1

STUDY UNIT THREE

GROSS INCOME II: INTEREST,
SECURITIES, AND DECEDENT

3.1 Interest Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

3.2 Income from Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
3.3 Income in Respect of a Decedent (IRD) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

This study unit is the second of two that presents items that are included in gross income, income
items that are excluded from gross income, and income items for which the Internal Revenue Code
provides a partial exclusion from gross income.

3.1 INTEREST INCOME

1. Interest is value received or accrued for the use of money.
a. Interest is reported under the doctrine of “constructive receipt” when the taxpayer’s
account is credited with the interest.
b. Accrued interest on a deposit that may not be withdrawn at the close of an individual’s
tax year because of an institution’s actual or threatened bankruptcy or insolvency is not
includible until the year in which such interest is withdrawable.
c. All interest is gross income for tax purposes unless an exclusion applies.
d. Examples of taxable interest include
1) A merchandise premium, e.g., a toaster given to a depositor for opening an interest-
bearing account
a) A noncash de minimis gift is tax-free if it does not have a value of more than
$10 for a deposit of less than $5,000 or $20 for a deposit of $5,000 or more.
2) Imputed interest on a below-market term loan
Imputed Interest
2. Loans at below-market interest rates may be the economic equivalent of a receipt of income in
the amount of forgone interest. Thus, interest is imputed on below-market loans.

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2 SU 3: Gross Income II: Interest, Securities, and Decedent

Below-Market Loan
3. Below-market loans (BMLs) are categorized as demand loans or term loans.
a. Demand loans are payable in full on demand or have indefinite maturity dates. A term loan
is any loan other than a demand loan.
b. A below-market demand loan is a loan on which interest is payable at a rate lower than
the applicable federal rate. The excess of the interest that would have been payable in
that year under the applicable federal rate over the actual interest payable is treated as
imputed interest.
1) The imputed interest is deemed transferred by the borrower to the lender on the last
day of each year. It may be deductible by the borrower. The imputed interest is then
deemed to be retransferred to the borrower by the lender. It could be either a gift,
compensation (employment relationship), or a dividend (corporation/shareholder
relationship) to the borrower.
c. A below-market term loan is a loan in which the amount lent exceeds the present value of
all payments due under the loan.
1) Gift term loans. The lender is treated as transferring the excess of the amount of the
loan over the present value of all principal and interest payments due under the
loan, at one time, when the loan is first made. The retransfer, however, is computed
at the end of each year.
2) Non-gift term loans are treated as original issue discount. Thus, the lender has
interest income over the course of the loan, and the borrower has interest expense.
d. The imputed interest rules apply to any below-market loan that is a
1) Gift loan
2) Loan between a corporation and a shareholder
3) Compensation-related loan between an employer and an employee or between an
independent contractor and a person for whom the independent contractor provides
services
4) Loan that has tax avoidance as one of its principal purposes
BML Exceptions
e. No interest is imputed for any day on which the total loans between borrower and lender
are below certain amounts.
1) If the BML (gift loan) between individuals is $10,000 or less, then there is no interest
imputation unless the loan was made to acquire income-producing assets.
a) In the case of gift loans between individuals, if the total debt is less than
$100,000, the amount deemed as transferred is limited to the borrower’s net
investment income, and such net investment income is treated as $0 unless it
exceeds $1,000.
i) This exception allows family gift loans without penalizing the lender.
2) If the BML between a corporation and its shareholder is $10,000 or less, there is no
interest imputation unless the loan’s principal purpose was tax avoidance.
3) Certain loans without a significant tax effect are excluded from the BML rules.

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 SU 3: Gross Income II: Interest, Securities, and Decedent 3

Original Issue Discount (OID)

4. OID is the excess, if any, of the stated redemption price at maturity over the issue price and is
included in income based on the effective interest rate method of amortization.
a. If there is OID of at least $10 for the calendar year and the term of the obligation exceeds
1 year, the interest income must be reported on Form 1099-OID.

EXAMPLE 3-1 Original Issue Discount

Cathy purchases a 20-year 7% bond at original issue for $10,000. The stated redemption price is $12,400,
and interest is paid annually. The ratable monthly portion of OID is $10. Assume that the effective rate of
interest is 10%. During the first year held, interest income is $1,000 ($10,000 × 10%) and interest received
is $868 ($12,400 × 7%). The difference of $132 ($1,000 – $868) is included in income under the effective
interest rate method. This amount increases the investor’s book value from $10,000 to $10,132. The second
year’s interest is $1,013.20, and the discount amortization is $145.20.

Redemption of U.S. Savings Bonds to Pay Educational Expenses

5. If a taxpayer pays qualified higher education expenses during the year, all or a part of the
interest received on redemption of a Series EE, or I, U.S. Savings Bond may be excluded.
a. To qualify,
1) The taxpayer, the taxpayer’s spouse, or a dependent incurs tuition and fees to attend
an eligible educational institution.
2) The taxpayer’s modified adjusted gross income must not exceed a certain limit. The
exclusion is phased out when certain levels of modified adjusted gross income are
reached.
a) The phaseout is inflation-adjusted each year.
b) The exclusion is reduced when AGI exceeds a threshold of $85,800 ($128,650
if a joint return) for tax years beginning in 2022. The amount at which the
benefit is completely phased out is $100,800 ($158,650 if a joint return) for
tax years beginning in 2022.
3) The purchaser of the bonds must be the sole owner of the bonds (or joint owner with
his or her spouse).
4) The issue date of the bonds must follow the 24th birthday(s) of the owner(s).
5) Married taxpayers must file a joint return.
b. If the qualified expenses are less than the total amount of principal and interest redeemed,
the interest is multiplied by the exclusion rate to determine the amount excludable. The
exclusion rate is qualified expenses divided by the total of principal and interest.

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4 SU 3: Gross Income II: Interest, Securities, and Decedent

Interest on State and Local Government Obligations

6. Payments to a holder of a debt obligation incurred by a state or local governmental entity (e.g.,
municipal or “muni” bonds) are generally exempt from federal income tax.
a. Exclusion of interest received is allowable even if the obligation is not evidenced by a bond,
is in the form of an installment purchase agreement, or is an ordinary commercial debt.
b. These obligations must be in registered form.
c. The exclusion applies to obligations of states, the District of Columbia, U.S. possessions,
and political subdivisions of each of them.
d. The interest on private activity bonds, which are not qualified bonds, and arbitrage bonds
is not excluded from gross income.
1) Private activity bonds are bonds of which more than 10% of the proceeds are to be
used in a private business and more than 10% of the principal or interest is secured
or will be paid by private business property, or more than 5% or $5,000,000 of the
proceeds are to be used for private loans, whichever is lesser.
2) Interest on qualified private activity bonds can still be excluded if the bond is for
residential rental housing developments or public facilities (such as airports or
waste removal), or for a qualified mortgage or VA bond, qualified small issue bond,
qualified student loan bond, qualified redevelopment bond, or qualified tax-exempt
organization bond.
e. Interest on state, local, and federal tax refunds is includible in income.
f. Tax-exempt interest is still reported on the taxpayer’s federal income tax return.
7. Recall that Form 1099-INT is the standard form used for reporting interest income. A nominee
distribution is a special distribution that generally occurs when several taxpayers are entitled
to interest while only one taxpayer has his or her name on the account. When interest on a
single form is intended to be awarded to more than one taxpayer in this manner, the taxpayer
receiving the Form 1099-INT has additional reporting responsibilities.
a. The taxpayer must first report all interest listed on the 1099-INT, regardless of its rightful
owner, on his or her Schedule B.
b. Next, the taxpayer may subtract the interest belonging to other owners from the amount
above to arrive at the total interest allocable to the taxpayer.
c. Finally, for each other recipient of interest, the taxpayer must file two copies of
Form 1099-INT: one to be furnished to the IRS, and the other to be furnished to the
recipient. The taxpayer must also send a Form 1096 to the IRS with the 1099-INT
indicating that the taxpayer is the “filer.”

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 SU 3: Gross Income II: Interest, Securities, and Decedent 5

3.2 INCOME FROM SECURITIES

Dividends
1. Amounts received as dividends are ordinary gross income.
a. Qualified dividends are dividends from domestic corporations or a qualified foreign
corporation and are taxed at a 0%, 15%, or 20% rate depending on filing status and
taxable income. Thresholds for capital gains rates are discussed in Study Unit 9,
Subunit 8. The dividends must be held for more than 60 days (90 days for preferred
stock).
b. A dividend for purposes of taxable income is, generally, any distribution of money or other
property made by a corporation to its shareholders, with respect to their stock, out of
earnings and profits.
c. Any distribution in excess of earnings and profits (both current and accumulated) is
considered a recovery of capital and therefore is not taxable but does reduce basis.
d. Once basis is reduced to zero, any additional distributions are capital gain and are taxed
as such.
e. Dividends paid or credited by a credit union or savings and loan are not qualified
dividends.
Mutual Funds
2. Mutual fund distributions depend upon the character of the income source.
a. Distributions or dividends from a fund investing in tax-exempt securities will be tax-exempt
interest.
b. Capital gain distributions are treated as long term regardless of the actual period the
mutual fund investment is held.
c. If the capital gain remains undistributed, the taxpayer still must report the amount as gross
income (i.e., as if the capital gain were actually received).
d. The tax rates for long-term capital gains are 0%, 15%, 20%, 25%, and 28%.
e. Mutual funds and REITs may retain their long-term capital gains and pay tax on them
instead of distributing them.
1) A taxpayer must treat his or her portion of these long-term capital gains as a
distribution even though the taxpayer did not actually receive a distribution.

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6 SU 3: Gross Income II: Interest, Securities, and Decedent

Dividend Reinvestment Plans

3. A dividend reinvestment plan allows a taxpayer to use his or her dividends to buy more shares of
stock in the corporation instead of receiving the dividends in cash.
a. The basis of stock received as a result of a dividend reinvestment plan is fair market value,
even if purchased at a discounted price.
b. A member of a dividend reinvestment plan that lets the member buy more stock at a price
equal to its fair market value must report the dividends as income.
c. A member of a dividend reinvestment plan that lets the member buy more stock at a
price of less than fair market value must report as income the fair market value of the
additional stock on the dividend payment date.
d. If the dividend reinvestment plan allows members to invest more cash to buy shares of
stock at a price of less than fair market value, the member must report as income the
difference between the cash the member invests and the fair market value of the stock
purchased. Fair market value of the stock is determined on the dividend payment date.
e. Any service charge subtracted from the cash dividends before the dividends are used to
buy additional stock is considered dividend income.

EXAMPLE 3-2 Dividend Reinvestment Plan

A taxpayer at a company with a dividend reinvestment plan has 100 shares of stock and opts to use the
cash dividend to purchase 10 more shares at a total price of $1 when the total FMV of 10 shares is $20. The
transaction cost $0.50, which is deducted from the cash dividends prior to the purchase of the stock. The
taxpayer’s dividend income is $20.50 [(10 shares × $2 per share) + $0.50 charge].

f. Reinvested dividends are taxable in the year paid.

g. Reinvested dividends are added to the basis of the stock or mutual fund.
h. Reinvested dividends are treated as ordinary dividends.
Stock Dividends
4. Generally, a shareholder does not include in gross income the value of a stock dividend (or right
to acquire stock) declared on its own shares unless one of five exceptions applies:
a. If any shareholder can elect to receive cash or other property, none of the stock dividends
are excluded (shareholders may, however, receive cash for fractional shares, which is
included in gross income).
b. Some shareholders receive cash or other property, and other shareholders receive stock,
which increases their proportionate interest in earnings.
c. Some common stock shareholders receive preferred stock, while other common stock
shareholders receive common stock.
d. The distribution is on preferred stock (but a distribution on preferred stock merely to adjust
conversion ratios as a result of a stock split or dividend is excluded).
e. If a shareholder receives common stock and cash for a fractional portion of stock, only the
cash received for the fractional portion is included in gross income.

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 SU 3: Gross Income II: Interest, Securities, and Decedent 7

Constructive Dividends
5. Payments of personal expenses by a corporation may be considered taxable constructive
dividends.
Nonstatutory Stock Option Plans
6. The term “nonstatutory stock options” refers to those options that do not qualify for the favorable
tax treatment accorded options that are covered by a specific Code provision, as are qualified
stock options, incentive stock options, employee stock purchase plans, and restricted stock
options.
a. Nonstatutory stock options usually are taxed at ordinary income rates at the time they
are granted, the options being considered compensation for services rendered by
the employee. Generally, if an option is acquired under a nonstatutory program, the
employee may be taxed when
1) The option is granted,
2) The option is exercised,
3) The option is sold, or
4) The restrictions on the disposition of the option-acquired stock lapse.
b. If an option has a readily ascertainable fair market value at the time it is granted in
connection with the performance of services, the person who performed the services
realizes compensation either (1) when the rights of the option become transferable or
(2) when the right in the option is not subject to a substantial risk of forfeiture.
1) If the option does not have an ascertainable fair market value at the time when it is
granted, taxation occurs when the right to receive the stock is unconditional.
2) The difference between the option cost and the fair market value of the stock at the
time the optionee has a right to receive it is taxed as compensation.

EXAMPLE 3-3 Nonstatutory Stock Options

Mary Martin is granted a nonstatutory option to buy 5,000 shares of her employer’s stock at $50 per share
for 5 years at the time the stock is selling for $45 per share. Three years later, Mary exercises the option
when the stock is selling for $55 per share. Mary has no income, and her employer receives no deduction
at the time the option is granted. Upon exercise of the option, Mary has ordinary compensation of $25,000,
the bargain element, and her employer receives a corresponding deduction. Mary’s basis in the stock is
$275,000. Upon a later sale, Mary generates a short- or long-term capital gain or loss with the holding period
starting at the time the option is exercised.

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8 SU 3: Gross Income II: Interest, Securities, and Decedent

Incentive Stock Options

7. An employee may not recognize income when an incentive stock option is granted or exercised
depending upon certain restrictions.
a. The employee recognizes long-term capital gain if the stock is sold 2 years or more after
the option was granted and 1 year or more after the option was exercised.
1) The employer is not allowed a deduction.
b. Otherwise, the excess of the stock’s FMV on the date of exercise over the option price is
ordinary income to the employee when the stock is sold.
1) The employer may deduct this amount.
2) The gain realized is short-term or long-term capital gain.
c. Nonqualified stock option
1) An employee stock option is not qualified if it does not meet numerous technical
requirements to be an incentive stock option.
2) If the option’s FMV is ascertainable on the grant date,
a) The employee has gross income equal to the FMV of the option,
b) The employer is allowed a deduction,
c) There are no tax consequences when the option is exercised, and
d) Capital gain or loss is reported when the stock is sold.
3) If the option’s FMV is not ascertainable on the grant date,
a) The excess of FMV over the option price is gross income to the employee
when the option is exercised.
b) The employer is allowed a corresponding compensation deduction.
c) The employee’s basis in the stock is the exercise price plus the amount taken
into ordinary income.

EXAMPLE 3-4 Incentive Stock Option

On July 1, Year 1, Mighty, Inc., granted Henry an incentive stock option to purchase 2,000 shares of its stock
for $40 a share (its FMV) for the next 5 years. On September 18, Year 2, Henry exercised the option and
paid $80,000 when the stock’s FMV was $53 a share. On November 23, Year 3, Henry sold the stock for
$124,000. Mighty, Inc., receives no deduction upon grant, exercise, or sale. Henry reports a long-term capital
gain of $44,000.
If Henry had sold the stock for $124,000 on April 15, Year 3, the special 2-year holding period would not
have been met. As a result, Henry would have had $26,000 of ordinary income and $18,000 of long-term
capital gain in Year 3, and Mighty, Inc., would have had compensation expense of $26,000.

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 SU 3: Gross Income II: Interest, Securities, and Decedent 9

Employee Stock Purchase Plans

8. An employee stock option plan is, generally, one permitting employees to buy stock in the
employer corporation at a discount. Options issued under an employee stock purchase plan
qualify for special tax treatment. No income is recognized under such a plan at the time the
option is granted; the recognition is deferred until stock acquired under the plan is disposed of.
a. If stock acquired under such a plan is disposed of after being held for the required period,
the employee will realize ordinary income to the extent of the excess of the fair market
value of the stock at the time that option was granted over the option price. Any further
gain is a capital gain.
1) If the stock is disposed of when its value is less than its value at the time the option
was granted, the amount of ordinary income will be limited to the excess of current
value over the option price.
b. An employee stock purchase plan must provide that only employees may be granted
options and must be approved by the stockholders of the granting corporation within
12 months before or after the date the plan is adopted. Other conditions that must be met
either by the plan or in the stock offering are
1) The option price may not be less than the smaller of
a) 85% of the fair market value of the stock when the option is granted or
b) 85% of the fair market value at exercise.
2) The option must be exercisable within 5 years from the date of grant, where the
option price is not less than 85% of the fair market value of the stock at exercise.
a) If the option price is stated in any other terms, the option must not be
exercisable after 27 months from the date of the grant.
3) No options may be granted to owners of 5% or more of the value or voting power of
all classes of stock of the employer or its parent or subsidiary.
4) No employee may be able to purchase more than $25,000 of stock in any 1 calendar
year.
5) The option may not be transferable (other than by will or laws of inheritance) and
may be exercisable only by the employee to whom it is granted.
6) If the exercise price was less than the value of the stock upon grant and the option
was exercised, the employee may have compensation income (with an offsetting
deduction by the employer) upon disposition, including a transfer at death.
a) The compensation equals the lesser of fair market value at grant or at
exercise, less the exercise price, and is added to the stock basis.
b) There is no offsetting deduction by the employer.

EXAMPLE 3-5 Employee Stock Purchase Plans -- Calculation

Alice Nichel was given an option to buy 200 shares of Delta, Inc., stock for $55 a share when it was selling
for $62. She exercised the option 2 years later when the stock was selling for $68 and sold the stock
after another 3 years for $81 a share. The lesser of $68 or $62, less $55 a share, which is $7 a share, is
compensation in the year of sale, i.e., $1,400. Alice’s basis is increased by $7 a share to $62. Thus, her long-
term capital gain is $19 per share ($81 – $62), or $3,800.

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10 SU 3: Gross Income II: Interest, Securities, and Decedent

3.3 INCOME IN RESPECT OF A DECEDENT (IRD)

The filer of a decedent’s income tax and estate tax returns is required to make the appropriate
allocation of income related to the decedent during the year of death. IRD is all amounts to which a
decedent was entitled as gross income but that were not includible in computing taxable income on
the final return. The person had a right to receive it prior to death, e.g., salary was earned or sale
contract was entered into.
1. Not includible on the final income tax return of a cash-method (CM) taxpayer are amounts not
received. Not includible on the final income tax return of an accrual-method (AM) taxpayer are
amounts not properly accrued.
Items of Income in Respect of a Decedent
IRD Not IRD
Salary earned prior to, but not received before, Salary earned and accrued by AM taxpayer
death of a CM taxpayer
Collection after death of A/R of CM taxpayer Collection of A/R by AM taxpayer
Gain on sale of property by CM taxpayer Gain on sale of property received before death
received not before death
Rent accrued but not received before death by Rent received before death
CM taxpayer
Interest on installment debt accrued before Interest on installment debt accrued after
death by CM taxpayer death by AM taxpayer
Installment income recognized after death on Installment contract income recognized before
contract entered into before death death

2. IRD is reported by the person receiving the income as if the recipient were the decedent.
a. The cash method applies to income once designated IRD.
b. IRD received by a trust or estate is fiduciary income.
3. A right to receive IRD has a transferred basis. The basis is not stepped-up to FMV on the date of
death, as is generally the case for property acquired from a decedent.

EXAMPLE 3-6 Right to Receive IRD -- Transferred Basis

Mrs. Hart had earned 2 weeks’ salary of $2,000 that had not been paid when she died. As a cash-method
taxpayer, her basis in the right to receive the $2,000 was $0. When her estate received the income, it had
$2,000 of ordinary income because its basis in the right to receive it was also $0. Note that the $2,000 is not
reported on Mrs. Hart’s final return.

4. IRD has the same character and tax status it would have had in the hands of the decedent.

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 SU 3: Gross Income II: Interest, Securities, and Decedent 11

5. IRD is taxable as income to the recipient and is includible in the gross estate. Double tax is
mitigated by deductions.
a. Deductions in respect of a decedent.
1) Expenses accrued before death, but not deductible on the final return because the
decedent used the cash method, are deductible when paid if otherwise deductible.
a) They are deductible on the return of the taxpayer reporting the IRD
(Form 1041).
b) They are also deductible on the estate tax return (Form 706).
b. Deduction for estate tax. Estate taxes attributable to IRD included in the gross estate are
deductible on the recipient’s income tax return.
1) Administrative expenses and debts of a decedent are deductible on the estate tax
return [Form 706, United States Estate (and Generation-Skipping Transfer) Tax
Return]. Some of them may also be deductible on the estate’s income tax return
(Form 1041, U.S. Income Tax Return for Estates and Trusts).
a) Double deductions are disallowed.
b) The right to deduct the expenses on Form 706 must be waived in order to
claim them on Form 1041.
2) Deduction (on Form 1041) is allowed for any excess of the federal estate tax over
the amount of the federal estate tax if the IRD had been excluded from the gross
estate.
c. The tax returns that would report IRD include, but are not limited to, the following:
1) The decedent’s estate, Form 1041, if the decedent’s estate receives right to the
income.
2) The beneficiary’s Form 1040, if the right to income arising out of the decedent’s
death is passed directly to the beneficiary and is never acquired by the decedent’s
estate.
3) The Form 1040 of any person to whom the decedent’s estate properly distributes the
income.
NOTE: The decedent’s final Form 1040 would not include IRD.

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12 SU 3: Gross Income II: Interest, Securities, and Decedent

EXAMPLE 3-7 IRD -- Return Presentation

Frank Johnson owned and operated an apple orchard. He used the cash method of accounting. He sold
and delivered 1,000 bushels of apples to a canning factory for $2,000, but did not receive payment before
his death. The proceeds from the sale are income in respect of a decedent. When the estate was settled,
payment had not been made and the estate transferred the right to the payment to his widow. When Frank’s
widow collects the $2,000, she must include that amount in her return. The amount is not reported on the
final return of the decedent or on the return of the estate.

EXAMPLE 3-8 IRD -- Recognized Income

Assume the same facts as in Example 3-7, except that Frank used the accrual method of accounting. The
amount accrued from the sale of the apples would be included on his final return. Neither the estate nor the
widow would realize income in respect of a decedent when the money is later paid.

EXAMPLE 3-9 IRD -- Recognized Gain

On February 1, George High, a cash-method taxpayer, sold his tractor for $3,000, payable March 1 of the
same year. His adjusted basis in the tractor was $2,000. George died on February 15, before receiving
payment. The gain to be reported as income in respect of a decedent is the $1,000 difference between the
decedent’s basis in the property and the sale proceeds. In other words, the income in respect of a decedent
is the gain the decedent would have realized had he lived.

EXAMPLE 3-10 IRD -- Recognized Income Assignment

Cathy O’Neil was entitled to a large salary payment at the date of her death. The amount was to be paid in
five annual installments. The estate, after collecting two installments, distributed the right to the remaining
installments to the beneficiary. The payments are income in respect of a decedent. None of the payments
were includible on Cathy’s final return. The estate must include in its income the two installments it received,
and the beneficiary must include in income each of the three installments as the installments are received.

EXAMPLE 3-11 IRD -- Recognized Income Assignment

Paige inherited the right to receive renewal commissions on life insurance sold by her father before his
death. Paige inherited the right from her mother, who acquired it by bequest from Paige’s father. Paige’s
mother died before she received all the commissions she had the right to receive, so Paige received the
rest. The commissions are income in respect of a decedent. None of these commissions were includible on
Paige’s father’s final return. The commissions received by Paige’s mother were included in her income. The
commissions Paige received are not includible in Paige’s mother’s income, even on her final return. Paige
must include them in her income.

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