Ch5 Book

Gifts and Inheritances: Legislative Intent

Beginning with the Income Tax Act of 1913 and continuing to the present, Congress has allowed the recipient of a gift to exclude the value of the property from gross income. The exclusion applies to gifts made during the life of the donor (inter vivos gifts) and transfers that take effect upon the death of the donor (bequests and inheritances). However, as discussed, the recipient of a gift of income-producing property is subject to tax on the income subsequently earned from the property. Also, as discussed, the donor or the decedent's estate may be subject to gift or estate taxes on the transfer. In numerous cases, gifts are made in a business setting. For example, a salesperson gives a purchasing agent free samples, an employee receives cash from his or her employer upon retirement, or a corporation makes payments to employees who were victims of a natural disaster. In these and similar instances, it is frequently unclear whether the payment was a gift or represents compensation for past, present, or future services. The courts have defined a gift as "a voluntary transfer of property by one to another without adequate [valuable] consideration or compensation therefrom." If the payment is intended to be for services rendered, it is not a gift, even though the payment is made without legal or moral obligation and the payor receives no economic benefit from the transfer. To qualify as a gift, the payment must be made "out of affection, respect, admiration, charity or like impulses." Thus, the cases on this issue have been decided on the basis of the donor's intent. In a landmark case, Comm. v. Duberstein, the taxpayer (Duberstein) received a Cadillac from a business acquaintance. Duberstein had supplied the businessman with the names of potential customers with no expectation of compensation. The Supreme Court concluded: ... despite the characterization of the transfer of the Cadillac by the parties [as a gift] and the absence of any obligation, even of a moral nature, to make it, it was at the bottom a recompense for Duberstein's past service, or an inducement for him to be of further service in the future. Duberstein was therefore required to include the fair market value of the automobile in gross income.

Employee Fringe Benefits: Flexible Spending Plans

Flexible spending plans (often referred to as flexible benefit plans) operate much like cafeteria plans. Under these plans, the employee accepts lower cash compensation (as much as $2,550 in 2015) in return for the employer agreeing to pay certain costs that the employer can pay without the employee recognizing gross income. For example, assume that the employer's health insurance policy does not cover dental expenses. The employee could estimate his or her dental expenses for the upcoming year and agree to a salary reduction equal to the estimated dental expenses. The employer then pays or reimburses the employee for the actual dental expenses incurred, with a ceiling of the amount of the salary reduction. If the employee's actual dental expenses are less than the reduction in cash compensation, the employee cannot recover the difference. Hence, these plans are often referred to as use or lose plans. To avoid forfeiture of unpaid amounts, the IRS allows a payment until March 15 of the following year to count. As is the case for cafeteria plans, flexible spending plans cannot be used to pay long-term care insurance premiums.

Gifts and Inheritances: Employer Payments to Employees

In the case of cash or other property received by an employee from his or her employer, Congress has eliminated any ambiguity. Transfers from an employer to an employee cannot be excluded as a gift.

Example 2

Mark purchases an insurance policy on his life and names his wife, Linda, as the beneficiary. Mark pays $45,000 in premiums. When he dies, Linda collects the insurance proceeds of $200,000. The $200,000 is exempt from Federal income tax.

Example 29

Megan purchases State of Virginia bonds for $10,000 on July 1, 2014. The bonds pay $400 interest each June 30 and December 31. On March 31, 2015, Megan sells the bonds for $10,500 plus $200 accrued interest. Megan must recognize a $500 gain ($10,500 - $10,000), but the $200 accrued interest is exempt from taxation.

Example 23

Mitch is a CPA employed by an accounting firm. The employer pays Mitch's annual dues to professional organizations. Mitch is not required to include the payment of the dues in gross income because if he had paid the dues, he would have been allowed to deduct the amount as an employee business expense.

Example 1 The Big Picture

Return to the facts of The Big Picture. The $1,500 paid to Paul by his summer employer was compensation for his services rather than a gift, even though the employer had not contracted to pay this additional amount. This results because the payment was most likely not motivated by the employer's generosity, but rather was made as a result of business considerations. Even if the payment had been made out of generosity, because the payment was received from his employer, Paul could not exclude the "gift."

Example 12 The Big Picture

Return to the facts of The Big Picture. The damages Paul received were awarded as a result of a physical personal injury. Therefore, all of the compensatory damages can be excluded. Note that 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 or sickness. Therefore, the $25,000 she received must be included in her gross income.

Example 20

Ryan is employed in New York as a ticket clerk for Trans National Airlines. He has a sick mother in Miami, Florida, but has no money for plane tickets. Trans National has daily flights from New York to Miami that often leave with empty seats. The cost of a round-trip ticket is $400. If Trans National allows Ryan to fly without charge to Miami, under the general gross income rules, Ryan has income equal to the value of a ticket. Therefore, Ryan must include $400 in gross income on a trip to Miami.

Example 26 Calculating the Exclusion

Sandra's trip to and from a foreign country in connection with her work were as follows: Arrived in Foreign Country | Returned to US March 10, 2014 | February 15, 2015 During the 12 consecutive months ending on March 10, 2015, Sandra was present in the foreign country for at least 330 days (365 days less 13 days in February and 10 days in March 2015). Therefore, all income earned in the foreign country through March 10, 2015, is eligible for the exclusion.

Example 7

When Logan's daughter Emily was born, he purchased an insurance policy on her life. Twenty-four 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 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.

Corporate Distributions to Shareholders: Stock Dividends

When a corporation issues a simple stock dividend (e.g., common stock issued to common shareholders), the shareholder has merely received additional shares that represent the same total investment. Thus, the shareholder does not realize income. However, if the shareholder has the option of receiving either cash or stock in the corporation, the individual realizes gross income whether he or she receives stock or cash. A taxpayer who elects to receive the stock could be deemed to be in constructive receipt of the cash he or she has rejected. However, the amount of the income in this case is the value of the stock received, rather than the cash the shareholder has rejected.

Example 22

Silver Corporation, which operates a department store, sells a television set to a store employee for $300. The regular customer price is $500, and the gross profit rate is 25%. The corporation also sells the employee a service contract for $120. The regular customer price for the contract is $150. The employee must include $75 in gross income. Customer price for property: $500 Less: Gross profit (25%): $(125) ----- $375 Employee price: $(300) == Income: $75 Customer price for service: $150 Less: 20%: $(30) ----- $120 Employee price: $(120) == Income: $-0-

Corporate Distributions to Shareholders: General Information

A corporate distribution is a payment to a shareholder with respect to his or her stock. Distributions are taxed as dividends to shareholders only to the extent the payments are made from either the corporation's current earnings and profits (similar to net income per books) or its accumulated earnings and profits (similar to retained earnings per books). Distributions that exceed earnings and profits are treated as a nontaxable recovery of capital and reduce the shareholder's basis in the stock. Once the shareholder's basis is reduced to zero, any subsequent distributions are taxed as capital gains. Some payments are frequently referred to as dividends but are not considered dividends for tax purposes: -Dividends received on deposits with savings and loan associations, credit unions, and banks are actually interest (a contractual rate paid for the use of money). -Patronage dividends paid by cooperatives (e.g., for farmers) are rebates made to the users and are considered reductions in the cost of items purchased from the association. The rebates are usually made after year-end (after the cooperative has determined whether it has met its expenses) and are apportioned among members on the basis of their purchases. -Mutual insurance companies pay dividends on unmatured life insurance policies that are considered rebates of premiums. -Shareholders in a mutual investment fund are allowed to report as capital gains their proportionate share of the fund's gains realized and distributed. The capital gain and ordinary income portions are reported on the Form 1099 that the fund supplies its shareholders each year.

Life Insurance Proceeds: Transfer for Valuable Consideration

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. The Code, however, provides four exceptions to the rule. These exceptions permit exclusion treatment for 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 a shareholder. -A transferee whose basis in the policy is determined by reference to the transferor's basis. The fifth exception applies to policies that were transferred pursuant to a tax-free exchange or were received by gift. Investment earnings arising from the reinvestment of life insurance proceeds are generally subject to income tax. Often the beneficiary will elect 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).

Compensation for Injuries and Sickness: 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. Generally, reimbursement for a loss of income is taxed the same as the income replaced (see the exception under Personal Injury below). 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. Personal Injury The legal theory of personal injury damages is that the amount received is intended "to make the plaintiff [the injured party] whole as before the injury." It follows that if the damages payments received were subject to tax, the after-tax amount received would be less than the actual damages incurred and the injured party would not be "whole as before the injury." In terms of personal injury damages, a distinction is made between compensatory damages and punitive damages. Compensatory damages are intended to compensate the taxpayer for the damages incurred. Only those compensatory damages received on account of physical personal injury or physical sickness can be excluded from gross income. Such exclusion treatment includes amounts received for loss of income associated with the physical personal injury or physical sickness. Compensatory damages awarded on account of emotional distress are not received on account of physical injury or physical sickness and thus cannot be excluded (except to the extent of any amount received for medical care) from gross income. Likewise, any amounts received for age discrimination or injury to one's reputation cannot be excluded. Punitive damages are amounts the person who caused the harm must pay to the victim as punishment for outrageous conduct. Punitive damages are not intended to compensate the victim, but rather to punish the party who caused the harm. Thus, it follows that amounts received as punitive damages may actually place the victim in a better economic position than before the harm was experienced. Thus, punitive damages are included in gross income. These rules are set forth in Concept Summary 5.1.

Example 33

A 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.

Income from Discharge of Indebtedness

A transfer of appreciated property (fair market value is greater than adjusted basis) in satisfaction of a debt is an event that triggers the realization of income. The transaction is treated as a sale of the appreciated property followed by payment of the debt. Foreclosure by a creditor is also treated as a sale or exchange of the property. In some cases, creditors will not exercise their right of foreclosure and will even forgive a portion of the debt to ensure the vitality of the debtor. In such cases, the debtor realizes income from discharge of indebtedness. The following discharge of indebtedness situations are subject to special treatment: 1. Creditors' gifts. 2. Discharges under Federal bankruptcy law. 3. Discharges that occur when the debtor is insolvent. 4. Discharge of the farm debt of a solvent taxpayer. 5. Discharge of qualified real property business indebtedness. 6. A seller's cancellation of the buyer's indebtedness. 7. A shareholder's cancellation of the corporation's indebtedness. 8. Forgiveness of certain loans to students. 9. Discharge of indebtedness on the taxpayer's principal residence that occurs between January 1, 2007, and January 1, 2015, and is the result of the financial condition of the debtor. If the creditor reduces the debt as an act of love, affection, or generosity, the debtor has simply received a nontaxable gift (situation 1). Rarely will a gift be found to have occurred in a business context. A businessperson may settle a debt for less than the amount due, but as a matter of business expediency (e.g., high collection costs or disputes as to contract terms) rather than generosity. 'In situations 2, 3, 4, 5, and 9, the Code allows the debtor to reduce his or her basis in the assets by the realized gain from the discharge. Thus, the realized gain is merely deferred until the assets are sold (or depreciated). Similarly, in situation 6 (a price reduction), the debtor reduces the basis in the specific assets financed by the seller. A shareholder's cancellation of the corporation's indebtedness to him or her (situation 7) usually is considered a tax-free contribution of capital to the corporation by the shareholder. Thus, the corporation's paid-in capital is increased, and its liabilities are decreased by the same amount. Many states make loans to students on the condition that the loan will be forgiven if the student practices a profession in the state upon completing his or her studies. The amount of the loan that is forgiven (situation 8) is excluded from gross income.

Example 6

Adam pays premiums of $4,000 for an insurance policy in the face amount of $10,000 upon 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 32

Agnes paid $20,000 into a qualified tuition program to be used for her son's college tuition. When her son graduated from high school, the fund balance had increased to $30,000 as a result of interest credited to the account. The interest was not included in Agnes's gross income. During the current year, $7,500 of the balance in the fund was used to pay the son's tuition and fees. None of this amount is included in either Agnes's or the son's gross income.

Example 34

Ali filed his 2014 income tax return as a single individual. His AGI for 2014 was $48,000. He had $6,350 in itemized deductions, including $1,200 in state income tax. His personal exemption was $3,950. In 2015, he received a $700 refund of the state income taxes that he paid in 2014. Because the standard deduction in 2014 was $6,200, the $1,200 of state income taxes Ali paid in 2014 yielded a tax benefit of only $150 ($6,350 itemized deductions − $6,200 standard deduction) in 2014. Under the tax benefit rule, only $150 of the state income tax refund is included in gross income in 2015.

Meals and Lodging: Other Housing Exclusions

An employee of an educational institution may be able to exclude the value of campus housing provided by the employer. Generally, the employee does not recognize income if he or she pays annual rents equal to or greater than 5 percent of the appraised value of the facility. If the rent payments are less than 5 percent of the value of the facility, the deficiency must be included in gross income. Ministers of the gospel and other religious leaders can exclude (1) the rental value of a home furnished as compensation; (2) a rental allowance paid to them as compensation, to the extent the allowance is used to rent, buy, or provide a home; or (3) the rental value of a home owned by the minister. The housing or housing allowance must be provided as compensation for the conduct of religious worship, the administration and maintenance of religious organizations, or the performance of teaching and administrative duties at theological seminaries. Military personnel are allowed housing exclusions under various circumstances. Authority for these exclusions generally is found in Federal laws that are not part of the Internal Revenue Code.

Employee Fringe Benefits: General Classes of Excluded Benefits

An employer can confer numerous forms and types of economic benefits on employees. Under the all-inclusive concept of income, the benefits are taxable unless one of the provisions previously discussed specifically excludes the item from gross income. The amount of the income is the fair market value of the benefit. Because Congress believed that taxing fringe benefits often yielded harsh results, § 132 was enacted to provide exclusion treatment. This provision established seven broad 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. The value of the services that the employer provides its employees are nontaxable under certain circumstances. No-Additional-Cost Services: Return to Example 20. This illustrates the reason for the no-additional-cost service type of fringe benefit. The services will be nontaxable if all of the following conditions are satisfied: -The employee receives services, as opposed to property. -The employer does not incur substantial additional cost, including forgone revenue, in providing the services to the employee. -The services are offered to customers in the ordinary course of the business in which the employee works. The no-additional-cost exclusion extends to the employee's spouse and dependent children and to retired and disabled former employees. However, the exclusion is not allowed to highly compensated employees unless the benefit is available on a nondiscriminatory basis. Qualified Employee Discounts: When the employer sells goods or services (other than no-additional-cost benefits just discussed) to the employee for a price that is less than the price charged regular customers, the employee realizes income equal to the discount. However, the discount, referred to as a qualified employee discount, can be excluded from the gross income of the employee, subject to the following conditions and limitations: -The exclusion is not available for real property (e.g., a house) or for personal property of the type commonly held for investment (e.g., 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 percent of the customer price. As in the case of no-additional-cost benefits, the exclusion applies to employees (including service partners), employees' spouses and dependent children, and retired and disabled former employees. Working Condition Fringes: Generally, an employee is not required to include in gross income the cost of property or services provided by the employer if the employee could deduct the cost of those items if he or she had actually paid for them. These benefits are called working condition fringes. Unlike the other fringe benefits discussed previously, working condition fringes can be made available on a discriminatory basis and still qualify for the exclusion. De Minimis Fringes: As the term suggests, de minimis fringe benefits are so small that accounting for them is impractical. The House Report contains the following examples of de minimis fringes: -Occasional personal use of a company copying machine, occasional company cocktail parties or picnics for employees, occasional supper money or taxi fare for employees because of overtime work, and certain holiday gifts of property with a low fair market value are excluded. -Subsidized eating facilities (e.g., an employees' cafeteria) operated by the employer are excluded if located on or near the employer's business premises, if revenue equals or exceeds direct operating costs, and if nondiscrimination requirements are met. When taxpayers venture beyond the specific examples contained in the House Report and the Regulations, there is obviously much room for disagreement as to what is de minimis. In Notice 2011-72, the IRS addressed the question of whether cell phones provided by the employer could be excluded from gross income as a working condition fringe benefit. Generally, the value of the cell phone can be excluded if it is provided for business reasons such as to enable the employee to be in contact with clients when the employee is away from the office. When the primary purpose test is satisfied, any personal use of the employer-provided cell phone will be excluded as a de minimis fringe benefit. Qualified Transportation Fringes: The intent of the exclusion for qualified transportation fringes is to encourage the use of mass transit for commuting to and from work. Qualified transportation fringes encompass 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. -Qualified bicycle commuting reimbursement. Statutory dollar limits are placed on the amount of the exclusion. Categories (1) and (2) above are combined for purposes of applying the limit. In this case, the limit on the exclusion for 2015 is $130 per month. Category (3) has a separate limit. For qualified parking, the limit on the exclusion for 2015 is $250 per month. Both of these dollar limits are indexed annually for inflation. A commuter highway vehicle is any highway vehicle with a seating capacity of at least six adults (excluding the driver). In addition, at least 80 percent of the vehicle's use must be for transporting employees between their residences and place of employment. Qualified parking includes the following: -Parking provided to an employee on or near the employer's business premises. -Parking provided to an employee on or near a location from which the employee commutes to work via mass transit, in a commuter highway vehicle, or in a carpool. The qualified bicycle commuting reimbursement enables an employee to 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). Qualified transportation fringes may be provided directly by the employer or may be in the form of cash reimbursements. Qualified Moving Expense Reimbursements: Qualified moving expenses that are reimbursed or paid by the employer are excludible from gross income. A qualified moving expense is an expense that would be deductible under § 217. Qualified Retirement Planning Services: Qualified retirement planning services include any retirement planning advice or information that an employer who maintains a qualified retirement plan provides to an employee or the employee's spouse. Congress decided to exclude the value of such services from gross income because they are a key part of retirement income planning. Such an exclusion should motivate more employers to provide retirement planning services to their employees. Nondiscrimination Provisions: For no-additional-cost services, qualified employee discounts, and qualified retirement planning services that are discriminatory in favor of highly compensated employees, exclusion treatment is denied. However, for the discriminatory plans, the exclusion treatment for non-highly compensated employees remains. De minimis (except in the case of subsidized eating facilities) and working condition fringe benefits can be provided on a discriminatory basis. The de minimis benefits are not subject to tax because the accounting problems that would be created are out of proportion to the amount of additional tax that would result. A review of employee fringe benefits is set forth in Concept Summary 5.2.

Example 31

Assume the same facts as in Example 30, except that Tracy's MAGI for 2015 is $80,000. The phaseout results in Tracy's interest exclusion being reduced by $311 {[($80,000 - $77,200)/$15,000] × $1,667}. Therefore, Tracy's exclusion is $1,356 ($1,667 - $311). If Pat's employer reduced Pat's salary by $2,000 (to $28,000) but paid his insurance premiums, Pat's tax liability would be only $7,000 ($28,000 [multiplication sign] .25). Thus, Pat would have $21,000 ($28,000 [minus sign] $7,000) to meet his other living needs. The change in the compensation plan would save Pat $500 ($21,000 [minus sign] $20,500), which is the marginal tax times the value of the insurance benefits, .25 [multiplication sign] $2,000 [equal sign] $500.

Meals and Lodging: General Rules for the Exclusion

As discussed, income can take any form, including meals and lodging. However, § 119 excludes from income the value of meals and lodging provided to the employee and the employee's spouse and dependents under the following conditions: -The meals and/or lodging are furnished by the employer on the employer's business premises for the convenience of the employer. -In the case of lodging, the employee is required to accept the lodging as a condition of employment. The courts have interpreted both of these requirements strictly. Furnished by the Employer: The following two questions have been raised with regard to the furnished by the employer requirement: -Who is considered an employee? -What is meant by furnished? The IRS and some courts have reasoned that because a partner is not an employee, the exclusion does not apply to a partner. However, the Tax Court and the Fifth Circuit Court of Appeals have ruled in favor of the taxpayer on this issue. The Supreme Court held that a cash meal allowance was ineligible for the exclusion because the employer did not actually furnish the meals. Similarly, one court denied the exclusion where the employer paid for the food and supplied the cooking facilities but the employee prepared the meal. On the Employer's Business Premises: The on the employer's business premises requirement, applicable to both meals and lodging, has resulted in much litigation. The Regulations define business premises as simply "the place of employment of the employee." Thus, the Sixth Circuit Court of Appeals held that a residence, owned by the employer and occupied by an employee, two blocks from the motel that the employee managed was not part of the business premises. However, the Tax Court considered an employer-owned house across the street from the hotel that was managed by the taxpayer to be on the business premises of the employer. Apparently, the closer the lodging is to the business operations, the more likely the convenience of the employer is served. For the Convenience of the Employer: The convenience of the employer test is intended to focus on the employer's motivation for furnishing the meals and lodging rather than on the benefits received by the employee. If the employer furnishes the meals and lodging primarily to enable the employee to perform his or her duties properly, it does not matter that the employee considers these benefits to be a part of his or her compensation. The Regulations give the following examples in which the tests for excluding meals are satisfied: -A restaurant requires its service staff to eat their meals on the premises during the busy lunch and breakfast hours. -A bank furnishes meals on the premises for its tellers to limit the time the employees are away from their booths during the busy hours. -A worker is employed at a construction site in a remote part of Alaska. The employer must furnish meals and lodging due to the inaccessibility of other facilities. Required as a Condition of Employment: The employee is required to accept test applies only to lodging. If the employee's use of the housing would serve the convenience of the employer but the employee is not required to use the housing, the exclusion is not available.

Example 5

Assume that Amber in Example 4 paid additional premiums of $4,000 during the six months it owned the policy. When Amber collects the life insurance proceeds of $75,000, it must include the $21,000 gain [$75,000 proceeds − ($50,000 cost + $4,000 additional premiums paid)] in gross income.

Interest on Certain State and Local Government Obligations

At the time the Sixteenth Amendment was ratified by the states, there was some question as to whether the Federal government possessed the constitutional authority to tax interest on state and local government obligations. Taxing such interest was thought to violate the doctrine of intergovernmental immunity in that the tax would impair the state and local governments' ability to finance their operations. Thus, interest on state and local government obligations was specifically exempted from Federal income taxation. However, the Supreme Court has concluded that there is no constitutional prohibition against levying a nondiscriminatory Federal income tax on state and local government obligations. Nevertheless, currently, the statutory exclusion still exists. Obviously, the exclusion of the interest reduces the cost of borrowing for state and local governments. A taxpayer in the 35 percent tax bracket requires only a 5.2 percent yield on a tax-exempt bond to obtain the same after-tax income as a taxable bond paying 8 percent interest [5.2% / (1-.35) = 8%] . The current exempt status applies solely to state and local government bonds. Thus, income received from the accrual of interest on a condemnation award or an overpayment of state income tax is fully taxable. Nor does the exemption apply to gains on the sale of tax-exempt securities. Although the Internal Revenue Code excludes from Federal gross income the interest on state and local government bonds, the interest on U.S. government bonds is not excluded from the Federal tax base. Congress has decided, however, that if the Federal government is not to tax state and local bond interest, the state and local governments are prohibited from taxing interest on U.S. government bonds. While this parity between the Federal and state and local governments exists in regard to taxing each other's obligations, the states are free to tax one another's obligations. Thus, some states exempt the interest on the bonds they issue, but tax the interest on bonds issued by other states.

Employee Fringe Benefits

Benefits other than wages and salary that are provided to employees by the employer are often referred to as fringe benefits. Generally, Congress decided that the availability of these benefits serve social goals. Moreover, the income tax exclusion will provide an incentive for employees to bargain for these fringe benefits in lieu of cash, thus increasing the use of this form of compensation. For example, if the employee is in the 25 percent marginal tax bracket, $1.00 of nontaxable fringe benefits is equivalent to $1.33 ($1.00/(1-.25)=$1.33) in taxable compensation. From the employer's perspective then, it costs only $1.00 to provide $1.33 in value to that employee in the form of a tax-favored fringe benefit. Various fringe benefits have been discussed (e.g., group term life insurance, accident and health insurance, and meals and lodging). Other employee benefits are discussed below.

Example 13 Exempt Benefits

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.

Employer-Sponsored Accident and Health Plans

Congress encourages employers to provide employees, retired former employees, and their dependents with accident and health benefits, disability insurance, and long-term care plans. The premiums are deductible by the employer and excluded from the employee's income. Although § 105(a) provides the general rule that the employee has includible income when he or she collects the insurance benefits, two exceptions are provided. Section 105(b) generally excludes payments received for medical care of the employee, spouse, and dependents. However, if the payments are for expenses that do not meet the Code's definition of medical care, the amount received must be included in gross income. In addition, the taxpayer must include in gross income any amounts received for medical expenses that were deducted by the taxpayer on a prior return. Section 105(c) excludes payments for the permanent loss or the loss of the use of a member or function of the body or the permanent disfigurement of the employee, the spouse, or a dependent. Payments that are a substitute for salary (e.g., related to the period of time absent) are includible.

Employee Fringe Benefits: Specific Benefits

Congress has dealt specifically with some other fringe benefits, which are summarized below. •The employee does not have to include in gross income the value of child and dependent care services paid for by the employer and incurred to enable the employee to work. The exclusion cannot exceed $5,000 per year ($2,500 if married and filing separately). For a married couple, the annual exclusion cannot exceed the earned income of the spouse who has the lesser amount of earned income. For an unmarried taxpayer, the exclusion cannot exceed the taxpayer's earned income. •The value of the use of a gymnasium or other athletic facilities by employees, their spouses, and their dependent children may be excluded from an employee's gross income. The facilities must be on the employer's premises, and substantially all of the use of the facilities must be by employees and their family members. •Qualified employer-provided educational assistance (tuition, fees, books, and supplies) at the undergraduate and graduate level is excludible from gross income. The exclusion does not cover meals, lodging, and transportation costs. In addition, it does not cover educational payments for courses involving sports, games, or hobbies. The exclusion is subject to an annual employee statutory ceiling of $5,250. •The employee can exclude from gross income up to $13,400 of expenses incurred to adopt a child where the adoption expenses are paid or reimbursed by the employer under a qualified adoption assistance program. The limit on the exclusion is the same even if the child has special needs (is not physically or mentally capable of caring for himself or herself). However, for a child with special needs, the $13,400 exclusion from gross income applies even if the actual adoption expenses are less than that amount. For 2015, the exclusion is phased out as adjusted gross income increases from $201,010 to $241,010.

Example 25

Dove Company's officers are allowed to purchase goods from the company at a 25% discount. All other employees are allowed only a 15% discount. The company's gross profit margin on these goods is 30%. Because the officers receive more favorable discounts, the plan is discriminatory in favor of the officers. In regard to all other employees, the discount is "qualified" because it is available to all employees (other than the officers who receive a more favorable discount) and the discount is less than the company's gross profit. Peggy, an officer in the company, purchased goods from the company for $750 when the price charged to customers was $1,000. Peggy must include $250 in gross income because the plan is discriminatory. Mason, an employee of the company who is not an officer, purchased goods for $850 when the customer price was $1,000. Mason is not required to recognize gross income because he received a qualified employee discount.

Gifts and Inheritances: Employee Death Benefits

Frequently, an employer makes payments (death benefits) to a deceased employee's surviving spouse, children, or other beneficiaries. If the decedent had a nonforfeitable right to the payments (e.g., the decedent's accrued salary), the amounts are generally taxable to the recipient as if the employee had lived and collected the payments. But when the employer makes voluntary payments, the gift issue arises. Generally, the IRS considers such payments to be compensation for prior services rendered by the deceased employee. However, some courts have held that payments to an employee's surviving spouse or other beneficiaries are gifts if the following are true: The payments were made to the surviving spouse and children rather than to the employee's estate. The employer derived no benefit from the payments. The surviving spouse and children performed no services for the employer. The decedent had been fully compensated for services rendered. Payments were made pursuant to a board of directors' resolution that followed a general company policy of providing payments for families of deceased employees (but not exclusively for families of shareholder-employees). When all of the above conditions are satisfied, the payment is presumed to have been made as an act of affection or charity. When one or more of these conditions is not satisfied, the surviving spouse and children may still be deemed the recipients of a gift if the payment is made in light of the survivors' financial needs. Income earned by an employee that was not received by the employee prior to his or her death is not an employee death benefit. These earnings are referred to as "income in respect of a decedent" and are generally taxable income to the decedent's beneficiary. This is another rare instance (see Alimony) where the beneficiary of the income, rather than the person who earned the income, is subject to tax.

Scholarships: Timing Issues

Frequently, the scholarship recipient is a cash basis taxpayer who receives the money in one tax year but pays the educational expenses in a subsequent year. The amount eligible for exclusion may not be known at the time the money is received. In that case, the transaction is held open until the educational expenses are paid.

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. However, the § 111 tax benefit rule provides that no income is recognized upon the recovery of a deduction, or the portion of a deduction, that did not yield a tax benefit in the year it was taken. If the taxpayer in Example 33 had no tax liability in the year of the deduction (e.g., itemized deductions and personal exemptions exceeded adjusted gross income), the recovery would be partially or totally excluded from gross income in the year of the recovery.

Example 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.

Tax Planning: Employee Fringe Benefits

Generally, employees view accident and health insurance, as well as life insurance, as necessities. Employees can obtain group coverage at much lower rates than individuals would have to pay for the same protection. Premiums paid by the employer can be excluded from the employees' gross income. Because of the exclusion, employees will have a greater after-tax and after-insurance income if the employer pays a lower salary but also pays the insurance premiums. Similarly, employees must often incur expenses for child care and parking. The employee can have more income for other uses if the employer pays these costs for the employee but reduces the employee's salary by the cost of the benefits. The use of cafeteria plans has increased dramatically in recent years. These plans allow employees to tailor their benefits to meet their individual situations. Thus, where both spouses in a married couple are working, duplications of benefits can be avoided and other needed benefits can often be added. If less than all of the employee's allowance is spent, the employee can receive cash. The meals and lodging exclusion enables employees to receive from their employer what they ordinarily must purchase with after-tax dollars. Although the requirements that the employee live and take his or her meals on the employer's premises limit the tax planning opportunities, the exclusion is an important factor in the employee's compensation in certain situations (e.g., hotels, motels, restaurants, farms, and ranches). The meals and lodging are clearly a benefit to the employee but are for the convenience of the employer and thus are excluded from income. The employees' discount provision is especially important for manufacturers and wholesalers. Employees of manufacturers can avoid tax on the manufacturer's, wholesaler's, and retailer's markups. The wholesaler's employees can avoid tax on an amount equal to the wholesale and retail markups. It should be recognized that the exclusion of benefits is generally available only to employees. Proprietors and partners must pay tax on the same benefits their employees receive tax-free. By incorporating and becoming an employee of the corporation, the former proprietor or partner can also receive these tax-exempt benefits. Thus, the availability of employee benefits is a consideration in the decision to incorporate.

Employee Fringe Benefits: Cafeteria Plans

Generally, if an employee is offered a choice between cash and some other form of compensation, the employee is deemed to have constructively received the cash even when the noncash option is elected. Thus, the employee has gross income regardless of the option chosen. An exception to this constructive receipt treatment is provided under the cafeteria plan rules. Under such a plan, the employee is permitted to choose between cash and nontaxable benefits (e.g., group term life insurance, health and accident protection, child care). If the employee chooses the otherwise nontaxable benefits, the cafeteria plan rules enable the benefits to remain nontaxable. Cafeteria plans provide tremendous flexibility in tailoring the employee pay package to fit individual needs. Some employees (usually the younger group) prefer cash, while others (usually the older group) will opt for the fringe benefit program.

Life Insurance Proceeds: Accelerated Death Benefits

Generally, if the owner of a life insurance policy cancels the policy and receives the cash surrender value, the taxpayer must recognize gain equal to the excess of the amount received over premiums paid on the policy (a loss is not deductible). The gain is recognized because the general exclusion provision for life insurance proceeds applies only to life insurance proceeds paid upon the death of the insured. If the taxpayer cancels the policy and receives the cash surrender value, the life insurance policy is treated as an investment by the insured. In a limited circumstance, however, the insured is permitted to receive the benefits of the life insurance contract without having to include the gain in gross income. Under the accelerated death benefits provisions, exclusion treatment is available for insured taxpayers who are either terminally ill or chronically ill. A terminally ill taxpayer can collect the cash surrender value of the policy from the insurance company or assign the policy proceeds to a qualified third party. The resultant gain, if any, is excluded from the insured's gross income. A terminally ill individual is a person whom a medical doctor certifies as having an illness that is reasonably expected to cause death within 24 months. In the case of a chronically ill patient, no gain is recognized if the proceeds of the policy are used for the long-term care of the insured. A person is chronically ill if he or she is certified as being unable to perform without assistance certain activities of daily living. These exclusions for the terminally ill and the chronically ill are available only to the insured. Thus, a person who purchases a life insurance policy from the insured does not qualify.

Employer-Sponsored Accident and Health Plans: Long-Term Care Insurance Benefits

Generally, long-term care insurance, which covers expenses such as the cost of care in a nursing home, is treated the same as accident and health insurance benefits. Thus, the employee does not recognize income when the employer pays the premiums. Also, the individual who purchases his or her own policy can exclude the benefits from gross income. However, statutory limitations (indexed for inflation) exist for the following amounts: -Premiums paid by the employer. -Benefits collected under the employer's plan. -Benefits collected from the individual's policy. The employer or insurance company generally provides the employee with information on the amount of his or her taxable benefits. The maximum amount excluded must be reduced by any amount received from third parties (e.g., Medicare, Medicaid). The exclusion for long-term care insurance is not available if it is provided as part of a cafeteria plan or a flexible spending plan.

Example 3

Gold Corporation purchases a life insurance policy to cover its 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.

Example 24

Gray Corporation's offices are located in the center of a large city. The company pays for parking spaces to be used by the company officers. Steve, a vice president, receives $300 of such benefits each month. The parking space rental qualifies as a qualified transportation fringe. Of the $300 benefit received each month by Steve, $250 is excludible from gross income. The balance of $50 is included in his gross income. The same result would occur if Steve paid for the parking and was reimbursed by his employer.

Example 19

Hawk Corporation offers its employees (on a nondiscriminatory basis) a choice of any one or all of the following benefits: Benefit || Cost Group term life insurance $200 Hospitalization insurance for family members $2,400 Child care payments $1,800 _______ $4,400 If a benefit is not selected, the employee receives cash equal to the cost of the benefit. Kay, an employee, has a spouse who works for another employer that provides hospitalization insurance but no child care payments. Kay elects to receive the group term life insurance, the child care payments, and $2,400 of cash. Only the $2,400 must be included in Kay's gross income.

Example 17

Hazel, who suffers from Alzheimer's disease, is a patient in a nursing home for the last 30 days of 2015. While in the nursing home, she incurs total costs of $7,600. Medicare pays $3,200 of the costs. Hazel receives $7,000 from her long-term care insurance policy, which pays while she is in the facility. The amount Hazel may exclude is calculated as follows: Greater of: -Daily statutory amount in 2015 ($330 x 30 days)=9,900 -Actual cost of the care=7,600 ===$9,900 Less: Amount received from Medicare=($3,200) ___________ Amount of exclusion= $6,700 Therefore, Hazel must include $300 ($7,000 − $6,700) of the long-term care benefits received in her gross income.

Example 28

In 2015, Carol, who is not married, had taxable income of $30,000 after excluding $100,800 of foreign earned income. Without the benefit of the exclusion, Carol's taxable income would have been $130,800 ($30,000 + $100,800). The tax on the taxable income of $30,000 is calculated using the marginal rate applicable to income between $99,200 and $129,200, which is 28%. Therefore, Carol's tax liability is $8,400 (.28 × $30,000).

Example 15

In 2015, Tab's employer-sponsored health insurance plan pays $4,000 for hair transplants that do not meet the Code's definition of medical care. Tab must include the $4,000 in his gross income for 2015.

Example 10

In August 2015, Sanjay received $10,000 as a scholarship for the academic year 2015-2016. Sanjay's expenditures for tuition, books, and supplies were as follows: Aug- Dec 2015: $3,000 Jan- May 2016: $4,500 = $7,500 Sanjay's gross income for 2016 includes $2,500 ($10,000 − $7,500) that is not excludible as a scholarship. None of the scholarship is included in his gross income in 2015.

Example 21

In Example 20, although the airplane may burn slightly more fuel because Ryan is on board and he may receive the same snacks and meals as paying customers, the additional costs to the airline would not be substantial. Thus, the trip could qualify as a no-additional-cost service, and the value of Ryan's flight can be excluded from his gross income.

Qualified ABLE Programs (§ 529A Plans)

In late 2014, a law change created a new type of program to assist individuals who became blind or disabled before age 26. The qualified ABLE program allows for § 529A plans, or ABLE (Achieving a Better Life Experience) plans, similar in concept to § 529 plans described earlier. The program must be established by a state. The ABLE account must be for the benefit of a designated beneficiary's disability expenses, and the beneficiary must have a disability certification from the government. Contributions to the account must be in cash and may not exceed the annual gift tax exclusion for the year ($14,000 for 2015). Contributions to the account are not deductible. The tax benefit of an ABLE account is that its earnings are not taxable. Distributions from the account also are not taxable provided they do not exceed the qualified disability expenses of the designated beneficiary.

Employer-Sponsored Accident and Health Plans: Medical Reimbursement Plans

In lieu of providing the employee with insurance coverage for hospital and medical expenses, the employer may agree to reimburse the employee for these expenses. The amounts received through the insurance coverage (insured plan benefits) are excluded from income under § 105 (as previously discussed). Unfortunately, in terms of cost considerations, the insurance companies that issue this type of policy usually require a broad coverage of employees. An alternative is to have a plan that is not funded with insurance (a self-insured arrangement). The benefits received under a self-insured plan can be excluded from the employee's income if the plan does not discriminate in favor of highly compensated employees. There is also an alternative means of accomplishing a medical reimbursement plan. The employer can purchase a medical insurance plan with a high deductible (e.g., the employee is responsible for the first $2,600 of the family's medical expenses) and then make contributions to the employee's Health Savings Account (HSA). The employer can make contributions each month up to the maximum contribution of 100 percent of the deductible amount. The monthly deductible amount is limited to one-twelfth of $3,350 under a high-deductible plan for self-only coverage. The monthly amount for an individual who has family coverage is limited to one-twelfth of $6,650 under a high-deductible plan. Withdrawals from the HSA must be used to reimburse the employee for the medical expenses paid by the employee that are not covered under the high-deductible plan. The employee is not taxed on the employer's contributions to the HSA, the earnings on the funds in the account, or the withdrawals made for medical expenses.

Example 16

Jill loses an eye in an automobile accident unrelated to her work. As a result of the accident, Jill incurs $2,000 of medical expenses, which she deducts on her return. She collects $10,000 from an accident insurance policy carried by her employer. The benefits are paid according to a schedule of amounts that vary with the part of the body injured (e.g., $10,000 for loss of an eye and $20,000 for loss of a hand). Because the payment is for loss of a member or function of the body, the $10,000 is excluded from gross income. Jill is absent from work for a week as a result of the accident. Her employer provides her with insurance for the loss of income due to illness or injury. Jill collects $500, which is includible in gross income.

Example 35

Juan owns land that serves as security for a $50,000 mortgage held by State Bank. Juan does not have personal liability for the mortgage (it is non-recourse debt). When Juan's basis in the land is $20,000 and the land's fair market value is $50,000, the bank forecloses on the loan and takes title to the land. Juan must recognize a $30,000 gain on the foreclosure, as though he sold the land for $50,000.

Example 36

Kayla is personally liable on a mortgage on her office building, but she is unable to make the payments. Both Kayla and the mortgage holder are aware of the depressed market for real estate in the area. Foreclosure would only result in the creditor's obtaining unsalable property. The creditor agrees to forgive all amounts past due and to reduce the principal amount of the mortgage. Because Kayla was personally liable on the debt (it is recourse debt), she must recognize income equal to the amount of the forgiven debt, unless one of the exceptions applies.

Example 27 Calculating the Exclusion

Keith qualifies for the foreign earned income exclusion. He was present in France for all of 2015. Keith's salary for 2015 is $120,000. Because all of the days in 2015 are qualifying days, Keith can exclude $100,800 of his $120,000 salary. Assume instead that only 335 days were qualifying days. Then Keith's exclusion is limited to $92,515, computed as follows: $100,800 x (335 days in foreign country / 365 days in the year) = $92,515

Example 9

Kelly receives a scholarship of $9,500 from State University to be used to pursue a bachelor's degree. She spends $4,000 on tuition, $3,000 on books and supplies, and $2,500 for room and board. Kelly may exclude $7,000 ($4,000 + $3,000) from gross income. The $2,500 spent for room and board is includible in Kelly's gross income.

Example 18

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.

Tax Planning: Life Insurance

Life insurance offers several favorable tax attributes. As discussed, the annual increase in the cash surrender value of the policy is not taxable (because no income has been actually or constructively received). By borrowing on the policy's cash surrender value, the owner can actually receive the policy's increase in value in cash without recognizing income.

Life Insurance Proceeds: General Rule

Life insurance proceeds paid to the beneficiary because of the death of the insured are exempt from income tax. Congress chose to exempt life insurance proceeds for the following reasons: For family members, life insurance proceeds serve much the same purpose as a nontaxable inheritance. In a business context (as well as in a family situation), life insurance proceeds replace an economic loss suffered by the beneficiary. Thus, in general, Congress concluded that making life insurance proceeds exempt from income tax was a good policy.

Qualified Tuition Programs (§ 529 Plans)

Nearly all, if not all, states have created programs whereby parents can in effect prepay their child's college tuition. The prepayment serves as a hedge against future increases in tuition. Generally, if the child does not attend college, the parents are refunded their payments plus interest. Upon first impression, these prepaid tuition programs resemble the below-market loans. That is, assuming that the tuition increases, the parent receives a reduction in the child's tuition in exchange for the use of the funds. However, Congress has created an exclusion provision for these programs. Under a qualified tuition program (§ 529 plan), the amounts contributed must be used for qualified higher education expenses. These expenses include tuition, fees, books, supplies, room and board, and equipment required for enrollment or attendance at a college, a university, or certain vocational schools. The allowable expenses include computers and computer technology, including software that provides access to the Internet. Qualified higher education expenses also include the expenses for special needs services that are incurred in connection with the enrollment and attendance of special needs students. The earnings of the contributed funds, including the discount on tuition charged to participants, are not included in Federal gross income provided the contributions and earnings are used for qualified higher education expenses. Some states also exclude these educational benefits from state gross income. If the parent receives a refund (e.g., child does not attend college), the excess of the amount refunded over the amount contributed by the parent is included in the parent's gross income. Qualified tuition programs have been expanded to apply to private educational institutions as well as public educational institutions.

Example 37

Pat receives a salary of $30,000. The company has group insurance benefits, but Pat is required to pay his own premiums as follows: Hospitalization and medical insurance: $1,400 Term life insurance ($30,000 coverage): $200 Disability insurance: $400 = $2,000 To simplify the analysis, assume that Pat's tax rate on income is 25%. After paying taxes of $7,500 (.25 × $30,000) and $2,000 for insurance, Pat has $20,500 ($30,000 - $7,500 - $2,000) for his other living needs. If Pat's employer reduced Pat's salary by $2,000 (to $28,000) but paid his insurance premiums, Pat's tax liability would be only $7,000 ($28,000 × .25). Thus, Pat would have $21,000 ($28,000 - $7,000) to meet his other living needs. The change in the compensation plan would save Pat $500 ($21,000 - $20,500), which is the marginal tax times the value of the insurance benefits (.25 x $2,000 = $500).

Scholarships: General Information

Payments or benefits received by a student at an educational institution may be (1) compensation for services, (2) a gift, or (3) a scholarship. If the payments or benefits are received as compensation for services (past or present), the fact that the recipient is a student generally does not render the amounts received nontaxable. Thus, a university teaching or research assistant is generally considered an employee, and his or her stipend is taxable compensation for services rendered. On the other hand, athletic scholarships generally are nontaxable when the individual is not required to participate in the sport. In general, amounts received to be used for educational purposes (other than amounts received from family members) cannot be excluded as gifts because conditions attached to the receipt of the funds mean that the payments were not made out of "detached generosity." The scholarship rules are intended to provide exclusion treatment for education-related benefits that cannot qualify as gifts but are not compensation for services. According to the Regulations, "a scholarship is an amount paid or allowed to, or for the benefit of, an individual to aid such individual in the pursuit of study or research." The recipient must be a candidate for a degree at an educational institution. As an exception to the compensation for services, nonprofit educational institutions can provide qualified tuition reduction plans for their employees and the employees can exclude the tuition from their gross income. The exclusion also applies to tuition reductions granted to the employee's spouse and the employee's dependent children. A scholarship recipient may exclude from gross income the amount used for tuition and related expenses (fees, books, supplies, and equipment required for courses), provided the conditions of the grant do not require that the funds be used for other purposes.

Example 11 The Big Picture

Return to the facts of The Big Picture. Paul was paid $400 a month by the university for teaching. This is reasonable compensation for his services. Although he received the assistantship because of his excellent academic record, the monthly pay of $400 must be included in his gross income because it is compensation for his services. However, the $6,000 graduate tuition reduction can be excluded from gross income.

Statutory Authority

Sections 101 through 150 provide the authority for excluding specific items from gross income. Each exclusion has its own legislative history and reason for enactment. Certain exclusions are intended as a form of indirect welfare payments. Other exclusions prevent double taxation of income or provide incentives for socially desirable activities (e.g., nontaxable interest on certain U.S. government bonds where the owner uses the funds for educational expenses). In some cases, Congress has enacted exclusions to rectify the effects of judicial decisions or IRS pronouncements. For example, in the past, the IRS and some courts interpreted gross income to include payments the taxpayer received from his or her insurance policy to cover temporary living expenses after the person's residence was destroyed by fire. Although the IRS's and the courts' reasoning may have been a sound interpretation of the meaning of gross income, Congress determined that taxing the person under such dire circumstances was bad policy. Therefore, in 1969, Congress enacted § 123, which exempts from tax the insurance proceeds received for extraordinary living expenses when the taxpayer's home has been destroyed by fire or other casualty. 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) would not be required to include in gross income payments received for living expenses, funeral expenses, and property damage resulting from the disaster.

Scholarships: Disguised Compensation

Some employers make scholarships available solely to the children of key employees. The tax objective of these plans is to provide a nontaxable fringe benefit to the executives by making the payment to the child in the form of an excludible scholarship. However, the IRS has ruled that the payments are generally includible in the gross income of the parent-employee.

Compensation for Injuries and Sickness: Workers' Compensation

State workers' compensation laws require the employer to pay fixed amounts for specific job-related injuries. The state laws were enacted so that the employee will not have to go through the ordeal of a lawsuit (and possibly not collect damages because of some defense available to the employer) to recover the damages. Although the payments are intended, in part, to compensate for a loss of future income, Congress has specifically exempted workers' compensation benefits from inclusion in gross income.

Tax Planning: Investment Income

Tax-exempt state and local government bonds are almost irresistible investments for high-income taxpayers, who may be subject to a 39.6 percent regular tax rate plus a 3.8 percent rate on their net investment income. To realize the maximum benefit from the exemption, the investor can purchase zero-coupon bonds. Like Series EE U.S. government savings bonds, these investments pay interest only at maturity. The advantage of the zero-coupon feature for a tax-exempt bond is that the investor can earn tax-exempt interest on the accumulated principal and interest. If the investor purchases a bond that pays the interest each year, the interest received may be such a small amount that an additional tax-exempt investment cannot be made. In addition, reinvesting the interest may entail transaction costs (brokers' fees). The zero-coupon feature avoids these problems. Series EE U.S. government savings bonds can earn tax-exempt interest if the bond proceeds are used for qualified higher education expenses. Many taxpayers can foresee these expenditures being made for their children's educations. In deciding whether to invest in the bonds, however, the investor must take into account the income limitations for excluding the interest from gross income.

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). Thus, the benefits are not a gift. However, because the tuition payment aids Terry in pursuing her studies, the payment is a scholarship.

Foreign Earned Income

The United States uses a global tax system as opposed to a territorial system. Under this global system, a U.S. citizen is generally subject to tax on his or her income regardless of its economic origin. Some other countries use a territorial system; that is, a person's income is taxed only in the country in which the income was earned. Under this global system, a U.S. citizen who earns income in another country could experience double taxation: the same income would be taxed in the United States and in the foreign country. Out of a sense of fairness and to encourage U.S. citizens to work abroad (so that exports might be increased), Congress has provided alternative forms of relief from taxes on foreign earned income. The taxpayer can elect either (1) to include the foreign income in his or her taxable income and then claim a credit for foreign taxes paid or (2) to exclude the foreign earnings from his or her U.S. gross income (the foreign earned income exclusion). The foreign tax credit option, but as is apparent from the following discussion, most taxpayers choose the exclusion. Foreign earned income consists of the earnings from the individual's personal services rendered in a foreign country (other than as an employee of the U.S. government). To qualify for the exclusion, the taxpayer must be either of the following: -A bona fide resident of the foreign country (or countries). -Present in a foreign country (or countries) for at least 330 days during any 12 consecutive months. As previously mentioned, the taxpayer may elect to include the foreign earned income in gross income and claim a credit (an offset against U.S. tax) for the foreign tax paid. The credit alternative may be advantageous if the individual's foreign earned income far exceeds the excludible amount so that the foreign taxes paid exceed the U.S. tax on the amount excluded. However, once an election is made, it applies to all subsequent years unless affirmatively revoked. A revocation is effective for the year of the change and the four subsequent years.

Educational Savings Bonds

The cost of a college education has risen dramatically during the past 15 years. According to U.S. Department of Education estimates, the cost of attending a publicly supported university for four years now commonly exceeds $60,000. For a private university, the cost often exceeds $200,000. Consequently, Congress has attempted to assist low- to middle-income parents in saving for their children's college education. One of the ways Congress assists such families is through an interest income exclusion on educational savings bonds. The interest on Series EE U.S. government savings bonds may be excluded from gross income if the bond proceeds are used to pay qualified higher education expenses. Qualified higher education expenses consist of tuition and fees paid to an eligible educational institution for the taxpayer, spouse, or dependent. If the redemption proceeds (both principal and interest) exceed the qualified higher education expenses, only a pro rata portion of the interest will qualify for exclusion treatment. The exclusion is limited by the application of the wherewithal to pay concept. That is, once the modified adjusted gross income exceeds a threshold amount, the phaseout of the exclusion begins. Modified adjusted gross income (MAGI) is adjusted gross income prior to the § 911 foreign earned income exclusion and the educational savings bond exclusion. The threshold amounts are adjusted for inflation each year. For 2015, the phaseout begins at $77,200 ($115,750 on a joint return). The phaseout is completed when MAGI exceeds the threshold amount by more than $15,000 ($30,000 on a joint return). The otherwise excludible interest is reduced by the amount calculated as follows: { [ (MAGI - $77,200) / $15,000 ] x Excludible interest before phaseout = Reduction in excludible interest } On a joint return, $115,750 is substituted for $77,200 (in 2015), and $30,000 is substituted for $15,000.

Compensation for Injuries and Sickness: Accident and Health Insurance Benefits

The income tax treatment of accident and health insurance benefits depends on whether the policy providing the benefits was purchased by the taxpayer or the taxpayer's employer. Benefits collected under an accident and health insurance policy purchased by the taxpayer are excludible even though the payments are a substitute for income. A different set of rules applies if the accident and health insurance protection was purchased by the individual's employer, as discussed in the following section.

Tax Planning

The present law excludes certain types of economic gains from taxation. Therefore, taxpayers may find tax planning techniques helpful in obtaining the maximum benefits from the exclusion of such gains. Following are some of the tax planning opportunities made available by the exclusions described in this chapter.

Example 4 Accelerated Death Benefits

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.

Example 30

Tracy's redemption proceeds from qualified savings bonds during the taxable year are $6,000 (principal of $4,000 and interest of $2,000). Tracy's qualified higher education expenses are $5,000. Because the redemption proceeds exceed the qualified higher education expenses, only $1,667 [($5,000/$6,000) × $2,000] of the interest is excludible.

Concept Summary 5.2 Employee Fringe Benefits

Type of Benefit || Exclusion ----------------------------------------- Group term life insurance (§ 79) | Premiums on up to $50,000 protection Employee achievement awards (§ 74) | Up to $1,600 in a year Accident, health, and long-term care insurance and medical reimbursement (§§ 105 and 106) | Insurance premiums paid by the employer and benefits collected High-deductible health insurance and contributions to employee's Health Savings Account (§§ 106 and 223) | Employer premiums on high-deductible medical insurance plus contributions to Health Savings Account (statutory limits, indexed for inflation). Meals and lodging furnished for the convenience of the employer (§ 119) | Value of meals and lodging on the employer's premises Child care provided by the employer or reimbursement for employee's cost (§ 129) | Services provided or reimbursement of expenses up to $5,000 a year Athletic facilities on the employer's premises (§ 132) | Value of services Educational assistance for tuition, fees, books, and supplies (§ 127) | Limited to $5,250 per year No-additional-cost services [e.g., use of employer's facilities (§ 132)] | Value of the use Employee discount on purchase of goods from employer at employer's cost (§ 132) | Employer's normal profit margin Employee discount for purchases of employer's services (§ 132) | Maximum of 20% of employer's normal price Working condition fringes [e.g., the mechanic's tools (§ 132)] | Employer's cost De minimis items so small that the accounting effort is not warranted [e.g., use of employer telephone (§ 132)] | Value of the goods or services Qualified transportation [e.g, transit passes and parking (§ 132)] | Statutory amounts, adjusted for inflation Moving expense reimbursement (§ 132) | Reimbursement to the extent otherwise deductible by employee Retirement planning services (§ 132) | Reasonable cost of services

Concept Summary 5.1 Taxation of Damages

Type of Claim || Taxation of Award or Settlement •Breach of contract (generally loss of income) || Taxable. •Property damages || Recovery of cost; gain to the extent of the excess over basis. A loss is deductible for business property and investment property to the extent of basis over the amount realized. A loss may be deductible for personal use property. •Personal injury --- ---Physical || All compensatory amounts are excluded unless previously deducted (e.g., medical expenses). Amounts received as punitive damages are included in gross income. ---Nonphysical || Compensatory damages and punitive damages are included in gross income.