Series 7

Risk and Tax Considerations - Income and Taxation

Within this section, we will examine the federal tax treatment of different income types, foreign securities, and wash sales. How taxes affect your client is extremely important to consider when providing information and recommendations.

Types of Income
U.S. federal tax authorities recognize three types of income:

  • Earned income is just what it sounds like: salary, bonus, perquisites, fees for services and other remuneration for work you perform. Earned income is subject to income tax at a rate proportional to a person's income
  • Investment income consists of interest, dividends, capital gains and gains (or losses) from selling securities or property.

    • A capital gain is the difference between the price at which you bought a security and the price at which it is now. If you haven't sold that security yet, the capital gain is said to be unrealized. Capital gains are not taxed until they are realized - that is to say, when you sell them. At that point, they become gains from selling securities and are generally taxed at a lower rate than other income.
    • Cash dividends are payable in the year paid and shareholders must pay tax on the full amount, even if they are reinvested.
      • On the other hand, companies who own stock in other companies will typically qualify for a corporate dividend exclusion of 70% (if they own less than 20% stock in the other company), or 80% (if they own more than 20% of the other company).
    • Stock dividends are not taxable until a capital gain on those securities is realized by selling the securities. At this point, the investor must adjust the cost basis of his or her position to reflect the stock dividend. As a result, capital gains (and its respective tax) will be higher due to the lower cost basis.

  • Passive income is income generated from business activities in which you do not participate materially during the year, such as rental activities (as long as you are not a real estate professional), partnerships (if you are not one of the operating partners), and residuals.

    • Residuals is best explained through the following examples:
      • A sales rep who gets a commission every time an old customer makes a new purchase.
      • A land owner who has hired a professional farmer to run the property
      • A former songwriter who makes a royalty every time his golden oldie is played on the radio (if he were still writing songs professionally, this would not be an example of passive income).
This type of income is treated similarly to earned income except that the tax code recognizes that - unlike earned income - there is the possibility of loss if the partnership or the rental property or the farm is wiped out. However, there is also a recognition that sometimes such losses occur on purpose so the holders of these properties can take a loss and avoid paying taxes. There is an entire unit of the IRS code, Section 469, which prescribes how to account for the risks and losses associated with passive income.





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