Ordinary Income - Explained
What is Ordinary Income?
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Table of ContentsWhat is Ordinary Income?How Does Ordinary Income Work? Examples of Ordinary IncomeSpecial ConsiderationsQualified Vs. Unqualified DividendsAcademic Research on Ordinary Income
What is Ordinary Income?
An ordinary income is a pretax income earned by individuals and organizations which is taxable using ordinary rates. Examples of ordinary income are salaries, wages, interests earned on bonds, tips, commissions and other forms of income different from long-term capital gains. Long-term capital gains are not ordinary income, they are regarded as dividends and are subject to a tax treatment different from that or ordinary income. Long-term capital gains are earned fro investments held for a period longer than one year.
How Does Ordinary Income Work?
Ordinary income earned by organizations is called business income while individuals earn personal income. There are many ways to generate ordinary income, for instance, businesses can generate ordinary income from their day to day activities or sale of products while individuals earn ordinary income as salaries, tips, wages, and commissions. Income made from the sale of long-term assets does not qualify as ordinary income, such income has a different tax treatment. The Internal Revenue Service (IRS), outlines the cash that qualifies as ordinary income, both for individuals and organizations. Here are some points to know about ordinary income;
- Ordinary income is earned by individuals and organizations and is taxable at ordinary rates.
- Ordinary income for individuals includes salaries, wages, tips, and commissions while organizations also earn ordinary income from interest from bonds, commissions, and others.
- Long-term capital gains earned from investments held for a period longer than one year is subjected to different tax treatment. Long-term capital gains do not qualify as ordinary income, given that they are dividends earned form long-term investments.
Examples of Ordinary Income
If a business development personnel at an organization earns a salary of $2,000 per month, this is an example of ordinary income. In addition to his salary, if the employee earns commission from a business referral or receives tips from clients, they also qualify as ordinary income, ordinary income is taxed using ordinary rates. In addition, if an individual property owner earns an amount as rental income of properties let out to people, such income is also ordinary income. The Internal Revenue Service (IRS) treats pretax profit earned by companies through the sales of products and services as ordinary income. Companies or organizations are required to report their annual income to the IRS for tax purposes. Ordinary income is taxed using ordinary rates, this type of income differs from long-term capital gains.
Capital gains earned on long-term investments and assets attract lower tax rates than ordinary income. The reason is that the government tries to encourage investment in long-term assets through the introduction of lower tax rates on capital gains. Before the introduction of lower tax rates, dividends, or capital gains were treated as ordinary income and taxed the same.
Qualified Vs. Unqualified Dividends
Not all dividends enjoy the lower tax rates offered by the IRS, to avoid confusion, the IRS separates qualified dividends from unqualified dividends. There are certain eligibility requirements that dividends must meet before they are qualified for favorable tax treatment. Examples of dividends that are unqualified for favorable tax treatments are dividends paid by master limited partnerships (MLPS), real estate investment trusts (REITs) and others. Dividends collected from tax-exempt companies and money market are also unqualified for favorable tax treatment.