Substitutes for Ordinary Income: Definition & Examples

Instructor: Yuanxin (Amy) Yang Alcocer

Amy has a master's degree in secondary education and has taught math at a public charter high school.

After reading this lesson, you'll understand why the IRS finds it important to classify certain monetary gains as a substitute for ordinary income. You'll also learn about some court cases that involve this substitute for ordinary income.

Ordinary Income

Everybody that works or gets income in some way or another in the United States has to pay taxes to the federal government and often the state as well. The states of Alaska, Nevada, Florida, South Dakota, Washington, Texas, and Wyoming have no income tax, so if you live in one of these states, then you only need to pay taxes to the federal government.

As of 2019, the more income you make, the more you pay in taxes. Income you make from working or business is referred to as ordinary income. This income is taxed anywhere from 10 percent to 39.6 percent. If you made $500,000 in one year, then you would end up paying an income tax of $500,000 * 0.396 = $198,000. Now that's quite a bit of money to be giving up each year.

Capital Gains

This is why some people try to earn money through capital gains instead of ordinary income. Capital gains is the profit you make from selling an asset such as land and stocks. If you've had the asset for more than a year, then your capital gains are taxed under the long-term capital gains percentages that start at 10 percent and go up to 20 percent.

Because these tax rates are lower than those for ordinary income, being able to label part of your income as capital gains will let you keep more of your money. If you make a lot of money each year, having part of your income reported as capital gains is financially beneficial for you.

Cars are also considered capital gains. If you buy a used car for $500, fix it up, then sell it for $2,000, the difference of $1,500 is your capital gains.

If you bought a used car, fixed it, and sold it at profit, it is considered capital gains if it is not for your business.
substitute ordinary income

Substitutes for Ordinary Income

A substitute for ordinary income is a doctrine that the IRS applies at times to certain sales of assets to make the money earned taxable as ordinary income. It's important to understand this doctrine so that you won't be surprised when a transaction that you think is capital gains is actually taxed as ordinary income.

Several court cases actually set the precedent for the application of this doctrine. In 1965, the Supreme Court case of United States v. Midland-Ross Corp defined a capital gains property as one that does not include a right or claim to ordinary income. This means that if your transaction involves income, either present or future, then that transaction is considered ordinary income and will be taxed as such.

With that said, going back to the cars example, if your business is that of buying used cars, fixing them up, and then reselling them for profit, then your earnings from doing so are no longer considered capital gains. They are now considered ordinary income and will be taxed accordingly.

Other examples of money earned from assets that will act as a substitute for ordinary income are rental properties and any interest you earn from your asset such as interest from a savings account.

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