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Classify wages, interest, and distributions as taxable, qualified, or nontaxable
Most returns open with the same three receipts: pay for work, interest on money, and distributions on stock and funds. Each one lands on its own line and answers its own question: is this pay, is this interest taxable or tax-exempt, and is this distribution ordinary, qualified, or a return of capital. This lesson settles all three.
Start from the reach of the tax. Gross income is all income from whatever source derived, unless the law excludes it, so for any receipt for work, the question is which exclusion, if any, removes it. Pay for services is income whether it arrives as cash, as property, or as services themselves.
Three forms of pay need special care. A secured note handed over as pay counts at its fair market value in the year it is received. When payments on the note come in later, a proportionate part of each payment is recovery of that value already taxed, and the rest of the payment is income in the year it is paid. The recovery is spread across every payment in proportion; it is not taken first. An unsecured nonnegotiable note works the other way: principal credited on it is compensation income when received. Severance pay and payments for canceling an employment contract are income, and severance payments are subject to social security and Medicare taxes, income tax withholding, and FUTA tax. Report pay on Form 1040 line 1a even when no Form W-2 arrives or the W-2 is short. Neighborhood work counts the same way: if you provide childcare, either in the child’s home or in your home or other place of business, the pay you receive must be included in your income — and if you babysit for relatives or neighborhood children, whether on a regular basis or only periodically, the rules for childcare providers apply to you. Pay also includes other forms of compensation such as fringe benefits and stock options; fringe benefits received in connection with services are compensation unless the recipient pays fair market value or the law specifically excludes them.
Rosa leaves her job in March. She receives her regular salary of $41,000, a $5,000 severance payment, and a secured note from her employer with a face amount of $4,000 and a fair market value of $3,000 as payment for consulting she performed before leaving. Each receipt is pay for services with no exclusion in play. Rosa reports $49,000 of compensation: salary, severance, and the note’s value, all in the year received. When the employer later pays $1,000 toward the note, only a proportionate part is recovery of the value already taxed: $3,000 of the $4,000 face, or 75%, so $750 is recovery and $250 is income in the year of payment. Every later payment on the note splits the same way.
26 CFR § 1.61-1 1.61-1(a) — 1.61-1
Gross income means all income from whatever source derived, unless excluded by law.View on the source
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Severance pay. You must include in income amounts you receive as severance pay and any payment for the cancellation of your employment contract.View on the source
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forms of compensation such as fringe benefits and stock options.View on the source
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Include all your pay on Form 1040 or 1040-SR, line 1a, even if you don’t receive Form W-2, or you receive a Form W-2 that doesn’t include all pay that should be included on the Form W-2.View on the source
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Fringe benefits received in connection with the performance of your services are included in your income as compensation unless you pay FMV for them or they’re specifically excluded by law.View on the source
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If your employer gives you a nonnegotiable unsecured note as payment for your services, payments on the note that are credited toward the principal amount of the note are compensation income when you receive them.View on the source
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Severance payments are subject to social security and Medicare taxes, income tax withholding, and FUTA tax.View on the source
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If your employer gives you a secured note as payment for your services, you must include the FMV (usually the discount value) of the note in your income for the year you receive it. When you later receive payments on the note, a proportionate part of each payment is the recovery of the FMV that you previously included in your income. Don’t include that part again in your income. Include the rest of the payment in your income in the year of payment.View on the source
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Childcare providers. If you provide childcare, either in the child’s home or in your home or other place of business, the pay you receive must be included in your income.View on the source
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Babysitting. If you babysit for relatives or neighborhood children, whether on a regular basis or only periodically, the rules for childcare providers apply to you.View on the source
An employer pays an employee for services with a secured note with a face amount of $10,000 and a fair market value of $8,000. How much must the employee include as compensation in the year the note is received?
Interest is split by source. Most interest a client receives — bank accounts, certificates of deposit, most bonds — is taxable interest. Interest on qualifying state and municipal obligations is tax-exempt interest: it still appears on the return for information, on line 2a, while taxable interest goes on line 2b. The split matters because only the taxable portion enters adjusted gross income. Only qualifying obligations produce tax-exempt interest: interest on a private activity bond that is not a qualified bond is taxable. The AMT caveat applies to private activity bonds only, not to ordinary municipal-bond interest: interest you receive on these tax-exempt private activity bonds, if issued after August 7, 1986, generally is a tax preference item and may be subject to the AMT, figured with Form 6251. The same caveat reaches fund shareholders: exempt-interest dividends paid from specified private activity bonds may be subject to the AMT, and the AMT subset should be shown in Form 1099-DIV box 13 as part of the box 12 exempt-interest dividends.
| Receipt | Treatment |
|---|---|
| Bank and most bond interest | Taxable, line 2b |
| Qualifying municipal-bond interest | Tax-exempt, line 2a |
| Savings-bond interest excluded for higher education expenses | Schedule B with Form 8815 |
The last table row is the education-savings exception: savings-bond interest you will exclude because of higher education expenses is still listed on Schedule B, and you also use Form 8815 to figure the exclusion.
Interest usually arrives documented: Forms 1099-INT and, for discount instruments, 1099-OID. When a 1099-INT shows the wrong amount, the recipient asks the issuer for a corrected form rather than silently adjusting the number.
Tom receives $1,400 of bank interest, $800 of interest on city bonds that qualify for exemption, and a Form 1099-INT that overstates the bank interest by $200. Tom reports $1,400 on line 2b and $800 on line 2a, then asks the bank for a corrected 1099-INT. The exempt $800 is disclosed but not taxed; the correction keeps the file matched to what the IRS receives.
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Tax-exempt interest Line 2a (See the instructions there). Taxable interest Line 2b (See the instructions there).View on the source
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Interest on a private activity bond that is not a qualified bond (defined below) is taxable.View on the source
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Interest you receive on these tax-exempt bonds, if issued after August 7, 1986, generally is a “tax preference item” and may be subject to the AMT. See Form 6251 and its instructions for more information.View on the source
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Exempt-interest dividends paid from specified private activity bonds may be subject to the AMT. The exempt-interest dividends subject to the AMT should be shown in Form 1099-DIV, box 13. See Form 6251 and its instructions for more information.View on the source
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Savings bond interest you will exclude because of higher education expenses Schedule B; also use Form 8815.View on the source
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If you receive a Form 1099-INT and interest as a nominee for another person, see the discussion on Nominee distributions, later. Incorrect amount. If you receive a Form 1099-INT that shows an incorrect amount (or other incorrect information), you should ask the issuer for a corrected form.View on the source
A taxpayer receives $600 of interest on qualifying state bonds that is tax-exempt, and $400 of interest on a bank savings account. How are the two amounts reported on Form 1040?
Ordinary dividends (box 1a). Distributions from a corporation or mutual fund start with a presumption: a dividend on common or preferred stock is an ordinary dividend unless the payer says otherwise. Ordinary dividends come out of earnings and profits and are ordinary income, shown in Form 1099-DIV box 1a.
Qualified dividends (line 3a). Some of those ordinary dividends also qualify for the lower capital-gain rate as qualified dividends, reported on line 3a against ordinary dividends on line 3b. The lower rate applies only if all three tests are met: the payer is a U.S. corporation or qualified foreign corporation, the dividend is not on the disqualified list, and the shareholder meets the holding period. For common stock that means holding more than 60 days during the 121-day period beginning 60 days before the ex-dividend date; for preferred stock with dividend periods totaling more than 366 days it means more than 90 days during the 181-day period beginning 90 days before the ex-dividend date. A box 1b figure alone does not make dividends qualified when the holding test fails.
Nondividend distributions (box 3). A nondividend distribution in box 3 is a return of capital rather than earnings: it reduces stock basis and is not taxed until basis is fully recovered, and only the excess after basis reaches zero is reported, on Form 8949 Part I (held 1 year or less) or Part II (held more than 1 year).
Exempt-interest dividends (box 12) and capital gain distributions (box 2a). Exempt-interest dividends from a mutual fund or regulated investment company, shown in box 12, pass through the fund’s tax-exempt interest to the shareholder for the calendar year. Capital gain distributions in box 2a are reported directly on Form 1040 line 7a or, when required, Schedule D line 13; a fund’s net realized short-term capital gains are not treated as capital gains but arrive as ordinary dividends.
Money market funds pay dividends, not interest. Money market funds are offered by non-bank financial institutions such as mutual funds and stock brokerage houses, and pay dividends: generally, amounts you receive from money market funds should be reported as dividends, not as interest. Report amounts you receive from money market funds as dividend income, and do not confuse them with bank money market accounts that pay interest.
Reinvested dividends, service charges, nominees, Schedule B. Reinvested dividends stay taxable: stock bought through a dividend reinvestment plan at fair market value is still dividend income, and any service charge subtracted before reinvestment is dividend income too. Dividends received as a nominee belong on Schedule B Part II with the nominee amount backed out, and ordinary dividends above $1,500 also require Schedule B Part II.
Ana’s Form 1099-DIV shows $2,000 in box 1a, of which the fund identifies $1,500 as qualified, plus $300 in box 3 and $400 in box 12. Her basis in the shares is $4,000, which fully covers the box 3 distribution. Ana reports $2,000 as ordinary dividends with $1,500 of that as qualified, reduces her basis by the $300 box 3 return of capital to $3,700 with nothing reported for it this year, and treats the $400 box 12 amount as exempt-interest dividends for the year.
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Ordinary dividends are the most common type of distribution from a corporation or a mutual fund. They are paid out of earnings and profits and are ordinary income to you.View on the source
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Ordinary Dividends Ordinary dividends are the most common type of distribution from a corporation or a mutual fund. They are paid out of earnings and profits and are ordinary income to you. This means they are not capital gains. You can assume that any dividend you receive on common or preferred stock is an ordinary dividend unless the paying corporation or mutual fund tells you otherwise. Ordinary dividends will be shown on Form 1099-DIV, box 1a.View on the source
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The maximum rate on qualified dividends applies only if all of the following requirements are met. • The dividends were paid by a U.S. corporation or a qualified foreign corporation. (See Qualified foreign corporation, later.) • The dividends are not of the type listed later under Dividends that are not qualified dividends. • You meet the holding period (discussed next).View on the source
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Holding period. You must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date.View on the source
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Exception for preferred stock. In the case of preferred stock, you must have held the stock more than 90 days during the 181-day period that begins 90 days before the ex-dividend date if the dividends are due to periods totaling more than 366 days.View on the source
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Basis adjustment. A nondividend distribution reduces the basis of your stock. It is not taxed until your basis in the stock is fully recovered.View on the source
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Nondividend distributions. Report nondividend distributions (Form 1099-DIV, box 3) only after your basis in the stock has been reduced to zero. After the basis of your stock has been reduced to zero, you must show this excess amount on Form 8949, Part I, if you held the stock 1 year or less. Show it on Form 8949, Part II, if you held the stock for more than 1 year.View on the source
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Capital gain distributions. If you received capital gain distributions, you report them directly on Form 1040 or 1040-SR, line 7a; or on Schedule D (Form 1040), line 13, depending on your situation.View on the source
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If you received capital gain distributions from a mutual fund or real estate investment trust (REIT), the distributions of net realized short-term capital gains are not treated as capital gains. Instead, they are included on Form 1099-DIV as ordinary dividends.View on the source
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If you use your dividends to buy more stock at a price equal to its fair market value, you must still report the dividends as income.View on the source
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You also must report as dividend income any service charge subtracted from your cash dividends before the dividends are used to buy the additional stock.View on the source
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You must complete Schedule B (Form 1040), Part II, and attach it to your Form 1040 or 1040-SR, if: • Your ordinary dividends (Form 1099-DIV, box 1a) are more than $1,500, or • You received, as a nominee, dividends that actually belong to someone else.View on the source
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box 12, shows exempt-interest dividends from a mutual fund or other regulated investment company (RIC) paid to you during the calendar year.View on the source
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Money market funds. Money market funds are offered by non-bank financial institutions such as mutual funds and stock brokerage houses, and pay dividends. Generally, amounts you receive from money market funds should be reported as dividends, not as interest.View on the source
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Money Market Funds Report amounts you receive from money market funds as dividend income. Money market funds are a type of mutual fund and should not be confused with bank money market accounts that pay interest.View on the source
A taxpayer bought stock for $100. An earlier nondividend distribution of $80 reduced basis to $20. This year the taxpayer receives another nondividend distribution of $30 on the same stock, held for years. How is the $30 treated?
The course asks you questions like these as you learn, brings back the ones you miss, and ends with full-length practice exams.
See the course Or take the free 12-question checkGroundSkill is independently produced and is not affiliated with or endorsed by the IRS. Sources last checked 2026-09-14. Exam preparation, not tax advice.