1. Chapter 4 Income Exclusions ©2009 South-Western, a part of Cengage Learning Kevin Murphy Mark Higgins Kevin Murphy Mark Higgins

2. 4-2 ©2009 South-Western, a part of Cengage Learning Income Exclusions Concept Review The all-inclusive income concept considers all income taxable unless a specific provision can be found that exempts it from taxation. Under the legislative grace concept, only Congress can provide income exclusion.

3. 4-3 ©2009 South-Western, a part of Cengage Learning Income Exclusions Major Reasons The major reasons income items are excluded rTo increase equity through relief provisions rTo provide incentives for taxpayers to engage in an activity

4. 4-4 ©2009 South-Western, a part of Cengage Learning Income Exclusions Categories There are four major categories of exclusions: FDonative items FEmployment-related FReturns of human capital FInvestment related

5. 4-5 ©2009 South-Western, a part of Cengage Learning ¶ Donative Items: Gifts and Inheritances rGifts are excluded to relieve double taxation caused by the gift tax rInheritances are excluded to relieve double taxation caused by the estate tax Donative items are increases in wealth that are not earned or the result of investment.

6. 4-6 ©2009 South-Western, a part of Cengage Learning ¶ Donative Items: Life Insurance Proceeds rLife Insurance Proceeds are excluded to provide equity with other types of inheritances FProceeds from policies purchased for consideration are not excluded FInterest income earned from the proceeds due to electing receipt as an annuity are not excluded

7. 4-7 ©2009 South-Western, a part of Cengage Learning ¶ Donative Items: Scholarships rScholarships are excluded to provide incentive for education. To qualify, the scholarship FMust not require the performance of future services FMust be used for direct costs of education such as tuition, fees, books, and supplies

8. 4-8 ©2009 South-Western, a part of Cengage Learning Scholarship Example rJake received an athletic scholarship to Small State University. Under the scholarship agreement, he received tuition ($1,500), books ($400), and room and board ($5,000). rHow much must Jake include in his gross income?

9. 4-9 ©2009 South-Western, a part of Cengage Learning · Employment Related: Foreign Earned Income rForeign Earned Income may be excluded to relieve double taxation. Taxpayers may choose one of two options: FExclude up to $87,600 of foreign earned income VMust be a resident of the foreign country, or VMust reside in the foreign country for 330 days FClaim a tax credit that is the lesser of VForeign taxes paid, or VU.S. tax that would have been paid on the foreign income

10. 4-10 ©2009 South-Western, a part of Cengage Learning · Employment Related: Payments Made by Employer rPayments made on behalf of an employee are excluded as an incentive to employers to provide these benefits. Examples of excluded payments are: FContributions to qualified pension plans FPremiums for group term life insurance FPremiums for health and accident insurance FMeals and lodging FFringe benefits

11. 4-11 ©2009 South-Western, a part of Cengage Learning Payments Made by Employer To Qualified Pension Plan rPayments made by employers to qualified pension plans Fare not included in income in the year of payment Fare included in income in the year of withdrawal

12. 4-12 ©2009 South-Western, a part of Cengage Learning Payments Made by Employer Group Term Life Insurance rPremiums paid for up to $50,000 of group term life insurance are excluded from income. FPlan may not discriminate in favor of highly paid employees FPremiums for insurance in excess of $50,000 are included in taxable income

13. 4-13 ©2009 South-Western, a part of Cengage Learning Payments Made by Employer Health and Accident Insurance rPremiums paid for health and accident insurance are excluded from income to encourage employers to provide insurance.

14. 4-14 ©2009 South-Western, a part of Cengage Learning Payments Made by Employer For Meals and Lodging rThe value of meals provided by the employer are excluded from income if the meals are provided Fon the employer’s premises Ffor the employer’s convenience rThe value of lodging provided must meet these conditions and also be a condition of employment

15. 4-15 ©2009 South-Western, a part of Cengage Learning Payments Made by Employer General Fringe Benefits rTwo types of fringe benefits are excludable from income if they are provided on a nondiscriminatory basis: FNo additional cost services FEmployee discounts Von goods, are limited to the gross profit % Von services, are limited to 20% FQualified retirement planning services

16. 4-16 ©2009 South-Western, a part of Cengage Learning Payments Made by Employer General Fringe Benefits rOther types of fringe benefits are excludable from income even if they are provided on a discriminatory basis: FWorking condition FDe minimus FChild and dependent care services up to $5,000 FEducational assistance programs up to $5,250 FEmployer’s athletic facility on premises

17. 4-17 ©2009 South-Western, a part of Cengage Learning Payments Made by Employer Employer Benefit Plans rCafeteria Plans allow employees to choose from a menu of benefits and are excludable unless an employee elects to take cash in lieu of benefits

18. 4-18 ©2009 South-Western, a part of Cengage Learning Payments Made by Employer Employer Benefit Plans rFlexible Benefit (Salary Reduction) Plans allow employees to use pre-tax compensation dollars to cover medical or child-care expenses

19. 4-19 ©2009 South-Western, a part of Cengage Learning Payments Made by Employer Employer Benefit Plans rHealth Savings Accounts are excluded to encourage employers and employees to purchase adequate medical coverage FMay be established for individuals covered only by high-deductible plans $2,200 for family or $1,100 for single FEmployer contributions are excluded from income and individual contributions are deductible for AGI

20. 4-20 ©2009 South-Western, a part of Cengage Learning ¸ Returns of Human Capital rPayments received that are intended to reimburse an individual for injuries are excluded under the capital recovery concept because they merely restore the individual to a previous condition. FPayments that are intended to replace lost income are not excluded.

21. 4-21 ©2009 South-Western, a part of Cengage Learning ¸ Returns of Human Capital: Worker’s Compensation rWorker’s compensation payments related to an injury suffered on the job are excluded because they help restore individuals to their previous condition and do not add to their wealth.

22. 4-22 ©2009 South-Western, a part of Cengage Learning ¸ Returns of Human Capital: Personal Physical Injury or Sickness rCompensatory damage payments received for a personal physical injury or sickness and medical payments for emotional distress are excluded to provide a return to equity rLoss of income damage payments are only excluded if they are related to personal physical injury or sickness rPunitive damage payments are never excluded

23. 4-23 ©2009 South-Western, a part of Cengage Learning ¸ Returns of Human Capital: Health and Accident Insurance rPayments or reimbursements for medical or health costs are excluded to provide an individual a return to equity rDisability payments are excluded if the policy was purchased by the employee but not excluded if the policy was purchased by the employer

24. 4-24 ©2009 South-Western, a part of Cengage Learning ¹ Investment Related: Municipal Bond Interest rInterest income received from investment in municipal bonds is excluded to allow state and local municipalities to sell bonds for a lower interest rate

25. 4-25 ©2009 South-Western, a part of Cengage Learning ¹ Investment Related: Stock Dividends rStock dividends are excluded from income because their receipt does not qualify as income under the realization concept rIf the shareholder has the option to receive cash instead of stock, realization has occurred and the value of the dividend is included in income

26. 4-26 ©2009 South-Western, a part of Cengage Learning ¹ Investment Related: Discharge of Indebtedness rAn amount received as a loan is generally excluded from income under the realization concept because it must be returned rIf a lender forgives all or a portion of the debt, realization occurs and the forgiven portion is income VDischarge due to insolvency or bankruptcy is excluded from income

27. 4-27 ©2009 South-Western, a part of Cengage Learning ¹ Investment Related: Leasehold Improvements rThe value of improvements to property made by a lessee are excluded under the wherewithal-to-pay concept