Types of income

A mutual insurance company is owned by its policyholders and has no stock. When an insurance company demutualizes, a policyholder’s ownership interest in the mutual company may be exchanged for shares in a stock life insurance company and/or cash. The exchange does not cause the policies to change, except for the name of the issuing company. The policyholder’s basis in the policy stays the same.

The treatment of the demutualization depends on whether it is a tax-free reorganization under Internal Revenue Code section 368(a)(1). Information on whether the reorganization qualifies under section 368(a)(1) may be obtained from the (former) mutual company.

If the demutualization qualifies as a tax-free reorganization and you elected to receive stock, you will not recognize any gain or loss on the receipt of the stock.

Note: You may be taxed on the gain or loss from stock when you sell or otherwise dispose of it at a later date. When you sell or otherwise dispose of the stock your basis in it is zero and your holding period is treated as beginning on the date you purchased the insurance policy.

If you elected to receive cash instead of stock in the tax-free reorganization, you are deemed to have received shares and then to have sold them back to the corporation (i.e., redeemed your shares). Generally this results in capital gain or loss reportable on Form 1040, Schedule D (PDF), Capital Gains and Losses. If you owned the policy for more than one year as of the date of the demutualization, the gain or loss is treated as long-term capital gain or loss. If you owned the policy for a year or less, the gain or loss is short-term capital gain or loss. Refer to Internal Revenue Code section 1223(1).

Refer to Revenue Ruling 71–233, 74–227, and 2003–19 regarding the Federal income tax consequence of a demutualization qualifying as a reorganization under section 368(a)(1).

If the demutualization does not qualify as a tax-free reorganization, you must recognize a capital gain or loss on the receipt of either cash or stock. If you elected to receive stock, your gain or loss is the difference between your zero basis in your mutual ownership interest and the fair market value of the stock, when you receive it. Your basis in the stock is the fair market value when you receive it. Your holding period for the stock begins when you receive it and does not include the period you owned your policy.

For more information, refer to Publication 550, Investment Income and Expenses.

Copies of Revenue Rulings are available in one of the local Federal Depositary Libraries in your community. To find the library nearest to you, visit the Governmental Printing Office Locate Federal Depository Libraries website at: www.gpoaccess.gov/libraries.html.

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This tax topic explains whether an individual who buys and sells securities qualifies as a “trader in securities,” and how traders must report the income and expenses resulting from the trading business. In order to better understand the special rules that apply to traders in securities, it is helpful to first review the meaning of the term “investor,” and the manner in which investors report the income and expenses relating to their investment activities.

Investors typically buy and sell securities and expect income from dividends, interest, or capital appreciation. Sales of these securities result in capital gains and losses that must be reported on Form 1040, Schedule D (PDF), Capital Gains and Losses. Investors are subject to the capital loss limitations described in section 1211(b), in addition to the section 1091 wash sales rules. Investors can generally deduct the expenses of producing taxable investment income. These include expenses for investment counseling and advice, legal and accounting fees, and investment newsletters. These expenses are deductible on Form 1040, Schedule A (PDF), Itemized Deductions, as miscellaneous deductions to the extent that they exceed 2% of adjusted gross income. Interest paid on money to buy or carry investment property that produces taxable income is also deductible on Schedule A, but under section 163(d) the deduction cannot exceed the net investment income. Commissions and other costs of acquiring or disposing of securities are not deductible but must be used to figure gain or loss upon disposition of the securities. An investor is not subject to self-employment tax. For more information on investors, refer to Publication 550, Investment Income and Expenses.

Traders

Special rules apply if you are a trader in securities, in the business of buying and selling securities for your own account. To be engaged in business as a trader in securities, you must meet all of the following conditions:

• You must seek to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation.
• Your activity must be substantial, and
• You must carry on the activity with continuity and regularity.

The following facts and circumstances should be considered in determining if your activity is a securities trading business:

• Typical holding periods for securities bought and sold.
• The frequency and dollar amount of your trades during the year.
• The extent to which you pursue the activity to produce income for a livelihood, and
• The amount of time you devote to the activity.

If the nature of your trading activities does not qualify as a business, you are considered an investor, and not a trader. It does not matter whether you call yourself a trader or a “day trader.” Further, a taxpayer may be a trader in some securities and hold other securities for investment. The special rules for traders do not apply to the securities held for investment. A trader must keep detailed records to distinguish the securities held for investment from the securities in the trading business. The securities held for investment must be identified as such in the trader’s records on the day he or she acquires them.

Traders report their business expenses on Form 1040, Schedule C (PDF), Profit or Loss From Business. The limit on investment interest expense, which applies to investors, does not apply to interest paid or incurred in a trading business. Commissions and other costs of acquiring or disposing of securities are not deductible but must be used to figure gain or loss upon disposition of the securities. Gains and losses from selling securities as part of a trading business are not subject to self–employment tax.

The tax treatment of sales of securities held in connection with a trading business depends on whether a trader has previously made an election under section 475(f) to use the mark-to-market method of accounting. If the mark-to-market election was not made, then the gains and losses from sales of securities are treated as capital gains and losses that must be reported on Form 1040, Schedule D (PDF). Both the limitations on capital losses and the wash sale rules continue to apply. However, if the mark-to-market election was timely made, then the gains and losses from sales of securities are treated as ordinary gains and losses (except for securities held for investment — see above) that must be reported on Part II of Form 4797 (PDF), Sales of Business Property. Further, neither the limitations on capital losses nor the wash sale rules apply to traders using the mark-to-market method of accounting.

In general, the mark-to-market election must be made by the due date (not including extensions) of the tax return for the year prior to the year for which the election becomes effective. The election is made by attaching a statement either to your income tax return or to a request for an extension of time to file your return. The statement should include the following information:

1. That you are making an election under section 475(f) of the Internal Revenue Code;
2. The first tax year for which the election is effective; and
3. The trade or business for which you are making the election.

Refer to the Form 1040, Schedule D Instructions for further instructions on how to make the mark to market election.

After making the election to change to the mark-to-market method of accounting, you must change your method of accounting for securities under Revenue Procedure 2002–9, as modified by Revenue Procedure 2002–19. In addition to making the election, you will also be required to file a Form 3115 (PDF), Application for Change in Accounting Method. The procedures for making an election are described in Publication 550 under the section called “Special Rules for Traders in Securities“. You may also refer to Revenue Procedure 99–17.

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In general, you do not include in your gross income qualified distributions from your Roth IRA. You may have to include part of other distributions from Roth IRA(s) in your income.

A qualified distribution is generally, any payment or distribution made after the 5–taxable–year period beginning with the first year for which a contribution was made to a Roth IRA set up for you, and that is made on or after you reach age 59 1/2, made because you are disabled, made to a beneficiary or to your estate after your death, or that is made to buy, build, or rebuild a first home.

A distribution used to buy, build or rebuild a first home must be used to pay qualified costs for the main home of a first time home buyer who is either yourself, your spouse, or you or your spouse’s child, grandchild, parent, or other ancestor.

Part of any distribution that is not a qualified distribution may be taxable as ordinary income and subject to the additional 10% tax on early distributions. Distributions of conversion contributions within a 5–year period following a conversion may be subject to the 10% early distribution tax, even if the contributions have been included as income in an earlier year. Refer to Topic 558 , Early Distributions from IRA’s, for more information.

If you converted your traditional IRA to a Roth IRA, but were not eligible to do so, your conversion will be treated as a taxable distribution from your traditional IRA and a regular contribution to your Roth IRA, and may be subject to additional tax on early withdrawals and an excise tax on excess contributions, unless the converted amount is recharacterized.

You may recharacterize your Roth IRA conversion by directly transferring the amount converted (including all net earnings from the date of conversion) back to a traditional IRA. You may do this prior to the due date, including extensions, for filing your tax return. Show the conversion on Form 8606 (PDF). Refer to the Form 8606 Instructions for information on reporting recharacterizations.

Refer to Topic 309 for information about Roth IRA contributions. For more information about all types of IRAs, refer to Publication 590, Individual Retirement Arrangements.

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If you are granted a statutory stock option under an employee stock purchase plan or an employee incentive stock option (ISO) plan, you generally do not include any amount in your gross income as a result of the grant or exercise of your option. However, you may be subject to Alternative Minimum Tax in the year you exercise an ISO. For more information, refer to the Form 6251 Instructions.

You have taxable income or deductible loss when you sell the stock you received by exercising the option. You generally treat this amount as a capital gain or loss. However, if you do not meet special holding period requirements, you will have to treat income from the sale as ordinary income. Refer to Publication 525, Taxable and Nontaxable Income, for specific details on the type of stock option, rules for when income is reported and how income is reported for income tax purposes.

If you are granted a nonstatutory stock option, the amount of income to include and the time to include it depends on whether the fair market value of the option can be readily determined and whether your rights in the stock are vested when you receive it. For most nonstatutory options, there is no taxable event when the option is granted and the fair market value of the stock received on exercise, less the amount paid, is included in income when the option is exercised. For specific information and reporting requirements, refer to Publication 525.

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Most categories of income (for example, wages, dividends, and interest) are reported on specified lines of Form 1040 (PDF). Less common types of income are reported in a general category called “other income”. Please refer to the Form 1040 Instructions for information on where to report this income. You can attach a statement to your return with additional information.

The following are examples of income to report on your Form 1040.

• Gambling winnings (lotteries, raffles), etc. Report the full amount received, not the net amount. If you itemize, report gambling losses on Schedule A, but not for an amount more than winnings claimed. You cannot otherwise deduct gambling losses.
• Prizes and awards received other than in connection with your trade or business. A prize or award that is received in connection with your trade or business is reported on Form 1040, Schedule C (PDF) or Form 1040, Schedule C-EZ (PDF), (if you are self–employed), or elsewhere on Form 1040 (if you are an employee).
• Fees for jury duty. (If you turn over all or a portion to your employer who continued to pay you while you served, show this reduction of the fee on line 36 and write “jury pay” on the dotted line.)
• Fees for being an executor, administrator or personal representative of an estate, unless you are engaged in the trade or business of being a professional executor, administrator, or personal representative. Fees for a nonprofessional are reported as other income on Form 1040 unless (1) the estate requires extensive managerial activities on your part for a long period of time and the activities may rise to the level of a trade or business, or (2) the estate includes an active trade or business in which you actively participate and the fee is for the operation of that trade or business. Fees for a professional executor, administrator, or personal representative (one who is engaged in the trade or business) are reported on Schedule C.
• Canceled debts. If a debt you owe is canceled or forgiven, other than as a gift or bequest, you may have to include it in income. Refer to Publication 525, Taxable and Nontaxable Income, for exceptions and exclusions. You may also refer to Publication 908 (PDF), Bankruptcy Tax Guide.
• Alaska Permanent Fund Dividends.
• Qualified state tuition program earnings if greater than the beneficiary’s adjusted qualified education expenses. Refer to Publication 970, Tax Benefits for Education.
• Income from rental of personal property (income from the rental of real estate is reported elsewhere on Form 1040 and Schedule E).
• Income from an activity not engaged in for profit, such as a hobby. Deductions relating to the activity cannot exceed the income from the activity and may be claimed only as itemized deductions on Schedule A.
• Damages received for the following: personal nonphysical injuries or sickness; backpay/lost profits (in most cases); and punitive damages relating to any injury or illness. Damages for emotional distress in a case not involving personal physical injury, except to the extent the damages are paid for medical care. (Interest on any award of damages is includable as interest income).
• Reimbursements or other amounts received for items deducted in an earlier year, such as medical expenses, real estate taxes, or home mortgage interest. Refer to “Recoveries” in Publication 525, Taxable and Nontaxable Income, for details on how to figure the amount to report.
• Loss on certain corrective distributions of excess deferrals resulting from contributions made to a qualified retirement plan. Refer to Publication 525, Taxable and Nontaxable Income, under Employee Compensation — Retirement Plan Contributions.

Note: Income reported on Form 1099-MISC (PDF) in Box 7 as non-employee compensation IS NOT included on Form 1040 as other income. Refer to Topic 408 for more information on how to report non-employee compensation.

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Generally, losses from passive activities that exceed the income from passive activities are disallowed for the current year. Unused passive losses are carried forward to all future years. A similar rule applies to credits from passive activities.

Passive activities are trade or business activities in which you do not materially participate. In general, all rental activities are passive activities, even if you do materially participate. You materially participate in an activity if you are involved in the operation of the activity on a regular, continuous, and substantial basis. Rental real estate activities are not passive activities if you are a real estate professional and meet certain requirements. Guidelines for determining material participation and the rules for a real estate professional can be found in Publication 925, Passive Activity and At–Risk Rules.

A special rule applies for rental real estate activities in which you actively participate. The rules for active participation are different from those for material participation and are also discussed in Publication 925.

Use Form 8582 (PDF), Passive Activity Loss Limitations, to summarize income and losses from passive activities and to compute the deductible losses. Use Form 8582CR (PDF) to report passive activity credit limitations.

Generally, you may deduct in full any previously disallowed passive activity loss in the year you dispose of your entire interest in the activity. In contrast, you may not claim unused passive activity credits upon disposition of your entire interest in the activity. However, you may elect to increase the basis of the credit property in an amount equal to the portion of the unused credit that previously reduced the basis of the credit property.

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A section 401(k) plan is a type of tax-qualified deferred compensation plan in which an employee can elect to have the employer contribute a portion of his or her cash wages to the plan on a pre–tax basis. These deferred wages (commonly referred to as elective deferrals) are not subject to income tax withholding at the time of deferral, and they are not reflected on your Form 1040 (PDF) since they were not included in the taxable wages on your Form W-2 (PDF). However, they are included as wages subject to social security, Medicare, and federal unemployment taxes.

The amount that an employee may elect to defer to a 401(k) plan is limited. Therefore, your elective contributions may be limited based on the terms of your 401(k) plan. Refer to Publication 525, Taxable and Nontaxable Income, for more information about elective deferrals. Employers should refer to Publication 560, Retirement Plans for Small Business, for information about setting up and maintaining retirement plans for employees, including 401(k) plans.

Distributions from a 401(k) plan may qualify for optional lump–sum distribution treatment or rollover treatment as long as they meet the respective requirements. For more information, refer to Topic 412, Lump–Sum Distributions, Topic 413, Rollovers from Retirement Plans, and Topic 555, 10–Year Tax Option for Lump–Sum Distributions.

Many 401(k) plans allow employees to make a hardship withdrawal because of immediate and heavy financial needs. Generally, hardship distributions from a 401(k) plan are limited to the amount of the employee’s elective deferrals only, and do not include any income earned on the deferred amounts. Hardship distributions are not treated as eligible rollover distributions.

Distributions received before age 59 1/2 are subject to an early distribution penalty of 10% additional tax unless an exception applies. For more information about the treatment of retirement plan distributions, refer to Publication 575, Pension and Annuity Income.

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If the only income you received during the tax year was your social security or equivalent railroad retirement benefits, your benefits are probably not taxable and you probably will not have to file a tax return.

If you also received other income, your benefits will not be taxed unless your modified adjusted gross income is more than the base amount for your filing status. If you have income in addition to your benefits, you may have to file a return even if none of your benefits are taxable. Your taxable benefits and modified adjusted gross income are figured in a worksheet in the Form 1040 Instructions or Form 1040A Instructions.

To make a determination if your benefits are taxable, complete the social security benefits worksheet in the Form 1040 or 1040A instruction book.

The taxable benefits, if any, must be included in the gross income of the person who has the legal right to receive them. For example, if you and your child received benefits, but the check for your child was made out in your name, you must use only your own portion of the benefits in figuring if any part is taxable to you. Half of the portion that belongs to your child must be added to your child’s other income to determine if any of those benefits are taxable to your child.

If you are married and file a joint return, you and your spouse must combine your incomes, social security benefits, and equivalent railroad retirement benefits when figuring the taxable portion of your benefits.

If part of your benefits is taxable, you must use Form 1040 (PDF) or Form 1040A (PDF). You cannot use Form 1040EZ.

You should receive your Form SSA–1099 or Form RRB–1099 by early February of the current tax year. The form will show benefits paid to the person who has the legal right to receive them, and the amount of any benefits you repaid. It will also show amounts by which the benefits were reduced because you received workers compensation benefits. The Substitute Workers Compensation benefits would be taxable to the same extent.

For additional information, refer to Publication 915, Social Security and Equivalent Railroad Retirement Benefits.

If any part of your social security or equivalent railroad retirement benefits will be taxable in the current tax year, you may request to have additional income tax withheld from your social security and/or tier 1 Railroad Retirement Benefits; you may request to have additional withholding from other income or pay estimated tax during the year. Refer to Topic 355 or Publication 505, Tax Withholding and Estimated Tax, for additional information on estimated tax.

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Some types of income you receive are not taxable. When you total your gross income to determine whether you are required to file a tax return, do not include your nontaxable income. Keep records of your nontaxable income. Some types of income that generally are not taxable include:

1. Child support payments,
2. Welfare benefits,
3. Life insurance proceeds received because of the death of an individual,
4. Interest on certain state or local government obligations,
5. Accident and health insurance proceeds, including certain long term care insurance contracts,
6. Certain property received as a gift or inheritance,
7. Benefits received under any law administered by the Department of Veteran’s Affairs,
8. Amounts received under a worker’s compensation act for an occupational sickness or injury,
9. Qualified distributions from Coverdell Education Savings Accounts (formerly called Education IRAs); refer to Topic 451 for more information,
10. Certain Roth IRA distributions; refer to Topic 428 for more information,
11. Certain amounts withdrawn from Medical Savings Accounts (MSA’s) to pay medical expenses,
12. Limited amounts of dependent care assistance paid through a dependent care assistance program,
13. Death gratuity benefits paid to survivors of deceased armed forces members for deaths occurring after September 10, 2001,
14. Homeowners assistance program payments, subject to certain limits, paid after November 11, 2003, by the Department of Defense, and
15. For tax years after 2002, Dependent Care Assistance Program payments paid by the military for military personnel.

All or a portion of your Social Security or equivalent Railroad Retirement Benefits may be nontaxable. Refer to Topic 423 for more information.

Some scholarship and fellowship grants may be non–taxable. For more information, refer to Topic 421, Scholarship and Fellowship Grants.

Publication 525, Taxable and Nontaxable Income, contains additional information on whether specific items of income are taxed.

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If you receive a scholarship or fellowship grant, all or part of the amounts you receive may be tax–free.

Qualified scholarship and fellowship grants are treated as tax–free amounts if all the following conditions are met:

1. You are a candidate for a degree at an educational institution that maintains a regular faculty and curriculum and normally has a regular enrolled body of students in attendance at the place where it carries on its educational activities;
2. Amounts you receive as a scholarship or fellowship are used for tuition and fees required for enrollment or attendance at the educational institution, or for books, supplies, and equipment required for courses of instruction; and
3. The amounts received are not a payment for your services.

However, if you receive a scholarship award under the National Health Service Corps Scholarship Program or the Armed Forces Health Professions Scholarship and Financial Assistance Program, the amount received is tax free without regard to any services you are obligated to perform.

You must include in gross income amounts used for incidental expenses, such as room and board, travel, and optional equipment, as well as amounts received as payments for teaching, research, or other services required as a condition for receiving the scholarship or fellowship grant.

If any part of your scholarship or fellowship grant is taxable, you may have to make estimated tax payments. For more information refer to Topic 355 or to Publication 970 , Tax Benefits for Education.

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