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Unit04. Gross Income: Exclusions 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. This week’s objective is to increase our understanding of which items are, by law, excluded from gross income.
Outline 2
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
Study Example 4-2
Outline of this Unit:
1. 2. 3. 4.
Items that are not income Major statutory exclusions Tax planning considerations Compliance and procedural considerations
1. Items that Are Not Income 3
1) 2) 3)
4)
Unrealized income Self-help income Rental value of personal-use property Selling price of property
1. Items that Are Not Income 1) Unrealized Income 4
Income that is not realized is not subject to income taxation. Examples: 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 5
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: 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 6
The rental value of a personal residence occupied by the 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 7
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.
2. Major Statutory Exclusions 8
Reasons for Statutory Exclusions Benevolence
(i.e. social generosity or sympathy)
EXAMPLE: Exclusion of payments for sickness and injury
Economic
Incentive
EXAMPLE:
education)
Exclusion of certain scholarships (encourage
2. Major Statutory Exclusions Types 9
Types of major statutory exclusions: 1) 2) 3) 4) 5) 6) 7) 8) 9) 10) 11) 12)
Gifts and inheritances Life insurance proceeds Adoption expenses Awards for meritorious achievement Scholarships and fellowships Distributions from qualified tuition programs Payments for injury and sickness Employee fringe benefits Foreign-earned income exclusion Income from the discharge of a debt Exclusion for gain from small business stock Other exclusions
2. Major Statutory Exclusions 1) Gift and Inheritances 10
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. 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 Exclusions 2) Life Insurance Proceeds 11
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.
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 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 4-6 and 4-7.
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 Exclusions 3) Adoption Expenses 13
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 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 Exclusions 4) Awards for Meritorious Achievement 14
Prizes and awards are generally taxable. Exclusion:
Awards for religious, charitable, scientific, etc. are not taxable if ALL criteria are met: Did not enter contest 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 16
Scholarships are excluded from gross income for degree candidates, if the scholarships are used for qualified tuition and related expenses Qualified Tuition,
Room
tuition and related expenses includes
fees, books, supplies, equipment
and board are not qualified
Study Example 4-13.
2. Major Statutory Exclusions 6) Distributions from Qualified Tuition Programs: §529 17
Earnings while in a §529 plan are not taxable Earnings distributed excluded from income if used by beneficiary for qualified tuition and related expenses
Distributions not used for qualified tuition expenses
Tuition, fees, books, supplies, equipment, AND Room and board if ≥ half-time student 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 Exclusions 7) Payments for Injury and Sickness 19
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 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 Exclusions 8) Employee Fringe Benefits 20
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 Tax
deductible for the employer Income exclusion for the employee Tax benefits for both employer and employee
2. Major Statutory Exclusions 8) Employee Fringe Benefits 21
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 Tax
deductible for the employer Income exclusion for the employee Tax benefits for both employer and employee
2. Major Statutory Exclusions 8) Fringe Benefits - Employer-Paid Insurance 22
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. 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 Exclusions 23
8) 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 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 Exclusions 8) Fringe Benefits - Employee Awards 24
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
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 Exclusions 8) Fringe Benefits - Meals and Lodging 26
Also excluded from an employee's gross income are employerprovided 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 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 Exclusions 8) Fringe Benefits - Meals and Entertainment 27
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 reimburses employee Employee
Study
does NOT recognize income
Example 4-26
2. Major Statutory Exclusions 8) Fringe Benefits - Employee Death Benefits 28
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 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 Exclusions 8) Fringe Benefits - Dependent Care 29
Nondiscriminatory (program cannot discriminate in favor of higher compensated employees) dependent care provided by the employer is excluded up to $5,000 annually. 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 Exclusions 8) Fringe Benefits - Educational Assistance 31
An exclusion of up to $5,250 is available for employer-paid qualified educational cost reimbursements (undergraduate and graduate).
2. Major Statutory Exclusions 8) Fringe Benefits - Cafeteria Plans 32
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.
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 Exclusions 8) Fringe Benefits - Interest-Free Loans 33
Interest must generally be imputed on interest-free loans Imputed
interest generally deductible by employer and taxable to employee Details will be discussed in a later Unit.
2. Major Statutory Exclusions 8) Fringe Benefits – Additional Notes 34
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 to employees, not to partners or proprietors. Special rules apply to health insurance premiums and retirement contributions for proprietors and partners.
2. Major Statutory Exclusions 9) Foreign-Earned Income Exclusion 35
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 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 Exclusions 10) Income from the Discharge of a Debt 36
Generally, taxpayer may have to include amount of debt forgiveness in gross income
Exceptions: nontaxable situations
Study Examples 4-32, 4-33, 4-34, 4-35
Student loans
Discharge occurs in bankruptcy Discharge occurs when taxpayer is insolvent
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 Exclusions 10) Exclusion for Gain from Small Business Stock 37
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. Corporations in the following industries are excluded from eligibility:
The amount of excluded gain per-issuer in a taxable year is limited to the greater of:
professional services, financial services, hospitality, and mining/oil/gas production.
$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 Exclusions 11) Other Exclusions (PAK Table 4-2) 38
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 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 39
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, 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 40
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 failure 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 42
Answers to Selected Textbook Problems:
Self-study Quizzes on Publisher’s website:
http://wps.prenhall.com/bp_pope_fedtax_2010/120/30827/7891749.c w/index.html
Homework Assignment for Unit04 (Graded)
http://www.fcs.utah.edu/~fan/fcs5530/Answers%20to%20Selected%20P roblems/AnswersSelectedUnit04.pdf
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.
