Damages are includible in gross income because they

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damages are includible in gross income because they are a substitute for income that would otherwise be taxable. Amounts received because of personal injury or sickness are generally excluded from gross income. All punitive damages are taxable even if awarded along with damages for sickness or physical injury. Awards for injury to personal reputation were formerly non-taxable but are now taxable. Damages for injury to business reputation are taxable.
L. Recovery of Previously Deducted Amounts (THE TAX BENEFIT RULE) Recovery (refund) of previously deducted amounts in a subsequent year may cause income recognition (i.e. Tax Benefit Rule). EXAMPLE: Taxpayer receives a state tax refund of $600 dollars in 2014 after filing her 2013 state tax return. Taxpayer had originally paid $3,000 of state income taxes in 2013. Whether the above refund is taxable or not depends upon what the taxpayer did on her US 1040 for year 2013. If she itemized and deducted those state income taxes for the full amount paid, then she deducted too much and the refund will be taxable to the extent of the tax benefit received from the deduction. If the taxpayer did not itemize, the state taxes couldn’t be deducted so there was no tax benefit from the deduction and no taxable income on the refund. The Tax Benefit Rule is an important concept that can guide you in determining whether a refund of an item is taxable. If the person deducted the cost of the item in a previous year, the refund is taxable. If no previous deduction was taken, the refund is not taxable. M. Claim of right 1. A taxpayer may receive funds normally constituting income but the right to keep all of it is contingent upon future events. Under the claim of right doctrine, the taxpayer must report the amounts received as income, unless taxpayer does not have control of the funds. An example of this would be someone who sells property but the full price is contingent upon a future event (for example, the purchaser must obtain zoning or licensing approval). The seller may have to refund some of the sales price if the future contingency fails to occur. 2. If the taxpayer is subsequently required to repay the disputed amount, a deduction is available in the year of repayment. N. Original Issue Discount (OID) Rules These rules apply to debt instruments (with exceptions notably US savings bonds, debt instruments with terms less than one year, and loans between individuals of less than $10,000) that are issued at a discount (purchase price less than face value) and mature at the face value. An accrual based borrower would deduct the interest as accrued while a cash based lender would normally recognize the interest income at maturity. The OID rules place both on the accrual basis for purposes of recognizing the discount element of interest. So, a cash basis taxpayer must amortize the discount as interest income (usually using the effective interest method) each year just like an accrual basis taxpayer.
O) Below Market Loans No-interest loans or below-market-interest loans are a back door way of doing the following: 1) Gift loans: used to assign of income (from higher bracket taxpayer to lower bracket taxpayer)

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