Chapter 10

1. Chapter 10 Individuals: Income, Deductions, and Credits

2. The Big Picture (slide 1 of 4) Donna and David Steele recently married and have come to you for tax advice. They both are employed, and they expect to have combined wages of $70,000 during the year. Donna recently completed an internship with a CPA firm. The firm was pleased with her work and gave her a $1,500 bonus to help with her graduate school expenses at State University. Because of Donna’s excellent academic record, the university awarded her a graduate assistantship that waived her tuition of $6,000 per semester and paid her $400 per month. In exchange, Donna was required to teach a principles of accounting course each semester. Donna used the $400 per month for books and incidental fees. 2

3. The Big Picture (slide 2 of 4) Donna paid $400 of interest on student loans from her undergraduate years. Donna and David also received a wedding gift of $10,000 from her grandmother. The couple earned $250 of interest on a savings account they opened with the money. David sold stock for $1,000 that was purchased two years ago for $5,000. 3

4. The Big Picture (slide 3 of 4) Late in the year, Donna was hit by a delivery van. The driver had a blood alcohol level of .12. Donna suffered a severe injury to her right arm that required her to miss work for a month or so. The delivery company’s insurance company settled the case by paying damages, itemized as follows: Compensatory damages: Medical expenses $ 30,000 Injury to Donna’s right arm 100,000 Pain and suffering 50,000 Loss of income 10,000 Legal fees 25,000 Punitive damages 160,000 $375,000 4

5. The Big Picture (slide 4 of 4) This is David’s second marriage, and he pays alimony to his ex-wife. He has custody of his 15-year-old son, Stephen, who lives with Donna and David for nine months each year. The Steeles rent their home, paid $3,500 of state income taxes, paid an $812 motor vehicle registration tax on their personal car, incurred additional medical expenses of $25,000, and made $2,500 of charitable contributions. Without calculating Donna and David’s tax liability, what are the tax implications of the transactions noted above? Are there other tax deductions or credits for which they may qualify or other tax issues about which they should be made aware? Read the chapter and formulate your response. 5

6. Specific Inclusions Applicable To Individuals The following provisions applicable to individuals are covered in this chapter: Alimony and separate maintenance payments Prizes and awards Unemployment compensation Social Security benefits 6

7. Alimony and Separate Maintenance Payments (slide 1 of 3) Alimony is: Deductible by payor Includible in gross income of recipient 7

8. Alimony and Separate Maintenance Payments (slide 2 of 3) Property settlements Transfer of property to former spouse No deduction or recognized gain or loss for transferor No gross income and carryover of transferor’s basis for transferee 8

9. Alimony and Separate Maintenance Payments (slide 3 of 3) Child support payments Payments made to satisfy legal obligation to support child of taxpayer Nondeductible by payor and not taxed to recipient (or child) May be difficult to determine whether an amount received is alimony or child support If amount of payment would be reduced due to some future event related to the child (e.g., child reaches age 21), such reduction is deemed child support 9

10. Alimony and Separate Maintenance Payments (slide 3 of 3) Child support payments Payments made to satisfy legal obligation to support child of taxpayer Nondeductible by payor and not taxed to recipient (or child) May be difficult to determine whether an amount received is alimony or child support If amount of payment would be reduced due to some future event related to the child (e.g., child reaches age 21), such reduction is deemed child support 10

11. Prizes and Awards General rule: FMV of item is included in income Exceptions: Taxpayer designates qualified organization to receive prize or award (subject to other requirements) Employee achievement awards of tangible personal property made in recognition of length of service or safety achievement (limits apply) 11

12. Prizes and Awards General rule: FMV of item is included in income Exceptions: Taxpayer designates qualified organization to receive prize or award (subject to other requirements) Employee achievement awards of tangible personal property made in recognition of length of service or safety achievement (limits apply) 12

13. Prizes and Awards General rule: FMV of item is included in income Exceptions: Taxpayer designates qualified organization to receive prize or award (subject to other requirements) Employee achievement awards of tangible personal property made in recognition of length of service or safety achievement (limits apply) 13

14. Unemployment Compensation Unemployment compensation is taxable in full 14

15. Social Security Benefits If taxpayer’s income exceeds a specified base amount, up to 85% of benefits may be taxable Two formulas for computing taxable benefits 15

16. Specific Exclusions Applicable To Individuals Certain items are specifically excluded from an individual’s income, including: Gifts and Inheritances Scholarships Certain damages Workers’ Compensation Accident and Health Insurance Benefits Interest on Educational Savings Bonds 16

17. Gifts and Inheritances (slide 1 of 3) • Gifts are nontaxable to donee if: • Transfer is voluntary without adequate consideration, and • Made out of affection, respect, admiration, charity, or donative intent

18. Gifts and Inheritances (slide 2 of 3) • 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.

19. Gifts and Inheritances (slide 3 of 3) • Transfers by employers to employees do not qualify as excludible gifts • May be excludible under other provisions, e.g., employee achievement awards

20. The Big Picture - Example 4Gifts to Employees Return to the facts of The Big Picture on p. 10-1. The $1,500 bonus paid to Donna by the CPA firm was compensation for services rather than a gift. The payment was most likely not motivated by the employer’s generosity, but as a result of business considerations. Even if the payment had been made out of generosity, because the payment was received from her employer, Donna could not exclude the “gift.” 20

21. Scholarships and Fellowships • 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

22. Scholarships and Fellowships • 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

23. The Big Picture - Example 5Scholarships Return to the facts of The Big Picture on p. 10-1. State University waives tuition for all graduate teaching assistants. The tuition waived is intended as compensation for services and is included in gross income. Therefore, the $6,000 tuition waiver Donna received each semester is compensation for her services. The $400 she received each month also is compensation for services. The fact that she used the funds for educational expenses does not change the tax treatment of the compensation. 23

24. Damages (slide 1 of 3) • Tax consequences of receipt of damages • Depends on type of harm taxpayer experienced • The taxpayer may seek damages for: • Loss of income • Expenses incurred • Property destroyed • Personal injury

25. Damages (slide 2 of 3) • Tax treatment of damages received for: • Loss of income • Generally, taxed the same as the income replaced • Exceptions exist related to personal injury • Reimbursement for expenses incurred • Not income, unless the expense was deducted • Damages that are a recovery of the taxpayer’s previously deducted expenses are generally taxable under the tax benefit rule

26. Damages (slide 3 of 3) • Tax treatment of damages received for: • Property damaged or destroyed • Treated as an amount received in a sale or exchange of the property • Thus, taxpayer has realized gain if damage payments exceed property’s basis • Personal injury • Receives special treatment

27. Compensation for Injuries and Sickness (slide 1 of 3) • Personal injury damages • Compensatory damages received on account of physical personal injuryor physical illness are excludible • Includes amounts received for loss of income associated with the physical personal injury or physical sickness • All other personal injury damages are taxable • Compensatory damages for nonphysical injury • All punitive damages

28. The Big Picture - Example 9Damages Return to the facts of The Big Picture on p. 10-1. The damages Donna received were awarded as a result of a physical personal injury. Therefore, all of the compensatory damages can be excluded. Even the compensation for the loss of income of $10,000 can be excluded. The punitive damages Donna received, however, must be included in her gross income. 28

29. 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

30. 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 • Different rules apply if the accident and health insurance protection was purchased by the individual’s employer

31. 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 • Different rules apply if the accident and health insurance protection was purchased by the individual’s employer

32. 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

33. Itemized Deductions(slide 1 of 2) Personal expenditures that are deductible from AGI as itemized deductions include: Medical expenses Certain taxes Mortgage and investment interest Charitable Contributions Miscellaneous itemized deductions 33

34. Itemized Deductions(slide 2 of 2) Itemized deductions provide a tax benefit only to extent that, in total, they exceed the standard deduction amount for the taxpayer 34

35. Medical Expenses (slide 1 of 6) Medical expenses are deductible to the extent unreimbursed medical expenses, in total, exceed 10% of AGI For taxpayers age 65 and older, the threshold is 7.5% of AGI until 2017, when it increases to 10% Prior to 2013, the percentage threshold for regular income tax purposes was 7.5% of AGI for all taxpayers 35

36. Medical Expenses (slide 2 of 6) Example of medical expense deduction limitation: Amy, age 24, has AGI of $10,000 and medical expenses of $1,500 Amy’s medical expense deduction = $500 [$1,500 – ($10,000 × 10%)] 36

37. Medical Expenses (slide 3 of 6) Example of medical expense deduction limitation: Bob, age 67, has AGI of $4,000 and medical expenses of $1,000 Bob’s medical expense deduction = $700 [$1,000 – ($4,000 × 7.5%)] 37

38. Medical Expenses (slide 4 of 6) Expenditures for: The diagnosis, cure, mitigation, treatment, prevention of disease, or The purpose of affecting any structure or function of the body of the taxpayer, spouse, or dependents Includes prescription drugs and insulin 38

39. Medical Expenses (slide 5 of 6) Does not include the cost of items such as : Unnecessary cosmetic surgery General health items Nonprescription drugs If cosmetic surgery is deemed necessary, it is deductible as a medical expense Cosmetic surgery is necessary when it ameliorates A deformity arising from a congenital abnormality A personal injury, or A disfiguring disease 39

40. Medical Expenses (slide 6 of 6) Medical expenditures are deductible in year paid Includes payment by check or credit card 40

41. The Big Picture - Example 13Medical Expenses Return to the facts of The Big Picture on p. 10-1. The medical expenses associated with Donna’s accident were later reimbursed by the delivery company’s insurance company. The Steeles had other qualifying medical expenses. Assuming that their AGI for the year is $200,000. They will need to itemize their deductions and have more than $20,000 ($200,000 X 10%) in unreimbursed medical expenses to receive a tax benefit from those expenses. 41

42. Nursing Home Expenditures If primary reason for being in nursing home is medical, costs (including meals and lodging) qualify If primary purpose of placement in home is personal, only specific medical costs qualify (no meals or lodging) 42

43. Capital Medical Expenditures May include a pool, air conditioners if they do not become permanent improvements, dust elimination systems, elevators, etc. Must be medical necessity, advised by a physician, used primarily by patient, and expense is reasonable Full amount of cost is medical expense in year paid Maintenance on capital expenditures also medical expense 43

44. Capital Improvement to Home Deductible medical expense only to extent cost exceeds increase in value of home Appraisal costs related to capital improvements are also deductible, but not as medical expenses Exception: removal of structural barriers to home of handicapped are deemed to add no value to home Thus, full amount is a medical expense 44

45. Medical Care of Spouse and Dependents Taxpayer may deduct cost of medical care for spouse and dependents Dependents need not meet gross income or joint return tests Medical expenses of children of divorced parents can be deducted by non-custodial parent even though child is claimed as dependent of custodial parent 45

46. Medical Transportation and Lodging Transportation costs to and from medical care are deductible Mileage allowance of 23.5 cents per mile (in 2014) may be used instead of actual out-of-pocket automobile expenses Lodging while away from home for medical care Allowable amount is $50 per person per night If parent and/or aide needs to accompany patient, their expenses are also deductible 46

47. Medical Transportation and Lodging Transportation costs to and from medical care are deductible Mileage allowance of 23 cents per mile (in 2015) may be used instead of actual out-of-pocket automobile expenses Lodging while away from home for medical care Allowable amount is $50 per person per night If parent and/or aide needs to accompany patient, their expenses are also deductible 47

48. Medical Insurance Premiums(slide 1 of 2) Premiums paid for medical care insurance are deductible medical expenses If employer pays all or part of taxpayer’s medical insurance premiums the amount paid by employer is Not included in gross income by employee Not deductible by the employee as medical expense 48

49. Medical Insurance Premiums(slide 2 of 2) For self-employed, 100% of insurance premiums are deductible for AGI Includes amounts paid for taxpayer’s spouse and dependents Not allowed if taxpayer is eligible to participate in a subsidized health plan maintained by any employer of the taxpayer or the taxpayer’s spouse Premiums paid for qualified long-term care insurance are deductible medical expenses Subject to limitations based on age of the insured 49

50. Health Savings Accounts Used in conjunction with a high deductible medical insurance policy Employee contributions to HSA are deductible for AGI and earnings on funds in account are not taxable Deductible contributions are limited to the sum of the monthly limitations. The monthly deductible amount is limited to the lesser of one twelfth of: The annual deductible under a high deductible plan or $3,350 for self-only ($6,650 for family coverage) in 2015 Withdrawals from HSA are excludible to the extent used for qualified medical expenses 50