Chapter 5 GROSS INCOME: EXCLUSIONS

GIFTS

1.
Gifts. The major reason for excluding gifts from income is to prevent
the tax laws from interfering with an individual's decision to make gifts,
especially gifts to family members. If the donee were required to pay an
income tax upon receipt of a gift, this would be equivalent to exacting a toll
charge on the intra-family transfers. Such a charge would be despised by the
voters and, probably, seldom paid.

a.
Definition of a gift. In deciding whether a gift has been made, the
courts look to reasons for making the payment or transferring the property.
Was the payment made out of "love, affection, or generosity?" The answer to
this question requires an analysis of the facts to determine the donor's intent.

LIFE INSURANCE PROCEEDS

2.
Life Insurance Proceeds. Life insurance proceeds payable to the
beneficiary by reason of the death of the insured are excludible from gross
income.
a.
Exceptions to exclusion treatment. The exclusion does not apply if an
individual cashes in his or her own policy or if there has been a prior transfer
for valuable consideration.
(1)
Example: In the current year, Veneia cashed in her life insurance
policy and received the cash surrender value of $25,000. She had paid
$13,000 in premiums. Veneia recognizes a $12,000 gain in the current year.
(2)
Note that although the difference between the premiums paid and the
cash surrender value is taxable, Veneia still enjoys favorable tax treatment.
That is, part of the premiums paid were for current protection. The cost of
the current protection is not deductible. While Veneia has benefitted from the
nondeductible current protection, she is allowed to subtract the total
premiums paid in arriving at the taxable gain.
b.
Buy-sell agreements. While transfers of life insurance policies between
individuals (or between an individual and a corporation) are ordinarily taxable
events, the law allows for nontaxable transfers in circumstances that are
intended to facilitate buy-sell and stock redemption agreements.
(1)
These agreements are frequently used by closely-held corporations to
assure a market for the stock when a shareholder dies.

(2)
The agreements also assure that the remaining shareholders will not
be forced to deal with an heir or another purchaser of the stock.
c.
Exception for accelerated death benefits. The insured under certain
circumstances may receive the life insurance proceeds prior to death and to
exclude the gain (i.e., proceeds received in excess of basis) from gross
income.
(1)
Terminally ill taxpayer. A taxpayer satisfies this definition if a medical
doctor certifies the individual as having an illness that is reasonably expected
to cause death within 24 months.
(2)
Chronically ill taxpayer. A taxpayer satisfies this definition if certified
as being unable to perform without assistance certain activities of daily living.
(3)
Note that in the case of the chronically ill insured taxpayer, the life
insurance proceeds paid to the insured prior to death must be used for the
individual's long-term care for the exclusion to apply. On the other hand, a
terminally ill insured taxpayer is not limited as to how the funds are used.
Thus, a terminally ill taxpayer who does not need the funds for medical
purposes has his or her choice of whether to receive the proceeds tax-free
prior to death or to allow the beneficiaries to receive the proceeds tax-free.

Exclusion treatment is available only to the insured.

e.
Key person insurance coverage. Even though the insurance may be a
key person policy (i.e., the insured is a key employee and the beneficiary is
the employer), the proceeds are excludible to the employer-beneficiary.

f.
Interest on life insurance proceeds. If the beneficiary elects to leave
the proceeds with the life insurance company and to collect them in
installments, the annuity rules apply.

(1)
The principal element of each installment payment is excludible from
gross income.

(2)

SCHOLARSHIPS

3.

a.
Services. Whether the payments are excludible depends upon why the
payments are being made, similar to the gift analysis.

The interest element is includible in gross income.

Scholarships.

(1)
If the payments are in exchange for services rendered to the payor
rather than merely to aid the recipient, the income cannot be excluded.

(2)

b.
Excludible items. Amounts excludible from gross income under a
scholarship include tuition and related expenses (i.e., fees, books, supplies,
and equipment required for courses).

c.
Room and board. The value of room and board provided to the student
cannot be excluded under the scholarship rule.

d.
Candidate for a degree. The recipient must be a candidate for a
degree at an educational institution.

e.
Timing. 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. Therefore, the transaction is held open until
the educational expenses are paid.

f.
Disguised compensation. If the scholarship is solely available to the
children of key employees, the amount paid by the employer is included in
the gross income of the parent-employee.

g.
Qualified tuition reduction plan. Employees of nonprofit educational
institutions are allowed to exclude a tuition waiver from gross income, if the
waiver is pursuant to a qualified tuition reduction plan.

(1)
The plan may not discriminate in favor of highly compensated
employees.

(2)
The exclusion applies to the employee, the employee's spouse, and the
employee's dependent children.

(3)
Reciprocal agreements between qualified nonprofit educational
institutions qualify.

(4)
Generally, the exclusion applies only for undergraduate education.
5)
However, for teaching or research assistants, the exclusion will apply
for their graduate tuition waivers if the waiver is in addition to reasonable
compensation that is paid to them for services rendered

Labeling the payment as a "scholarship" does not control the outcome.

COMPENSATION FOR INJURIES AND SICKNESS DAMAGES

.
Purpose. Damages are intended to restore the person to his or her
former position before the unfortunate event occurred and, thus, receipt of
the damage award does not result in economic gain. Nevertheless, the
taxpayer may realize taxable income.
a.
Amounts received for property losses. Amounts received to restore for
a loss of property are generally treated as proceeds from the sale of the
property. Thus, gain is recognized if the amount received exceeds the
recipient's basis in the property.
b.
Goodwill. A payment for damages to the goodwill of a corporation is
usually taxable because the corporation has no basis in the goodwill.
c.
Loss of income. Payments for the loss of income are taxed the same
as the income replaced.
d.
Worker's compensation benefits. Worker's compensation benefits are
intended to compensate employees for their on the job injuries that often
cause personal and economic consequences. These benefits are excluded
from gross income.
5.
Personal Injury. The general principles (a., b., and c. above) are
generally inapplicable to damages received for physical personal injury or
physical sickness. These payments are nontaxable even though the
payments replace income that would have been otherwise taxable.
o Slender case and get money taxable income
a.
Such damages must be in the nature of compensatory damages (i.e.,
intended to compensate the taxpayer for the damages incurred).

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 for any amount received for medical care).
6.
Punitive Damages

a.

b.
These are amounts the person who caused the harm must pay to the
victim as punishment for outrageous conduct.

9.

Meals and Lodging (provided by employer)

d.

Requirements for exclusion treatment.

Punitive damages are always taxable.

(1)

The meals and/or lodging are

(a)

furnished by the employer,

(b)

on the employer's business premises, and

(c)

for the convenience of the employer.

(2)
In the case of lodging, the employee is also required to accept the
lodging as a condition of employment. If the employee has the option of cash
or lodging, the required test is not satisfied.

OTHER EMPLOYEE FRINGE BENEFITS

10.

a.
The employer 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 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 taxpayers earned income.

b.
The value of the use of an athletic facility by employees, their spouses,
and their dependent children may be excluded. The facilities must be on the
employers premises, and substantially all of the use of the facilities must be
by employees and their family members.
c.
Qualified employer-provided educational assistance (i.e., tuition, fees,
books, and supplies) at the undergraduate and graduate level is excluded.
The exclusion is subject to an annual employee ceiling of $5,250.

Specific Benefits.

d.
The employee can exclude up to $12,650 of expenses incurred to
adopt a child where the adoption expenses are paid or reimbursed by the
employer under a qualified adoption assistance program.

11.

a.
Cafeteria plans are very effective means of maximizing an employee's
after-tax income. Under flexible spending plans, the employee accepts lower
cash compensation in return for the employer agreeing to pay certain costs
that the employer can pay without the employee recognizing gross income.

Cafeteria (or Flexible Benefits) Plans.

b.
Example. Consider the case of a parent of a child who will be wearing
dental braces for two years. If the employer has a cafeteria plan and the
employee has not maximized the benefits of the plan, the employee could
have his or her salary reduced by the amount of the monthly orthodontist bill
and the employer could pay the orthodontist for the employee. Thus,
formerly, when the employee paid the orthodontist $100, the after-tax cost
was $100 (assuming the employee does not have sufficient medical expenses
in excess of 7.5% of adjusted gross income and thus the expenses do not
become an itemized deduction). With the medical reimbursement plan
included in the cafeteria plan, the after-tax cost is $100 less the tax on that
amount. Once the child no longer needs braces, the parent can elect to
receive cash.

c.
Such plans enable an employee to choose between cash and some
other form of compensation (i.e., in the form of nontaxable benefits) without
activating the constructive receipt doctrine.

d.
Frequently, younger employees opt for cash while older employees
choose the nontaxable fringe benefits.

e.
Flexible spending plans. The employee accepts lower cash
compensation in return for the employer agreeing to pay certain costs that
the employer can pay without the employee recognizing gross income.
These plans are often referred to as use or lose plans.

12.
Other Employee Fringe Benefits. (see Concept Summary 5.2 in the
text)

a.
No-additional-cost services. No-additional-cost services provided by
the employer to employees in the same line of business in which the
employee works are excludible by the employee. In determining whether a
benefit has no additional cost to the employer, foregone profits are
considered costs.

(1)
Thus, the no-additional-cost benefit is limited to excess capacity
situations (e.g., the airline employee occupies an otherwise empty seat).

(2)
The exclusion is limited to cases of no "substantial" additional costs.
Even in the airline example, there will be some additional cost (e.g., a meal in
flight), but those costs are de minimis.

(3)
The no-additional-cost services exclusion applies only to services.
Thus, meals provided cannot qualify for the exclusion because the meal

includes property, unless the meals are a de minimis part of the total cost (as
in the case of the air transportation discussed above).

(4)
The exclusion is available to the employee, the employee's spouse, the
employee's dependent children, and to retired and disabled former
employees.

(5)
The exclusion is not available to highly compensated employees unless
the availability of the benefit is not discriminatory.

b.
Qualified employee discounts. Qualified employee discounts are
excludible from the employee's gross income.

(1)
In the case of services, the exclusion is limited to 20 percent of the
customer price.

(2)
In the case of property, the exclusion is limited to the gross profit
component of the price to customers.

(3)
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
stock).

(4)
The property or services must be from the same line of business in
which the employee works.

(5)
The exclusion is available to the employee, the employee's spouse, the
employee's dependent children, and to retired and disabled former
employees.

(6)
The exclusion is not available to highly compensated employees unless
the availability of the discount is not discriminatory.

c.
Working condition fringe. The working condition fringe is perhaps the
least significant of the employee fringe benefit rules.

(1)
A working condition fringe is excludible from the employee's gross
income. This fringe benefit consists of the cost of any property or services
provided by the employer to the employee for which the employee could
deduct the cost if he or she had paid for them (e.g., professional dues).

(2)
Professional dues and subscriptions are eligible for the working
condition fringe exclusion. Thus, in the case of a CPA firm, if the employer
pays the employees AICPA dues, the employee is not required to include the
amount in gross income. Note that, although the dues would be eligible for
deduction by the employee (as a non reimbursed employee expense) if he or

she paid the dues, the expense would produce tax benefits if the employee
itemized his or her deduction, and then only if the total miscellaneous
itemized deductions exceeded 2% of the employee's adjusted gross
income. Thus, the employee should bargain for reduced salary with
the employer paying the professional dues.

d.
De minimis fringes. A de minimis fringe is excludible from the
employee's gross income. These are fringe benefits that are so small that
accounting for them is impractical (e.g., personal use of company copying
machine). TAX BENEFIT RULE

18.

a.
State income tax refunds. The most frequently encountered
example of the application of the tax benefit principle is the reporting of
refunds of state income tax received by an individual.

Tax Benefit Rule.

o
o
o

Under general rule state tax should be refundable for us

Ex: made $100,000, MN tax withheld $7,000, get $800 refund with
standard deduction
Hypothetically, assume she itemized and get $500 more than itemized.
This means next year she need to report $300 as taxable income

(1)
The refund is taxable only if the taxpayer itemized deductions in the
year to which the refund relates.

(2)
Taxpayers can use this rule to advantage. For example, a taxpayer
expects his income to decrease significantly for the next tax year. For the
current year, he can make a generous payment of estimated state income
taxes (to increase his itemized deductions), part of which will be income as a
refund in the next year when he is in the lower marginal tax bracket.

b.
Claim of right. The converse of the tax benefit rule was discussed in
Chapter 4. That is, a taxpayer who has reported income received under a
claim of right may deduct amounts he must repay in a subsequent tax period.
An important distinction is that under the claim of right rule the taxpayer can
effectively elect either (1) to deduct the repayment for the tax year in which
income was reported, or (2) to take the deduction in the year the repayment
was made.

c.
Income recovery. When an expense item resulted in only partial tax
benefit, any recovery is first considered to be from the benefit received.

INCOME FROM DISCHARGE OF INDEBTEDNESS

19.

Income from Discharge of Indebtedness.

o
o
o

Ex case) bought a 1M house in CA borrowed 0.9M and shortly after

house price dropped 0.5 M. and owner lost job. -> fore closer
Mortgage company forgiven the debt, and have $400,000 liability.
($900,000-$500,000)
When assets are lower than liability - sorbent

a.
Transfer of property in satisfaction of debt versus debt adjustment.
Note the distinction between a transfer of property in satisfaction of a debt (a
taxable exchange) and a debt adjustment. In some cases, the income from
debt adjustments can be deferred (through basis adjustments).

b.

Foreclosure. Foreclosure would produce currently taxable income.

c.

Special situations.

(1)
A shareholder who forgives the corporation on a debt is considered to
have made a capital contribution to the corporation, thereby increasing the
shareholder's basis in the stock and increasing the corporation's paid-in
capital.

(2)
Buyer reduced indebtedness. When the seller finances the sale and
the seller later reduces the buyer's indebtedness to the seller, the buyer's
basis in the property is reduced.

d.

If the statutory requirements are satisfied, the amount of the student loan
that is forgiven is excluded from the taxpayers gross income.

A key requirement is the loan was originally made on the condition that it
would be forgiven if the student practices a profession in the state for a
period of time upon completing his or her studies.

Homework
o Read Chapter 5
o Do Chapter 5 - 6,9,12,25, 31,34,56
o 31
A. not taxable. Because it was a company policy
B. taxable. Income in respect of decadent (IRD)
C. code 49. company can provide 50k
D. it was a life insurance policy. Potential tax

Forgiveness of student loan.