Chapter 5

1. Chapter 5 Gross Income: Exclusions

2. The Big Picture (slide 1 of 3) Paul is a graduate accounting student and was an intern with a CPA firm this past summer The CPA firm was so pleased with Paul’s work that at the conclusion of his internship He was given a bonus of $1,500 more than the firm had agreed to pay him. The extra amount was intended to help with his graduate school expenses. The CPA firm has offered him a full-time job after he completes his graduate program in December. Paul has a graduate assistantship that waives his tuition of $6,000 per semester and pays him $500 per month. Paul is required to teach a principles of accounting course each semester. Paul has used the $500 per month for books and for room and board. 2

3. The Big Picture (slide 2 of 3) In November, Paul was hit by a delivery van. The driver of had a blood alcohol level of .12. Paul suffered a severe injury to his right arm. The delivery company’s insurance company settled the case by paying damages, itemized as follows: Compensatory damages: Medical expenses $ 30,000 Injury to Paul’s right arm 100,000 Pain and suffering 50,000 Loss of income 15,000 Legal fees 25,000 Punitive damages 160,000 $380,000 3

4. The Big Picture (slide 3 of 3) Paul’s mother was with him in the crosswalk but the van did not hit her She did suffer emotional distress and received $25,000 in the settlement. Besides being Paul’s girlfriend, you also are a senior accounting major and have a keen interest in taxation. You tell Paul that you will look into the tax consequences of the settlement. Read the chapter and formulate your response. 4

5. Exclusions Defined Items of income that are specifically designated as not included in gross income Exclusions are generally found in Sections 101 through 150 5

6. Gifts and Inheritances (slide 1 of 5) • Gifts are nontaxable to donee if: • Transfer is voluntary without adequate consideration, and • Made out of affection, respect, admiration, charity, or donative intent

7. 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.

8. 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 • Victims of a qualified disaster who are reimbursed by their employers for living expenses, funeral expenses, and property damage can exclude the payments from gross income

9. 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

10. 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

11. Life Insurance Proceeds (slide 1 of 5) • Exempt income to beneficiary if paid solely due to death of insured • Relationship to decedent not determinative

12. Life Insurance Proceeds (slide 2 of 5) • 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

13. Life Insurance Proceeds (slide 3 of 5) • 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

14. Life Insurance Proceeds (slide 4 of 5) • 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 for policy transfers: • To facilitate funding of buy-sell agreements, • Pursuant to a tax-free exchange, and • For receipt of a policy by gift

15. Life Insurance Proceeds (slide 5 of 5) • Investment earnings arising from the reinvestment of life insurance proceeds are generally subject to income tax • e.g., Beneficiary elects to collect the insurance proceeds in installments • The annuity rules are used to apportion the installment payment between the principal element (excludible) and the interest element (includible)

16. 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

17. 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

18. The Big Picture - Example 6Scholarships Return to the facts of The Big Picture on p. 5-2. 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 Paul received each semester is compensation for his services. The $500 he received each month also is compensation for services. The fact that he used the funds for educational expenses does not change the tax treatment of the compensation. 18

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. The Big Picture - Example 12Damages Return to the facts of The Big Picture on p. 5-2. The damages Paul 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 $15,000 can be excluded. The punitive damages Paul received, however, must be included in his gross income. Paul’s mother did not suffer a personal physical injury. Therefore, the $25,000 she received must be included in gross income. 25

26. Employer-Sponsored Accident and Health Plans (slide 1 of 3) • 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

27. Employer-Sponsored Accident and Health Plans (slide 2 of 3) • Payments for expenses that do not meet the Code’s definition of medical care must be included in gross income • Amounts received for medical expenses deducted on a prior return must be included in gross income

28. Employer-Sponsored Accident and Health Plans (slide 3 of 3) • One way to provide a medical reimbursement plan for employees is as follows • The employer purchases a medical insurance plan with a high deductible then make contributions to the employee’s Health Savings Account (HSA) • 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 • $3,050 for self-only ($6,150 for family coverage) • Withdrawals from HSA are excludible to the extent used for qualified medical expenses

29. Employer paid insurance premiums for employee’s long-term care are excludible subject to annual limits as follows: Insured’s Age before Close of Tax Year20102011 40 or less $ 330 $ 340 41 to 50 620 640 51 to 60 1,230 1,270 61 to 70 3,290 3,390 More than 70 4,110 4,240 Long-Term Care Insurance (slide 1 of 2)

30. Long-Term Care Insurance (slide 2 of 2) • Exclusion of benefits received from policy is limited to the greater of: • $300 in 2011 for each day patient receives long-term care (indexed amount for 2010 is $290) • The actual cost of the care • Reduced by any amounts received from other third parties (e.g., damages received)

31. 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

32. 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

33. 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 • Includes tuition, fees, books, and supplies

34. Other Fringe Benefits (slide 3 of 3) • Adoption assistance programs • Employee adoption expenses paid or reimbursed by employer are excludible • Exclusion limited to $13,360 • Exclusion phases-out as AGI increases from $185,210 to $225,210

35. Cafeteria Plans • Allow 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 • Provide tremendous flexibility in tailoring the employee pay package to fit individual needs

36. Flexible Spending Plans • Allow 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 • Recently issued IRS rules allow a 2 ½ month grace period (until the 15th day of the 3rd month after the end of the plan year) to use the funds for qualified expenses

37. Classes of Nontaxable Employee Benefits • No-additional-cost services • Qualified employee discounts • Working condition fringes • De minimis fringes • Qualified transportation fringes • Qualified moving expense reimbursements • Qualified retirement planning services

38. 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

39. 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% of the customer price on services • Benefit is offered on nondiscriminatory basis

40. 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% floor on miscellaneous deductions

41. De Minimis Fringes (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

42. De Minimis Fringes (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

43. Qualified Transportation Fringes • 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 • Limit on the exclusion for 2010 and 2011 is $230 per month • Qualified parking • Limit on the exclusion for 2010 and 2011 is $230 per month • Qualified bicycle commuting reimbursement • Can exclude up to $20 per month received from an employer as reimbursement for the cost of commuting by bicycle • i.e., Bicycle purchase, improvement, repair, and storage • May be provided directly by the employer or may be in the form of cash reimbursements

44. Moving Expenses • Employer payment or reimbursement of employee’s qualified moving expenses is excludible • No deduction by employee is allowed for reimbursed moving expenses

45. 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

46. Nondiscrimination Provisions • For no-additional-cost services, qualified employee discounts, and qualified retirement planning services • If the plan is discriminatory in favor of highly compensated employees, these key employees are denied exclusion treatment • Non-highly compensated employees can still exclude these benefits from income

47. 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

48. Foreign Earned Income (slide 2 of 3) • Exclusion amount is limited to $92,900 • For married persons, both with foreign earned income, the exclusion is computed separately for each spouse • Congress recently decreased its benefit by requiring a special tax computation • The tax on taxable income after the foreign earned income exclusion is calculated using the tax rate that would apply if the excluded foreign earned income were included in gross income

49. Foreign Earned Income (slide 3 of 3) In addition, reasonable housing costs in excess of a base amount may be excluded from gross income The base amount is 16% of the statutory amount ($92,900 for 2011) assuming all days are qualifying days for the foreign earned income exclusion The housing costs exclusion is limited to 30% of the statutory amount (as indexed) for the foreign earned income exclusion 49

50. 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