In order for an individual to calculate their income tax, they must first calculate their Gross Income (GI). Once that is calculated, the individual can subtract deductions from their gross income to calculate their Adjusted Gross Income (AGI).
The applicable tax rate is then applied to the individual’s AGI. The result of that calculation is the amount of income tax the individual owes.
What is Gross Income?
The Internal Revenue Code defines gross income in Section 61 as, “all income, from whatever source derived.” This means that gross income in any income which is received during a tax year, which includes:
- Wages or salary from employment;
- Profits from the sale of stocks;
- Income from rentals; and
- Even income from illegal activities.
An individual who gives financial gifts may owe taxes on the amounts given. There are, however, limitations and qualifications on this rule.
For the majority of taxpayers, the tax year is the calendar year. This means that any income which is received between January 1 and December 31 of the calendar year is the gross income for that particular tax year.
It is important to note that not all income is taxed and some types of income may be exempt. Determining gross income, however, is the first step to calculate taxable income, as noted above. With certain exceptions, all income from any source is required to be included in gross income.
What is Adjusted Gross Income?
A taxpayer’s adjusted gross income (AGI) is their gross income minus certain deductions which are permitted by the Internal Revenue Code. A deduction is an amount of money which can be subtracted from an individual’s gross income in order to calculate their AGI.
Individuals do not pay taxes on income which is deducted from their gross income. It is important for an individual not to confuse a tax deduction with a tax credit.
A tax credit is an amount which an individual can deduct from the amount of taxes which the individual owed after their gross income has been calculated.
What is Taxable Income?
Taxable income is the amount of income which an individual must pay taxes for. Each taxpayer needs to determine whether to take the standard deduction or itemize their deductions.
The standard deduction is the amount of money which the government specifies that every taxpayer may deduct from their gross income. The majority of taxpayers take the standard deduction because it will result in the lowest AGI.
If an individual chooses to itemize their deductions, they are required to list the deductions to which they are entitled and subtract those from their gross income. In some cases, this results in a lower AGI for a taxpayer.
A taxpayer calculates their taxable income by subtracting either the standardized deduction or the itemized deductions from their AGI. Once a taxpayer has calculated their taxable income, they can calculate their income tax by applying their current tax rate to their taxable income.
Tax rates will vary depending on several factors, including:
- Their adjusted gross income;
- Marital status; and
- The number of dependents they have.
Of course, if the taxpayer has had state or federal taxes withheld from their paychecks or income payments, the final step will require them to compare the amount of tax owed with the withholdings. If the taxes they owe are less than the withholdings, the taxpayer will receive a refund.
If the amount of the withholdings is less than the taxes which are owed, the taxpayer will be required to pay the difference to the IRS or the state taxing agency.
What is an Income Tax Audit?
Taxpayers may be subject to tax audits if the IRS does not believe they paid their fair share of taxes or that they have deducted items which they should not have deducted. If a taxpayer is involved in an income tax audit, they will meet with an IRS representative who may ask them specific questions regarding their tax returns.
This meeting will ensure that the taxpayer did, in fact, provide a full report of their income as well as proof that any deductions made were appropriate and lawful. If an IRS representative determines that the taxpayer was honest in their tax return, then the case will be closed.
If, however, the IRS determines that the taxpayer lied or did not report certain forms of income which should have been reported, they may be subject to monetary penalties and supplemental taxes. Therefore, it is essential for taxpayers to keep records of their past tax returns as well as expense records which support their deductions.
Additionally, if the IRS demands a payment of less than $50,000 in taxes in a single year, the taxpayer may petition the United States Tax Court to review the case. A taxpayer is permitted to dispute the amount of income taxes which they owe in Tax Court.
The taxpayer will then receive a decision from the Tax Court. It is important to note that judgments received from this court are considered to be final.
Are Prizes and Awards Taxable?
In general, yes, prizes and awards are taxable. If a taxpayer wins a sweepstakes or receives a prize from a competition, this income would be considered taxable.
If prizes were awarded, the amount which would be included for those prizes would be the fair market value of the items at the time at which they were received.
How Are Prizes Distinguished from a Gift?
A prize or award is typically given in recognition of some affirmative action by the recipient, which may include:
- Entering a contest;
- Providing an exceptional performance at work; or
- Inventing something new.
Gifts, on the other hand, usually depend on the intent of the provider. The provider typically makes the payment with disinterested and detached generosity. Typically, a gift is not a payment that is made out of a moral or legal obligation for some past services.
In most cases, a gift will not require any action from the recipient.
Are There Exceptions to the Taxability of Prizes and Awards?
Yes, there are exceptions to the taxability of prizes and awards. There are certain qualified scholarships and fellowships which are not taxable, even if they are considered a prize or an award.
In addition, awards which are provided for recognition of certain types of achievements, including:
- Educational; and
- Civic are not taxable if:
- The recipient is chosen without any action on their party, such as entering a contest or submitting their work for review;
- The recipient is not required to provide any substantial future services as a condition of receiving the award; and
- The recipient is required to assign the award to charity. In other words, it cannot be used by the recipient or certain closely related members.
Therefore, even Pulitzer and Nobel prizes are taxable to the recipients if they do not satisfy the three conditions listed above.
Are My Company Party Prizes and Awards Taxable?
Yes, an employee prize or award is generally taxable to the recipient. However, some awards which are provided for length of service and employee safety can be excluded from the recipient’s income if certain requirements are met.
An employee award which is very small in monetary amount and is not provided frequently may be considered a tax-free de minimis” fringe benefit to the recipient. In general, there is no such thing as a gift between employers and employees.
The majority of gratuitous payments between employers and employees will be scrutinized because the IRS is especially wary of prizes and awards being disguised compensation.
Do I Need an Attorney to Help Me with My Tax Problems?
The laws governing taxes and income taxes are complicated and may change every year. There are many tax preparation services and softwares available to help you file your taxes but they are not able to provide the same level of service as an experienced tax attorney can.
Your tax attorney can provide you advice if you are unsure about the characterization of your income or you need someone to represent you before the IRS.