Figures: tax year 2026
An individual's income projection begins with the legal character of each receipt, including amounts recognized without receiving cash. Gross income includes compensation, taxable interest and other accessions to wealth unless an exclusion applies.
The principal classifications are:
For certain items of gross income, the physical-injury connection determines exclusion: qualifying damages require physical injury or sickness. Emotional distress alone generally does not establish that exclusion, although qualifying medical reimbursements receive separate treatment.
Adjusted gross income (AGI) links gross income to taxable income by subtracting the adjustments allowed before itemized deductions or the standard deduction. A permitted direct health-account contribution can reduce AGI; an itemized charitable deduction generally operates later.
The computation follows this order:
- Classify receipts and recognize taxable amounts.
- Apply exclusions without also claiming deductions for those same excluded amounts.
- Subtract adjustments that determine AGI.
- Compare eligible itemized deductions with the available standard deduction.
- Apply separately permitted deductions and their limitations.
- Compute income tax using the supplied brackets and applicable preferential rates.
Common mistakes
- Omitting compensation from basis. Birch's sale gain would incorrectly become if the $6,000 compensation inclusion were omitted from basis.
- Adding unused deductions twice. Adding Lena's undeducted $6,000 personal taxes would incorrectly increase AMTI from $172,100 to $178,100.
- Treating wages as election income. Priya's wages prevent the parental reporting election even though her return also contains interest.
Bottom line
- Taxable income depends on receipt classification, valid exclusions, AGI adjustments and deductions applied in their proper order.
- Equity awards require separate grant, vesting, exercise, settlement and sale analysis, with compensation included in basis before sale gain is measured.
- AMTI adjusts regular-tax income before exemptions and rates, while ISO exercise can create income and basis differences without sale proceeds.
- Below-market loans can create imputed income, foreign earnings require independent exclusion qualification, and eligible child unearned income requires parental-rate comparison.
Exam shortcut
Mark every equity date before calculating income. Identify what transferred, whether it vested, and whether compensation has already increased basis. For a loan, test exceptions before computing forgone interest. For foreign wages, test tax home and qualification before applying the exclusion ceiling. In a child-income problem, separate the deduction, net unearned income, remaining taxable income and parental tax increment before combining the results.
The full lesson (about 17,318 words, 115 min read) adds 21 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- I.A1
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