Chapter 4 Income Exclusions ©2007 South-Western Kevin Murphy Mark Higgins Kevin Murphy Mark Higgins

Chapter 4Chapter 4

Income ExclusionsIncome Exclusions

©2007 South-Western©2007 South-Western©2007 South-Western©2007 South-Western

Kevin MurphyKevin MurphyMark HigginsMark Higgins

Kevin MurphyKevin MurphyMark HigginsMark Higgins

Transparency 4-2Transparency 4-2© 2007 South-Western© 2007 South-Western

Income ExclusionsConcept Review

Income ExclusionsConcept 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.


Income ExclusionsMajor Reasons

Income ExclusionsMajor Reasons

The major reasons income items are excluded

To increase equity through relief provisions

To provide incentives for taxpayers to engage in an activity


Income ExclusionsCategories

Income ExclusionsCategories

There are four major categories of exclusions:Donative itemsEmployment-related Returns of human capitalInvestment related


Donative Items: Gifts and Inheritances

Donative Items: Gifts and Inheritances

Gifts are excluded to relieve double taxation caused by the gift tax

Inheritances 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.


Donative Items:Life Insurance Proceeds

Donative Items:Life Insurance Proceeds

Life Insurance Proceeds are excluded to provide equity with other types of inheritancesProceeds from policies purchased for

consideration are not excludedInterest income earned from the proceeds

due to electing receipt as an annuity are not excluded


Donative Items: Scholarships

Donative Items: Scholarships

Scholarships are excluded to provide incentive for education. To qualify, the scholarshipMust not require the performance of future

servicesMust be used for direct costs of education

such as tuition, fees, books, and supplies


Scholarship ExampleScholarship Example

Jekabs 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). Jekabs must report $5,000 as income but may exclude $1,900.


Employment Related:Foreign Earned Income

Employment Related:Foreign Earned Income

Foreign Earned Income may be excluded to relieve double taxation.Taxpayers may choose one of two options:Exclude up to $80,000 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


Employment Related:Payments Made by Employer

Employment Related:Payments Made by Employer

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 plansPremiums for group term life insurancePremiums for health and accident insuranceMeals and lodgingFringe benefits


Payments Made by EmployerTo Qualified Pension Plan

Payments Made by EmployerTo Qualified Pension Plan

Payments made by employers to qualified pension plansare not included in income in the year of

payment are included in income in the year of

withdrawal


Payments Made by EmployerGroup Term Life Insurance

Payments Made by EmployerGroup Term Life Insurance

Premiums paid for up to $50,000 of group term life insurance are excluded from income.Plan may not discriminate in favor of highly

paid employeesPremiums for insurance in excess of

$50,000 are included in taxable income


Payments Made by EmployerHealth and Accident

Insurance

Payments Made by EmployerHealth and Accident

InsurancePremiums paid for health and accident

insurance are excluded from income to encourage employers to provide insurance.


Payments Made by EmployerFor Meals and Lodging

Payments Made by EmployerFor Meals and Lodging

The value of meals provided by the employer are excluded from income if the meals are providedon the employer’s premisesfor the employer’s convenience

The value of lodging provided must meet these conditions and also be a condition of employment


Payments Made by EmployerGeneral Fringe Benefits


Two types of fringe benefits are excludable from income if they are provided on a nondiscriminatory basis:No additional cost servicesEmployee discounts

on goods, are limited to the gross profit % on services, are limited to 20%

Qualified retirement planning services




Other types of fringe benefits are excludable from income even if they are provided on a discriminatory basis:Working conditionDe minimusChild and dependent care services up to $5,000Educational assistance programs up to $5,250Employer’s athletic facility on premises


Payments Made by EmployerEmployer Benefit Plans


Cafeteria Plans allow employees to choose from a menu of benefits and are excludable unless an employee elects to take cash in lieu of benefits




Flexible Benefit (Salary Reduction) Plans allow employees to use pre-tax compensation dollars to cover medical or child-care expenses




Health Savings Accounts are excluded to encourage employers and employees to purchase adequate medical coverageMay be established for individuals covered

only by high-deductible plans• $2,100 for family or $1,000 for single

Employer contributions are excluded from income and individual contributions are deductible for AGI


Returns of Human CapitalReturns of Human Capital

Payments 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.Payments that are intended to replace lost

income are not excluded.


Returns of Human Capital:Worker’s Compensation

Returns of Human Capital:Worker’s Compensation

Worker’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.


Returns of Human Capital: Personal Physical Injury or Sickness

Returns of Human Capital: Personal Physical Injury or Sickness

Compensatory damage payments received for a personal physical injury or sickness and medical payments for emotional distress are excluded to provide a return to equity

Loss of income damage payments are only excluded if they are related to personal physical injury or sickness

Punitive damage payments are never excluded


Returns of Human Capital:Health and Accident Insurance

Returns of Human Capital:Health and Accident InsurancePayments or reimbursements for

medical or health costs are excluded to provide an individual a return to equity

Disability payments are excluded if the policy was purchased by the employee but not excluded if the policy was purchased by the employer


Investment Related: Municipal Bond Interest

Investment Related: Municipal Bond Interest

Interest income received from investment in municipal bonds is excluded to allow state and local municipalities to sell bonds for a lower interest rate


Investment Related: Stock Dividends

Investment Related: Stock Dividends

Stock dividends are excluded from income because their receipt does not qualify as income under the realization concept

If the shareholder has the option to receive cash instead of stock, realization has occurred and the value of the dividend is included in income


Investment Related:Discharge of Indebtedness

Investment Related:Discharge of Indebtedness

An amount received as a loan is generally excluded from income under the realization concept because it must be returned

If a lender forgives all or a portion of the debt, realization occurs and the forgiven portion is income

Discharge due to insolvency or bankruptcy is excluded from income


Investment Related:Leasehold Improvements

Investment Related:Leasehold Improvements

The value of improvements to property made by a lessee are excluded under the wherewithal-to-pay concept

End of Chapter 4

Documents

Chapter 4 Income Exclusions ©2007 South-Western Kevin Murphy Mark Higgins Kevin Murphy Mark Higgins