The IRS can tax individuals based on what is classified as taxable income. In general, most income that an individual earns is considered taxable income by the IRS and one of the primary considerations in an IRS audit is whether all taxable income has been properly reported.
What is Taxable Income?
As a basic rule, taxable income is the gross income of an individual or corporation, less any allowable tax deductions. The definition of “taxable income” is found in the Internal Revenue Code Section 63. “Gross income” is defined in Section 61 of the Internal Revenue Code. Gross income is an individual’s total personal income before taking taxes or deductions into account. Taxable income of course includes salary and wages, but it can also encompass profits from stock or real estate sales and gambling winnings. In short, taxable income is composed of earned income and unearned income.
What is Earned Income?
Earned income includes all the taxable income and wages you get from working or from certain disability payments. Taxable earned income includes wages, salaries, tips, and other taxable employee pay. It can also include union benefits and long-term disability benefits received prior to retirement age. Non-cash fringe benefits received from your employer may also be considered earned income. If you are self-employed, then earned income is defined as the net earnings from that self-employment if you own or operate a business or farm.
What Qualifies as Unearned Income?
Some kinds of income do not quality as earned income. Income that does not qualify as earned income is referred to as unearned income. Examples of this type of income include interest and dividends, retirement income, social security benefits, alimony, and unemployment benefits.
Unearned income may also include interest from bank accounts, investment accounts, time deposits, loans you made to others, savings bonds, and debt instruments sold at a discount. Many people are also surprised to learn that benefits acquired by bartering or canceled debt are considered taxable income by the IRS.
Even though these amounts are not earned income, the IRS still considers them a source of unearned income. The unearned income that you receive every year must be added to the earned income amounts to calculate your taxable income.
Certain Items are Not Considered as Income
The IRS has clarified that certain common items may be part of your gross income but do not constitute taxable income. Child support payments do not qualify as income so they are not taxable. At the same time, a taxpayer may not deduct these amounts. Proceeds from life insurance policies are non-taxable, as are educational grants and scholarships in some circumstances. Other non-taxable items include gifts, bequests, and inheritances as well as welfare and workers’ compensation benefits. If you are involved in a lawsuit and are awarded compensatory damages for physical injury or illness, these amounts may not be considered taxable income.
What if I have not accounted for all taxable income on previously filed tax returns?
If you know or suspect that previously filed tax returns may not have accounted for all of your income, then the first thing that you should do is hope you do not get audited. However, if the IRS sends you a notice that you are being audited, then you should seek the counsel of an experienced tax attorney immediately. There are numerous protections, rules and procedures that the IRS must follow during an audit, however if you are unaware of these protections, rules and procedures then an IRS agent can lead you down a path of voluntarily providing more information that you are legally obligated to provide. Failing to provide information that you are legally obligated to provide, could cause an IRS agent to expand the scope of an audit, but so can providing more information than necessary. An experienced tax attorney can provide you valuable guidance throughout the audit process.
The Tax Lawyer – William D Hartsock has been helping people navigate IRS audits since the early 1980’s. Mr. Hartsock offers free consultations with the full benefit of attorney client privilege. Call to schedule your free consultation today.