Earned and investment income

U.S. citizens are taxed on all worldwide income unless specifically deemed nontaxable or exempt from United States tax pursuant to Title 26 IRC §61. Income is taxed in the year the taxpayer either has unrestricted access to it (“constructive receipt,” cash method) or has the right to receive it under the “all events test” (accrual method: all events have occurred that fix the taxpayer’s right to receive the income and the amount can be determined with reasonable accuracy). Details will be provided later in the course.

Sources of taxable income

Listed below are common sources of income which will be discussed in this chapter:

• Wage, salaries, tips, and other compensation (Form W-2)
• Interest and dividend income (Form 1040, Schedule B)
• Unemployment benefits and refund of state and local taxes (Form 1099-G). Both go in Part I of Schedule 1 (Form 1040), which collects additional income that has no line of its own on Form 1040; Part II holds the adjustments to income.
• Other income (prizes, hobby income, etc.) - see the IRS website for more examples
• Nonemployee or other compensation (Form 1099-NEC, 1099-MISC)
• Retirement plan distribution, annuities, and Social Security benefits (Form 1099-R, SSA-1099)
• Rent and royalty income (Form 1040, Schedule E). Royalties from copyrights, patents, and oil, gas, and mineral properties are ordinary income, reported with their expenses in Part I of Schedule E, or on Schedule C for a self-employed writer, inventor, or artist or an operating oil, gas, or mineral interest. The passive activity rules that limit rental losses are taught in Capital gains and income.
• Treasure trove (found money)
• Sale of securities, personal and business and investment property (Form 8949, Form 1040, Schedule D, Form 4797)
• Estate and trust income (Schedule K-1 (Form 1041), reported on Form 1040, Schedule E), and farm income (Form 1040, Schedule F) will be discussed in detail later in the course.

Sources of nontaxable income

Listed below are common nontaxable sources of income. These items are exclusions - they never enter gross income in the first place, unlike a deduction (which reduces income after it’s counted) or a credit (which reduces tax owed):

• Life insurance proceeds and certain death benefits
• Child support
• Alimony and separate maintenance payments (for court decrees after 2018)
• SNAP (a.k.a., food stamps) and TANF (a.k.a., welfare) benefits
• Medicaid benefits
• Compensatory damages for personal physical injury or physical sickness (including emotional distress damages due to that physical injury); punitive damages are ordinary income in most cases, even if they relate to a physical injury or sickness
• Combat pay (excluded from income; the taxpayer may elect to count it as earned income for the earned income credit)

Combat zone pay and other military provisions

A member of the Armed Forces excludes pay for any month in which they served in a combat zone for even one day, or were hospitalized for wounds, disease, or injury incurred there. An enlisted member, warrant officer, or commissioned warrant officer excludes all of it. A commissioned officer’s exclusion is capped each month at the highest rate of enlisted pay plus any imminent danger/hostile fire pay received: $10,983 a month for 2025. Excluded pay is left out of Form W-2, box 1 and shown in box 12 with code Q. Retirement pay and pensions don’t qualify.

• Earned income credit election. The member may elect to count nontaxable combat pay as earned income for the EIC (Form 1040, line 1i). The election covers all of it or none of it, and on a joint return each spouse makes their own. It can raise or lower the credit, so the credit is figured both ways.
• Deadline extension. The deadlines to file, pay, claim a refund, and take other actions with the IRS are extended for 180 days after the last day in the combat zone (or the last day of continuous qualified hospitalization for an injury from service there), plus the number of days that were left to act when the member entered the zone. No penalties or interest are charged for the extension period.
• Adjustments to income. Unreimbursed travel for reserve duty more than 100 miles from home (Form 2106) and an active-duty member’s moving expenses for a permanent change of station (Form 3903) are adjustments to income, taught in Business, other income, and adjustments.

Wages, salaries, tips and other compensation

This category includes an employee’s regular earnings based on a fixed rate or salary, which is paid for services performed. Compensation shown on Box 1, Form W-2 includes wages, salaries, tips, and other taxable compensation paid to an employee during the calendar year. This amount is typically lower than an employee’s total gross earnings because it excludes pre-tax deductions like contributions to a 401(k) or health savings account (HSA). An employer’s own contributions to a qualified retirement plan for the employee generally aren’t wages when contributed, and a church’s contributions to a minister’s tax-sheltered annuity plan aren’t part of the minister’s net earnings from self-employment.

• Reported tips (Box 1 and Box 7): Cash, check, or credit card tips that an employee reports to their employer. These are included in Box 1 (wages) and are also shown separately in Box 7 (Social Security tips) of the W-2.
• Allocated tips (Box 8): Tips that an employer must assign to an employee when the total reported tips are less than 8% of the establishment’s gross sales. These are shown separately in Box 8 and are not included in Box 1 - unlike reported tips, which are already part of taxable wages. The employee must still add allocated tips to wages on their return (and pay Social Security and Medicare tax on them using Form 4137) unless they have adequate records showing they received less.

Tips and overtime pay

“No Tax on Tips” applies to voluntary tips received in occupations that customarily received tips before 2025, as listed by the Treasury, such as wait staff, bartenders, salon workers, personal trainers, and ride-share drivers. It is a tax deduction (not an exemption) of up to $25,000 for voluntary tips. Workers must be in occupations that customarily receive tips. For further information, see this IRS form.

“No Tax on Overtime”, also under the One Big Beautiful Bill Act, is a deduction for qualified overtime compensation: only the premium the Fair Labor Standards Act requires above the regular rate of pay (the “half” of time-and-a-half), up to $12,500 ($25,000 for married filing jointly). Both deductions, up to $25,000 of qualified tips and up to $12,500 ($25,000 joint) of qualified overtime, are phased out if MAGI exceeds $150,000 ($300,000 for married filing jointly) and apply for the 2025 through 2028 tax years. They cover qualified tips and overtime received at any time in 2025, not only after the law was enacted on July 4, 2025, and married taxpayers must file jointly to claim either one. They reduce taxable income only: tips and overtime are still wages for income tax withholding and are still subject to Social Security and Medicare taxes.

Example:

Karen works at a dinner/theater. In one week she earns $600 in regular wages, $200 in overtime pay, and $100 in tips.

• Federal income tax withholding, Social Security, and Medicare all apply to her full $900 in wages ($600 + $200 + $100).
• On her 2025 return (Schedule 1-A), she can deduct the $100 of qualified tips.
• If her $200 of overtime was paid at time-and-a-half, only the premium, about $67 (one-third of $200), is qualified overtime she can deduct.
• Her regular wages and the rest of her overtime stay subject to federal income tax; Social Security and Medicare still apply to the full $900 regardless.

Qualifying information will be entered on new IRS Schedule 1-A, Additional Deductions (see link below.)

The deduction will appear after the adjusted gross income is computed but before the taxable income is computed - it’s a below-the-line deduction (not an exclusion and not an above-the-line adjustment to income). See link for more information.

Other compensation

This category includes various forms of taxable income and benefits that an employer provides to an employee.

Examples:

• Bonuses and awards: Additional cash or non-cash compensation, including prizes.
• Taxable fringe benefits: Perks and non-cash benefits that are considered taxable income.
  • Personal use of a company car: The value of an employee’s personal use of a company vehicle.
  • Group-term life insurance: The cost of employer-provided life insurance coverage that exceeds $50,000.
  • Employee discounts: The part of a discount on the employer’s own goods or services above the employer’s gross profit percentage (for merchandise) or above 20% of the price charged to customers (for services).
• Taxable reimbursements: Non-qualified moving expenses or employee business expense reimbursements that are taxable.
• Imputed income: The value of non-cash benefits, such as a social club membership, that is added to an employee’s wages for tax purposes.
• Educational assistance: Taxable amounts of educational assistance paid by the employer.

A working condition fringe, such as a cell phone the employer provides primarily for noncompensatory business reasons, is excluded from wages to the extent the employee could have deducted its cost as a business expense.

Employee stock options

How an option granted as pay is taxed depends on its type:

• Nonstatutory option: generally no income at grant. At exercise, the spread (the stock’s value minus the exercise price) is wages, included in Form W-2, box 1, and shown in box 12 with code V; it is added to the stock’s basis.
• Incentive stock option (ISO): no regular tax at grant or exercise (Form 3921 reports the exercise), but the spread is an AMT adjustment in the year of exercise unless the stock is sold that same year. Stock held more than 2 years after the grant and more than 1 year after the exercise produces only long-term capital gain. A sale before both periods end is a disqualifying disposition: the gain is ordinary income up to the spread at exercise, and any excess is capital gain; a loss is entirely capital.
• Employee stock purchase plan (section 423): the same no-income-at-exercise rule and holding periods apply (Form 3922), and the option price can be as low as 85% of the stock’s value. On a qualifying disposition, ordinary income is the lesser of the discount at grant (value at grant minus option price) or the actual gain. On a disqualifying disposition, it is the full spread at exercise, even if that exceeds the gain, and it is added to basis.

Example: ISO disqualifying disposition

On March 12, 2023, Lena’s employer granted her an ISO to buy 100 shares at $10, the stock’s value that day. She exercised it on January 7, 2024, when the stock was worth $12, and sold the shares on January 27, 2025, for $15.

• Total gain: $1,500 − $1,000 = $500
• Spread at exercise: $1,200 − $1,000 = $200

Answer: Lena held the shares more than a year after exercise, but less than 2 years had passed since the grant, so the sale is a disqualifying disposition: $200 is wages and $300 is long-term capital gain. Had she sold after March 12, 2025, all $500 would have been long-term capital gain.

Interest, FBAR, and dividends

Definitions

Interest

Payment to an individual or entity for the use of money.

Dividends

The shareholder’s portion of a corporation’s earnings and profits.

Interest income is earned when money is lent or invested. Certain bond interest is exempt from federal taxation, but may be taxable at the state and local level. Payers report interest on Form 1099-INT (for $10 or more) or Form 1099-OID, but all interest is reportable even without a form, and an incorrect form should be replaced by a corrected one from the issuer. Taxable interest goes on Form 1040, line 2b, with Schedule B if it is over $1,500 or includes seller-financed mortgage interest from a buyer who used the property as a home (Schedule B then lists the buyer’s name, address, and SSN).

Education savings bond exclusion. Interest on Series EE bonds issued after 1989 and Series I bonds can be excluded (Form 8815) when the bonds are cashed in a year the taxpayer pays qualified higher education expenses: tuition and fees, not room and board, for the taxpayer, spouse, or dependent. The owner must have been at least 24 before the bond’s issue date, and married filing separately can’t claim it. For 2025 the exclusion phases out as modified AGI rises from $99,500 to $114,500 ($149,250 to $179,250 for joint returns).

U.S. citizens, resident, corporation, partnerships, limited liability companies, trusts, and estates who have foreign accounts totalling more than $10,000 at anytime during the year must file a Report of Foreign Bank and Financial Accounts (FBAR). The FBAR is an annual report due April 15 following the year reported, like individual tax returns. An automatic extension until October 15 is available to file an FBAR, no application needed. An FBAR is not filed with the federal tax return. Form 8938 is a separate requirement, attached to the return, with higher thresholds; International information reporting compares the two.

Dividend income represents a distribution of a corporation’s earnings to its shareholders and is taxable to the shareholder. Dividends are entered on Schedule B, Form 1040, when ordinary dividends exceed $1,500. Qualified dividends are ordinary dividends that meet the criteria to be taxed at capital gains tax rates, which are lower than income tax rates for some taxpayers. To qualify, the dividend must be paid by a U.S. corporation or a qualified foreign corporation, and the shareholder must have held the stock more than 60 days during the 121-day period that begins 60 days before the ex-dividend date (the first day a buyer isn’t entitled to the declared dividend). For preferred stock with dividends due to periods totaling more than 366 days, the test is more than 90 days during the 181-day period that begins 90 days before the ex-dividend date.

Example: Holding period

Dana buys stock 10 days before its ex-dividend date and sells it 40 days after that date. Her Form 1099-DIV shows the $500 dividend in box 1b as qualified. Is it a qualified dividend for her?

Answer: No. Counting the day of sale but not the day of purchase, she held the stock 50 days of the 121-day period, not more than 60. The $500 is taxed at ordinary rates even though the payer reported it in box 1b.

Form 1099-DIV also reports other distributions:

• Capital gain distributions (box 2a) from mutual funds and REITs are long-term capital gains, however long the shares were held. A taxpayer with no capital losses whose only capital gains are these distributions (with nothing in boxes 2b through 2d) reports them without Form 8949 or Schedule D.
• Nondividend distributions (box 3) are a return of capital: not taxed, but they reduce the stock’s basis. Once basis reaches zero, further nondividend distributions are capital gain.
• Exempt-interest dividends (box 12) from a mutual fund aren’t taxable but are shown on Form 1040, line 2a.
• Reinvested dividends are taxable as if received in cash, and the amount reinvested is the basis of the new shares.

Constructive dividends arise when a corporation gives a shareholder a benefit without formally declaring a dividend. When a C corporation pays a shareholder’s personal expenses, the payment is generally treated as a distribution: dividend income to the shareholder to the extent of the corporation’s earnings and profits, and not deductible by the corporation. Other transactions treated as distributions include cancelling a shareholder’s debt, selling property to a shareholder for less than fair market value, making a shareholder a below-market loan (the interest not charged), and paying a shareholder-employee an unreasonably high salary or a shareholder unreasonably high rent (the excess).

Example: Personal expenses paid by a corporation

Omar owns all the stock of a C corporation with $500,000 of earnings and profits. In 2025 the corporation pays $18,000 of Omar’s family vacation and home landscaping bills and records them as business expenses.

Answer: The $18,000 is a constructive dividend. Omar reports it as dividend income, and the corporation can’t deduct it.