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Concepts in Federal Taxation Chapter 4: Income Exclusions

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1 Concepts in Federal Taxation Chapter 4: Income Exclusions
September 21, 2012

2 administrative GSI: Jennifer Chen
Office Hours: By appointment bSpace: Updated with slides Still need to upload chapters 1 & 2 Ask if want to post syllabus

3 Homework Problems Problems Assignment #4 Chapter 4 P26, 32, 34, 37, 65 Extra Problems: P45, 46

4 Income exclusions Income “Broadly Defined” (includes income from all sources) Minus: Excluded income Equals: Gross income (Chapter 3) Minus: Deductions and exemptions Equals: Taxable income X Tax rate (schedule of rates) Equals: Income tax Minus: Tax credits Tax prepayments Equals: Tax (refund) due with return

5 #26 Allison dies during the current year. She is covered by a $1,000,000 life insurance policy payable to her husband Bob. Bob elects to receive the policy proceeds in 10 annual installments of $120,000. Write a letter to Bob explaining the tax consequences of the receipt of each installment.

6 #26 Life insurance proceeds are excluded from tax
$1,000,000 face value of the policy is excluded as it is received the earnings on the policy during the time it is held by the insurance company are not excludable The total interest earned is $200,000 [($120,000 x 10) - $1,000,000] As each payment on the policy is received, Bob will exclude $100,000 ($1,000,000 ÷ 10) and include $20,000 ($200,000 ÷ 10) in gross income Exclusion Ratio = Cost of the contract Number of Payments

7 #26 Additional considerations for life insurance proceeds:
An exception to the exclusion for life insurance proceeds is made for amounts paid to the owner of a policy that was obtained for a consideration Receipt is realization of income

8 #32 Lucinda, a welder for Big Auto Inc. dies in an automobile accident on March 14 of this year. Big Auto has a company policy of paying $5,000 to the spouse of any employee who dies. In addition to the $5,000 payment, Big Auto pays Harvey, Lucinda’s husband, $1,600 in salary and $1,100 in vacation pay Lucinda had earned before her death. Harvey also collects $120,000 from a group-term life insurance policy Big Auto provided as part of Lucinda’s compensation package. Lucinda had contributed to a qualified employer sponsored pension plan. Big Auto had matched Lucinda’s contributions to the plan. The plan lets the beneficiary of an employee who dies before payments begin take the plan balance as an annuity or in a lump-sum. Harvey elects to take the $250,000 plan balance in a lump-sum. Write a letter to Harvey explaining the tax consequences of each payment he receives.

9 #32 Payment due to death - the $5,000 payment to Lucinda’s spouse is included in gross income. Death benefits are fully taxable. Salary and vacation pay - the $1,600 salary and $1,100 of vacation pay were earned prior to Lucinda’s death and must be included in gross income. Life insurance proceeds - the $120,000 life insurance proceeds are excludable. Pension plan payment - because the $250,000 is from a qualified plan, none of the amounts contributed to the plan or the earnings on the contributions have been subject to tax. Therefore, the entire $250,000 payment is taxable.

10 #34 Boris is an unmarried systems specialist with a public accounting firm. During all of 2012, he is on temporary assignment in London. He pays $21,000 in British income tax on his $90,000 salary. Boris knows little about taxes and seeks your advice on the taxability of the salary he earns while in London. Write Boris a memorandum explaining the tax treatment of his London salary. Assume that Boris has no other income sources and that he does not itemize deductions.

11 #34 Taxpayers may include the foreign-earned income in their taxable income, calculate the U.S. tax on the income, and take a tax credit for any foreign taxes paid. The amount of the allowable tax credit is the lesser of: The actual foreign taxes paid The U.S. tax that would have been paid on the foreign-earned income Individuals may exclude up to $95,100 in foreign-earned income for each full year they work in a foreign country Individuals must be a resident of the foreign country or be present in the foreign country for 330 days in any 12 consecutive months

12 #34 The tax under the exclusion is equal to the difference between the tax on taxable income without the exclusion and the tax on the amount excluded: Tax on taxable income without exclusion $XXX Less: Tax on exclusion amount (XXX) Equals: Tax on taxable income $XXX

13 #34 Since Boris has worked in London for the entire year, he has the option of excluding his $90,000 British income (<$95,100) from his U.S. income or including his British income in his U.S. income and taking a foreign tax credit for the $21,000 of British income tax he paid (the foreign tax credit cannot exceed the U.S. tax he would have paid on his British income). Without the exclusion, his taxable income is $80,250. If Boris elects to exclude $90,000 of his British income, his taxable income will be zero. Using the foreign tax credit, his net tax is also zero. He cannot get a refund of foreign taxes paid.

14 #34 Calculation of taxable income without exclusion: Gross income $90,000 Deductions from adjusted gross income: Standard deduction (5,950) Personal exemption (3,800) Taxable income $ 80,250

15 #34 Options: Exclude $90,000: Taxable Income = $0
Include $90,000 salary income Tax on $80,250: $4, [25% x ($80, $35,350)] = $16,093 Tax credit for British taxes paid = ($16,093) Net tax = $0 The entire U.S. tax is due to British income, so his maximum tax credit is the $16,093 of U.S. taxes.

16 #37 Bear Company provides all its employees with a $10,000 group term life insurance policy. Elk Company does not provide any life insurance but pays $10,000 to survivors of employees who die. Jackie, an employee of Bear Company, and her sister-in-law, Rosetta, an employee of Elk Company, both die during the current year. Their husbands, Bo and Carl, do not understand the tax effects of the $10,000 payments they receive. Write a letter to Bo and Carl explaining the tax effects of the $10,000 payments each receives.

17 #37 Bo Carl Life Insurance
Bear Company Elk Company Bo Carl Life Insurance Payments received from life insurance policies are excluded from the gross income of the recipient. Death Benefits Death benefit payments are fully taxable.

18 #37 Bear Company Elk Company $10,000 group term life insurance policy
Excluded from gross income $10,000 death benefit Included in gross income This provision is intended to encourage employers to provide life insurance to all their employees so that their families have a cushion if the employee dies while still working (a social goal).

19 #65 Jonas owns a building that he leases to Dipper, Inc., for $5,000 per month. The owner of Dipper has been complaining about the condition of the restrooms and has proposed making improvements that will cost $24,000. Dipper’s owner is willing to pay to have the improvements made if Jonas will reduce the monthly rent on the building to $4,000 for one year. Write a letter to Jonas explaining the tax effects for Jonas of the proposal by Dipper’s owner.

20 #65 Improvements made by a lessee to property are not income to the lessor until the lessor realizes the value of the improvements (i.e., the property is sold or otherwise disposed of in a taxable transaction). If the improvements are made in lieu of rental payments, the improvements must be included in the gross income of the lessor as rental income.

21 #65 The improvements attributable to the $1,000 ($5,000 lease agreement - $4,000 proposed rent for one year) monthly rent reduction will be included in Jonas’ gross income because they are made in lieu of the normal rental payments. Jonas will have $12,000 (12 x $1,000) of rental income under the proposal. The remaining cost of the improvements to the property ($12,000) will not be recognized until Jonas realizes the value of the improvements through sale or other taxable disposition of the property (deferred). The $12,000 rental reduction improvements is included in Jonas’ basis in the building.

22 Extra problems - #45 Determine whether the taxpayer has received taxable income in each of the following situations. Explain why any amount(s) may be excluded: a. Jim is an employee of Fast Tax Prep, Inc. All employees of Fast Tax Prep are eligible for a 50% discount on the preparation of their income tax return. Jim’s tax return preparation would normally have cost $300, but he paid only $150 because of the discount. Because the discount is available to all employees, it qualifies for exclusion. However, the exclusion for discounts on services is limited to 20%. Thus, only $60 ($300 x 20%) of the $150 discount is excluded from gross income. The additional $90 discount is included in Jim’s gross income.

23 Extra problems - #45 b. Mabel is a lawyer for a large law firm, Winken, Blinken, and Nod. Winken pays Mabel’s annual license renewal fee of $400 and her $300 annual dues to the American Lawyers’ Association. Mabel also takes advantage of Winken’s educational assistance plan and receives payment of the $6,000 cost of taking two night school courses in consumer law. Mabel would have been able to deduct the licensing fee and association membership as an employee business expense had she paid for them herself, so $700 is excluded as a working condition fringe benefit. Employees can exclude up to $5,250 of reimbursements from qualified educational assistance plans that reimburse an employee for the cost of coursework. Mabel must include $750 ($6, $5,250) in gross income.

24 Extra problems - #45 c. Lori Company runs a nursery near its offices. Employees are allowed to leave their children at the nursery free of charge during working hours. Nonemployees may also use the facility at a cost of $300 per month per child. Dolph is an employee of Lori with 2 children who stay at Lori’s facility while Dolph is at work. The value of employer-provided day care is excluded up to a maximum of $5,000/year. In this case, the value received is $7,200 ($300 x 2 x 12) and Dolph is taxed on the $2,200 ($7, $5,000) excess.

25 Extra problems - #45 d. At the sporting goods store where Melissa works, her employer lets all employees to buy goods at a 40% discount. Melissa purchases for $300 camping and fishing supplies that retail for $500. The goods had cost her employer $250. This is a qualified employee discount and is not taxable to Melissa. The discount is less than the employer’s gross profit percentage (50%) and therefore, is not included in Melissa’s gross income.

26 Extra problems - #46 Courtney is an employee of Freemont Company. An average of three times a week, she works out during her lunch hour at a health club provided by Freemont. Discuss the taxability of Freemont’s provision of the health club in the following situations: a. The health club is owned by Freemont and is located on its business premises. All employees and their dependents are allowed to use the facility. The cost of joining a comparable facility is $60 per month. Employees can exclude the value of using an employer’s athletic facility if the facility is on the employer’s premises and substantially all of the use of the facility is by employees and their families. These conditions are met and Courtney does not have any income from the use of health club.

27 Extra problems - #46 b. The health club is located in Freemont’s office building, but is owned by Manzer Fitness World. Freemont pays the $60 per month health club dues. Because the health club is not owned by Freemont Co., Courtney cannot exclude the value of the health club dues. Courtney must include the $720 ($60 x 12) of health club dues paid by Freemont in her gross income.

28 Extra problems - #46 c. Freemont is in the health club business. The health club is used primarily by customers, although several employees, including Courtney, use it, too. Courtney cannot exclude the value of the health club dues under the provision for use of an employer’s athletic facility because the primary use of the facility is by customers, not employees. However, if free use of the health club is available to all of Freemont’s employees, it is excluded as a no-additional cost service. If all employees are not allowed to use the health club, then Courtney must include the $720 ($60 x 12) of health club dues in her gross income.

29 Income exclusions by category table 4-2
Major Problems Donative Items Gifts What is a gift? Inheritances No exclusion for future earnings on amounts excluded for gifts, inheritances, and life insurance proceeds Life insurance proceeds Use annuity exclusion formula Scholarships Only direct costs of education excludable for scholarships

30 Income exclusions by category table 4-2
Major Problems Employment Related Exclusions Foreign-earned income Two options: exclude or take credit Pension plan payments Payments not taxable until withdraw Group term life insurance Exclude first $50,000; nondiscriminatory Health/accident insurance Nondiscriminatory Meals and lodging Cash meal allowances taxable No additional cost services Nondiscriminatory; same line of business as employee Employee discounts Nondiscriminatory; same line; goods: > cost; services: <20% Qualified retirement planning services Working-condition fringes Can be discriminatory; $240/month for parking De minimis fringes Items too small to permit reasonable accounting Child care $5,000/year Athletic facilities On employer’s premises and used primarily by employees Educational assistance $5,250/year; nondiscriminatory Cafeteria plans Taxable if elect to receive cash Flexible benefits Unused portion not returned Health savings accounts Unused amount can be carried forward

31 Income exclusions by category table 4-2
Major Problems Returns of Human Capital Workers’ compensation Unemployment payments are taxable Damages for personal physical injury Must have origin of physical injury or sickness; punitive payments are taxable Payments from employee-purchased health/accident plan All health and accident insurance payments are excluded Payments from employer-provided health/accident insurance for medical expenses Limited to medical care and loss of body parts

32 Income exclusions by category table 4-2
Major Problems Investment-Related Exclusions Municipal bond interest Exclude bonds issued by state and local governments Stock dividends If option to receive cash, dividend is taxed Discharge of indebtedness—Insolvent debtor Determine solvency after debt discharge Discharge of indebtedness—Qualified principal residence indebtedness $2M acquisition indebtedness Improvements by a lessee Payments in lieu of rent is taxable

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