In general, income is taxable unless it is specifically exempted by law. Such taxable income must be reported and is subject to taxation. Income that is nontaxable, however, may still have to be reported on your tax return.
Even if you have not cashed a valid check you received before the end of a certain tax year, it is still considered income constructively received in that year and thus is taxable. For instance, if you were mailed the check but you were not home to receive it, you must still include it in your income for the year in which it arrived, even if it was the last day of the tax year.
However, if the check was mailed to you in such a way that you couldn’t access the funds before the end of the tax year, it is counted as income for the following year. Income received by your agent is also considered income constructively received in the year it is received. If a third party receives income for you, it must be included in your income in the year the third party receives it.
Compensation for future services is usually counted as income in the year it is received. If you use an accrual method of accounting, taxation of prepaid income received for the next tax year is deferred and payments are included as income you earned by performing the services.
Now, let’s look at other forms of income and how they are taxed by the IRS.
All compensation received for personal services, including fringe benefits and stock options, must be included in your gross income. The payment amount can be found on your W-2 form. If you provide child care in the child’s home, in your own home or at any other location, you must include the payment as income. If you’re not an employee, report the payments on Schedule C, Profit or Loss from Business. Child care regulations apply when regularly or occasionally babysitting for relatives or neighborhood children.
Fringe benefits are treated as compensation unless you pay fair market value or they’re excluded by law. If you have a noncompete agreement and haven’t yet provided services, treat them as performed. Even if you give the benefit to someone else, you still received it. Fringe benefits can be received by a partner, director or independent contractor.
Partnership income isn’t taxable, but income, gains, losses, deductions and credits are passed through to partners based on their shares. Even if the income is not distributed, report your share on your tax return. Losses are restricted to the adjusted basis of your partnership interest at the end of the year in which the losses occurred.
S corporations don’t pay taxes on income since it’s passed through to shareholders. Income, losses, deductions and credits are passed through based on your stock, but you still need to report them on your return. Use Form 1120-S to show the corporation’s results and the items affecting shareholders’ tax returns.
PTET changes the rules
Also note that some states have a pass-though entity tax that may change the situation. This is a state or local tax on an entity that is classified as a pass-through entity for federal purposes. As noted in the Journal of Accountancy: “Under Notice 2020-75, the IRS stated that the payment of a PTET to domestic jurisdictions is deductible in computing the entity’s nonseparately stated income or loss and is not taken into account in applying the cap to an individual partner or shareholder in the entity.” The rules are complex; be sure to ask your tax advisor if a PTET can help you.
Income from royalties for copyrights, patents, and oil, gas and mineral properties is taxable. Report royalties in Part 1 of Schedule E, Supplemental Income and Loss. If you’re self-employed, report income and expenses on Schedule C. Publication 525, Taxable and Nontaxable Income, has additional details.
Virtual currencies, whether they are sold, exchanged, used to purchase goods or services, or held as an investment, could result in tax liability. Include them in your income at the fair market value at the time you received it. For more information, see Tax Topic 420.