A "988 income" doesn't directly relate to a specific type of income itself. Instead, the term "988" refers to Section 988 of the Internal Revenue Code (IRC), which deals with the tax treatment of certain foreign currency transactions. So, "988 income" is income resulting from a Section 988 transaction. This means it's income generated from transactions involving currencies other than the functional currency of the taxpayer.
Essentially, if your business or personal financial activities involve dealing with foreign currencies, the gains or losses you experience due to fluctuations in exchange rates are treated as ordinary income or loss under Section 988.
Here's a more detailed breakdown:
What Makes a Transaction Subject to Section 988?
A transaction falls under Section 988 if it meets these criteria:
- It's a Section 988 transaction: This includes acquiring or becoming obligor under a debt instrument, accruing expenses, or receiving revenues that are denominated in a foreign currency.
- The amount you're entitled to receive or required to pay is stated in terms of a nonfunctional currency. A nonfunctional currency is any currency other than the currency of the economic environment in which the taxpayer operates. Usually, this is the U.S. dollar.
- There would be a gain or loss recognized because of changes in exchange rates. This means that exchange rate fluctuations between the date of the transaction and the date of payment can create taxable gains or deductible losses.
Examples of Section 988 Transactions:
- Sale of goods or services denominated in a foreign currency: A U.S. company sells goods to a customer in Europe and bills them in Euros. The exchange rate between the dollar and the Euro changes between the date of the sale and the date the company receives payment. This exchange rate difference can lead to a gain or loss.
- Purchase of goods or services denominated in a foreign currency: A U.S. company buys supplies from a supplier in Japan and pays them in Yen. If the exchange rate fluctuates between the date of the purchase and the date of payment, the company may experience a gain or loss.
- Loans denominated in a foreign currency: A U.S. company borrows money from a bank in Switzerland and the loan is denominated in Swiss Francs. Exchange rate changes between the dollar and the Franc during the loan term can create gains or losses.
Tax Treatment of Section 988 Gains and Losses:
Gains or losses from Section 988 transactions are generally treated as ordinary income or ordinary loss, not capital gains or losses. This means they are taxed at the taxpayer's ordinary income tax rate. The treatment as ordinary income/loss can be favorable because ordinary losses can offset other ordinary income without the limitations that often apply to capital losses.
Exceptions to Section 988:
Certain transactions are specifically excluded from Section 988 treatment, such as:
- Certain hedging transactions that are properly identified.
- Transactions related to personal use property.
In Summary:
"988 income" isn't a specific, stand-alone type of income. It's a shorthand way of referring to the income (or loss) generated from transactions involving foreign currencies, as governed by Section 988 of the Internal Revenue Code. These gains or losses result from fluctuations in exchange rates and are generally treated as ordinary income or loss for tax purposes. If you deal with foreign currencies, understanding Section 988 is crucial for proper tax compliance.
