Taxable Income: How is it Determined?

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How to determine your taxable incomeOne of the most common questions I'm asked as a tax attorney is, "What's taxable?" Believe it or not, that's a pretty difficult question to answer, because the list is so lengthy. A much easier question would be, "What isn't taxable?" This is because our tax system is considered inclusive. In other words, all income is considered taxable unless otherwise excluded.

To figure your taxable income, you must first calculate total income. To do this, include everything you receive in payment for services. That means wages, salaries, commissions, fees, tips, as well as fringe benefits and stock options. Income that is available to you, such as an uncashed check, can still be included under the doctrine of constructive receipt. The same theory applies to deferred compensation: If you could take the income without incurring a significant penalty, it's considered yours when made available -- not when you take it.
In addition to payment for services, you must include other items of income, such as interest and dividends, alimony, business and farm income, capital gains, retirement income, partnership income, net proceeds from rentals and "other income." "Other income" may include income from the pursuit of a hobby; it may also include gambling income or income from illegal activities, like drug sales or prostitution (and no, I'm not making that up).

And don't be fooled -- income doesn't have to be in the form of cash or check. You can also receive income in the form of property or services.

After you've figured your total income, you can deduct some expenses right off the top to determine adjusted gross income (AGI). These include certain qualified expenses for teachers, moving expenses and student loan interest. It also includes alimony paid out, deductions for IRA contributions and one-half of self-employment tax paid.

Next, subtract personal exemptions and deductions. Use the larger of your standard deduction or your itemized deductions in your calculation. The result is your taxable income.

You can boil these steps down to this basic formula:

Adjusted Gross Income - (deductions + personal exemptions) = taxable income

Your taxable income is what you'll use to calculate the tax due, using the applicable tax rates.

The rules for credits and deductions can vary from year to year, as do tax rates. Check back with WalletPop to see how changes in 2010 could affect your bottom line.
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