Income tax is levied on “all income from whatever source derived” unless specifically excluded. Consequently, knowledge of authorized exclusions from taxable income is a key tool in tax planning.

Unit04. Gross Income: Exclusions1

exclusions from taxable income is a key tool in tax planning.

This week’s objective is to increase our understanding of which items are, by law, excluded from gross income.

Outline

� To avoid being taxed, there are alternatives to the taxpayer

� Establish that an item is not income� Study Example 4-1

� Establish that a specific exclusion applies

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� Establish that a specific exclusion applies� Study Example 4-2

� Outline of this Unit:1. Items that are not income

2. Major statutory exclusions

3. Tax planning considerations

4. Compliance and procedural considerations

1. Items that Are Not Income

1) Unrealized income

2) Self-help income

3) Rental value of

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3) Rental value of personal-use property

4) Selling price of property

1. Items that Are Not Income1) Unrealized Income

� Income that is not realized is not subject to income taxation.

� Examples:

� Land valued at $20,000 beginning of year

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� Land valued at $20,000 beginning of year appreciates to $45,000 at end of year, The $25,000 increase in value is unrealized income and not taxable

� If the value of certain stock held by the taxpayer appreciates from $10,000 at the beginning of the tax year to $25,000 at the end of the tax year, that $15,000 unrealized income is not subject to tax.

1. Items that Are Not Income 2) Self-Help Income

� Taxpayers often do work at home to improve the value of their home.

� This kind of self-help work saves money for the taxpayer. The amount saved is not subject to tax

Examples:

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� Examples:�Cleaning your own carpet

� Repairing your car

� Note: Exchange of services is taxable (bartering), while an act of friendship that is repaid is not taxable.

1. Items that Are Not Income 3) Rental Value of Personal-Use Property

� The rental value of a personal residence occupied by the taxpayer is not subject

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taxpayer is not subject to tax, even though the taxpayer could have rented the house.

1. Items that Are Not Income 4) Selling Price of Property

� Only the gain (i.e. selling price less the costs of sale and tax adjusted basis) in a taxpayer disposition of property is subject to tax, rather than the entire sales proceeds.

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2. Major Statutory Exclusions

� Reasons for Statutory Exclusions

� Benevolence (i.e. social generosity or sympathy)

� EXAMPLE: Exclusion of payments for sickness and injury

� Economic Incentive

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Economic Incentive

� EXAMPLE: Exclusion of certain scholarships (encourage education)

2. Major Statutory ExclusionsTypes

� Types of major statutory exclusions:1) Gifts and inheritances

2) Life insurance proceeds

3) Adoption expenses

4) Awards for meritorious achievement

5) Scholarships and fellowships

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5) Scholarships and fellowships

6) Distributions from qualified tuition programs

7) Payments for injury and sickness

8) Employee fringe benefits

9) Foreign-earned income exclusion

10) Income from the discharge of a debt

11) Exclusion for gain from small business stock

12) Other exclusions

2. Major Statutory Exclusions1) Gift and Inheritances

� Transfers of property with donative intent, whether made during life (gift) or at the death of the transferor (inheritance), are excluded from gross income. Income earned from such property is subject to the regular income tax rules.

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to the regular income tax rules.� EXAMPLE: Mother gives daughter bonds having a value of $100,000. The value of the gift ($100,000) is excludable from the daughter's gross income. Any taxable interest earned by the daughter subsequent to the transfer is included in the daughter's gross income.

� Study PAK Example 4-3, 4-4, 4-5

2. Major Statutory Exclusions2) Life Insurance Proceeds

� Life insurance proceeds paid by reason of the death of the insured are generally nontaxable.

� Any amounts received in excess of the face amount are taxable as interest to recipient.

� Study Examples 4-6 and 4-7.

� If the life insurance policy is purchased from another individual, the owner treats the proceeds as a gain from investment (i.e., the excess of the proceeds over the acquisition cost + premiums paid is taxable gain). Certain policy acquisitions

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acquisition cost + premiums paid is taxable gain). Certain policy acquisitions related to partnerships and closely-held corporations are excluded from this rule.

� Study Example 4-8.

� If a life insurance policy matures or is surrendered, the excess of proceeds over the premiums paid is generally taxable to the recipient. However, an exclusion is available for accelerated death benefits paid to a terminally ill person or periodic payments paid to a chronically ill person.

� Study Examples 4-9, 4-10

� Dividends on life insurance and endowment policies non-taxable to the extent they are equal to or less than the premiums paid.

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2. Major Statutory Exclusions3) Adoption Expenses

� Tax benefits are provided in two ways

� Adoption tax credit (discussed later with all tax credits)

� An exclusion for amounts paid pursuant to an adoption assistance plan created by an employer

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� Employee may exclude up to $12,150 (2009)

� Subject to AGI phase-out.

� The income exclusion is relevant to this chapter.

� Study Examples 4-11 and 4-12

2. Major Statutory Exclusions4) Awards for Meritorious Achievement

� Prizes and awards are generally taxable.

� Exclusion: � Awards for religious, charitable, scientific, etc. are not taxable if ALL criteria are met:� Did not enter contestIs not required to perform substantial future services

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� Is not required to perform substantial future services� Designates a qualified charitable organization to receive the payment

� EXAMPLE: If the taxpayer receives the Nobel prize in recognition of her discovery of the cure for cancer, the award will be included in her gross income unless properly assigned to a qualifying non-profit organization.

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2. Major Statutory Exclusions 5) Scholarships and Fellowships

� Scholarships are excluded from gross income for degree candidates, if the scholarships are used for qualified tuition and related expenses

�Qualified tuition and related expenses includes

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Qualified tuition and related expenses includes

� Tuition, fees, books, supplies, equipment

� Room and board are not qualified

� Study Example 4-13.

2. Major Statutory Exclusions 6) Distributions from Qualified Tuition Programs: §529

� Earnings while in a §529 plan are not taxable

� Earnings distributed excluded from income if used by beneficiary for qualified tuition and related expenses� Tuition, fees, books, supplies, equipment, AND

Room and board if ≥ half-time student

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� Room and board if ≥ half-time student

� Distributions not used for qualified tuition expenses� Included in beneficiary’s income, AND

� Subject to a 10% penalty

� Beneficiary must be “family” member

� Beneficiary may be changed w/o tax consequences

� Study Example 4-14

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2. Major Statutory Exclusions7) Payments for Injury and Sickness

� Amounts received as compensation for injury and sickness are excluded, whether paid by insurance or otherwise. The exclusion only applies to personal physical injuries or physical sickness. Most damages on nonphysical injuries are taxable. Punitive damages are taxable per statute.

Payments under a disability income policy are nontaxable if

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� Payments under a disability income policy are nontaxable if the policy was purchased by the taxpayer, but are fully taxable if the policy is purchased by the taxpayer's employer.

� Any reimbursed medical expenses cannot be deducted as an itemized deduction.

� Study Examples 4-15, 4-16, 4-17, 4-18, 4-19.

2. Major Statutory Exclusions8) Employee Fringe Benefits

� In general employee compensation is taxable regardless of the form it takes. However, the tax law encourages certain types of fringe benefits. These benefits are either

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� Tax deductible for the employer

� Income exclusion for the employee

� Tax benefits for both employer and employee

2. Major Statutory Exclusions8) Employee Fringe Benefits

� In general employee compensation is taxable regardless of the form it takes. However, the tax law encourages certain types of fringe benefits. These benefits are either

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� Tax deductible for the employer

� Income exclusion for the employee

� Tax benefits for both employer and employee

2. Major Statutory Exclusions8) Fringe Benefits - Employer-Paid Insurance

� Employer-paid premiums on health, accident, disability, and qualifying group term life insurance are usually excluded from employee’s gross income and deductible by employer.

� The benefits from nondiscriminatory self-insured accident and health plans are also excluded from the employee's income.

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and health plans are also excluded from the employee's income.

� Most employee life insurance premiums paid by the employer are taxable to the employee. An exception exists for group-term life insurance coverage not exceeding $50,000 per employee. Premiums for coverage exceeding $50,000 will be taxable to the employee.

� Study Examples 4-20, 4-21

2. Major Statutory Exclusions8) Fringe Benefits - Section132 Fringe Benefits

� No additional cost benefits (i.e. Standby flight benefits for airline employees)

� Employee discounts (i.e. 20% discount on legal services for law firm’s receptionists)

� Working condition benefits (i.e. free membership to

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� Working condition benefits (i.e. free membership to organizations)

� De minimis benefits (i.e. free personal copies on employer’s copier)

� Transportation fringes (i.e. free UTA bus pass)

� Athletic facilities (i.e. free use of employer’s swimming pool)

2. Major Statutory Exclusions8) Fringe Benefits - Employee Awards

� Certain employee achievement awards and qualified plan awards are excluded from an employee's gross income.

� EXAMPLE: Taxpayer receives a watch (value $350) from his employer as recognition of 10 years of service. The value of the watch is excluded from gross income.

Rules for exclusion

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� Rules for exclusion

� Must be tangible personal property

� Limited to average of $400/employee

� Max award $1,600

� Must be based on safety records or length of service

� Must not discriminate in favor of highly paid employees

� Study Example 4-22

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2. Major Statutory Exclusions8) Fringe Benefits - Meals and Lodging

� Also excluded from an employee's gross income are employer-provided meals and lodging� If they are provided on the employer's premises for the convenience of the employer.

� If the employee is required to accept the lodging as a condition of employment.

EXAMPLE: Taxpayer is the day restaurant manager. She is required

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� EXAMPLE: Taxpayer is the day restaurant manager. She is required by her employer to stay on the restaurant premises during the hours of 8:00 a.m. through 5:00 p.m. to handle all management responsibilities. The employer provides the taxpayer her noon meal for each working day. The value of these provided meals is excluded from the taxpayer's gross income.

� Study Example 4-23, 4-24, 4-25

2. Major Statutory Exclusions8) Fringe Benefits - Meals and Entertainment

� 50% of meal or cost of entertaining customers is deductible

� Includes cost of employee’s meal or entertainment

� Employer gets deduction if employer pays or

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� Employer gets deduction if employer pays or reimburses employee

� Employee does NOT recognize income

� Study Example 4-26

2. Major Statutory Exclusions8) Fringe Benefits - Employee Death Benefits

� Occasionally an employer may make payments to the family of an employee who dies

� If the payment is meant to be compensation (bonus, salary, etc) then the amount is

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� Deductible for the employer (company)

� Taxable for the employee or family

� If the payment is meant to be a gift then the amount is

� Not deductable for the employer (company)

� Excusable for the employee or family subject to gift tax limitations.

2. Major Statutory Exclusions8) Fringe Benefits - Dependent Care

� Nondiscriminatory (program cannot discriminate in favor of higher compensated employees) dependent care provided by the employer is excluded up to $5,000 annually.

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� EXAMPLE: Taxpayer is a nurse. The hospital where she is employed provides free child care for the taxpayer's four children. The value of this child care is $6,000. Taxpayer must include $1,000 ($6,000 - allowable dependent care exclusion of $5,000) in gross income.

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2. Major Statutory Exclusions8) Fringe Benefits - Educational Assistance

� An exclusion of up to $5,250 is available for employer-paid qualified educational cost reimbursements (undergraduate and graduate).

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2. Major Statutory Exclusions8) Fringe Benefits - Cafeteria Plans

� Also called flexible spending accounts

� Employer may provide qualifying cafeteria plans through which employees can select from cash or nontaxable fringe benefits, without destroying the exclusion for the non-cash benefits.

� Cafeteria plans have two basic designs.

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� Cafeteria plans have two basic designs. � Supplemental wage plans involve additional compensation in the form of fringe benefits.

� Wage reduction plans allow employees to reduce wages to pay for fringe benefits.

� Wage reduction medical reimbursement plans are a common form of cafeteria plan. � UofU offers a wage reduction FSA for medical and dependent care for its employees

2. Major Statutory Exclusions8) Fringe Benefits - Interest-Free Loans

� Interest must generally be imputed on interest-free loans

� Imputed interest generally deductible by employer and taxable to employee

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� Details will be discussed in a later Unit.

2. Major Statutory Exclusions8) Fringe Benefits – Additional Notes

� The major advantage of taking fringe benefits in lieu of a cash payment is that employees do not have to use after-tax income to obtain the product or service.

� Study Examples 4-27 and 4-28

The exclusion for many fringe benefits is only available

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� The exclusion for many fringe benefits is only available to employees, not to partners or proprietors.

� Special rules apply to health insurance premiums and retirement contributions for proprietors and partners.

2. Major Statutory Exclusions9) Foreign-Earned Income Exclusion

� U.S. citizens are subject to U.S. income tax on worldwide income

� This can create double taxation if the foreign income is also taxed by foreign country

� Two alternatives are used to mitigate this double taxation problem:� Foreign tax credit (FTC) – discussed in a later unit, or

� Foreign earned income exclusion up to $91,400 (Additional exclusion for

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� Foreign earned income exclusion up to $91,400 (Additional exclusion for foreign housing costs)

� To qualify for foreign earned income exclusion� Must be bonafide resident of foreign country(ies) for entire taxable year, OR

� Be physically present in foreign country for 330 days during a 12 month period� If 12-month period spans two tax years, exclusion pro rated based on [# days/365]

� Study Examples 4-29, 4-30, 4-31

2. Major Statutory Exclusions10) Income from the Discharge of a Debt

� Generally, taxpayer may have to include amount of debt forgiveness in gross income� Exceptions: nontaxable situations

� Discharge occurs in bankruptcy

� Discharge occurs when taxpayer is insolvent

� Study Examples 4-32, 4-33, 4-34, 4-35

Student loans

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� Student loans� Discharge excluded from gross income if discharge contingent on the performing certain public services4-36

� Study Example

� Foreclosure on principal residence� Up to $2M may be forgiven in 2009 if caused by decline in value of real estate� Related to sub-prime mortgage problem

2. Major Statutory Exclusions10) Exclusion for Gain from Small Business Stock

� 50% of the gain on the disposition of certain qualified small business stock may be excluded by noncorporate taxpayers.� The stock must be issued after August 10, 1993 and be held more than five years.

� A qualified small business for this purpose is a C corporation with not more than $50 million of gross assets, with 80% of the value of its assets used in the active conduct of a trade or business.

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used in the active conduct of a trade or business.

� Corporations in the following industries are excluded from eligibility:� professional services, financial services, hospitality, and mining/oil/gas production.

� The amount of excluded gain per-issuer in a taxable year is limited to the greater of:� $10,000,000 less prior year exclusions, or

� 10 times the aggregate adjusted bases of the stock disposed of by the taxpayer, computed on a FMV basis.

� Study Example 4-37, 4-38

2. Major Statutory Exclusions11) Other Exclusions (PAK Table 4-2)

� Gain from sale of personal residence is excluded up to $250,000 for singles and $500,000 for married filing jointly (Discussed in more detail in a later unit)

� Annuities paid to survivors of public safety officers are excluded

� Certain military-related payments such as disability pay, combat pay, etc. are excluded

� Housing allowance for ministers are excluded

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� Housing allowance for ministers are excluded

� Limited exclusion for employees of educational institutes if they are provided with on-campus housing

� Foster care payments

� Rural letter carrier’s allowance

� Roth IRA distributions (Discussed in a later unit)

� Education IRA distributions (Discussed in a later unit)

� Personal foreign currency gains

3. Tax Planning Considerations

� Employee fringe benefits� Employers must carefully evaluate both taxable and nontaxable employee fringe benefits from the employee perspective, as the employer is able to deduct both as forms of compensation.

� Providing a cafeteria plan may provide the best alternative,

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� Providing a cafeteria plan may provide the best alternative, so that employees can select the benefits which they desire, rather than the employer making that decision.

� Self-help income and use of personally owned property� The tax law encourages the ownership of personal residences over the rental of the same property. Deductions for carrying costs (interest and taxes) are available for purchased residences while rent on personal residences is not deductible.

4. Compliance and Procedural Considerations

� Withholding and W-2 reporting for fringe benefits vary with the type of benefit. Penalties are provided for employers who fail to withhold or report properly.� For failure to report – $50 per failureFor failure to withhold – 100%

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� For failure to withhold – 100%� Penalty can be imposed on employer and other people, such as officers or accountants

� Nontaxable fringe benefits are not reported by the employer on the W-2 or by the employee on his/her tax return � Except for tax-exempt interest sand Social Security income

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Addition Things to Study

� Answers to Selected Textbook Problems:� http://www.fcs.utah.edu/~fan/fcs5530/Answers%20to%20Selected%20Problems/AnswersSelectedUnit04.pdf

� Self-study Quizzes on Publisher’s website: � http://wps.prenhall.com/bp_pope_fedtax_2010/120/30827/7891749.cw/index.html

� Homework Assignment for Unit04 (Graded)

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� Homework Assignment for Unit04 (Graded)� PAK, Chapter 4 Problems: 4-34, 4-40, 4-43, 4-47, 4-49, 4-55

� Please go to Week 4 folder on course Homepage to find the link. You can also access it directly through the “Assignments” link.

� Discussion Topic for Unit04(Graded)� Don’t forget to post your thoughts on the discussion topic of the week.

� Go to the Week 4 folder on course Homepage to find the link. You can also access it directly through the “Discussions” link.