1. © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Chapter 4 Income Exclusions Murphy & Higgins, Concepts in Federal Taxation, 2010 edition

2. 4-2 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Income Exclusions Concept Review All-inclusive income concept considers all income taxable unless a specific provision can be found that exempts it from taxation Under the legislative grace concept, only Congress can provide income exclusion

3. 4-3 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. The major reasons income items are excluded To increase equity through relief provisions To provide incentives for taxpayers to engage in an activity Most incentive provisions encourage firms to provide medical coverage for their employees Income Exclusions Major Reasons

4. 4-4 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. There are four major categories of exclusions: Donative items Employment-related Returns of human capital Investment related Income Exclusions Categories

5. 4-5 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Donative items are increases in wealth that are not earned or the result of investment Gifts are excluded to relieve double taxation caused by the gift tax Exclusion of gifts is an equity measure that prevents a double tax on a gift Inheritances are excluded to relieve double taxation caused by the estate tax Donative Items Gifts and Inheritances

6. 4-6 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Life Insurance Proceeds are excluded to provide equity with other types of inheritances Proceeds from policies purchased for consideration are not excluded Interest income earned from the proceeds due to electing receipt as an annuity are not excluded Donative Items Gifts and Inheritances

7. 4-7 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Scholarships are excluded to provide incentive for education. To qualify, the scholarship Must not require the performance of future services Must be used for direct costs of education such as tuition, fees, books, and supplies Donative Items Scholarships

8. 4-8 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Scholarship Example Jekabs received an athletic scholarship to Small State University. Under the scholarship agreement, he received tuition ($1,500), books ($400), and room and board ($5,000). Jekabs must report $5,000 as income but may exclude $1,900

9. 4-9 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Employment Related Foreign Earned Income Excluded to relieve double taxation Taxpayers may choose one of two options: Exclude up to $91,400 of foreign earned income Must be a resident of the foreign country, or Must reside in the foreign country for 330 days

10. 4-10 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Claim a tax credit that is the lesser of Foreign taxes paid, or U.S. tax that would have been paid on the foreign income Payments made on behalf of an employee are excluded as an incentive to employers to provide these benefits Employment Related Foreign Earned Income

11. 4-11 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Examples of excluded payments are Contributions to qualified pension plans Premiums for group term life insurance Premiums for health and accident insurance Meals and lodging Fringe benefits Employment Related Foreign Earned Income

12. 4-12 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Payments Made by Employer To Qualified Pension Plan Payments made by employers to qualified pension plans are not included in income in the year of payment are included in income in the year of withdrawal

13. 4-13 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Payments Made by Employer Group Term Life Insurance Premiums paid for up to $50,000 of group term life insurance are excluded from income Plan may not discriminate in favor of highly paid employees Premiums for insurance in excess of $50,000 are included in taxable income

14. 4-14 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Payments Made by Employer Health and Accident Insurance Premiums paid for health and accident insurance are excluded from income to encourage employers to provide insurance

15. 4-15 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Payments Made by Employer For Meals and Lodging The value of meals provided by the employer are excluded from income if the meals are provided on the employer’s premises for the employer’s convenience The value of lodging provided must meet these conditions and also be a condition of employment

16. 4-16 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Payments Made by Employer General Fringe Benefits Two types of fringe benefits are excludable from income if they are provided on a nondiscriminatory basis: No additional cost services Employee discounts on goods, are limited to the gross profit % on services, are limited to 20% Qualified retirement planning services

17. 4-17 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Other types of fringe benefits are excludable from income even if they are provided on a discriminatory basis Working condition De minimus Child and dependent care services up to $5,000 Educational assistance programs up to $5,250 Employer’s athletic facility on premises Payments Made by Employer General Fringe Benefits

18. 4-18 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Payments Made by Employer Employer Benefit Plans Cafeteria Plans allow employees to choose from a menu of benefits and are excludable unless an employee elects to take cash in lieu of benefits Flexible Benefit (Salary Reduction) Plans allow employees to use pre-tax compensation dollars to cover medical or child-care expenses

19. 4-19 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Payments Made by Employer Employer Benefit Plans Health Savings Accounts are excluded to encourage employers and employees to purchase adequate medical coverage May be established for individuals covered only by high-deductible plans $2,300 for family or $1,150 for single Employer contributions are excluded from income and individual contributions are deductible for AGI

20. 4-20 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Returns of Human Capital Payments received that are intended to reimburse an individual for injuries are excluded under the capital recovery concept because they merely restore the individual to a previous condition Payments that are intended to replace lost income are not excluded

21. 4-21 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Returns of Human Capital Worker’s Compensation Worker’s compensation payments related to an injury suffered on the job are excluded because they help restore individuals to their previous condition and do not add to their wealth

22. 4-22 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Returns of Human Capital Personal Physical Injury or Sickness Compensatory damage payments received for a personal physical injury or sickness and medical payments for emotional distress are excluded to provide a return to equity Loss of income damage payments are only excluded if they are related to personal physical injury or sickness Punitive damage payments are never excluded

23. 4-23 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Returns of Human Capital Health and Accident Insurance Payments or reimbursements for medical or health costs are excluded to provide an individual a return to equity Disability payments are excluded if the policy was purchased by the employee but not excluded if the policy was purchased by the employer

24. 4-24 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Investment Related Municipal Bond Interest Interest income received from investment in municipal bonds is excluded to allow state and local municipalities to sell bonds for a lower interest rate

25. 4-25 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Investment Related Stock Dividends Stock dividends are excluded from income because their receipt does not qualify as income under the realization concept If the shareholder has the option to receive cash instead of stock, realization has occurred and the value of the dividend is included in income

26. 4-26 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Investment Related Discharge of Indebtedness An amount received as a loan is generally excluded from income under the realization concept because it must be returned If a lender forgives all or a portion of the debt, realization occurs and the forgiven portion is income Discharge due to insolvency or bankruptcy is excluded from income

27. 4-27 © 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password- protected website for classroom use. Investment Related Leasehold Improvements The value of improvements to property made by a lessee are excluded under the wherewithal-to- pay concept