ACCT 330: Chap 5: Gross Income Exclusions

Tax Benefit Rule

-Generally, if a taxpayer obtains 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 in the year received. -No income is recognized upon the recovery of a deduction that did not yield a tax benefit in the year it was taken. • State tax refund ex.:—Itemize in year one, state tax refund in year two ->Refund is income to extend of year one benefit ->Review: Taxpayer generally takes the higher of standard deduction or Schedule A—Itemized deductions • What is the maximum State Tax deduction on Schedule A—Itemized deduction? = $10,000 ($5,000 if married filing separately)

Gifts and Inheritances

-Gifts are nontaxable to donee if: -->Transfer is voluntary without adequate consideration and made out of affection, respect, admiration, charity or like impulses -->"a voluntary transfer of property by one to another without adequate [valuable] consideration or compensation therefrom." -->Iinter vivos - means among the living

Gifts and Inheritances Exs:

-Income earned on gifts or inheritances is taxable under normal rules -->Ex.—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 -->Ex.—Granddaughter inherits an apartment building from her grandmother. The apartment building (property) is excluded from the daughter's US Federal gross income; however, the monthly rental payments received by the granddaughter are included in her US Federal gross income. -Transfers from employers to employees GENERALLY do not qualify as excludible gifts -->May be excludible under other provisions, for example, 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

Employer Sells Goods or Services

-No-additional cost services—exclude from gross income ->•Ex. Hair cut at a barbershop taxpayer works( if barber wasn't busy and fit you in for a hair cut) -A qualified employee discount may be excluded from the gross income of the employee: •Rules: •Not available for real property( a house) •Held for investment(ex.,common stocks) •The property or services must be from the same line of business in which the employee works •In the case of property, the exclusion is limited to the gross profit component of the price to customers •In the case of services, the exclusion is limited to 20% of the customer price.

General 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 -Qualified military base realignment and closure fringes

Life Insurance Proceeds

-Paid to the beneficiary because of the death of the insured are excluded from gross income -Life insurance proceeds are chosen to be exempt due to the following: ->Life insurance proceeds serve much the same purpose as a nontaxable inheritance ->Replace an economic loss suffered by the business -Accelerated death benefits ->• Gain on cash surrender or transfer of life insurance policy by terminally or chronically ill individual (taxpayer) is excludible ->Exclusion for chronically ill is limited to amounts used for long-term care ->A person is terminally ill if a medical doctor certifies that death is likely to occur within 24 months.

Employer-Sponsored Accident and Health Plans

-Premiums paid by employer for insurance coverage of employee, spouse, and dependents are deductible by the employer and excluded from the employee's income -Amounts received from insurance are not taxable when received for medical care or for permanent loss of body part or function -Payments received for expenses that do not meet the Code's definition of medical care must be included in gross income -Amounts received for medical expenses that were deducted on a prior return must be included in gross income -One way to provide a medical reimbursement plan for employees is as follows: ->• The employer purchases a medical insurance plan with a high-deductible and then makes contributions to the employee's Health Savings Account (HSA) -->• Employer's contribution to HSA and earnings on funds in the account are excludable -->•Contributions limited to 100% of deductible amount for individual or family coverage --->•Monthly deductible amount is limited to one-twelfth of $3,500 under a high-deductible plan for self-only coverage (one-twelfth of $7,000 for an individual who has family coverage) -Withdrawals from H S A must be used to reimburse the employee for the medical expenses paid by the employee that are not covered under the high-deductible plan

Ex 5-6: Indicate Taxable/ Nontaxable: Billy fell off a bar stool and hurt his back. As a result, he was unable to work for 3 months. He sued the bar owner and collected $100,000 for the physical injury and $50,000 for the loss of income. Billy also collected $15,000 from an income replacement insurance policy he purchased. Amber collected $30,000 under an income replacement insurance policy purchased by her employer. Billy: ~$100,000 for physical injury: ~$50,000 for loss of income: ~$15,000 from an income replacement policy: Amber: ~$30,000 from an income replacement policy:

Billy: ~$100,000 for physical injury: Nontaxable ~$50,000 for loss of income: Nontaxable b/c he was hurt and couldn't work ~$15,000 from an income replacement policy: Nontaxable b/c he paid for policy Amber: ~$30,000 from an income replacement policy: Taxable b/c her employer pd. for

Scholarships

• An amount paid to or for the benefit of a student to aid in pursuing a degree at an educational institution • Non taxable to the extent of tuition and related expenses (Examples: fees, books, supplies, and equipment required for courses) • Amounts received for room and board are TAXABLE

Employee Death Benefits

• Employee death benefits—Amount paid by employer to deceased employee's surviving spouse, children, or other beneficiaries -->• If decedent had a nonforfeitable right to payments (example—accrued salary), amounts are taxable to recipient as if the employee had lived and collected the payments •Employee death benefits may be excludable 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 board of directors' resolution under a general company policy --> Payments made pursuant to board of directors' resolution under a general company policy

Other Fringe Benefits

•Child and dependent care ->•Up to $5,000 per year of care costs paid for by the employer can be excluded •Athletic facilities ->• Value of the use of athletic facilities located on employer premises can be excluded •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, & supplies Does not cover ->Meals, lodging, and transportation costs ->Educational payments for courses involving sports, games, or hobbies

Employer Benefits

•Congress encourages employers to provide employees ->•premiums are deductible by the employer and excluded from the employee's income

Life Insurance Proceeds Examples

•Ex 2: Linda purchases an insurance policy on her life and names her husband, Mark, as the beneficiary. Linda pays $45,000 in premiums. When she dies, Mark collects the insurance proceeds of $200,000. The $200,000 is excluded from Mark's gross income (and exempt from Federal income tax). • Ex 3: Gold Corporation purchases a life insurance policy to cover its CEO (a key employee). If the proceeds were taxable, the corporation would require more insurance coverage to pay the tax as well as to cover the economic loss of the employee.

Employer-Sponsored Accident and Health Plans Exs:

•Ex. 13: Bonnie purchases a medical and disability insurance policy. The insurance company pays Bonnie $1,000 per week to replace wages she loses while in the hospital. Although the payments serve as a substitute for income, the amounts received are tax- exempt benefits collected under Bonnie's insurance policy. •Ex. 14: Joe's injury results in a partial paralysis of his left foot. He receives $20,000 for the injury from his accident insurance company under a policy he had purchased. The $20,000 accident insurance proceeds are tax-exempt.

Nondiscrimination Provisions

•For no-additional-cost services, qualified employee discounts, and qualified retirement planning services ->•Non-discriminatory—all employees then exclude from gross income ->•If the plan is discriminatory—these key employees are denied exclusion treatment

Meals and Lodging Ex:

Khalid is the manager of a large apartment complex. The employer requires Khalid to live on the premises but does not charge him rent. The rental value of his apartment is $9,600 a year. Although Khalid considers the rent-free housing a significant benefit, he is not required to include the value of the housing in his gross income.

Before & After Tax Benefit: Wilbur has been offered a job at a salary that would put him in the 24% marginal tax bracket. In addition to his salary, he would receive health insurance coverage. Another potential employer does not offer health insurance comparable to that provided by the other potential employer is $9,000 per year. -Wilbur will not be able to deduct the insurance as a medical expense b/c of the adjusted gross income floor & or the standard deduction How much more in salary must the second potential employer pay so that Wilbur's financial status will be the same under both offers?

$11,842 [9,000/ (1-.24)] Additional Salary Requirement: [Benefit ( 1-.tax rate )]

Qualified Transportation Fringes Ex: Gray Corp. offices are located in the center of a large city. The company pays for parking to be used by the company officers. Steve, a VP, receives $300 of such benefits each month during 2019. The parking space rental qualifies as a qualified transportation fringe. Of the $300 benefit received each month by Steve, $265 of it is excludable from gross income. The balance of $35 is included in his gross income. The same result would occur if Steve paid for the parking and was reimbursed by his employer.

$300 - $265 = $35 included in gross income

****Damages

-A person who suffers harm caused by another is often entitled to compensatory damages. •The tax consequences of the receipt of damages depend on the type of harm the taxpayer has experienced. The taxpayer may seek recovery for •(1) a loss of income •(2) expenses incurred •(3) property destroyed or •(4) personal injury.

Fringe Benefits

-Benefits other than wages and salary that are provided to employees by the employer are often referred to as fringe benefits.

Notes on Gifts and Inheritances Slide:

-Some exclusions are intended as tax relief measures, such as the exclusion on up to $500,000 of gain from sale of a principal residence. Others are to encourage and support certain activities, such as higher education. Some exclusions relate to design of the income tax. For example, damages received for physical injury are excluded under the premise that they are restoring damage to one's body rather than increasing one's personal wealth. -At times, Congress responds to specific events. For example, in 2001, Congress enacted § 139, Disaster Relief Payment, to ensure that victims of a qualified disaster (disaster resulting from a terrorist attack, Presidentially-declared disaster, or common carrier accident of a catastrophic nature) could exclude from gross income payments received for living expenses, funeral expenses, and property damage resulting from the disaster. -For some types of transactions, the IRS does not tax what is in fact income because the revenue involved is not worth the collection effort or it is too difficult to measure the income. For example, the IRS has decided that it will not attempt to tax the value of frequent flier miles earned on airline tickets purchased for business use.

****Damages:

-The recovery of an expense is not income unless the expense was deducted. ->• Tax benefit rule ->• Ex: Business car - Basis $10,000 - Insurance proceeds $11,000 - gain of $1,000 -Damages for personal injuries receive special treatment under the Code. ->•Compensatory damages—Under specified circumstances, compensatory damages may be excluded from gross income ->•Benefits collected under a disability policy purchased by the taxpayer are excludable. However, disability benefits received from a policy paid by the employer is reported as income by the employee. •Compensatory damages are excluded from gross income, even though the amount replaces a loss of income, if the amount was received as a result of physical personal injury. [DQ.05-07] • Punitive damages—always part of gross income

De Minimis Fringes

-These benefits are so small that accounting for them is impractical and thus excludible • Examples include: ->• Occasional supper money or taxi fare for employees because of overtime work (Public Accounting) ->•Occasional personal use of company copying machine ->•Occasional company cocktail parties or picnics for employees—campus lunch with recruiters ->•Certain holiday gifts of property with a low fair market value •Subsidized eating facilities operated by employer are excluded if: ->•Located on or near employer's business premises—inspires more work ->•Revenue equals or exceeds direct operating costs ->•Nondiscrimination requirements are met—all employees not just executives

Tax Drill: Transferred Insurance Policy: Leland pays premiums of $5,000 for an insurance policy in the face amount of $25,000 upon the life of Caleb and subsequently transfers the policy to Tyler for $7,500. Over the years, Tyler pays subsequent premiums of $1,500 on the policy. Upon Caleb's death, Tyler receives the proceeds of $25,000. As a result Tyler is required to include $____________ in his gross income?

-Tyler includes $16,000 in gross income [$25,000-($7,500 paid for policy + $1,500 in subsequent premiums pd.)] = $16,000 -There are exceptions to the general rule that life insurance proceeds paid to the beneficiary because of the death of the insured are exempt from income tax. -A life insurance policy (other than one associated with accelerated death benefits) may be transferred after it is issued by the insurance company. If the policy is transferred for valuable consideration, the insurance proceeds are includible in the gross income of the transferee to the extent the proceeds received exceed the amount paid for the policy by the transferee plus any subsequent premiums paid.

****Damages: Explanation

-Usually, reimbursement for a loss of income is taxed the same as the income replaced. -The recovery of an expense is 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. -A payment for damaged or destroyed property is treated as an amount received in a sale or exchange of the property. Thus, the taxpayer has a realized gain if the damages payments received exceed the property's basis. Damages for personal injuries receive special treatment under the Code. -In terms of personal injury damages, a distinction is made between compensatory damages and punitive damages. Under specified circumstances, compensatory damages may be excluded from gross income. Under no circumstances may punitive damages be excluded from gross income. -The income tax treatment of accident and health insurance benefits, as well as income replacement policies, depends on whether the policy providing the benefits was purchased by the taxpayer or the taxpayer's employer. Benefits collected under a disability policy purchased by the taxpayer are excludable. However, disability benefits received from a policy paid by the employer is reported as income by the employee.

****Concept Summary 5.2- Employee Fringe Benefits

Photo important

Accelerated Death Benefits Ex: Example 4: Tom owned a term life insurance policy at the time he was diagnosed as having a terminal illness. After paying $5,200 in premiums, he sold the policy to Amber Benefits, Inc., a company that is authorized by the state of Virginia to purchase such policies. Amber paid Tom $50,000. When Tom died six months later, Amber collected the face amount of the policy, $75,000.

Tom is not required to include the $44,800 gain ($50,000 - $5,200) on the sale of the policy in his gross income.

*****Damages Chart:

Type of Claim: 1.) Breach of Contract (generally loss of income) - Taxable 2.)Property Damage- Gain to the extent damages received exceed basis. A loss is deductible for business property and investment property to the extent of basis over the amount realized. In certain cases, a loss may be deductible for personal use property. 3.)Personal Injury (physical & nonphysical): --> Physical Injury: All compensatory amounts are excluded unless previously deducted (e.g., medical expenses). Amounts received as punitive damages are included in gross income. Punitive damages ALWAYS TAXED. -->Non-physical Injury: Compensatory damages and punitive damages are included in gross income.

Qualified Transportation Ex: Eagle Life Insurance Company pays its employees $.30 per mile for driving their personal automobiles to and from work. The company reimburses each employee who rides the bus $100 a month for the cost of a pass. Tom, in his Mazda car, collected $100 for his automobile mileage and Mason received $100 as reimbursement for the cost of a bus pass. a. What are the effects of the $100 reimbursement on Tom and Mason's gross income? b. Assume that Tom and Mason are in the 24% marginal tax bracket and the actual before tax cost for Tom to drive to and from work is $.30 per mile. What are Tom's and Mason's after tax costs of commuting to and from work?

a. Tom INCLUDES and Mason EXCLUDES the $100 in gross income. b. Tom: Tax cost of benefit=($100 x .24)=$24 Mason: Not income so no tax cost reimbursement is NOT taxable

Tax Drill: Damages for Personal Injuries: T/F a. Compensatory damages received on account of physical personal injury or physical sickness can be excluded from gross income. b. A payment for damaged or destroyed property is treated as an amount received in a sale or exchange of the property. c. Compensatory damages awarded on account of emotional distress cannot be excluded. d. Punitive damages are excluded from gross income. e. Compensatory damages received for age discrimination or injury to one's reputation cannot be excluded.

a. True b. True c. True d. False e. True

Tax Drill: Are Conditions that need to be satisfied in order for employer death benefits payments to beneficiaries to be considered a gift, Yes/ No? a. The payments were made to the surviving spouse and children rather than to the employee's estate. b. The employer derived no benefit from the payments. c. The surviving spouse and children performed no services for employer. d. The decedent had been fully compensated for services rendered. e. Payments represent earnings of the decedent that were not paid by prior to death. (earned wages not received b4 death) f. Payments were made pursuant to be a board of directors' resolution that followed a general company policy of providing payments for families of deceased employees.

a. Yes b. Yes c. Yes d. Yes e. No f. Yes

Qualified Employee Discounts Ex:

need to add

Transfer for Valuable Consideration Examples:

• Example 6: Adam pays premiums of $4,000 for an insurance policy that has a face amount of $10,000 on the life of Beth and subsequently transfers the policy to Carol for $6,000. Upon Beth's death, Carol receives the proceeds of $10,000. The amount Carol can exclude from gross income is limited to $6,000 plus any premiums she paid subsequent to the transfer. •Example 7:When Logan's daughter Emily was born, he purchased an insurance policy on her life. 24 years later after Emily graduated from college and married, Logan sold her the policy for its fair value. When Emily dies, the transfer for consideration rules will not apply. Because the transfer was to the insured, the policy proceeds paid to Emily's beneficiaries will be excluded from the recipient's gross income. The results would be the same if Logan gave (rather than sold) the policy to Emily. -A life insurance policy (other than one associated with accelerated death benefits) may be transferred after it is issued by the insurance company. If the policy is transferred for valuable consideration, the insurance proceeds are includible in the gross income of the purchaser to the extent the proceeds received exceed the amount paid for the policy plus any subsequent premiums paid. -The Code, however, provides 5 exceptions to the rule illustrated in Example 6. Exclusion treatment is allowed for transfers to the following: 1.)The insured under the policy.A partner of the insured. 2.)A partnership in which the insured is a partner. 3.)A corporation in which the insured is an officer or a shareholder. 4.)A transferee whose basis in the policy is determined by reference to the transferor's basis. 5.)Applies to policies that were transferred in a tax-free exchange or were received by gift.

Life Insurance Proceeds (Reinvestment of LI Proceeds)

• Investment earnings arising from the reinvestment of life insurance proceeds are generally subject to income tax ->• Beneficiary will elect to collect the insurance proceeds in installments -->•The annuity rules (chapter 3) are used to apportion the installment payment between the principal element (excludible) and the interest element (includible)

Damages

• Tax consequences of receipt of damages -> Depends on the type of harm taxpayer has experienced • The taxpayer may seek recovery for: ->• Loss of income -->Generally taxed the same as income replaced --->• Exceptions exist related to personal injury ->• Expenses incurred -->Reimbursement for expenses incurred --->Not income, unless the expense was deducted --->• If the expense was deducted, the damages are generally taxable under the tax benefit rule ->• Property destroyed -->• Treated as an amount received in a sale or exchange of the property -->•Thus,the taxpayer has a realized gain if damage payments exceed property's basis ->•Personal injury (receives special treatment) -->Compensatory damages received on account of physical personal injury or physical sickness are EXCLUDIBLE --->• Include 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 (paid by the person who caused the harm)

Life Insurance Proceeds (Transfers)

• Transfers for valuable consideration (if the taxpayer sells the policy) -->If policy is transferred for valuable consideration, proceeds are taxable to the extent they exceed amount paid for policy plus subsequent premiums paid -Exceptions exist for policy transfers to the following: -->• The insured under the policy -->• A partner of the insured -->• A partnership in which the insured is a partner -->• A corporation in which the insured is an officer or shareholder -->• A transferee whose basis in the policy is determined by reference to the transferor's basis -->• Applicable to policies transferred in a tax-free exchange or were received by gift

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 use or lose plan since reduction in pay cannot be recovered if covered expenses are less than expected •Recently issued I R S rules allow a 2&1⁄2 month grace period (until the fifteenth day of the third month after the end of the plan year) to use the funds for qualified expenses

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

Qualified Employee Discounts

•Are nontaxable if: ->Exclusion is not on real property or investment property ->Property or services must be from the same line of business in which the employee works ->In case of property, exclusion is limited to the gross profit component of the customer price ->In case of services, exclusion cannot exceed 20% of the customer price on services

Tax Benefit Rule

•If tax payer claims 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 -Example 33: An accrual basis taxpayer deducted as a loss a $1,000 receivable from a customer when it appeared the amount would never be collected. The following year, the customer paid $800 on the receivable. The taxpayer must report the $800 as gross income in the year it is received. -Example 34: Ali filed his 2018 income tax return as a single individual. His AGI for 2018 was $78,000. He had $12,600 in itemized deductions, including $6,200 in state income tax and no other state or local taxes. In 2019, he received a $700 refund of the state income taxes that he paid in 2018. Because the standard deduction in 2018 was $12,000, the $6,200 of state income taxes Ali paid in 2018 yielded a tax benefit from only $600 of the state income tax deduction ($12,600 itemized deductions − $12,000 standard deduction). Under the tax benefit rule, only $600 of the state income tax refund is included in gross income in 2019.

Working Condition Fringe

•Not taxable if the employee could deduct the cost of items if they had actually paid for them: ->•Can be made available on a discriminatory basis and still qualify for the exclusion

Meals and Lodging

•Not taxable to employee if: •Furnished by the employer ->•On the employer's business premises ->•For the convenience of the employer • In case of lodging, the employee is required to accept the lodging as a condition of employment • From 2018 through 2025, the employer may only deduct 50% of the cost of the meals provided (rather than 100%) ****BIG change during the TCJA -->•After 2025, employers may not claim any deduction for these meals • If the employer continues to provide such meals, their value remains as an exclusion for the employees

Qualified Transportation Fringes

•Qualified transportation fringe benefits encourage the use of mass transit for commuting to and from work. • Qualified transportation fringes include the following transportation benefits provided by the employer to the employee: ->Transportation in a commuter highway vehicle between the employee's residence and the place of employment. ->A transit pass. ->Qualified parking. ->Dollar limits will be provided.

Scholarships Exs:

•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 • Example 8: Terry enters a contest sponsored by a local newspaper. Each contestant is required to submit an essay on local environmental issues. The prize is one year's tuition at State University. Terry wins the contest. The newspaper has a legal obligation to Terry (as contest winner). As a result, the benefits are not a gift. However, because the tuition payment aids Terry in pursuing her studies, the payment is a scholarship. • Example 10: Kelly received an athletic scholarship from State University. The scholarship pays her tuition of $9,000 and books and supplies of $2,400. She also receives $4,500 a year for costs of attendance, which she uses to pay for housing, food, laundry, and transportation. The tuition and the cost of books and supplies are excluded from gross income as a scholarship. The $4,500 received as costs of attendance does not qualify for the scholarship exclusion, and Kelly must include that amount in her gross income.

Qualified Transportation Fringes

•This fringe benefit is designed to encourage the use of mass transit for commuting to and from work •Includes: ->•Transportation in commuter highway vehicle and transit passes -->Annual limit on the exclusion for 2019 is $265 per month -->Incentive to use public transportation • Qualified parking • Annual limit on the exclusion for 2019 is $265 per month •May be provided directly by the employer or may be in the form of cash reimbursements

Gifts and Inheritances

•Transfers that take effect upon the death of the donor and are nontaxable to beneficiary at the by the Federal government -Commissioner v. Duberstein, 363 U.S. 278 (1960)

No additional cost services

•Value of the services is nontaxable if: ->Employee receives services(not property) ->Employer incurs no substantial additional cost in providing the services ->Services offered are in the ordinary course of business in which the employee works ->Exclusion is not allowed to highly compensated employees unless it is available on a nondiscriminatory basis

Compensation for Injuries and Sickness

•Wrongful incarceration Section 139 F, enacted in 2015, exempts amounts received as damages for being wrongfully incarcerated -->The exclusion applies to an individual who was convicted of a Federal or state crime but is later exonerated • Workers' compensation—make sure you understand the difference between worker's compensation and unemployment compensation. -->• Although payments are intended to compensate for a loss of future income, workers' compensation is specifically excluded from gross income •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