Chapter 4 Income Exclusions ©2009 South-Western, a part of Cengage Learning ©2009 South-Western, a part of Cengage Learning Kevin Murphy Kevin Murphy Mark Higgins Mark Higgins
Chapter 4Chapter 4
Income ExclusionsIncome Exclusions
©2009 South-Western, a part of Cengage Learning©2009 South-Western, a part of Cengage Learning©2009 South-Western, a part of Cengage Learning©2009 South-Western, a part of Cengage Learning
Kevin MurphyKevin MurphyMark HigginsMark Higgins
Kevin MurphyKevin MurphyMark HigginsMark Higgins
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Income ExclusionsConcept Review
Income ExclusionsConcept Review
The 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.
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Income ExclusionsMajor Reasons
Income ExclusionsMajor Reasons
The major reasons income items are excluded
To increase equity through relief provisions
To provide incentives for taxpayers to engage in an activity
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Income ExclusionsCategories
Income ExclusionsCategories
There are four major categories of exclusions:Donative itemsEmployment-related Returns of human capitalInvestment related
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Donative Items: Gifts and Inheritances
Donative Items: Gifts and Inheritances
Gifts are excluded to relieve double taxation caused by the gift tax
Inheritances are excluded to relieve double taxation caused by the estate tax
Donative items are increases in wealth that are not earned or the result of investment.
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Donative Items:Life Insurance Proceeds
Donative Items:Life Insurance Proceeds
Life Insurance Proceeds are excluded to provide equity with other types of inheritancesProceeds from policies purchased for
consideration are not excludedInterest income earned from the proceeds
due to electing receipt as an annuity are not excluded
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Donative Items: Scholarships
Donative Items: Scholarships
Scholarships are excluded to provide incentive for education. To qualify, the scholarshipMust not require the performance of future
servicesMust be used for direct costs of education
such as tuition, fees, books, and supplies
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Scholarship ExampleScholarship Example
Jake 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).
How much must Jake include in his gross income?
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Employment Related:Foreign Earned Income
Employment Related:Foreign Earned Income
Foreign Earned Income may be excluded to relieve double taxation.Taxpayers may choose one of two options:Exclude up to $87,600 of foreign earned income
Must be a resident of the foreign country, or Must reside in the foreign country for 330 days
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
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Employment Related:Payments Made by Employer
Employment Related:Payments Made by Employer
Payments made on behalf of an employee are excluded as an incentive to employers to provide these benefits.
Examples of excluded payments are:Contributions to qualified pension plansPremiums for group term life insurancePremiums for health and accident insuranceMeals and lodgingFringe benefits
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Payments Made by EmployerTo Qualified Pension Plan
Payments Made by EmployerTo Qualified Pension Plan
Payments made by employers to qualified pension plansare not included in income in the year of
payment are included in income in the year of
withdrawal
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Payments Made by EmployerGroup Term Life Insurance
Payments Made by EmployerGroup 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 employeesPremiums for insurance in excess of
$50,000 are included in taxable income
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Payments Made by EmployerHealth and Accident
Insurance
Payments Made by EmployerHealth and Accident
InsurancePremiums paid for health and accident
insurance are excluded from income to encourage employers to provide insurance.
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Payments Made by EmployerFor Meals and Lodging
Payments Made by EmployerFor Meals and Lodging
The value of meals provided by the employer are excluded from income if the meals are providedon the employer’s premisesfor the employer’s convenience
The value of lodging provided must meet these conditions and also be a condition of employment
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Payments Made by EmployerGeneral Fringe Benefits
Payments Made by EmployerGeneral Fringe Benefits
Two types of fringe benefits are excludable from income if they are provided on a nondiscriminatory basis:No additional cost servicesEmployee discounts
on goods, are limited to the gross profit % on services, are limited to 20%
Qualified retirement planning services
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Payments Made by EmployerGeneral Fringe Benefits
Payments Made by EmployerGeneral Fringe Benefits
Other types of fringe benefits are excludable from income even if they are provided on a discriminatory basis:Working conditionDe minimusChild and dependent care services up to $5,000Educational assistance programs up to $5,250Employer’s athletic facility on premises
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Payments Made by EmployerEmployer Benefit Plans
Payments Made by EmployerEmployer 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
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Payments Made by EmployerEmployer Benefit Plans
Payments Made by EmployerEmployer Benefit Plans
Flexible Benefit (Salary Reduction) Plans allow employees to use pre-tax compensation dollars to cover medical or child-care expenses
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Payments Made by EmployerEmployer Benefit Plans
Payments Made by EmployerEmployer Benefit Plans
Health Savings Accounts are excluded to encourage employers and employees to purchase adequate medical coverageMay be established for individuals covered
only by high-deductible plans• $2,200 for family or $1,100 for single
Employer contributions are excluded from income and individual contributions are deductible for AGI
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Returns of Human CapitalReturns 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.
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Returns of Human Capital:Worker’s Compensation
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.
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Returns of Human Capital: Personal Physical Injury or Sickness
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
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Returns of Human Capital:Health and Accident Insurance
Returns of Human Capital:Health and Accident InsurancePayments 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
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Investment Related: Municipal Bond Interest
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
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Investment Related: Stock Dividends
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
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Investment Related:Discharge of Indebtedness
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
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Investment Related:Leasehold Improvements
Investment Related:Leasehold Improvements
The value of improvements to property made by a lessee are excluded under the wherewithal-to-pay concept