1. Chapter 5 Gross Income: Exclusions Copyright ©2005 South-Western/Thomson Learning Eugene Willis, William H. Hoffman, Jr., David M. Maloney, and William A. Raabe

2. C5 - 2 Exclusions Defined Items of income that are specifically designated as not included in gross income Exclusions are generally found in Sections 101 through 150 Items of income that are specifically designated as not included in gross income Exclusions are generally found in Sections 101 through 150

3. C5 - 3 Gifts and Inheritances (slide 1 of 5) Gifts are nontaxable to donee if: –Transfer is voluntary without adequate consideration, and –Made because of affection, respect, admiration, charity, or donative intent Gifts are nontaxable to donee if: –Transfer is voluntary without adequate consideration, and –Made because of affection, respect, admiration, charity, or donative intent

4. C5 - 4 Gifts and Inheritances (slide 2 of 5) Inheritances are nontaxable to beneficiary Income earned on gifts or inheritances is taxable under normal rules –Example: Father gifts corporate bond to daughter. Gift is excluded from daughter’s gross income, but interest income earned after gift date is taxable to her. Inheritances are nontaxable to beneficiary Income earned on gifts or inheritances is taxable under normal rules –Example: Father gifts corporate bond to daughter. Gift is excluded from daughter’s gross income, but interest income earned after gift date is taxable to her.

5. C5 - 5 Gifts and Inheritances (slide 3 of 5) Transfers by employers to employees do not qualify as excludible gifts –May be excludible under other provisions, e.g., employee achievement awards  Question 3 Transfers by employers to employees do not qualify as excludible gifts –May be excludible under other provisions, e.g., employee achievement awards  Question 3

6. C5 - 6 Gifts and Inheritances (slide 4 of 5) Employee death benefits: amount paid by employer to deceased employee’s spouse, child, or others –If decedent had a nonforfeitable right to payments (e.g., accrued salary), amounts are taxable to employee Employee death benefits: amount paid by employer to deceased employee’s spouse, child, or others –If decedent had a nonforfeitable right to payments (e.g., accrued salary), amounts are taxable to employee

7. C5 - 7 Gifts and Inheritances (slide 5 of 5) Employee death benefits may be excludible as a gift if: Paid to surviving spouse or children (not employee’s estate), Employer derived no benefit from payments, Surviving spouse and children performed no services for employer, Decedent had been fully compensated for services rendered, and Payments made pursuant to board of director’s resolution under a general company policy Employee death benefits may be excludible as a gift if: Paid to surviving spouse or children (not employee’s estate), Employer derived no benefit from payments, Surviving spouse and children performed no services for employer, Decedent had been fully compensated for services rendered, and Payments made pursuant to board of director’s resolution under a general company policy

8. C5 - 8 Life Insurance Proceeds (slide 1 of 4) Exempt income to beneficiary if paid solely due to death of insured –Relationship to decedent not determinative Exempt income to beneficiary if paid solely due to death of insured –Relationship to decedent not determinative

9. C5 - 9 Life Insurance Proceeds (slide 2 of 4) If owner of life insurance policy cancels the policy and receives the cash surrender value –Gain must be recognized to extent amount received exceeds premiums paid on policy –Loss is not recognized If owner of life insurance policy cancels the policy and receives the cash surrender value –Gain must be recognized to extent amount received exceeds premiums paid on policy –Loss is not recognized

10. C5 - 10 Life Insurance Proceeds (slide 3 of 4) Accelerated death benefits –Gain on cash surrender or transfer of life insurance policy by terminally or chronically ill individual is excludible Exclusion for chronically ill is limited to amounts used for long-term care Accelerated death benefits –Gain on cash surrender or transfer of life insurance policy by terminally or chronically ill individual is excludible Exclusion for chronically ill is limited to amounts used for long-term care

11. C5 - 11 Life Insurance Proceeds (slide 4 of 4) Transfers for valuable consideration –If policy is transferred for valuable consideration, proceeds are taxable to extent they exceed amount paid for policy plus subsequent premiums paid –Exceptions exist to facilitate funding of buy-sell agreements, transfers pursuant to a tax-free exchange and receipt of a policy by gift Transfers for valuable consideration –If policy is transferred for valuable consideration, proceeds are taxable to extent they exceed amount paid for policy plus subsequent premiums paid –Exceptions exist to facilitate funding of buy-sell agreements, transfers pursuant to a tax-free exchange and receipt of a policy by gift

12. C5 - 12 Scholarships and Fellowships (slide 1 of 2) An amount paid to or for the benefit of a student to aid in pursuing a degree at an educational institution –Nontaxable to extent of tuition and related expenses (e.g., fees, books, supplies, and equipment required for courses) Amounts received for room and board are taxable  Problem 34 An amount paid to or for the benefit of a student to aid in pursuing a degree at an educational institution –Nontaxable to extent of tuition and related expenses (e.g., fees, books, supplies, and equipment required for courses) Amounts received for room and board are taxable  Problem 34

13. C5 - 13 Scholarships and Fellowships (slide 2 of 2) Qualified tuition waivers or reductions by nonprofit educational institutions are excluded from income –Generally limited to undergraduate tuition waivers –Exception for graduate teaching or research assistants (included as income) Qualified tuition waivers or reductions by nonprofit educational institutions are excluded from income –Generally limited to undergraduate tuition waivers –Exception for graduate teaching or research assistants (included as income)

14. C5 - 14 Compensation for Injuries and Sickness (slide 1 of 3) Personal injury damages –Compensatory damages received on account of physical personal injury or physical illness are excludible All other personal injury damages taxable –Compensatory damages for nonphysical injury –All punitive damages –Payments solely for loss of income are also taxable  Problem 37 Personal injury damages –Compensatory damages received on account of physical personal injury or physical illness are excludible All other personal injury damages taxable –Compensatory damages for nonphysical injury –All punitive damages –Payments solely for loss of income are also taxable  Problem 37

15. C5 - 15 Compensation for Injuries and Sickness (slide 2 of 3) Workers’ compensation –Although may be payment for loss of wages, workers’ compensation is specifically excluded from gross income Workers’ compensation –Although may be payment for loss of wages, workers’ compensation is specifically excluded from gross income

16. C5 - 16 Compensation for Injuries and Sickness (slide 3 of 3) Accident and health insurance benefits –Benefits received under policy purchased by taxpayer are excludible Even if benefits are substitute for income Accident and health insurance benefits –Benefits received under policy purchased by taxpayer are excludible Even if benefits are substitute for income

17. C5 - 17 Employer-Sponsored Accident and Health Plans (slide 1 of 2) Premiums paid by employer for insurance coverage of employee, spouse, and dependents are not taxable to employee Amounts received from insurance are not taxable when received for medical care or for permanent loss of body part or function Premiums paid by employer for insurance coverage of employee, spouse, and dependents are not taxable to employee Amounts received from insurance are not taxable when received for medical care or for permanent loss of body part or function

18. C5 - 18 Employer-Sponsored Accident and Health Plans (slide 2 of 2) Health Savings Accounts (high deductible insurance plans) –Employer contribution to HSA and earnings on funds in the account are excludible Contributions limited to 100% of deductible amount for individual or family coverage –Monthly deductible amount is limited to the lesser of: One twelfth of the annual deductible under a high deductible plan or $2,250 for self-only ($4,500 for family coverage) –Withdrawals from HSA are excludible to the extent used for qualified medical expenses Health Savings Accounts (high deductible insurance plans) –Employer contribution to HSA and earnings on funds in the account are excludible Contributions limited to 100% of deductible amount for individual or family coverage –Monthly deductible amount is limited to the lesser of: One twelfth of the annual deductible under a high deductible plan or $2,250 for self-only ($4,500 for family coverage) –Withdrawals from HSA are excludible to the extent used for qualified medical expenses

19. C5 - 19 Long-Term Care Insurance Employer paid insurance premiums for employee’s long-term care are excludible, limited to the greater of: $230 in 2004 for each day patient receives long- term care (indexed amount for 2003 is $220) The actual cost of the care –Reduced by any amounts received from other third parties (e.g., damages received)  Problem 38 (a) (b) Employer paid insurance premiums for employee’s long-term care are excludible, limited to the greater of: $230 in 2004 for each day patient receives long- term care (indexed amount for 2003 is $220) The actual cost of the care –Reduced by any amounts received from other third parties (e.g., damages received)  Problem 38 (a) (b)

20. C5 - 20 Meals and Lodging Not taxable to employee if: –Furnished by employer On employer’s business premises For convenience of employer –In the case of lodging, employee is required to accept lodging as a condition of employment  Problem 43 Not taxable to employee if: –Furnished by employer On employer’s business premises For convenience of employer –In the case of lodging, employee is required to accept lodging as a condition of employment  Problem 43

21. C5 - 21 Other Fringe Benefits (slide 1 of 3) Dependent care –Up to $5,000 of care costs paid for by employer can be excluded Athletic facilities –Value of use of athletic facilities located on employer premises can be excluded Dependent care –Up to $5,000 of care costs paid for by employer can be excluded Athletic facilities –Value of use of athletic facilities located on employer premises can be excluded

22. C5 - 22 Other Fringe Benefits (slide 2 of 3) Educational assistance programs –Employer-provided educational assistance for undergraduate and graduate education is excludible Exclusion limited to $5,250 per year Educational assistance programs –Employer-provided educational assistance for undergraduate and graduate education is excludible Exclusion limited to $5,250 per year

23. C5 - 23 Other Fringe Benefits (slide 3 of 3) Adoption assistance programs –Employee adoption expenses paid or reimbursed by employer are excludible Exclusion limited to $10,390 Exclusion phases-out as AGI increases from $155,860 to $195,860 Adoption assistance programs –Employee adoption expenses paid or reimbursed by employer are excludible Exclusion limited to $10,390 Exclusion phases-out as AGI increases from $155,860 to $195,860

24. C5 - 24 Cafeteria Plans Allows employees to choose between cash and certain nontaxable benefits –If cash is chosen, the amount received is taxable –If a nontaxable benefit is chosen, the benefit remains nontaxable Allows employees to choose between cash and certain nontaxable benefits –If cash is chosen, the amount received is taxable –If a nontaxable benefit is chosen, the benefit remains nontaxable

25. C5 - 25 Flexible Spending Plans Allows employees to accept lower cash compensation in return for employer agreeing to pay certain costs without the employee recognizing income –Called a use or lose plan since reduction in pay cannot be recovered if covered expenses are less than expected  Problem 38 (c), 40 Allows employees to accept lower cash compensation in return for employer agreeing to pay certain costs without the employee recognizing income –Called a use or lose plan since reduction in pay cannot be recovered if covered expenses are less than expected  Problem 38 (c), 40

26. C5 - 26 Classes of Nontaxable Employee Benefits No-additional-cost services (N-D) Qualified employee discounts (N-D) Working condition fringes De minimis fringes Qualified transportation fringes Qualified moving expense reimbursements Qualified retirement planning services (N-D) No-additional-cost services (N-D) Qualified employee discounts (N-D) Working condition fringes De minimis fringes Qualified transportation fringes Qualified moving expense reimbursements Qualified retirement planning services (N-D)

27. C5 - 27 No Additional Cost Services Are nontaxable if: –Employee receives services (not property) –Employer incurs no substantial additional cost in providing the services –Services offered are within line of business in which employee works –Benefit is offered on nondiscriminatory basis Are nontaxable if: –Employee receives services (not property) –Employer incurs no substantial additional cost in providing the services –Services offered are within line of business in which employee works –Benefit is offered on nondiscriminatory basis

28. C5 - 28 Qualified Employee Discounts Are nontaxable if: –Discount is not on realty or investment property –Item discounted is from same line of business in which employee works –Discount cannot exceed gross profit on property or 20% on services –Benefit is offered on nondiscriminatory basis Are nontaxable if: –Discount is not on realty or investment property –Item discounted is from same line of business in which employee works –Discount cannot exceed gross profit on property or 20% on services –Benefit is offered on nondiscriminatory basis

29. C5 - 29 Working Condition Fringes Not taxable if employee could have deducted cost of item if they had actually paid for them –Includes personal use of auto by full-time auto salespeople and employee business expenses that would be eliminated by the 2 percent floor on miscellaneous deductions –Can be discriminatory Not taxable if employee could have deducted cost of item if they had actually paid for them –Includes personal use of auto by full-time auto salespeople and employee business expenses that would be eliminated by the 2 percent floor on miscellaneous deductions –Can be discriminatory

30. C5 - 30 De Minimis Benefits (slide 1 of 2) These benefits are so small that accounting for them is impractical Examples include: –Supper money –Occasional personal use of company copying machine –Company cocktail parties –Picnics for employees These benefits are so small that accounting for them is impractical Examples include: –Supper money –Occasional personal use of company copying machine –Company cocktail parties –Picnics for employees

31. C5 - 31 De Minimis Benefits (slide 2 of 2) Subsidized eating facilities operated by employer are excluded if: –Located on or near employer’s premises –Revenue equals or exceeds direct operating costs –Nondiscrimination requirements are met Subsidized eating facilities operated by employer are excluded if: –Located on or near employer’s premises –Revenue equals or exceeds direct operating costs –Nondiscrimination requirements are met

32. C5 - 32 Qualified Transportation This fringe benefit is designed to encourage the use of mass transit for commuting to work –Includes: Transportation in commuter highway vehicle and transit passes (limited to $100 per month) Qualified parking (limited to $195 per month) Employee can choose between employer-provided benefit and cash without loss of exclusion This fringe benefit is designed to encourage the use of mass transit for commuting to work –Includes: Transportation in commuter highway vehicle and transit passes (limited to $100 per month) Qualified parking (limited to $195 per month) Employee can choose between employer-provided benefit and cash without loss of exclusion

33. C5 - 33 Moving Expenses Employer reimbursement of employee’s moving expenses is excludible –No deduction is allowed for reimbursed moving expenses  Problem 48 Employer reimbursement of employee’s moving expenses is excludible –No deduction is allowed for reimbursed moving expenses  Problem 48

34. C5 - 34 Qualified Retirement Planning Services Value of any retirement planning advice or information provided by employer who maintains a qualified retirement plan is excluded from income Designed to motivate more employers to provide retirement planning services Value of any retirement planning advice or information provided by employer who maintains a qualified retirement plan is excluded from income Designed to motivate more employers to provide retirement planning services

35. C5 - 35 Foreign Earned Income (slide 1 of 3) Income from personal services in a foreign country can be excluded from income To qualify for the exclusion, must be either: –A bona fide resident of foreign country, or –Present in foreign country at least 330 days during any 12 consecutive months Income from personal services in a foreign country can be excluded from income To qualify for the exclusion, must be either: –A bona fide resident of foreign country, or –Present in foreign country at least 330 days during any 12 consecutive months

36. C5 - 36 Foreign Earned Income (slide 2 of 3) Exclusion amount is limited to $80,000 –For married persons, both of whom have foreign earned income, the exclusion is computed separately for each spouse In addition, reasonable housing costs in excess of a base amount may be excluded from gross income –The base amount is 16% of the U.S. government pay scale for a GS–14 (Step 1) employee Exclusion amount is limited to $80,000 –For married persons, both of whom have foreign earned income, the exclusion is computed separately for each spouse In addition, reasonable housing costs in excess of a base amount may be excluded from gross income –The base amount is 16% of the U.S. government pay scale for a GS–14 (Step 1) employee

37. C5 - 37 Foreign Earned Income (slide 3 of 3) Example of foreign earned income exclusion: –Taxpayer lived in Japan from August 1, 2003 to July 19, 2004. For 2004, taxpayer has $90,000 foreign earned income. –Exclusion for 2004 = $77,377 (354/366 x $80,000) Example of foreign earned income exclusion: –Taxpayer lived in Japan from August 1, 2003 to July 19, 2004. For 2004, taxpayer has $90,000 foreign earned income. –Exclusion for 2004 = $77,377 (354/366 x $80,000)

38. C5 - 38 Interest on State and Local Government Obligations Interest from municipal bonds is tax exempt –Reduces borrowing costs of state and local governments –High-income taxpayers can increase after-tax yields with municipal bonds –Municipal interest is considered for Social Security benefits inclusion and may be considered for alternative minimum tax calculation Interest from municipal bonds is tax exempt –Reduces borrowing costs of state and local governments –High-income taxpayers can increase after-tax yields with municipal bonds –Municipal interest is considered for Social Security benefits inclusion and may be considered for alternative minimum tax calculation

39. C5 - 39 Dividends Taxable to extent paid out of either current or accumulated earnings and profits (E&P) Dividends in excess of E&P are treated: –As return of capital to extent of stock basis (which is reduced) –As capital gain to extent in excess of basis Taxable to extent paid out of either current or accumulated earnings and profits (E&P) Dividends in excess of E&P are treated: –As return of capital to extent of stock basis (which is reduced) –As capital gain to extent in excess of basis

40. C5 - 40 Stock Dividends Stock dividends (e.g., common stock issued to common shareholders) are not taxable –If shareholder has the option to receive stock or cash, the dividend is taxable whether the shareholder receives cash or stock Stock dividends (e.g., common stock issued to common shareholders) are not taxable –If shareholder has the option to receive stock or cash, the dividend is taxable whether the shareholder receives cash or stock

41. C5 - 41 Educational Savings Bonds Interest on Series EE U.S. Savings Bonds may be excluded from income if: –Proceeds used to pay for qualified higher educational expenses –Bonds issued after 12/31/89, and –Bonds issued to person at least 24 years old Exclusion is phased-out once modified AGI exceeds threshold amount Interest on Series EE U.S. Savings Bonds may be excluded from income if: –Proceeds used to pay for qualified higher educational expenses –Bonds issued after 12/31/89, and –Bonds issued to person at least 24 years old Exclusion is phased-out once modified AGI exceeds threshold amount

42. C5 - 42 Qualified Tuition Programs Amounts contributed must be used to pay qualified higher education expenses (tuition, fees, books, supplies, room and board, and equipment) –Earnings on contributions, including discounted tuition for plan participants, are not taxable if used for qualified higher education expenses –Refunds from program are taxable to the extent they exceed contributions Amounts contributed must be used to pay qualified higher education expenses (tuition, fees, books, supplies, room and board, and equipment) –Earnings on contributions, including discounted tuition for plan participants, are not taxable if used for qualified higher education expenses –Refunds from program are taxable to the extent they exceed contributions

43. C5 - 43 Tax Benefit Rule If taxpayer receives a deduction for an item in one year and in a later year recovers all or a portion of the prior deduction, the recovery is included in gross income –Amount included in income is limited to the amount for which a tax benefit was received  Problem 50 If taxpayer receives a deduction for an item in one year and in a later year recovers all or a portion of the prior deduction, the recovery is included in gross income –Amount included in income is limited to the amount for which a tax benefit was received  Problem 50

44. C5 - 44 Discharge from Indebtedness Income from the forgiveness of debt is taxable –Certain discharge of indebtedness situations get special treatment: Creditors’ gifts Discharges in bankruptcy and when debtor is insolvent Discharge of farm debt Discharge of qualified real property indebtedness Seller’s cancellation of buyer’s debt Shareholder’s cancellation of corporation’s debt Forgiveness of certain student loans  Problem 58 Income from the forgiveness of debt is taxable –Certain discharge of indebtedness situations get special treatment: Creditors’ gifts Discharges in bankruptcy and when debtor is insolvent Discharge of farm debt Discharge of qualified real property indebtedness Seller’s cancellation of buyer’s debt Shareholder’s cancellation of corporation’s debt Forgiveness of certain student loans  Problem 58

45. C5 - 45 That’s it, Folks! Do not forget to go to the Meet the Firm Night 6:00- 9:00 PM Wednesday, October 20 Upper Common That’s it, Folks! Do not forget to go to the Meet the Firm Night 6:00- 9:00 PM Wednesday, October 20 Upper Common