1. Chapter 4 Income- Exclusions Howard Godfrey, Ph. D
Chapter 4 Income- Exclusions Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2013, Dr. Howard Godfrey Edited August 10, 2013.

2. 1. Introduction
2. Donative Items Gifts, Inheritances, Life insurance proceeds, Scholarships
3. Employment related income Foreign earned income, Payments made by employer [fringes], Employee benefit plans.
4. Returns of Human Capital Workers comp., Damages for injury, Payments from health and accident plans.
5. Investment related Exclusions Municipal bond interest, Stock dividends, Discharge of debt, Improvements by lease.

5. Exclusions Gifts Inheritances Life Insurance
Proceeds received are tax-free but any interest income on proceeds is taxable
Inside buildup (increase in cash surrender value) is not taxable income unless policy is liquidated for more than premiums paid

6. Gifts Mickey was given 2 tickets to the World Series by a friend.
Mickey sold the tickets for $500 each.
What is the tax impact of these events?

7. Death Payments
Bob, a manager for Petros Pizza (PP), dies in an accident on July 12. PP pays his wife, Penelope, $600 in salary that had accrued before Bob died. Bob was covered by a $90,000 group term life insurance policy, which is also paid to Penelope. In addition, the board of directors of PP authorizes payment of $6,000 to Penelope and $4,000 to their child in recognition of Bob's years of loyal service to the company.
What are the tax consequences of the payments to Penelope and her child?

8. Death Payments
Penelope has $6,600 ($ $6,000) of gross income. Death benefit payments are fully taxable.
Penelope must include in income the $6,000 she receives from PPP due to Bob’s loyal service and the $600 salary Bob earned prior to his death.
The receipt of the $90,000 life insurance proceeds is excluded.
Her daughter must include in income the $4,000 she receives from PPP.

9. Life Insurance-1
Allison dies during the current year. She is covered by a $1,000,000 life insurance policy payable to her husband Bob. Bob elects to receive the policy proceeds in 10 annual installments of $120, Explain the tax consequences of the receipt of each installment.

10. Life Insurance-2
Life insurance proceeds are excluded from tax. The $1,000,000 face value of the policy is excluded as it is received. The earnings on the policy during the time it is held by the insurance company are not excludable.
The total interest earned is $200,000 [($120,000 x 10) - $1,000,000].
As each payment on the policy is received, Bob will exclude $100,000 ($1,000,000 ÷ 10) and include $20,000 ($200,000 ÷ 10) in gross income.

11. Scholarships-1.
Qualified scholarships are excluded from gross income
“Scholarship” includes only tuition, fees, books, supplies, equipment, and related expenses required for courses
Amounts designated or spent for room, board, and laundry are included in income and are taxable

12. Scholarships-2
Any grant received in return for past, present, or future services must be included in gross income
Funds received by students in return for teaching or research services are taxable
When taxable portion cannot be determined until end of academic year, taxable income can be deferred until the taxable year in which the academic year ends

16. Foreign Earned Income
Foreign Earned Income may be excluded to relieve double taxation.
Taxpayers may choose one of two options:
Exclude up to $97,600 (2013) of foreign earned income
Must be a resident of the foreign country, or
Must reside in the foreign country for 330 days
Claim a tax credit that is the lesser of
Foreign taxes paid, or
U.S. tax that would have been paid on the foreign income

17. Foreign Earned Income-1
Joan (single) works for Big Oil, Inc. In all of 2011, she is stationed in West Africa. She pays West African taxes of $19,000 on her Big Oil salary of $88,000. Her taxable income without considering her salary from Big is $36,000. How should Joan treat the salary from Big Oil on her 2011 U.S. tax return?

18. Foreign Earned Income-2
Because Joan worked in West Africa for the entire year, she can exclude the $88,000 salary from her income (less than $91,400) or include the entire salary in her income and taking a foreign tax credit for West African taxes she paid (the foreign tax credit cannot exceed the U.S. tax that would have been paid on her West African income).

19. Foreign Earned Income-3
If Joan elects the exclusion option, her taxable income will be $36,000 ($88,000 - $88,000 + $36,000). The exclusion cannot exceed her salary. The tax on the $36,000 is the difference between the tax on the taxable income without the exclusion ($124,000) and the tax on the excluded amount ($88,000). Under the foreign tax credit option, taxable income will be $124,000 ($88,000 + $36,000).

22. Foreign Earned Income-5
The foreign tax credit cannot exceed the amount of U.S. tax that would have been paid on the West African income. In this case, the U.S. tax on her West African income is $20,110 and Joan is allowed a foreign tax credit for the $18,000 of actual taxes paid:
$27,337 x ($88,000  $124,000) = $20,110

24. Taxpayers Subject to U.S. Tax
U.S. citizens, resident aliens, and U.S. corporations are subject to U.S. tax on their worldwide income
Resident alien – individual who is not a U.S. citizen who has a legal residence in U.S. established through
Green card or
Substantial presence test (183 days)
Nonresident alien – individual who is not U.S. citizen and does not satisfy test to be resident alien

25. Fringe Benefits
Payments made on behalf of an employee are excluded as an incentive to employers to provide these benefits.
Examples of excluded payments are:
Contributions to qualified pension plans
Premiums for group term life insurance
Premiums for health & accident insurance
Meals and lodging
Fringe benefits

26. Pension Plan
Jill works for Close Corp. for 24 years. Close has a qualified, noncontributory pension plan that pays employees with more than 5 years of service $100 per month per year of service when they reach age 65. Jill turns 65 in February of this year and retires in June. Payments from Close's plan begin in July. How much is Jill’s gross income from pension payments?
All payments to Jill are included in income

27. Group Term Life Insurance
Bear Co. provides all its employees with a $10,000 group-term life insurance policy. Elk Co. does not provide life insurance but pays $10,000 to survivors of employees who die. Jackie, an employee of Bear Co.
Rosetta, an employee of Elk Company.
Both die during the current year.
What are the tax effects of the $10,000 payments received by beneficiaries?
Only the insurance benefits are excluded.

28. Health and Accident Insurance -1
Abe is an employee of Hand, Inc. Hand provides basic health and accident insurance to all its employees through a contract with an insurance company. Because the Minor policy does not cover 100% of medical costs, Hand provides all executive officers with a self-insured plan to pay any medical costs not covered by Minor's policy. Abe is eligible for both plans. During the current year, premiums on the Minor policy for Abe were $1,450. Abe is reimbursed for $1,900 of his medical costs from the self-insured plan. What is the treatment?
One amount is income – which one?

29. Health and Accident Insurance-2
Because all employee's are covered by the policy, the premiums paid on the Minor policy are excludible.
Self-insured medical reimbursement plans are also excludible if they do not discriminate in favor of highly compensated employees.
In this case, it would appear that only highly compensated employees (executive officers) receive benefits from the plan and Abe would, therefore, be taxed on the $1,900 of reimbursements received from the plan.

30. Payments Made by Employer For Meals and Lodging
The value of meals provided by the employer are excluded from income if the meals are provided
on the employer’s premises
for the employer’s convenience
The value of lodging provided is excluded if these conditions are met - and also be a condition of employment. (Must use the lodging)

31. Payments Made by Employer General Fringe Benefits
Two types of fringe benefits are excludable from income if they are provided on a nondiscriminatory basis:
No additional cost services
Employee discounts
on goods, are limited to the gross profit %
on services, are limited to 20%
Qualified retirement planning service

32. Payments Made by Employer General Fringe Benefits
Other types of fringe benefits are excludable from income even if they are provided on a discriminatory basis:
Working condition
De minimus
Child and dependent care services up to $5,000
Educational assistance programs up to $5,250
Employer’s athletic facility on premises

33. Meals and Lodging
Adam works during the summer as a fire watcher for the Oregon forest service. He spends 3 weeks in the woods in a forest service watchtower and then gets a week off. Because of the remoteness of the location, groceries are flown in by helicopter to Adam each week. Does Adam have any taxable income from this arrangement? Explain. Yes

34. Fringe Benefits
Jim is an employee of Fast Tax Prep, Inc. All employees of Fast Tax Prep are eligible for a 50% discount on the preparation of their income tax return. Jim's tax return preparation would normally have cost $300, but he paid only $150 because of the discount. Is this tax-free?

35. Health Savings Accounts provide incentive for employers and employees to purchase adequate medical coverage
May be established for individuals covered only by high-deductible plans
$2,400 for family or $1,200 for single
Employer contributions are excluded from income and individual contributions are deductible for AGI

37. Accident & Health Insurance-1.
Accident & health insurance proceeds from are tax-free to extent they pay qualified medical or dental expenses; excess benefits taxable if employer provided policy

38. Accident & Health Insurance-2
Disability insurance—substitute for lost pay
If premiums for disability insurance paid by employer, then benefits received are taxable
If premiums paid by employee, exception allows benefits to be tax free

40. Municipal Bond Interest-1
Sue owns $100,000, 6% City of Concord bonds that pay interest of $3,000 on June 30 & Dec Sue is in the 20% marginal tax bracket. What rate is needed on a taxable bond to provide the same after-tax return?

42. Interest Income.
Interest income from savings accounts, certificates of deposit, corporate bonds, and Treasury bills is included in gross income
Interest on state and local (municipal) bonds is excluded from gross income
High income taxpayers may have a higher after-tax return on municipal bonds than taxable bonds offering a higher interest tax
Gain on the sale of tax-exempt securities must be included gross income

45. Municipal Bonds. CARL-1.
Carl paid $40,000 to the City of Hollywood for general revenue bonds. During the current year, he receives $2,300 interest income from the bonds.
Market interest rates drop causing the value of the bonds to increase so Carl sells the bonds for $43,000.
How much gross income must Carl report for the year?

46. The interest is nontaxable because these are municipal bonds.
Municipal Bonds. CARL-2.
Carl recognizes gain of $3,000 ($43,000 - $40,000) on the sale of the stock.
The interest is nontaxable because these are municipal bonds.

47. Nontaxable Bonds- Jessica-1
Jessica has $10,000 invested in corporate bonds with a stated interest rate of 8 percent and $10,000 in tax-exempt municipal bonds issued for governmental activities with a stated interest rate of 6 percent. Calculate her after-tax cash flow from each investment if:
a. Her marginal tax rate is 35 percent. b. Her marginal tax rate is 15 percent.

50. Stock Dividends
Stock dividends are distributions of a corporation’s own stock to its shareholder (stock splits)
Usually stock dividends are not taxable to the shareholder (unless shareholder has option of receiving cash)
Shareholders simply own a greater number of shares and the basis in their original holdings is divided among all shares of stock now held

51. Stock Dividend.
The Board of Directors of CYZ Corp. votes to issue two shares of stock for each share held as a stock dividend to shareholders.
Before the dividend, Cheryl owns 100 shares of CYZ Corp. stock that she purchased for $10 per share.
She receives 200 new shares as a result of the dividend.
How much gross income does Cheryl report as a result of the dividend and what is her stock basis after the dividend?

52. Stock Dividend.
Cheryl recognizes no income from the receipt of the stock dividend.
She will spread the basis of the original 100 shares over the new total of 300 shares.
Each of the 300 shares will now have a basis of $3.33 [(100 x $10)/300].

55. Government Transfer Payments.
Need-based payments, such as welfare payments, school lunches & food stamps, are excluded from income.

56. Discharge of Debt.
If a legal obligation is satisfied for less than the outstanding debt, the amount of debt forgiven represents an increase in the taxpayer’s wealth and is subject to taxation
Exceptions are provided for debtors who are bankrupt or insolvent

57. Cancellation of Debt.
Markum Corporation owes a creditor $60,000.
Markum transfers property to the creditor to satisfy the debt.
Markum purchased the property four years ago for $45,000 and it is currently worth $60,000.
Does Markum have any gross income as a result of this transaction?

58. Cancellation of Debt.
Markum must recognize a $15,000 ($60,000 - $45,000) taxable gain on the transfer of the property as if it had sold the property for $60,000 and used the proceeds to pay the debt.

59. Other Exclusions-1
Improvements made on leased property are excluded from landlord’s income unless improvements made in lieu of paying rent. (Make-over cases)
Fringe benefits discussed in next chapter

60. End