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Chapter 5
Gross IncomeExclusions
©2012 CCH. All Rights Reserved.4025 W. Peterson Ave.Chicago, IL 60646-60851 800 248 3248www.CCHGroup.com
CCH Federal Taxation Basic Principles 2 of 34
1. Social Security Benefits
2. Interest on U.S. Savings Bonds
3. EE Bonds Used for Education
4. Fringe Benefits
5. Group Life Insurance
6. Annuities
7. Compensation for Injuries and Sickness
8. Insurance Reimbursement Summary
9. Damage Awards
Chapter 5, Exhibit Contents A
Chapter 5 Exhibits
CCH Federal Taxation Basic Principles 3 of 34
10. Cafeteria Plans
11. Adoption Assistance
12. Employee Tuition Reduction Plans
13. Dependent Care Assistance Program
Chapter 5, Exhibit Contents B
Chapter 5 Exhibits
CCH Federal Taxation Basic Principles 4 of 34
Social Security Benefits
A portion of Social Security income is taxable to the extent that a taxpayer’s provisional income exceeds certain base amounts.
Provisional income equals adjusted gross income, plus one-half of Social Security received, plus some non-taxable items such as tax exempt interest.
Chapter 5, Exhibit 1a
CCH Federal Taxation Basic Principles 5 of 34
Social Security Benefits
1st threshold base amounts - $25,000 for single - $32,000 for married filing jointly
If a taxpayer’s provisional income exceeds the 1st threshold (but does not exceed the 2nd threshold), the taxable portion of Social Security is the lesser of:
A. 50% of Social Security benefits or
B. 50% of the excess of the taxpayer’s provisional income over the base.
Chapter 5, Exhibit 1b
CCH Federal Taxation Basic Principles 6 of 34
Social Security Benefits2nd threshold base amounts - $34,000 for single
- $44,000 for married filing jointly
If a taxpayer’s provisional income exceeds the 2nd threshold, the taxable portion of Social Security is the lesser of:
A. 85% of Social Security benefits OR
B. 85% of the amount that provisional income exceeds the threshold plus the smaller of
(1) the amount of SS benefits included under the prior law
or (2) $4,500 for unmarried taxpayers or $6,000 for
married filing jointly.Chapter 5, Exhibit 1c
CCH Federal Taxation Basic Principles 7 of 34
Social Security Benefits
Married taxpayers filing separately have no base amount and must include in gross income the lesser of
A. 85% of Social Security benefits OR
B. 85% of their provisional income
Chapter 5, Exhibit 1d
CCH Federal Taxation Basic Principles 8 of 34
Interest on U.S. Savings Bonds
The general rule is that interest on U.S. savings bonds is fully taxable.
Cash basis taxpayers may report interest income on a yearly basis or defer the recognition of interest income until the bonds mature.
Chapter 5, Exhibit 2
CCH Federal Taxation Basic Principles 9 of 34
EE Bonds Used for Education
However, interest earned on U.S. savings bonds may be excluded if the proceeds are used to finance the higher education of the taxpayer, taxpayer’s spouse or dependents.
Qualified higher education expenses. Tuition and fees qualify. Room and board and expenses incurred outside of the degree program (e.g., sports, clubs) do not qualify. The bonds must be redeemed during the same tax year in which qualified educational expenses are incurred.
Chapter 5, Exhibit 3a
CCH Federal Taxation Basic Principles 10 of 34
EE Bonds Used for Education
1. If the qualified educational expenses exceed the Series EE proceeds (principal and interest), then all the interest may be excluded, subject to the income phase out rules.
2. If the qualified educational expenses are less than the Series EE proceeds (principal and interest), then only a portion of the interest may be excluded based on the following formula:
Exclusion amount=
Interest on EE savings bond x Qualified educational expenses
Series EE proceeds
Chapter 5, Exhibit 3b
CCH Federal Taxation Basic Principles 11 of 34
EE Bonds Used for Education
The phase out thresholds in 2012 are:
Modified AGI
Ceiling Floor Phaseout Range (Ceiling – Floor)
Married filing jointly $139,250 $109,250 $30,000
Single and head of household $ 87,850 $72,850 $15,000
Married filing separately (not eligible) N/A N/A N/A
Chapter 5, Exhibit 3c
CCH Federal Taxation Basic Principles 12 of 34
Example 1
Mary, a single mother, has modified AGI of $81,850. She redeems Series EE bonds and receives $5,000 of principal and $2,500 of interest. Mary’s daughter attends college and has qualified educational expenses of $8,000. How much of the $2,500 interest may be excluded from gross income?
Answer
The qualified educational expenses of $8,000 exceed the Series EE proceeds of $7,500. Mary would have been able to exclude the full $2,500 except for the fact that she is
subject to the phase out for higher income taxpayers.
Chapter 5, Exhibit 3d
EE Bonds Used for Education
CCH Federal Taxation Basic Principles 13 of 34
Example
The phaseout amount of the exclusion is calculated as:
[(Income – phaseout floor) / phaseout range] x Interest
[($81,850 - $72,850) $15,000] x $2,500 = $1,500
Interest income excluded is $1,000 ($2,500 – $1,500).
Therefore, taxable interest income is $1,500.
Chapter 5, Exhibit 3e
EE Bonds Used for Education
CCH Federal Taxation Basic Principles 14 of 34
Fringe BenefitsThe following 4 non-statutory fringe benefits are excluded from gross income.
1. No-additional-cost services
Generally excluded from gross income if:
no significant additional costs are incurred by the employer and the service provided is offered for sale to customers in the
ordinary course of the line of business for which the employee is working.
Example: Free travel is offered to airline employees who fly on standby. Spouses and dependent children may be included with no income tax consequences.
Chapter 5, Exhibit 4a
CCH Federal Taxation Basic Principles 15 of 34
2. Qualified employee discounts
Generally excluded from gross income.
For property purchased at a discount, the exclusion may not exceed the employer’s gross profit margin. For services purchased at a discount, the exclusion may not exceed 20%.
Chapter 5, Exhibit 4b
Fringe Benefits
CCH Federal Taxation Basic Principles 16 of 34
3. Working condition fringe benefitsThe fair market value of any property or services provided to an employee is excluded by that employee if it represents an ordinary and necessary business deduction to the employer.
Examples: Cell phone used by the employee for the primary convenience of the employer, but also available for personal use; subscriptions to business periodicals; on-the-job training; inventory being tested by the employees outside of the employer’s workplace.
Chapter 5, Exhibit 4c
Fringe Benefits
CCH Federal Taxation Basic Principles 17 of 34
4. De minimis fringe benefits
Excluded when the value of property or services provided to the employee are so minimal that accounting for it would be unreasonable.
Examples: Using the copy machine for personal purposes; occasional tickets to sports events, coffee and snacks, occasional company picnics
Chapter 5, Exhibit 4d
Fringe Benefits
CCH Federal Taxation Basic Principles 18 of 34
Group Life Insurance
An employee can exclude the cost of group term life insurance provided by an employer as long as the face value of the policy does not exceed $50,000.
If over $50,000 of coverage is provided by an employer, the cost of the premium for the excess coverage must be included in the gross income of the employee.
Chapter 5, Exhibit 5
CCH Federal Taxation Basic Principles 19 of 34
Annuities
Income received as an annuity from an annuity, endowment or life insurance contract generally consists of 2 parts:
1) non-taxable return of investment
2) taxable gain on investment
Chapter 5, Exhibit 6a
CCH Federal Taxation Basic Principles 20 of 34
Annuities
The tax free portion of the annuity is spread evenly over the taxpayer’s lifetime.
The amount of the annuity payment that may be excluded from gross income is the annuity payments received multiplied by the exclusion ratio
Exclusion Ratio = Investment in contract expected return under the
contract*
* expected return is calculated by multiplying the annual annuity payment by the multiplier on the appropriate table.
Chapter 5, Exhibit 6b
CCH Federal Taxation Basic Principles 21 of 34
Example:
John retired at age of 70 and purchased an annuity contract for $19,000. The annuity contract provides for him to receive $150 per month for life.
Step One: Compute expected return under the contract.
Multiplier from Table 2 16.0
x Annual annuity payments $1,800 ($150 x 12)
= Expected return $28,800
Chapter 5, Exhibit 6c
Annuities
CCH Federal Taxation Basic Principles 22 of 34
Step Two: Compute the exclusion ratio
Exclusion Ratio = Investment in the contract
Expected return under the contract
66% = $19,000
$28,800
Chapter 5, Exhibit 6d
Annuities
CCH Federal Taxation Basic Principles 23 of 34
Step Three: Compute amount excluded
Total payment for the year x Exclusion ratio = Amount of exclusion
$1,800 x 66% = $1,188
The remainder of the annuity payment received
($1,800 - $1,188 = $612) is included in gross income.
Chapter 5, Exhibit 6e
Annuities
CCH Federal Taxation Basic Principles 24 of 34
Worker’s Compensation
Amounts received as compensation for occupational personal injury or sickness are excluded from gross income.
Amounts received as compensation for non-occupational personal injury or sickness are taxable.
Chapter 5, Exhibit 7a
Compensation for Injuries and Sickness
CCH Federal Taxation Basic Principles 25 of 34
Compensation for Injuries and Sickness
Accident and Health Insurance Plans
Benefits received from employee-paid plans are excluded from gross income.
Benefits received from employer-paid plans are taxable UNLESS the following conditions are met:
1. Permanent injury or loss of bodily function if amounts are paid on the nature of the injury and not on work time lost.
2. Reimbursement for actual medical expenses incurred by employee, spouse or dependents.
Chapter 5, Exhibit 7b
CCH Federal Taxation Basic Principles 26 of 34
Insurance Reimbursement Summary
Insurance Plan Excluded from gross income Included in gross income
Workers’ Compensation Plans
Amounts received as compensation for an occupational personal injury or sickness.
Amounts received as compensation for an
non-occupational personal injury or sickness.
Accident and Health Plans
Amounts received for personal injury or sickness from employee-paid plans.
Amounts received for personal injury or sickness from employer-paid plans.
Note: For the above exclusions to apply, the benefits must be on account of
1. personal physical injuries or sickness or
2. emotional distress, limited to actual medical expenses incurred.
Chapter 5, Exhibit 8
CCH Federal Taxation Basic Principles 27 of 34
Damage Awards
Tax Treatment for Damages
Type Damages
1 Physical Injury or Sickness Excluded from taxable income
2 Non Physical Injury or Sickness Taxable, except if damages are used to pay for medical expenses related to emotional distress.
3 Lost Wages Taxable Income
4 Punitive Damages Taxable Income
Chapter 5, Exhibit 9a
CCH Federal Taxation Basic Principles 28 of 34
Example:
Sally’s professional reputation is damaged as a result of a false credit report. As a result of her ensuing emotional distress, Sally makes several visits to a qualified counselor, incurring medical expenses totaling $5,000. Later, she receives a $25,000 non-punitive award for damage to professional reputation. $5,000 of the $25,000 award is excludable.
Chapter 5, Exhibit 9b
Damage Awards
CCH Federal Taxation Basic Principles 29 of 34
Tax Advantage of Cafeteria Plans
Under a cafeteria plan, each employee is permitted to choose between cash or nontaxable benefits. Employees are not subject to federal income tax for the amount of menu items that are nontaxable. In addition, the cost of these fringes is deductible as compensation to the employer.
Chapter 5, Exhibit 10a
Cafeteria Plans
CCH Federal Taxation Basic Principles 30 of 34
Cafeteria PlansNontaxable Items Allowable Under Cafeteria Plans
Group-term life insurance coverage below $50,000 Health and accident protection and dental plans Child care Vacation days Dependent care assistance Adoption assistance
Unused benefits from one plan year may not be accumulated by an employee and carried over to succeeding years.
Chapter 5, Exhibit 10b
CCH Federal Taxation Basic Principles 31 of 34
Adoption Assistance
An employee may exclude from gross income of up to $12,650 of adoption expenses per child, where such expenses are paid for by the taxpayer’s employer under a qualified adoption assistance program.
Qualified adoption expenses include ordinary and necessary adoption expenses, court costs, attorney fees and other expenses incurred for the principal purpose of the legal adoption of a child.
The exclusion is phased out for taxpayers with an adjusted gross income between $189,710 and $229,710.
Chapter 5, Exhibit 11
CCH Federal Taxation Basic Principles 32 of 34
Employee Tuition Reduction Plans
Payments of up to $5,250 per year paid by an employer to, or on behalf of, an employee for tuition and course-related material may be excluded from employee income.
Qualified educational expenses includes the payment or provision of tuition, fees, books, supplies, and equipment.
Chapter 5, Exhibit 12
CCH Federal Taxation Basic Principles 33 of 34
Dependent Care Assistance Program
$5,000 exclusion
A qualified dependent care assistance program is a separate written plan of an employer under which the employer pays or incurs dependent care costs for the exclusive benefit of employees. Employees can exclude up to $5,000 ($2,500 for married persons filing separately).
Chapter 5, Exhibit 13a
CCH Federal Taxation Basic Principles 34 of 34
The exclusion is subject to an earned income limitation. An unmarried taxpayer may not exclude more than his or her earned income for the year. A married taxpayer may not exclude more than the lesser of his or her earned income or the spouse’s earned income.
The earned income of an incapacitated or student spouse is deemed to be $250 per month for one qualifying dependent or $500 per month for 2 or more qualifying dependents.
Chapter 5, Exhibit 13b
Dependent Care Assistance Program
