected date) of contribution;” and

(8) the method of and specific basis for the valuation.

Qualified Appraiser. Section 170(f)(11)(E)(ii) provides that a “qualified appraiser” is an individual who (I) has earned an appraisal designation from a recognized professional appraiser organization or has otherwise met minimum education and experience requirements set forth in regulations, (II) regularly performs appraisals for which the individual receives compensation, and (III) meets such other requirements as may be prescribed . . . in regulations or other guidance. An appraiser must also demonstrate “verifiable education and experience in valuing the type of property subject to the appraisal.” The regulations add that the appraiser must include in the appraisal summary a declaration that he or she (1) “either holds himself or herself out to the public as an appraiser or performs appraisals on a regular basis;” (2) is “qualified to make appraisals of the type of property being valued;” (3) is not an excluded person specified in paragraph (c)(5)(iv) of the regulation; and (4) understands the consequences of a “false or fraudulent overstatement” of the property’s value. Treas. Reg. § 1.170A-13(c)(5)(i). The regulations prohibit a fee arrangement for a qualified appraisal “based, in effect, on a percentage . . . of the appraised value of the property.” Id. at subpara. (6)(i).

Substantial Compliance with Qualified Appraisal Requirements. The qualified appraisal requirements are directory, rather than mandatory, as the requirements “do not relate to the substance or essence of whether or not a charitable contribution was actually made.” See Bond v. Commissioner , 100 T.C. 32, 41 (1993). Thus, the doctrine of substantial compliance may excuse a failure to strictly comply with the qualified appraisal requirements. If the appraisal discloses sufficient information for the IRS to evaluate the reliability and accuracy of a valuation, the Tax Court may deem the requirements satisfied. Bond , 100 T.C. at 41–42. Substantial compliance allows for minor or technical defects but does not excuse taxpayers from the requirement to disclose information that goes to the “essential requirements of the governing statute.” Estate of Evenchik v. Commissioner , T.C. Memo. 2013-34, at *12. The Tax Court generally declines to apply substantial compliance where a taxpayer’s appraisal either (1) fails to meet substantive requirements in the regulations or (2) omits entire categories of required information.

Reasonable Cause to Avoid Denial of Charitable Contribution Deduction. Taxpayers who fail to comply with the qualified appraisal requirements may still be entitled to charitable contribution deductions if they show that their noncompliance is “due to reasonable cause and not to willful neglect.” 26 U.S.C. § 170(f)(11)(A)(ii)(II). This defense is construed similarly to the defense applicable to numerous other Code provisions that prescribe penalties and additions to tax. See id. at § 6664(c)(1). To show reasonable cause due to reliance on a professional adviser, the Tax Court generally requires that a taxpayer show (1) that their adviser was a competent professional with sufficient expertise to justify reliance; (2) that the taxpayer provided the adviser necessary and accurate information; and (3) that the taxpayer actually relied in good faith on the adviser’s judgment. See Neonatology Assocs., P.A. v. Commissioner , 115 T.C. 43, 99 (2000), aff’d , 299 F.3d 221 (3d Cir. 2002).  “Unconditional reliance on a tax return preparer or C.P.A. does not by itself constitute reasonable reliance in good faith; taxpayers must also exercise ‘[d]iligence and prudence’.” See Stough v. Commissioner , 144 T.C. 306, 323 (2015) (quoting Estate of Stiel v. Commissioner, T.C. Memo. 2009-278, 2009 WL 4877742, at *2)).

Section 6662(a) Penalty. Section 6662(a) and (b)(1) and (2) imposes a 20% penalty on any underpayment of tax required to be show on a return that is attributable to negligence, disregard of rules or regulations, or a substantial understatement of income tax. Negligence includes “any failure to make a reasonable attempt to comply” with the Code, 26 U.S.C. § 6662(c), or a failure “to keep adequate books and records or to substantiate items properly,” Treas. Reg. § 1.6662-3(b)(1). An understatement of income tax is “substantial” if it exceeds the greater of 10% of the tax required to be shown on the return or $5,000. 26 U.S.C. § 6662(d)(1)(A). Generally, the IRS bears the initial burden of production of establishing via sufficient evidence that a taxpayer is liable for penalties and additions to tax; once this burden is met, the taxpayer must carry the burden of proof with regard to defenses such as reasonable cause. Id. at § 7491(c); see Higbee v. Commissioner , 116 T.C. 438, 446–47 (2001). The IRS bears the burden of proof with respect to a new penalty or increase in the amount of a penalty asserted in his answer. See Rader v. Commissioner , 143 T.C. 376, 389 (2014); Rule 142(a), aff’d in part, appeal dismissed in part , 616 F. App’x 391 (10th Cir. 2015); see also RERI Holdings I, LLC v. Commissioner , 149 T.C. 1, 38–39 (2017), aff’d sub nom. Blau v. Commissioner , 924 F.3d 1261 (D.C. Cir. 2019). As part of the burden of production, the IRS must satisfy section 6751(b) by producing evidence of written approval of the penalty by an immediate supervisor, made before formal communication of the penalty to the taxpayer.

Reasonable Cause Defense to Section 6662(a) Penalty. A section 6662 penalty will not be imposed for any portion of an underpayment if the taxpayers show that (1) they had reasonable cause and (2) acted in good faith with respect to that underpayment. 26 U.S.C. § 6664(c)(1). A taxpayer’s mere reliance “on an information return or on the advice of a professional tax adviser or an appraiser does not necessarily demonstrate reasonable cause and good faith.” Treas. Reg. § 1.6664-4(b)(1). That reliance must be reasonable, and the taxpayer must act in good faith. In evaluating whether reliance is reasonable, a taxpayer’s “education, sophistication and business experience will be relevant.” Id. para. (c)(1).

Insights: Going forward, this opinion of Estate of Hoenshied v. Commissioner will likely be a go-to source for any practitioner involved in a taxpayer’s proposed transfer of corporate shares (or other property) to a donor-advised fund or other charitable organization as part of a buy-sell transaction that is anywhere close in time to the proposed donation.

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Home > QSBS Case Law > The Benefits and Potential Consequences Behind Gifting QSBS

The Benefits and Potential Consequences Behind Gifting QSBS

The provisions of Qualified Small Business Stock (QSBS) found under IRC Section 1202 are inarguably complicated to navigate. There are several aspects to consider when it comes to gifting QSBS. The stock donor and beneficiary will want to ensure that the QSBS gifting specifications are followed with total accuracy to guarantee that the profitable gifted stock doesn’t become a long-term legal or financial burden for either party.    

Timing is Everything

The first key aspect to consider when giving and receiving QSBS is timing. If done correctly, timing can be the difference between saving millions of dollars versus paying tax on the gifted stock. Gifting of QSBS is allowed under Section 1202(h)(1) and can greatly benefit the donee of the QSBS. The donee will become the recipient of the QSBS in the same manner in which the donor received the stock. Additionally, the QSBS recipient will be seen to have held such stock for the same period of time the donor held it — also referred to as “tacking on.”

However, there is a possibility that there will be a tax placed on the gifted QSBS if the IRS finds that the donor has gifted QSBS in an “anticipatory” manner (i.e. gifting said stock after signing a merger agreement with another corporation). This is known as the “Assignment of Income Doctrine.” 

What is the Assignment of Income Doctrine?

To get a broad concept of an “Assignment of Income Doctrine,” we should first look at West’s Tax Law dictionary that states the doctrine:

 “[T]reats gratuitous transfers of income as ineffective for the purpose of shifting income. The transferor is taxed when the transferee receives the income pursuant to the transfer. Sometimes referred to as the anticipatory assignment of income doctrine.”   Assignment of Income Doctrine, West’s Tax Law Dictionary § A3170 (updated Feb. 2022).

This doctrine also taxes income to individuals who have created an interest “to receive it and enjoy the benefit of it when paid.” Helvering v. Horst, 311 U.S. 112, 119 (1940) . A prominent case, Commissioner v. P. G. Lake, Inc. , decided by the Supreme Court, stated that if a taxpayer is “entitled to receive at a future date interest on a bond or compensation for services, makes a grant of it by anticipatory assignment, he realizes taxable income as if he had collected the interest or received the salary and then paid it over.” Comm’r v. P. G. Lake, Inc. , 356 U.S. 260, 267, 78 S. Ct. 691, 695, 2 L. Ed. 2d 743 (1958) .

When is the Doctrine Triggered?

There is not yet a definitive answer from the IRS or the Tax Court on what exactly triggers a gift to fall under the “Assignment of Income Doctrine.” However, it appears that it is very fact-specific to the case at hand. In Palmer v. Commissioner , 62 T.C. 684, 693 (1974) , the Tax Court held that mere anticipation of redemption does not trigger the “Assignment of Income Doctrine” if the taxpayer were to gift assets before the redemption was to be agreed upon. 

As a result of the Palmer case, the IRS followed Palmer’s analysis for the “Assignment of Income Doctrine” by creating Rev. Rul. 78-197, 1978-1 C.B. 83 (1978) . Which states if the facts of the case purport to have a charitable contribution followed by a prearranged redemption plan, then the income will not be considered to fall under the “Assignment of Income Doctrine.” In Palmer , the shareholder gifted stock to a charitable foundation that the shareholder also had some control over. The next day, the shareholder then had the charitable foundation, the donee, arrange the redemption of the stock — hence the “prearranged redemption” plan.

Learn more about the details and intricacies of gifting QSBS under Section 1202 here . 

However, the doctrine will be triggered if a taxpayer agrees to a merger then gifts his shares to a donee. As a result, the donor will be held liable to pay taxes upon the gift. See Est. of Applestein v. Comm’r of Internal Revenue , 80 T.C. 331 (1983) . Legally, this can be classified as avoiding tax liability. In this circumstance, the taxpayer was legally bound by the merger agreement, and there was no prearranged plan to gift such assets.

Future Planning for Gifting of QSBS

As seen in these court rulings, as long as the taxpayer has prearranged the gifting of QSBS with donees (other than spouses) before a known exit event, the “Assignment of Income Doctrine” is unlikely to come into play. QSBS gifting should occur before the QSBS holder enters a sales agreement or has reason to know of the acquired qualified business. As stated previously, the QSBS tax exemption could be multiplied if a taxpayer, in good faith, plans on distributing his assets to others through gifts. However, taxpayers need to navigate a fine line if the company they hold stock in is approaching a transaction.

Are you planning or preparing to gift QSBS stock, or are you the recipient of QSBS eligible stock? Our team of QSBS experts here at CapGains.com can assist you in navigating the nuances of QSBS qualifications and ensure QSBS eligibility of your stock over time.  

This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.

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Timing Is Critical for Gift of Appreciated Stock to Avoid Capital Gain From Sale of Company

Business owners contemplating selling their companies often look to their tax advisers for options to reduce the potential tax impact upon sale. One option routinely considered is having the owner contribute a portion of the appreciated stock to a charitable organization before the transaction closes to avoid income taxes on the donated shares. This leads to a critical question: How far in advance of the closing must the charitable contribution occur?

On March 15, 2023, the Tax Court issued an opinion concluding that donating stock two days before closing on a third-party sale transaction was clearly too late to avoid tax. The Tax Court declined to specify a “bright line” deadline for making a donation and instead focused on the substance of the underlying transactions. All in all, these taxpayers paid income taxes on the recognized gain on the shares they no longer owned and didn’t get the charitable tax deduction for failure to meet the strict substantiation rules.

In the Estate of Scott M. Hoensheid, et al. v. Commissioner (T.C. Memo 2023-34), the taxpayers were clear at the outset that they wanted to “wait as long as possible to pull the trigger” on donating shares valued at more than $3 million to charity because they wanted to make sure the sale of the company was going to occur. They were also clear that the purpose for donating was to avoid paying income taxes on any gain associated with the donated shares. To reach these stated goals, the taxpayers worked closely with their tax/estate planning attorney and a financial adviser to structure the stock sale transaction hoping for an $80 million target price and to find a charity that was willing to accept the stock and then participate in the third-party sale transaction without much hassle.

In early 2015, the taxpayers’ financial adviser started soliciting bids for the company and received significant interest from private equity firms. In mid-April 2015, the taxpayers’ tax attorney advised them that “the transfer [to the charity] would have to take place before there is a definitive agreement in place.” Concurrently, the taxpayers began working with Fidelity Investments Charitable Gift Fund, a large tax-exempt organization that serves as a sponsoring organization with regard to establishing donor-advised funds, to accept the donation of company stock. Fidelity Charitable provided a similar warning to the taxpayers that the gift must take place before any purchase agreement is executed to avoid the Internal Revenue Service raising the anticipatory assignment of income doctrine.

Anticipatory Assignment of Income Doctrine

The anticipatory assignment of income doctrine has been around since at least the 1930s. See Lucas v. Earl , 281 U.S. 111 (1930). Under this doctrine, income is taxed “to those who earn or otherwise create the right to receive it.” See Helvering v. Horst , 311 U.S. 112, 119 (1940). The courts have been clear that taxpayers cannot avoid tax by entering into anticipatory arrangements and contracts where a person with a fixed right to receive income from property arranges for another person to gratuitously take title before the income is actually received.

The person who gratuitously takes title usually has a lower effective income tax rate or does not pay tax at all on recognized gains (i.e., many charitable organizations). If the doctrine is triggered, the donor is deemed to have effectively realized the income and then assigned that income to another. This results in the donor paying tax on the income that he or she did not actually receive. For charitable donations, the donor likely is unable to force the charity to rescind the transaction, causing the taxpayer to use personal funds to pay the taxes on the income received by the charity.

Unfortunately, the Tax Court’s ruling in Estate of Hoensheid did not specify a bright line deadline for making a donation to give donors assurance that the anticipatory assignment of income doctrine would not apply. Instead, to determine who has a fixed right to the income, the Tax Court stated that it looks at the realities and substance of the underlying transactions rather than formalities or hypothetical possibilities. Factors considered include (i) the donee’s obligation to sell the shares, (ii) the acts of the parties to effect the sale transactions, (iii) unresolved sale contingencies as of the date of the donation and (iv) corporate formalities necessary to effect the transaction.

In reviewing the substance of the underlying transactions in the Estate of Hoensheid case, the Tax Court found that Fidelity Charitable did not have any obligation to sell the shares, which was a factor in favor of the taxpayers. However, the court was not persuaded by the taxpayers’ arguments that the donation occurred over a month before the transaction closed. Importantly, nine days before the transaction closed, the taxpayers’ attorney indicated that the amount of shares being transferred was unclear and that the stock assignment had not been executed.

In the end, the court concluded that Fidelity Charitable accepted the gift only two days before the stock sale transaction closed when one of the taxpayers’ advisers emailed a copy of the company stock certificate issued in the name of Fidelity Charitable.

As of the date of contribution, the Tax Court opined that there were no unresolved sale contingencies and noted that the shareholders had emptied the company’s working capital by distributing cash to the owners (not including Fidelity Charitable).

Finally, the Tax Court looked at the corporate formalities. While the taxpayers argued that negotiations were ongoing all the way through the closing date of July 15, 2015, the Tax Court said the signing of the definitive purchase agreement on that date was purely ministerial and any decision not to sell as of the date of donation was remote and hypothetical. These facts led to the conclusion that the transaction was “too far down the road to enable [the taxpayers] to escape taxation on the gain attributable to the donated shares.”

When considering the enumerated factors, donors should be very careful to avoid creating an informal, prearranged understanding with the charity that would constitute an obligation for the charity to agree to sell. Additionally, the donor must bear some risk at the time of the contribution that the sale will not close. In the Estate of Hoensheid , the taxpayers sought to eliminate any risk that the sale would not go through, and as a result, the Tax Court agreed with the Internal Revenue Service imposing the anticipatory assignment of income doctrine to force the taxpayers to recognize gain on the contributed shares as a result of the later sale to the private equity firm.

The key takeaways from this case are: (i) waiting until shortly before a purchase agreement is executed significantly increases the risk that the Internal Revenue Service will assert the anticipatory assignment of income doctrine; and (ii) the Internal Revenue Service and the courts will look closely at the transaction documents, intent of the donor, correspondence between the donor and his or her advisers, and the records of the charity to determine the date of the gift and the application of this doctrine.  This does not mean that donors must make such gifts before a transaction is contemplated, or even before a nonbinding letter of intent is executed. This case is simply a cautionary tale to remind taxpayers that the Internal Revenue Service will closely scrutinize donations of stock in advance of a stock sale transaction. Maybe one day the Internal Revenue Service or the courts will provide a “bright line,” but for now caution is key.

Loss of Charitable Deduction

After reaching its conclusion related to the anticipatory assignment of income doctrine, the Tax Court turned to the Internal Revenue Service’s argument that the taxpayers should not be permitted a charitable deduction for the donated shares for failing to comply with the rigid substantiation requirements. For a more complete discussion of these requirements, see McGuireWoods’ Nov. 10, 2022, alert .   As a reminder, when the Internal Revenue Service challenges a charitable deduction on procedural grounds, it is not disputing the fact that a charitable contribution was made.  In fact, the Internal Revenue Service admits that the contribution was made but nonetheless challenges the taxpayers’ ability to claim a tax deduction. 

Here, the Internal Revenue Service argued that the taxpayers failed to engage a qualified appraiser and the appraisal did not satisfy the basic requirements for a qualified appraisal.

A qualified appraiser is someone who has obtained an appraisal designation from a recognized professional organization or otherwise has sufficient education and experience, and who regularly performs appraisals for compensation. The qualified appraisal must include all of the following:

• A description of the contributed property in sufficient detail, including the physical condition of any real or tangible property.
• The valuation effective date. For qualified appraisals prepared before the date of contribution, the valuation effective date must be no earlier than 60 days before the date of contribution and no later than the actual date of contribution. For qualified appraisals prepared after the contribution, the valuation effective date must be the date of contribution.
• The fair market value of the contributed property on the valuation effective date.
• The date or expected date of contribution.
• The terms of any agreement relating to the use, sale or other disposition of the contributed property. This includes any restrictions on the donee’s ability to dispose of the property, any rights to income from the property or rights to vote any contributed securities.
• The name, address and taxpayer identification number of the qualified appraiser or the partnership or employer who employs the qualified appraiser.
• The qualifications of the appraiser, including education and experience.
• A statement that the appraisal was prepared for income tax purposes.
• The method of valuation used (e.g., income approach, market-data approach, replacement-cost-less-depreciation approach) and the specific basis for the valuation (e.g., specific comparable sales, statistical sampling).
• A description of the fee arrangement between the donor and qualified appraiser.
• This declaration: “I understand that my appraisal will be used in connection with a return or claim for refund. I also understand that, if there is a substantial or gross valuation misstatement of the value of the property claimed on the return or claim for refund that is based on my appraisal, I may be subject to a penalty under Section 6695A of the Internal Revenue Code, as well as other applicable penalties. I affirm that I have not been at any time in the three-year period ending on the date of the appraisal barred from presenting evidence or testimony before the Department of Treasury of the Internal Revenue Service pursuant to 31 U.S.C. 330(c).”
• The signature of the qualified appraiser and the appraisal report date. The qualified appraisal must be signed and dated no earlier than 60 days before the date of contribution and no later than the due date for the tax return (including extensions) on which the deduction is claimed.

In Estate of Hoensheid , the taxpayers decided to use the services of their financial adviser that worked on the sales transaction to save the costs of having an outside expert prepare the appraisal. This cost-saving move ended up actually costing the taxpayers their entire $3.3 million claim of a charitable deduction for the donated stock. Because the taxpayers’ financial adviser did not have any appraisal certifications, did not hold himself out as an appraiser, and prepares valuations only once or twice a year in order to solicit business for his financial advisory firm, the Tax Court agreed with the Internal Revenue Service that the taxpayer failed to engage a qualified appraiser.

The Tax Court reviewed the Internal Revenue Service’s arguments that the contents of the appraisal attached to the tax return were deficient. The Tax Court agreed and indicated that the appraisal (i) included the incorrect date of contribution, (ii) did not include the statement that it was prepared for federal income tax purposes, (iii) included a premature date of appraisal, (iv) did not sufficiently describe the method for the valuation, (v) was not signed by the appraiser, (vi) did not include the appraiser’s qualifications as an appraiser, (vii) did not describe the donated property in sufficient detail and (viii) did not include an explanation of the specific basis for the valuation.

While the taxpayers did not dispute that the appraisal had defects, they sought to rely on the “substantial compliance” doctrine to excuse these stringent substantiation requirements. The Tax Court analyzed the substantial compliance argument but rejected it, stating that the appraisal failed with regard to multiple substantive requirements of the applicable regulations. As a result, no deduction for the contribution of shares to Fidelity Charitable was allowed.

Again, it is critical for taxpayers and their advisers to closely review the Treasury regulations that set forth the substantiation requirements to minimize the risk that the Internal Revenue Service challenges a charitable deduction on procedural grounds.

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Anticipatory assignment of income, charitable contribution deduction, and qualified appraisals.

Estate of Hoenshied v. Comm’r, T.C. Memo. 2023-34 | March 15, 2023 | Nega, J. | Dkt. No. 18606-19

Summary: In this 49-page opinion the Tax Court addresses a deficiency arising from the charitable contribution of appreciated shares of stock in a closely held corporation to a charitable organization that administers donor-advised funds for tax-exempt purposes under section 501(c)(3). The contribution in issue was made near contemporaneously with the selling of those shares to a third party. The timeline (truncated heavily for this blog) is as follows:

On June 11, 2015, the shareholders of the corporation in issue unanimously ratified the sale of all outstanding stock of the corporation. Immediately following the shareholder meeting, the corporation’s board of directors unanimously approved Petitioner’s request to be able to transfer a portion of his shares to Fidelity Charitable Gift Fund, a tax-exempt charitable organization under section 501(c)(3). Thereafter, the corporation and the purchaser of shares continued drafting and revising the Contribution and Stock Purchase Agreement.

On July 13, 2015, Fidelity Charitable first received a stock certificate from Petitioner.

On July 14, 2015, the Contribution and Stock Purchase Agreement was revised to specify that Petitioner contributed shares to Fidelity Charitable on July 10, 2015, and on July 15, 2015, the Contribution and Stock Purchase Agreement was signed and the transaction was funded.

Fidelity Charitable, having provided an Irrevocable Stock Power as part of the transaction, received $2,941,966 in cash proceeds from the sale, which was deposited in Petitioner’s donor-advised fund giving account.

On November 18, 2015, Fidelity Charitable sent Petitioner a contribution confirmation letter acknowledging a charitable contribution of the corporate shares and indicating that Fidelity Charitable received the shares on June 11, 2015.

In its 2015 tax return, Petitioner did not report any capital gains on the shares contributed to Fidelity Charitable but claimed a noncash charitable contribution deduction of $3,282,511. In support of the claimed deduction, a Form 8283 was attached to the return.

Petitioner’s 2015 tax return was selected for examination. The IRS issued to Petitioners a notice of deficiency, determining a deficiency of $647,489, resulting from the disallowance of the claimed charitable contribution deduction, and a penalty of $129,498 under section 6662(a).

Key Issues:

Whether and when Petitioners made a valid contribution of the shares of stock? Whether Petitioners had unreported capital gain income due to their right to proceeds from the sale of those shares becoming fixed before the gift? Whether Petitioners are entitled to a charitable contribution deduction? Whether Petitioners are liable for an accuracy-related penalty under section 6662(a) with respect to an underpayment of tax?

Primary Holdings:

(1) Petitioners failed to establish that any of the elements of a valid gift was present on June 11, 2015. No evidence was presented to credibly identify a specific action taken on June 11 that placed the shares within Fidelity Charitable’s dominion and control. Instead, the valid gift of shares was made by effecting delivery of a PDF of the certificate to Fidelity Charitable on July 13.

(2) Yes. None of the unresolved contingencies remaining on July 13, 2015 were substantial enough to have posed even a small risk of the overall transaction’s failing to close. Thus, Petitioners, through the doctrine of anticipatory assignment of income, had capital gains on the sale of the 1,380 appreciated shares of stock, even though Fidelity Charitable received the proceeds from that sale.

(3) No, Petitioners failed to show that the charitable contribution met the qualified appraisal requirements of section 170. The appraiser was not shown to be qualified, per regulations, at trial or in the appraisal itself, and the appraisal did not substantially comply with the regulatory requirements. “The failure to include a description of such experience in the appraisal was a substantive defect. . . . Petitioners’ failure to satisfy multiple substantive requirements of the regulations, paired with the appraisal’s other more minor defects, precludes them from establishing substantial compliance.” In addition, Petitioners failed to establish reasonable cause for failing to comply with the appraisal requirements “because petitioner knew or should have known that the date of contribution (and thus the date of valuation) was incorrect.” Thus, the IRS’s determination to disallow the charitable contribution deduction is sustained.

(4) No. While Petitioners did not have reasonable cause for their failure to comply with the qualified appraisal requirement, their liability for an accuracy-related penalty was a separate analysis, and the IRS did not carry the burden of proof. Petitioners did not follow their professional’s advice to have the paperwork for the contribution ready to go “well before the signing of the definitive purchase agreement.” But, Petitioners adhered to the literal thrust of the advice given: that “execution of the definitive purchase agreement” was the firm deadline to contribute the shares and avoid capital gains (even if that proved to be incorrect advice under the circumstances).

Key Points of Law:

Gross Income. Gross income means “all income from whatever source derived,” including “[g]ains derived from dealings in property.” 26 U.S.C. § 61(a)(3). In general, a taxpayer must realize and recognize gains on a sale or other disposition of appreciated property. See id. at § 1001(a)–(c). However, a taxpayer typically does not recognize gain when disposing of appreciated property via gift or charitable contribution. See Taft v. Bowers, 278 U.S. 470, 482 (1929); see also 26 U.S.C. § 1015(a) (providing for carryover basis of gifts). A taxpayer may also generally deduct the fair market value of property contributed to a qualified charitable organization. See 26 U.S.C. § 170(a)(1); Treas. Reg. 16 § 1.170A-1(c)(1). Contributions of appreciated property are thus tax advantaged compared to cash contributions; when a contribution of property is structured properly, a taxpayer can both avoid paying tax on the unrealized appreciation in the property and deduct the property’s fair market value. See, e.g., Dickinson v. Commissioner, T.C. Memo. 2020-128, at *5.

Donor-Advised Fund. The use of a donor-advised fund further optimizes a contribution by allowing a donor “to get an immediate tax deduction but defer the actual donation of the funds to individual charities until later.” Fairbairn v. Fid. Invs. Charitable Gift Fund, No. 18-cv-04881, 2021 WL 754534, at *2 (N.D. Cal. Feb. 26, 2021).

Two-Part Test to Determine Charitable Contribution of Appreciated Property Followed by Sale by Donee. The donor must (1) give the appreciated property away absolutely and divest of title (2) “before the property gives rise to income by way of a sale.” Humacid Co. v. Commissioner, 42 T.C. 894, 913 (1964). Valid Gift of Shares of Stock. “Ordinarily, a contribution is made at the time delivery is effected.” Treas. Reg. § 1.170A-1(b). “If a taxpayer unconditionally delivers or mails a properly endorsed stock certificate to a charitable donee or the donee’s agent, the gift is completed on the date of delivery.” Id. However, the regulations do not define what constitutes delivery, and the Tax Court evaluates applicable state law for the threshold determination of whether donors have divested themselves of their property rights via gift. See, e.g., United States v. Nat’l Bank of Com., 472 U.S. 713, 722 (1985). In determining the validity of a gift, Michigan law, for example (and as applied in Estate of Hoensheid), requires a showing of (1) donor intent to make a gift; (2) actual or constructive delivery of the subject matter of the gift; and (3) donee acceptance. See Davidson v. Bugbee, 575 N.W.2d 574, 576 (Mich. Ct. App. 1997).

Present Intent. The determination of a party’s subjective intent is necessarily a highly fact-bound issue. When deciding such an issue, the Tax Court must determine “whether a witness’s testimony is credible based on objective facts, the reasonableness of the testimony, the consistency of statements made by the witness, and the demeanor of the witness.” Ebert v. Commissioner, T.C. Memo. 2015-5, at *5–6. If contradicted by the objective facts in the record, the Tax Court will not “accept the self-serving testimony of [the taxpayer] . . . as gospel.” Tokarski v. Commissioner, 87 T.C. 74, 77 (1986).

Delivery. Under Michigan law, the delivery requirement generally contemplates an “open and visible change of possession” of the donated property. Shepard v. Shepard, 129 N.W. 201, 208 (Mich. 1910). Manually providing tangible property to the donee is the classic form of delivery. Manually providing to the donee a stock certificate that represents intangible shares of stock is traditionally sufficient delivery. The determination of what constitutes delivery is context-specific and depends upon the “nature of the subject-matter of the gift” and the “situation and circumstances of the parties.” Shepard, 129 N.W. at 208. Constructive delivery may be effected where property is delivered into the possession of another on behalf of the donee. See, e.g., In re Van Wormer’s Estate, 238 N.W. 210, 212 (Mich. 1931). Whether constructive or actual, delivery “must be unconditional and must place the property within the dominion and control of the donee” and “beyond the power of recall by the donor.” In re Casey Estate, 856 N.W.2d 556, 563 (Mich. Ct. App. 2014). If constructive or actual delivery of the gift property occurs, its later retention by the donor is not sufficient to defeat the gift. See Estate of Morris v. Morris, No. 336304, 2018 WL 2024582, at *5 (Mich. Ct. App. May 1, 2018).

Delivery of Shares. Retention of stock certificates by donor’s attorney may preclude a valid gift. Also, a determination of no valid gift may occur where the taxpayer instructs a custodian of corporate books to prepare stock certificates but remained undecided about ultimate gift. In some jurisdictions, transfer of shares on the books of the corporation can, in certain circumstances, constitute delivery of an inter vivos gift of shares. See, e.g., Wilmington Tr. Co. v. Gen. Motors Corp., 51 A.2d 584, 594 (Del. Ch. 1947); Chi. Title & Tr. Co. v. Ward, 163 N.E. 319, 322 (Ill. 1928); Brewster v. Brewster, 114 A.2d 53, 57 (Md. 1955). The U.S. Court of Appeals for the Sixth Circuit has stated that transfer on the books of a corporation constitutes delivery of shares of stock, apparently as a matter of federal common law. See Lawton v. Commissioner, 164 F.2d 380, 384 (6th Cir. 1947), rev’g 6 T.C. 1093 (1946); Bardach v. Commissioner, 90 F.2d 323, 326 (6th Cir. 1937), rev’g 32 B.T.A. 517 (1935); Marshall v. Commissioner, 57 F.2d 633, 634 (6th Cir. 1932), aff’g in part, rev’g in part 19 B.T.A. 1260 (1930). The transfers on the books of the corporation were bolstered by other objective actions that evidenced a change in possession and thus a gift. See Jolly’s Motor Livery Co. v. Commissioner, T.C. Memo. 1957-231, 16 T.C.M. (CCH) 1048, 1073.

Acceptance. Donee acceptance of a gift is generally “presumed if the gift is beneficial to the donee.” Davidson, 575 N.W.2d at 576.

Anticipatory Assignment of Income. The anticipatory assignment of income doctrine is a longstanding “first principle of income taxation.” Commissioner v. Banks, 543 U.S. 426, 434 (2005). The doctrine recognizes that income is taxed “to those who earn or otherwise create the right to receive it,” Helvering v. Horst, 311 U.S. 112, 119 (1940), and that tax cannot be avoided “by anticipatory arrangements and contracts however skillfully devised,” Lucas v. Earl, 281 U.S. 111, 115 (1930). A person with a fixed right to receive income from property thus cannot avoid taxation by arranging for another to gratuitously take title before the income is received. See Helvering, 311 U.S. at 115–17; Ferguson, 108 T.C. at 259. This principle is applicable, for instance, where a taxpayer gratuitously assigns wage income that the taxpayer has earned but not yet received, or gratuitously transfers a debt instrument carrying accrued but unpaid interest. A donor will be deemed to have effectively realized income and then assigned that income to another when the donor has an already fixed or vested right to the unpaid income. See Cold Metal Process Co. v. Commissioner, 247 F.2d 864, 872–73 (6th Cir. 1957), rev’g 25 T.C. 1333 (1956). The same principle is often applicable where a taxpayer gratuitously transfers shares of stock that are subject to a pending, prenegotiated transaction and thus carry a fixed right to proceeds of the transaction. See Rollins v. United States, 302 F. Supp. 812, 817–18 (W.D. Tex. 1969).

Determining Anticipatory Assignment of Income. In determining whether an anticipatory assignment of income has occurred with respect to a gift of shares of stock, the Tax Court looks to the realities and substance of the underlying transaction, rather than to formalities or hypothetical possibilities. See Jones v. United States, 531 F.2d 1343, 1345 (6th Cir. 1976) (en banc); Allen v. Commissioner, 66 T.C. 340, 346 (1976). In general, a donor’s right to income from shares of stock is fixed if a transaction involving those shares has become “practically certain to occur” by the time of the gift, “despite the remote and hypothetical possibility of abandonment.” Jones, 531 F.2d at 1346. The mere anticipation or expectation of income at the time of the gift does not establish that a donor’s right to income is fixed. The Tax Court looks to several other factors that bear upon whether the sale of shares was virtually certain to occur at the time of a purported gift as part of the same transaction. Relevant factors may include (1) any legal obligation to sell by the donee, (2) the actions already taken by the parties to effect the transaction, (3) the remaining unresolved transactional contingencies, and (4) the status of the corporate formalities required to finalize the transaction.

Corporate Formalities. Also relevant is the status of the corporate formalities necessary for effecting the transaction. See Estate of Applestein, 80 T.C. at 345–46 (finding that taxpayer’s right to sale proceeds from shares had “virtually ripened” upon shareholders’ approval of proposed merger agreement). Under Michigan law, a proposed plan to exchange shares must generally be approved by a majority of the corporation’s shareholders. Formal shareholder approval of a transaction has often proven to be sufficient to demonstrate that a right to income from shares was fixed before a subsequent transfer. However, such approval is not necessary for a right to income to be fixed, when other actions taken establish that a transaction was virtually certain to occur. See Ferguson, 104 T.C. at 262–63. Charitable Contribution Deduction. Section 170(a)(1) allows as a deduction any charitable contribution (as defined) payment of which is made within the taxable year. “A charitable contribution is a gift of property to a charitable organization made with charitable intent and without the receipt or expectation of receipt of adequate consideration.” Palmolive Bldg. Invs., LLC v. Commissioner, 149 T.C. 380, 389 (2017). Section 170(f)(8)(A) provides that “[n]o deduction shall be allowed . . . for any contribution of $250 or more unless the taxpayer substantiates the contribution by a contemporaneous written acknowledgement of the contribution by the donee organization that meets the requirements of subparagraph (B).” For contributions of property in excess of $500,000, the taxpayer must also attach to the return a “qualified appraisal” prepared in accordance with generally accepted appraisal standards. 26 U.S.C. § 170(f)(11)(D) and (E). Contemporaneous Written Acknowledgement (“CWA”). A CWA must include, among other things, the amount of cash and a description of any property contributed. 26 U.S.C. § 170(f)(8)(B). A CWA is contemporaneous if obtained by the taxpayer before the earlier of either (1) the date the relevant tax return was filed or (2) the due date of the relevant tax return. Id. at § 170(f)(8)(C). For donor-advised funds, the CWA must include a statement that the donee “has exclusive legal control over the assets contributed.” 26 U.S.C. § 170(f)(18)(B). These requirements are construed strictly and do not apply the doctrine of substantial compliance to excuse defects in a CWA.

Qualified Appraisal for Certain Charitable Contributions. Section 170(f)(11)(A)(i) provides that “no deduction shall be allowed . . . for any contribution of property for which a deduction of more than $500 is claimed unless such person meets the requirements of subparagraphs (B), (C), and (D), as the case may be.” Subparagraph (D) requires that, for contributions for which a deduction in excess of $500,000 is claimed, the taxpayer attach a qualified appraisal to the return. Section 170(f)(11)(E)(i) provides that a qualified appraisal means, with respect to any property, an appraisal of such property which—(I) is treated for purposes of this paragraph as a qualified appraisal under regulations or other guidance prescribed by the Secretary, and (II) is conducted by a qualified appraiser in accordance with generally accepted appraisal standards and any regulations or other guidance prescribed under subclause (I). The regulations provide that a qualified appraisal is an appraisal document that, inter alia, (1) “[r]elates to an appraisal that is made” no earlier than 60 days before the date of contribution and (2) is “prepared, signed, and dated by a qualified appraiser.” Treas. Reg. § 1.170A-13(c)(3)(i).

Qualified Appraisal Must Include: Treasury Regulation § 1.170A-13(c)(3)(ii) requires that a qualified appraisal itself include, inter alia:

(1) “[a] description of the property in sufficient detail for a person who is not generally familiar with the type of property to ascertain that the property that was appraised is the property that was (or will be) contributed;”

(2) “[t]he date (or expected date) of contribution to the donee;”

(3) “[t]he name, address, and . . . identifying number of the qualified appraiser;”

(4) “[t]he qualifications of the qualified appraiser;”

(5) “a statement that the appraisal was prepared for income tax purposes;”

(6) “[t]he date (or dates) on which the property was appraised;”

(7) “[t]he appraised fair market value . . . of the property on the date (or expected date) of contribution;” and

(8) the method of and specific basis for the valuation.

Qualified Appraiser. Section 170(f)(11)(E)(ii) provides that a “qualified appraiser” is an individual who (I) has earned an appraisal designation from a recognized professional appraiser organization or has otherwise met minimum education and experience requirements set forth in regulations, (II) regularly performs appraisals for which the individual receives compensation, and (III) meets such other requirements as may be prescribed . . . in regulations or other guidance. An appraiser must also demonstrate “verifiable education and experience in valuing the type of property subject to the appraisal.” The regulations add that the appraiser must include in the appraisal summary a declaration that he or she (1) “either holds himself or herself out to the public as an appraiser or performs appraisals on a regular basis;” (2) is “qualified to make appraisals of the type of property being valued;” (3) is not an excluded person specified in paragraph (c)(5)(iv) of the regulation; and (4) understands the consequences of a “false or fraudulent overstatement” of the property’s value. Treas. Reg. § 1.170A-13(c)(5)(i). The regulations prohibit a fee arrangement for a qualified appraisal “based, in effect, on a percentage . . . of the appraised value of the property.” Id. at subpara. (6)(i).

Substantial Compliance with Qualified Appraisal Requirements . The qualified appraisal requirements are directory, rather than mandatory, as the requirements “do not relate to the substance or essence of whether or not a charitable contribution was actually made.” See Bond v. Commissioner, 100 T.C. 32, 41 (1993). Thus, the doctrine of substantial compliance may excuse a failure to strictly comply with the qualified appraisal requirements. If the appraisal discloses sufficient information for the IRS to evaluate the reliability and accuracy of a valuation, the Tax Court may deem the requirements satisfied. Bond, 100 T.C. at 41–42. Substantial compliance allows for minor or technical defects but does not excuse taxpayers from the requirement to disclose information that goes to the “essential requirements of the governing statute.” Estate of Evenchik v. Commissioner, T.C. Memo. 2013-34, at *12. The Tax Court generally declines to apply substantial compliance where a taxpayer’s appraisal either (1) fails to meet substantive requirements in the regulations or (2) omits entire categories of required information.

Reasonable Cause to Avoid Denial of Charitable Contribution Deduction. Taxpayers who fail to comply with the qualified appraisal requirements may still be entitled to charitable contribution deductions if they show that their noncompliance is “due to reasonable cause and not to willful neglect.” 26 U.S.C. § 170(f)(11)(A)(ii)(II). This defense is construed similarly to the defense applicable to numerous other Code provisions that prescribe penalties and additions to tax. See id. at § 6664(c)(1). To show reasonable cause due to reliance on a professional adviser, the Tax Court generally requires that a taxpayer show (1) that their adviser was a competent professional with sufficient expertise to justify reliance; (2) that the taxpayer provided the adviser necessary and accurate information; and (3) that the taxpayer actually relied in good faith on the adviser’s judgment. See Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002). “Unconditional reliance on a tax return preparer or C.P.A. does not by itself constitute reasonable reliance in good faith; taxpayers must also exercise ‘[d]iligence and prudence’.” See Stough v. Commissioner, 144 T.C. 306, 323 (2015) (quoting Estate of Stiel v. Commissioner, T.C. Memo. 2009-278, 2009 WL 4877742, at *2)).

Section 6662(a) Penalty. Section 6662(a) and (b)(1) and (2) imposes a 20% penalty on any underpayment of tax required to be show on a return that is attributable to negligence, disregard of rules or regulations, or a substantial understatement of income tax. Negligence includes “any failure to make a reasonable attempt to comply” with the Code, 26 U.S.C. § 6662(c), or a failure “to keep adequate books and records or to substantiate items properly,” Treas. Reg. § 1.6662-3(b)(1). An understatement of income tax is “substantial” if it exceeds the greater of 10% of the tax required to be shown on the return or $5,000. 26 U.S.C. § 6662(d)(1)(A). Generally, the IRS bears the initial burden of production of establishing via sufficient evidence that a taxpayer is liable for penalties and additions to tax; once this burden is met, the taxpayer must carry the burden of proof with regard to defenses such as reasonable cause. Id. at § 7491(c); see Higbee v. Commissioner, 116 T.C. 438, 446–47 (2001). The IRS bears the burden of proof with respect to a new penalty or increase in the amount of a penalty asserted in his answer. See Rader v. Commissioner, 143 T.C. 376, 389 (2014); Rule 142(a), aff’d in part, appeal dismissed in part, 616 F. App’x 391 (10th Cir. 2015); see also RERI Holdings I, LLC v. Commissioner, 149 T.C. 1, 38–39 (2017), aff’d sub nom. Blau v. Commissioner, 924 F.3d 1261 (D.C. Cir. 2019). As part of the burden of production, the IRS must satisfy section 6751(b) by producing evidence of written approval of the penalty by an immediate supervisor, made before formal communication of the penalty to the taxpayer.

Reasonable Cause Defense to Section 6662(a) Penalty. A section 6662 penalty will not be imposed for any portion of an underpayment if the taxpayers show that (1) they had reasonable cause and (2) acted in good faith with respect to that underpayment. 26 U.S.C. § 6664(c)(1). A taxpayer’s mere reliance “on an information return or on the advice of a professional tax adviser or an appraiser does not necessarily demonstrate reasonable cause and good faith.” Treas. Reg. § 1.6664-4(b)(1). That reliance must be reasonable, and the taxpayer must act in good faith. In evaluating whether reliance is reasonable, a taxpayer’s “education, sophistication and business experience will be relevant.” Id. para. (c)(1).

Insights: Going forward, this opinion of Estate of Hoenshied v. Commissioner will likely be a go-to source for any practitioner involved in a taxpayer’s proposed transfer of corporate shares (or other property) to a donor-advised fund or other charitable organization as part of a buy-sell transaction that is anywhere close in time to the proposed donation.

Have a question? Contact Jason Freeman , Managing Member Legal Team.

Mr. Freeman is the founding and managing member of Freeman Law, PLLC. He is a dual-credentialed attorney-CPA, author, law professor, and trial attorney. Mr. Freeman has been recognized multiple times by D Magazine, a D Magazine Partner service, as one of the Best Lawyers in Dallas, and as a Super Lawyer by Super Lawyers, a Thomson Reuters service. He was honored by the American Bar Association, receiving its “On the Rise – Top 40 Young Lawyers” in America award, and recognized as a Top 100 Up-And-Coming Attorney in Texas. He was also named the “Leading Tax Controversy Litigation Attorney of the Year” for the State of Texas” by AI.

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The Assignment of Income Doctrine

Tax Court ruling of special interest to church treasurers.

Ferguson v. Commissioner, 108 T.C. 244 (1997)

Background. Donors occasionally attempt to “assign” their right to receive income to a church, assuming that they are avoiding any receipt of taxable income.

Example. Rev. T is senior pastor of First Church. He conducts a service at Second Church, and is offered compensation of $500. Rev. T refuses to accept any compensation, and asks the pastor of Second Church to put the $500 in the church’s building fund. Rev. T, and the treasurer at Second Church, assume that there is no income to report. Unfortunately, they may be wrong.

The United States Supreme Court addressed this issue in a landmark ruling in 1940. Helvering v. Horst, 311 U.S. 112 (1940). The Horst case addressed the question of whether or not a father could avoid taxation on bond interest coupons that he transferred to his son prior to the maturity date. The Supreme Court ruled that the father had to pay tax on the interest income even though he assigned all of his interest in the income to his son. It observed: “The power to dispose of income is the equivalent of ownership of it. The exercise of that power to procure the payment of income to another is the enjoyment and hence the realization of the income by him who exercises it.” The Supreme Court reached the same conclusion in two other landmark cases. Helvering v. Eubank, 311 U.S. 122 (1940), Lucas v. Earl, 281 U.S. 111 (1930).

Example. A taxpayer earned an honorarium of $2,500 for speaking at a convention. He requested that the honorarium be distributed to a college. This request was honored, and the taxpayer assumed that he did not have to report the $2,500 as taxable income since he never received it. The IRS ruled that the taxpayer should have reported the $2,500 as taxable income. It noted that “the amount of the honorarium transferred to the educational institution at the taxpayer’s request … is includible in the taxpayer’s gross income [for tax purposes]. However, the taxpayer is entitled to a charitable contribution deduction ….” The IRS further noted that “the Supreme Court of the United States has held that a taxpayer who assigns or transfers compensation for personal services to another individual or entity fails to be relieved of federal income tax liability, regardless of the motivation behind the transfer” (citing the Horst case discussed above). Revenue Ruling 79 121.

A recent Tax Court ruling. The Tax Court has issued an important ruling addressing the assignment of income to a church. Don owned several shares of stock in Company A. On July 28, Company A agreed to merge with Company B. Pursuant to the merger agreement, Company B offered to purchase all outstanding shares of Company A for $22.50 per share (an 1,100% increase over book value). On August 15, Don informed his stockbroker that he wanted to donate 30,000 shares of Company A to his church. On September 8 Don deposited 30,000 shares in his brokerage account and on September 9 signed an authorization directing his broker to transfer the shares to his church. A few days later the church issued Don a receipt acknowledging the contribution. The receipt listed the “date of donation” as September 9. The church sold all of the shares to Company B for $22.50 per share. Don claimed a charitable contribution deduction for $675,000 (30,000 shares at $22.50 per share). He did not report any taxable income in connection with the transaction..

The IRS audited Don, and conceded that a gift of stock had been made to the church. It insisted, however, that Don should have reported the “gain” in the value of his stock that was transferred to the church. Not so, said Don. After all, he never realized or “enjoyed” the gain, but rather transferred the shares to the church to enjoy.

The IRS asserted that Don had a legal right to redeem his Company A shares at $22.50 per share at the time he transferred the shares to the church. As a result, Don had “assigned income” to the church, and could not avoid being taxed on it.

The Tax Court agreed with the IRS. It began its opinion by addressing the date of Don’s gift. Did the gift to the church occur before he had a legal right to receive $22.50 per share for his Company A stock? If so, there was no income that had been assigned and no tax to be paid. Or, did Don’s gift occur after he had a legal right to receive $22.50 per share? If so, Don had “assigned income” to the church and he would have to pay tax on the gain. The court concluded that Don’s gift occurred after he had a legal right to receive $22.50 per share. It quoted the following income tax regulation addressing the timing of gifts of stock:

Ordinarily, a contribution is made at the time delivery is effected …. If a taxpayer unconditionally delivers or mails a properly endorsed stock certificate to a charitable donee or the donee’s agent, the gift is completed on the date of delivery or, if such certificate is received in the ordinary course of the mails, on the date of mailing. If the donor delivers the stock certificate to his bank or broker as the donor’s agent, or to the issuing corporation or its agent, for transfer into the name of the donee, the gift is completed on the date the stock is transferred on the books of the corporation.

The critical issue was whether Don’s broker was acting as Don’s agent or the church’s agent in handling the transaction. The court concluded that the broker had acted as Don’s agent. The broker “facilitated” Don’s gift of stock to the church, and was acting on the basis of Don’s instructions. The court concluded:

[Don has] failed to persuade us that depositing stock in his brokerage account with instructions to [the stockbroker] to transfer some of the stock to the [church] constituted the unconditional delivery of stock to a charitable donee’s agent …. [Don] has failed to persuade us that depositing stock in [his] brokerage account with instructions to [his stockbroker] to transfer some of the stock to the [church] constituted the unconditional delivery of stock to a charitable donee’s agent pursuant to [the regulations] …. Based on the circumstances surrounding the gift … we believe that [the stockbroker] acted as [Don’s] agent in the transfer of the stock and that [he] relinquished control of the stock on September 9 when the letters of authorization were executed, and we so find. The gift to the [church], therefore, was complete on September 9.

The court concluded that on the date of the gift (September 9) Don had a legal right to receive $22.50 per share for all his shares of Company A, and therefore his gift to the church was a fully taxable “assignment of income.” The court observed:

It is a well-established principle of the tax law that the person who earns or otherwise creates the right to receive income is taxed. When ]the right to income has matured at the time of a transfer of property, the transferor will be taxed despite the technical transfer of that property …. An examination of the cases that discuss the anticipatory assignment of income doctrine reveals settled principles. A transfer of property that is a fixed right to income does not shift the incidence of taxation to the transferee …. [T]he ultimate question is whether the transferor, considering the reality and substance of all the circumstances, had a fixed right to income in the property at the time of transfer.

The court concluded that Don did have a “fixed right to income” at the time he donated the 30,000 shares to his church. According to the terms of the merger agreement between Company A and Company B, each outstanding share of Company A was “converted” into a right to receive $22.50 per share in cash. In essence, the stock in Company A “was converted from an interest in a viable corporation to a fixed right to receive cash.”

Conclusions. Here are a few principles for church treasurers to consider:

* Charitable contribution reporting. Note that the “assignment of income” doctrine does not bar recognition of a charitable contribution. Both the Tax Court and IRS conceded that Don was eligible for a charitable contribution deduction as a result of his gift of stock.

* Timing of a gift of stock. This case will provide helpful guidance to church treasurers in determining the date of a gift of stock. The income tax regulations (quoted above) contain the following three rules:

(1) Hand delivery. if a donor unconditionally delivers an endorsed stock certificate to a charity or an agent of a charity, the gift is completed on the date of delivery

(2) Mail. if a donor mails an endorsed stock certificate to a charity or an agent of a charity, the gift is completed on the date of mailing

(3) Delivery to an agent. if a donor delivers a stock certificate to his or her bank or stockbroker as the donor’s agent (or to the issuing corporation or its agent) for transfer into the name of a charity, the gift is completed on the date the stock is transferred on the books of the corporation

* Notification of income consequences. While certainly not required, church treasurers may want to inform some donors about the assignment of income doctrine. It often comes as a shock to donors (such as Don) to discover that their charitable contribution is “offset” by the taxable income recognized under the assignment of income doctrine. Assignments of income most often occur in connection with donations of stock rights or compensation for services already performed.

* Gifts of appreciated stock not affected. Many donors give stock that has appreciated in value to their church. Such transactions are not affected by the court’s ruling or by the assignment of income doctrine because the donor ordinarily has no “fixed right to income” at the time of transfer. Don’s case was much different. He had a contractual right to receive $22.50 per share for all of his shares of Company A stock as a result of the merger.

Key point. Persons who donate stock often can deduct the fair market value of the stock as a charitable contribution (there are some important limitations to this rule) and they have no “assigned income” to report.

Example. Jill is employed by a local business. Her company declares a $1,000 Christmas bonus. Jill asks her supervisor to send the bonus directly to her church. The supervisor does so. The church treasurer should be aware of the following: (1) Jill will be taxed on the bonus under the assignment of income doctrine. The church treasurer may want to point this out to Jill, although this is not required. There is no need for the church to report this income, or issue Jill a W-2 or 1099. (2) Jill should be given credit for a charitable contribution in the amount of the bonus. Since the bonus was in excess of $250 the receipt issued by the church should comply with the charitable contribution substantiation rules that apply to contributions of $250 or more.

This content is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. "From a Declaration of Principles jointly adopted by a Committee of the American Bar Association and a Committee of Publishers and Associations." Due to the nature of the U.S. legal system, laws and regulations constantly change. The editors encourage readers to carefully search the site for all content related to the topic of interest and consult qualified local counsel to verify the status of specific statutes, laws, regulations, and precedential court holdings.

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