What is Considered Taxable Income?
One of the fundamental questions a business must figure out is: what is income?
Income is defined by the IRS code as “all income from whatever sources derived.” This means that if you make money, Uncle Sam wants their cut.
What’s interesting about income is that Uncle Sam does not care where the income comes from. If it’s income, Uncle Sam wants their cut.
The first rule of what is considered business income is that anything of value that you receive is considered income unless it is excluded by Congress. And some sources of income can be noncash, meaning that you don’t receive money in exchange for something, but what you receive is still taxable.
Here’s a list of noncash sources of income that are considered taxable income by the IRS:
Barter or trade
Bartering or trading is when you exchange services or goods in exchange for other services or goods. The value of what you receive is considered taxable income.
Joe runs a very popular Pokemon trading card store. He decided to trade his one of a kind Charizard Pokemon card to the video game next door for a mint condition Nintendo. The mint condition Nintendo is worth twice as much as the one of a kind Charizard Pokemon card. Joe should report the value of the mint condition Nintendo to the IRS on his annual tax return.
These types of taxable exchanges happen all the time between business owners, but it is often very difficult for the IRS to track whether the exchanges actually happened. Just because you may be able to get away with not reporting a barter or trade to the IRS doesn’t make it legal.
Constructive income is an interesting—and somewhat difficult—concept to understand. Constructive income states that if you have the ability to access money or goods, then you should be taxed for having the ability to access the money or goods.
Jim owns Jim’s Ice Cream Truck. Jim’s business is an LLC taxed as an S-Corporation and Jim is having a record year—he will be taxed at the highest individual tax rate of 37%. In December Jim receives a large check from his largest ice cream supplier as a thank you for all of the thousands of pounds of ice cream Jim purchased. Since Jim is already in the highest tax bracket and the check is dated December 27, 2019, Jim decides to not cash the check until January 1, 2020, so that a large percentage of the check would not go to Uncle Sam.
While Jim thinks he has pulled a fast one on Uncle Sam, the legal doctrine of constructive income applies and the IRS would tax the check Jim received for 2019 since the check was dated December 27, 2019.
Illegal and off-the-books income
The IRS does not care whether you received your money from hard manual labor or from laundering money for the drug cartels. The IRS only cares that you report your income. A great example of this would be Al Capone—he was sent to prison for not reporting income and not murder, bootlegging, or racketeering.
Since Jim’s Ice Cream Truck is largely a cash business, Jim also helps launder money for one of the largest drug dealers in his state. Jim receives compensation from the drug dealer. He also receives flashy cars, watches, and clothes. The money, flashy cars, watches, and clothes Jim receives from the drug dealer are all taxable income in the eyes of Uncle Sam. If Jim does not report these items as income, then Jim could very well suffer the same fate of Al Capone.
If your main source of income is illegal or off-the-books, then you may want to consider filing a fifth amendment tax return. The fifth amendment tax return allows you to not list the source of your illegal income for the IRS. If you have questions about filing a fifth amendment return, please reach out to our firm.
American citizens working in foreign countries—and businesses operating in foreign countries—is becoming more and more common. And as you may have guessed, Uncle Sam wants their cut even if the income is foreign sourced. Any foreign income earned either in the form of wages or self-employment is taxable, except for two exceptions discussed below.
Delilah traveled to Peru to celebrate her 30th birthday. While in Peru she unknowingly purchased a rare Incan piece of pottery for a $100 from a local ancient tribe near Cusco, Peru. While at the airport in Lima, Peru, a pottery dealer noticed the rare piece of pottery and offered Delilah $1,000 for the piece of pottery. Delilah gladly accepted the $1,000.
You guessed it. Uncle Sam wants their cut. Delilah owes Uncle Sam taxes on the difference between what she paid for it ($100), and the amount she sold it for ($1,000).
There are two main exceptions to the rule that foreign income is taxable:
If you are an American citizen working abroad, you can exclude $105,900 (2019). This is called the Foreign Earned Income Exclusion. The purpose behind the Foreign Earned Income Exclusion is that the IRS does not want American citizens working abroad to be doubled tax—a fancy way of saying taxed in both countries.
There are many requirements that must be met to see if you qualify for the Foreign Earned Income Exclusion. The most important requirement is the physical present test which states that you must be present in the foreign country for 330 days out of the year. The test is a bit more complicated than this, so we recommend speaking to a qualified tax attorney if you have questions about whether or not you qualify for the Foreign Earned Income Exclusion.
Some taxpayers wrongly believe that if they qualify for the Foreign Earned Income Exclusion and their income is below the exclusion amount of $105,900 (2019) that they do not have to file a tax return. You must file your tax return in order to qualify for the Foreign Earned Income Exclusion.
Delilah decides to move to Peru to teach abroad for a year. While in Peru she makes $35,000 and she spends 350 days in Peru. All of Delilah’s $35,000 will not be taxed by Uncle Sam as long as Delilah files her tax return here in the United States and claims the Foreign Earned Income Exclusion.
If you don’t qualify for the Foreign Earned Income Exclusion but made money in a foreign country, you may be able to receive a tax credit for your United States taxes. You can receive the tax credit when you earned income in a foreign country and you paid taxes on that foreign country for that income.
Delilah is hired by a Peruvian company as an environment expert for a new construction project in Lima. Delilah spends only four months working in Peru. She was paid $50,000 by the Peruvian company. The company withheld $10,000 in taxes and paid these taxes to the Peruvian government as income tax.
Delilah will be able to claim a $10,000 tax credit for the taxes withheld in Peru. She must file a return here in the U.S. to claim the credit.
Three additional notes for American citizens working abroad:
- If you renounce your citizenship and move abroad you will still be subject to U.S. tax law for ten years. Uncle Sam always wants their cut.
- Foreign income may be subject to self-employment taxes here in the U.S.
- Your investment income earned overseas is taxable.