Chapter 4- Gross Income: Exclusions

Items Specifically Excluded from Gross Income If an income item is within the all-inclusive definition of gross income, the item can be excluded only if the

taxpayer can locate specific authority for doing so Taxes play an important role in employee benefits, as well as other situations

o Attaining an exclusion is another means of enhancing after-tax income The tax adviser’s ideal is to attach the right labels or provide the right wording to render income non-taxable

without affecting the economics of the transaction Summary of principal exclusions from gross income:

o 1. Donative items Gifts, bequests & inheritances Life insurance proceeds paid by reason of death Accelerated death benefits Survivor benefits for public safety officer killed in the line of duty Scholarships

o 2. Personal & welfare items Injury or sickness payments Public assistance payments Amounts received under insurance contracts for certain living expenses Reimbursement for the costs of caring for a foster child Disaster relief payments

o 3. Wage & salary supplements A. Fringe benefits

Accident and health benefits Health Savings Accounts Lodging & meals furnished for the convenience of the employer Rental value of parsonages Employee achievement awards Employer contributions to employee group term life insurance Cafeteria plans Educational assistance payments Child or dependent care Services provided to employees at no additional cost to the employer Employee discounts Working condition & de minimis fringes Athletic facilities provided to employees Qualified transportation fringe Qualified moving expense reimbursement Qualified retirement planning services Tuition reductions granted to employees of educational institutions Child adoption expenses Long term care insurance

B. Military benefits Combat pay Housing, uniforms & other benefits

C. Foreign earned incomeoo 4. Investor Items

Interest on state & local government obligations Improvements by tenant to landlord’s property

75% exclusion for gain from sale of certain small business stocko 5. Benefits for the elderly

Social security benefits (except in the case of certain higher-income taxpayers)o 6. Other benefits

Income from discharge of indebtedness Recovery of a prior year’s deduction that yielded no tax benefit Gain from the sale of personal residence Educational savings bonds Qualified tuition program Coverdell Education Savings Account Lessee construction allowances for short-term leases Conservation cost-sharing payments

Statutory Authority Sections 101-150 provide the authority for excluding specific items from gross income

o Other exclusions are also scattered throughout the code Certain exclusions are intended as a form of indirect welfare payments Other exclusions prevent double taxation of income Some exclusions provide incentives for socially desirable activities In some cases, Congress has enacted exclusions to rectify the effects of judicial decisions At times, Congress responds to specific events-

i.e. 2001- victims of a qualified disaster would not be required to include payments received for living expenses, funeral expenses & property damage resulting from the disaster in gross income

Gifts & InheritancesGeneral

Beginning with the Income Tax Act of 1913 & continuing to the present, Congress has allowed the recipient of a gift to exclude the value of the property from gross income

o The exclusion applies to gifts made during the life of the donor (inter vivos gifts) & transfers that take effect upon the death of the donor (bequests & inheritances)

o The recipient of a gift of income producing property is subject to tax on the income subsequently earned from the property

The donor or the decedent’s estate may be subject to gift/estate taxes on the transfer In numerous cases, gifts are made in a business setting (i.e. a salesperson giving a purchasing agent free

samples)o 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 there from”.o If a payment is intended to be for services rendered, it is not a gift, even though the payment is made

without legal or moral obligation & 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”

o Cases have been decided on the basis of the donor’s intento Comm. V. Duberstein- landmark case

Gifts to Employees Transfers from an employer to an employee cannot be excluded as a gift

o Victims of a qualified disaster who are reimbursed by their employers for living/funeral expenses and property damage can exclude payments from gross income

Employee Death Benefits Frequently, an employer makes payments (death benefits) to a deceased employee’s surviving spouse, children,

or other beneficiaries

o If the decedent had a non-forfeitable right to the payments (i.e. the decedent’s accrued salary), the amounts are generally taxable to the recipient the same as if the employee had lived & collected the payments

o When the employer makes voluntary payments, the gift issue arises In general, the IRS considers such payments to be compensation for prior services rendered by

the deceased employee Some courts have held that payments to an employee’s surviving spouse/ other beneficiaries

are gifts if the following are true: The payments were made to the surviving spouse & children rather than to the

employee’s estate The employer derived no benefit from the payments The surviving spouse & 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 employeeso But not exclusively for families of shareholder-employeeso If all of the above conditions are satisfied, the payment is presumed to have

been made as an act of affection or charityo When one or more of these conditions is not satisfied, the surviving spouse &

children may still be deemed the recipients of a gift if the payment is made in light of the survivors’ financial needs

Life Insurance ProceedsGeneral Rule

Life insurance proceeds paid to the beneficiary because of the death of the insured are exempt from income taxo Congress chose to exempt life insurance proceeds because:

For family members, life insurance proceeds serve much the same purpose as nontaxable inheritance

In a business context/family situation, life insurance proceeds replace an economic loss suffered by the beneficiary

Accelerated Death Benefits If the owner of a life insurance policy cancels the policy & 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)

o The gain is realized because the general provision for life insurance proceeds applies only to those paid upon death of the insured

o If the policy is cancelled, it 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 incomeo Under the accelerated death benefits provisions, exclusion treatment is available for insured taxpayers

who are either terminally 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 3rd party The resultant gain, if any, is excluded from the insured’s gross income A terminally ill individual is one 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/she is certified as being unable to perform without

assistance certain activities of daily living These exclusions are available only to the insured

A person who purchases a life insurance policy from the insured does not qualifyTransfer 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

o 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 provides 4 exceptions to this rule that permit exclusion treatment for transfers to the following:o 1. A partner of the insuredo 2. A partnership in which the insured is a partnero 3. A corporation in which the insured is an officer or shareholder

The first 3 exceptions facilitate the use of insurance contracts to fund buy-sell agreementso 4. A transferee whose basis in the policy is determined by reference to the transferor’s basis

This 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 taxo Often, the beneficiary will elect to collect the insurance proceeds in installments

Annuity rules are used to apportion the installment payments between the principal element (excludible) and the interest element (includible)

ScholarshipsGeneral Information

Payments or benefits received by a student at an educational institution may be o 1. Compensation for serviceso 2. A gifto 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 does not generally render the amounts received nontaxable

The scholarship rules are intended to provide exclusion treatment for education-related benefits that cannot qualify as gifts but are not compensation for services

o 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 education institutiono A scholarship recipient may exclude from gross income the amount used for tuition and related

expenses (books, supplies, etc), provided the conditions of the grant don’t require that the funds be used for other purposes

o Amounts received for room and board are NOT excludible & are treated as earned income for purposes of calculating the standard deduction for a taxpayer who is another taxpayer’s dependent

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 yearo The amount eligible for exclusion may not be known at the time the money is received

In such a case, the transaction is help open until the educational expenses are paidDisguised Compensation

Some employers make scholarships available solely to the children of key employeeso 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 The IRS has ruled that the payments are generally includible in the gross income of the parent-

employeeQualified Tuition Reduction Plans

Employees (including retired/disabled former employees) of nonprofit educational institutions are allowed to exclude a tuition waiver from gross income if the waver is pursuant to a qualified tuition reduction plan

o The plan may not discriminate in favor of highly compensated employeeso The exclusion applies to the employee, the employee’s spouse & the employee’s dependent children

It also extends to tuition reductions granted by any nonprofit educational institution to employees of any other nonprofit educational institution (reciprocal agreements)

o The exclusion is generally limited to undergrad. Tuition waivers However, in the case of teaching/research assistants, graduate tuition waivers may also qualify

for exclusion treatment The exclusion is limited to the value of the benefit in excess of the employee’s

reasonable compensationo A tuition reduction that has a substitute for cash compensation cannot be

excluded

Compensation for Injuries & SicknessDamages

A person who suffers harm caused by another is often entitled to compensatory damageso The tax consequences of the receipt of damages depend on the type of harm the taxpayer has

experienced The taxpayer may seek recovery for

o 1. A loss of incomeo 2. Expenses incurredo 3. Property destroyedo Or 4. Personal injury

Reimbursement for a loss of income is generally taxed the same as the income replaced (exception: Personal Injury)

The recovery of an expense is not income, unless the expense was deductedo 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

propertyo The taxpayer has a realized gain if the damage payments received exceed the property’s basis

Personal Injury- o A distinction is made between compensatory (excludible under specified circumstances) and punitive

damages (never excludible) Compensatory damages are intended to compensate the taxpayer for the damages incurred

Only those 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 cannot be excluded (except to the extent of any amount received for medical care)

Any amounts received for age discrimination or injury to one’s reputation are non-excludible

Punitive damages are amounts the person who caused the harm must pay to the victim as punishment for outrageous conduct

They are not intended to compensate the victim, but rather punish the party who caused the harm

They are included in gross income

Worker’s Compensation State workers’ compensation laws require the employer to pay fixed amounts for specific job-related injuries

o They were enacted so the employee will not have to go through the ordeal of a lawsuit (and possibly not collect damages) to recover damages

o 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

Accident & Health Insurance Benefits The income tax treatment of accident & health insurance benefits depends on whether the policy providing the

benefits was purchased by the taxpayer or the taxpayer’s employero Benefits collected under an accident &health insurance policy purchased by the taxpayer are excludible,

even though they are income

Employer-Sponsored Accident & Health Plans Congress encourages employers to provide employees, former employees & their dependents with accident and

health benefits, disability insurance and long term care planso The PREMIUMS are deductible by the employer and excluded from the employee’s income

Although § 105(b) provides the general rule that the employee has includible income when he/she collects insurance benefits, 2 exceptions are provided:

o If payments are for expenses that do not meet the Code’s definition of medical care (usually excluded for employee, spouse & dependents), the amount received must be included in gross income

The taxpayer must include in gross income any amounts received for medical expenses that were deducted by the taxpayer on a prior return

o Section 105 (c) excludes payments for the permanent loss or the loss of the use of a member of function of the body or the permanent disfigurement of the employee, spouse or dependent

Payments that are a substitute for a salary (i.e. related for the period of time absent) are includible

Medical Reimbursement Plans Instead of providing the employee with insurance coverage for hospital & medical expenses, the employer may

agree to reimburse the employee for these expenseso The amounts received through the insurance coverage (insurance plan benefits) are excluded from

income 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)o Benefits received under a self-insured plan can be excluded from the

employee’s income if the plan doesn’t discriminate in favor of highly compensated employees

Instead of a medical reimbursement plan, the employer can purchase a medical insurance plan with a high deductible (i.e. employee is responsible for the first $x of the family’s medical expenses) and then make contributions to the employee’s Health Savings Account (HSA)

o The employer can make contributions each month up to the maximum contribution of 100% of the deductible amount

The monthly deductible amount is limited to 1/12 of $3,050 under a high deductible plan for self-only coverage

The monthly amount for an individual who has family coverage is limited to 1/12 of $6,150 under a high-deductible plan

o Withdrawals from the HSA must be used to reimburse the employee for 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

Long Term Care Insurance Benefits Long term care insurance covers expenses such as the cost of care in a nursing home

o It is generally treated the same as accident & health insurance benefitso The employee doesn’t recognize income when the employer pays the premiumso The exclusion is subject to annual limitso When benefits are received from the policy, whether the employer or individual purchased the policy,

the exclusion from gross income is limited to the greater of the following amounts:

$290 in 2010 (indexed amount) for each day the patient receives the long term care The actual cost of the care

The above amount is reduced by any amounts received from other 3rd parties (i.e. damages received)

o 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

Meals & LodgingFurnished for the Convenience of the Employer

Section 119 excludes from income the value of meals and lodging provide to the employee & the employee’s spouse & dependents under the following conditions:

o The meals and/or lodging are furnished by the employer, on the employer’s business premises, for the convenience of the employer

o In the case of lodging, the employee is required to accept the lodging as a condition of employment Furnished by the Employer- there are 2 questions raised with regard to this requirement:

o 1. Who is considered an employee?o 2. What is meant by furnished?

IRS & some courts have reasoned that a partner is not an employee, thus the exclusion doesn’t apply

However, the Tax Court & 5th Circuit Court of Appeals have ruled in favor of the taxpayer The Supreme Court held that a cash meal allowance was ineligible for the exclusion because the

employer did not actually furnish the meals Another court denied the exclusion where the employer paid for the food & supplied

the cooking facilities but the employee prepared the meal On the Employer’s Business Premises- this requirement is applicable to both meals and lodging

o The Regulations define premises as “the place of employment of the employee” The 6th Circuit Court of Appeals held that a residence, owned by the employer & occupied by an

employee, 2 blocks from the motel that the employee managed was not part of the business premises

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

The closer the lodging to the business operations, the more likely the convenience of the employer is served

For the Convenience of the Employer- this test is intended to focus on the employer’s motivation for furnishing the meals & lodging rather than on the benefits received by the employee

o If the employer furnishes the meals & lodging primarily to enable the employee to perform his/her duties properly, it doesn’t matter that the employee considers these benefits to be a part of his/her compensation

o Examples from the Regulations in which tests for excluding meals are satisfied: A restaurant requires its service staff to eat their meals on the premises during the busy

lunch/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 & lodging due to the inaccessibility of other facilitieso If more than ½ of the employees to whom meals are furnished receive their meals for the convenience

of the employer, then all such employee meals are treated as provided for the convenience of the employer

Required as a Condition of Employment- this test applies only to lodgingo 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 availableo If the employee has the option of cash or lodging, the required test is not satisfied

Other Housing Exclusions

Employees of Educational Institutions- an employee of an educational institution may be able to exclude the value of campus housing provided by the employer

o Generally, the employee doesn’t recognize income if he/she pays annual rents equal to or greater than 5% of the appraised value of the facility

o If the rent payments are less than 5% of the value of the facility, the deficiency must be included in gross income

Ministers of the Gospel-o Ministers of the gospel 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 or provide a home 3. The Rental value of a home owned by the minister

o The housing/housing allowance must be provided as compensation for the conduct of religious worship, the administration & maintenance of religious organizations, or the performance of teaching & administrative duties at theological seminaries

Military Personnel- o Military personnel are allowed housing exclusions under various circumstanceso Authority for these exclusions is generally found in Federal laws that aren’t a part of the IRC

Other Employee Fringe BenefitsSpecific Benefits

Congress has enacted exclusions to encourage employers to:o 1. Finance & make available child care facilitieso 2. Provide athletic facilities for employeeso 3. Finance certain employees’ educationo And 4. Pay or reimburse child adoption expenses

Provisions:o The employee doesn’t have to include in gross income the value of child & dependent care services paid

for by the employer & incurred to enable the employee to work The exclusion can’t exceed $5,000 per year ($2,500 if married & filing separately) The annual exclusion for a married couple cannot exceed the earned income of the spouse who

has the lesser amount of earned income For an unmarried taxpayer, the exclusion can’t exceed the taxpayer’s earned income

o The value of the use of a gym or other athletic facilities by employees, their spouses & 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 & their family members

o Qualified employer-provided educational assistance at the undergrad/grad level is excludible from gross income

The exclusion doesn’t cover meals, lodging & transportation costs 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

o The employee can exclude up to $12,170 of expense incurred to adopt a child where the adoption expenses are paid or reimbursed by the employer under a qualified adoption assistance program

The exclusion limit is the same even if the child has special needs However, for a child with special needs, the $12,170 exclusion applies even if the actual

adoption expenses are less than that amount The exclusion is phased out as AGI increases from $182,520 to $222,520

Cafeteria Plans Generally, if an employee is offered a choice between cash & some other form of compensation, the employee

has gross income regardless of the option choseno An exception to this treatment is provided under cafeteria plan rules

The employee is permitted to choose between cash & nontaxable benefits If the employee chooses the otherwise nontaxable benefits, the cafeteria plan rules enable the

benefits to remain nontaxable Congress excluded long term care insurance from the excludible benefits that can be provided

under a cafeteria plan An employer must provide these benefits separate from the cafeteria plan

Flexible Spending Plans Flexible spending plans (flexible benefit plans)- the employee accepts lower cash compensation in return for the

employer to agreeing to pay certain costs that the employer can pay without the employee recognizing gross income

o The employee can estimate certain expenses & agree to a salary reduction equal to the estimated expense

The employer then pays or reimburses the employee for the actual expenses incurred, with a ceiling of the amount of the salary reduction

If the actual expenses are less than the reduction in cash compensation, the employee can’t recover the difference

o These plans are often referred to as use or lose plans They can ‘t be used to pay long term care insurance premiums Recently issued IRS rules for these plans- the taxpayer has until the 15th day of the 3rd month after the end of the

plan year to use the funds for qualified expenses (a 2.5 month grace period)o Employers have generally amended their plans to provide that payments made during the grace period

will be first taken from the balance in the flex spending account at the beginning of the plan yearGeneral Classes of Excluded Benefits

Benefits given to employees from an employer are taxable unless they fall in the categories of the aforementioned provisions

o The amount of income is the fair market value of the benefit To avoid undesirable results & create uniform rules for fringe benefits, Congress established 7 broad classes of

nontaxable benefits: 1. No-additional cost services- the services will be nontaxable if all of the following conditions are satisfied:

o 1. The employee receives services, as opposed to propertyo 2. The employer doesn’t incur substantial additional cost, including forgone revenue, in providing the

services to the employeeo 3. The services are offered to customers in the ordinary course of business in which the employee works

The Code allows for the exclusion for reciprocal benefits offered by employers in the same line of business

The no-additional cost exclusion extends to the employee’s spouse & dependent children & to retired & disabled former employees

IRS has conceded that partners who perform services for the partnership are employees for the purposes of the exclusion

The exclusion isn’t allowed to highly compensated employees unless the benefit is available on a non-discriminatory basis

2. Qualified Employee Discounts- o When the employer sells goods/services to the employee for a price that is less than the price charged

regular customers, the employee realizes income equal to the discounto However, the qualified employee discount can be excluded from the gross income of the employee

subject to the following conditions: The exclusion is not available for real property or for personal property of the type commonly

held for investment 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% of the customer price

o The exclusion applies to employees (including service partners), employees’ spouses and dependent children & retired & disabled former employees

o It does not apply to highly compensated individuals unless the discount is available on a nondiscriminatory basis

3. Working Condition Fringes- an employee is not required to include in gross income the cost of property/services provided by the employer if the employee could deduct the cost of those items if he/she has actually paid for them (working condition fringes)

o In many cases, this exclusion merely avoids reporting income & an offsetting deductiono The working condition fringe benefit rules allow an exclusion where the expense would not be

deductible if paid by the employee in 2 specific situations: Auto salespeople are allowed to exclude the value of certain personal use of company

demonstrators The employee business expense would be eliminated by the 2% floor on miscellaneous itemized

deductions under section 67o These benefits can be made on a discriminatory basis & still qualify for the exclusion

4. De Minimis Fringes- benefits so small that accounting for them is impracticalo Examples:

The typing of a personal letter by a company secretary, occasional company cocktail parties, occasional personal use of a company copying machine, occasional supper money or taxi fare for employees b/c of overtime & certain holiday gifts of property w/ a low fair market value are excluded

Subsidized eating facilities operated by the employer are excluded if located on or near the employer’s business premises, if revenue equals or exceeds direct operating costs & if non-discrimination requirements are met

o Except in the case of subsidized eating facilities, the de minimis fringe benefits can be granted in a manner that favors highly compensated employees

5. Qualified Transportation Fringes- the intent of this exclusion is to encourage the use of mass transit for commuting to and from work

o Qualified transportation fringes encompass the following transportation benefits provided by the employer to the employee:

1. Transportation in a commuter highway vehicle b/w the employee’s residence & the place of employment

2. A transit pass 3. Qualified parking 4. Qualified bicycle commuting reimbursement

o The combined limit for 1 and 2 is $230/montho The limit for category 3 is $230/month

Both of these dollar limits are indexed annually for inflationo A commuter highway vehicle is any highway vehicle with a seating capacity of at least 6 adults (excluding

the driver) Also, at least 80% of the vehicle’s use must be for transporting employees b/w their residences

& places of employmento 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 carpoolo The qualified bicycle commuting reimbursement provides an exclusion of up to $20/month received

from an employer as reimbursement for the cost of commuting by bicycleo Qualified transportation fringes may be provided directly by the employer or may be in the form of cash

reimbursements 6. Qualified Moving Expense Reimbursements-

o Qualified moving expenses that are reimbursed/paid by the employer are excludible from gross income

o Must be deductible under Section 217 7. Qualified Retirement Planning Services- include any retirement planning advice or info that an employer who

maintains a qualified retirement plan provides to an employee or the employee’s spouseo Congress decided to exclude the value of such services from gross income because they are a key part of

retirement income planning 8. Nondiscrimination Provisions-

o For no-additional cost services, qualified employee discounts and qualified retirement planning services, if the plan is discriminatory in favor of highly compensated employees, these key employees are denied exclusion treatment

o However, the non-highly compensated employees who receive benefits from the plan can still enjoy exclusion treatment for the no-additional-cost services, qualified employee discounts & qualified retirement planning services

o De minimis (except subsidized eating facilities) and working condition fringe benefits (b/c types of services required vary with the job) can be provided on a discriminatory basis

o The qualified transportation fringe & the qualified moving expense reimbursement can be provided on a discriminatory basis

Taxable Fringe Benefits If the fringe benefits can’t qualify for any of the specific exclusions or do not fit into any of the general classes of

excluded benefits, the taxpayer must recognize gross income equal to the fair market value of the benefits If a fringe benefit plan discriminates in favor of highly compensated employees, generally those employees

aren’t allowed to exclude the benefits they receive that other employees don’t enjoy However, the highly compensated employees, as well as the other employees, are generally allowed to exclude

the nondiscriminatory benefits

Foreign Earned Income A US citizen is generally subject to US tax on his/her income regardless of the income’s geographic origin

o The income may also be subject to tax in the foreign country Thus, the taxpayer must carry a double tax burden

For fairness & to encourage US citizens to work abroad (so exports might be increased), Congress has provided alternative forms of relief from taxes on foreign earned income- the taxpayer can elect either:

o 1. To include the foreign income in his/her taxable income & then claim a credit for foreign taxes paido Or 2. To exclude the foreign earnings from his/her US gross income (the foreign earned income

exclusion)- most taxpayer choose this 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 US government)o 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 The exclusion is limited to an indexed amount of $91,500 for 2010

o For married persons who both have foreign earned income, the exclusion is computed separately for each spouse

o Community property rules do not apply The community property spouse is not deemed to have earned ½ of the other spouse’s foreign

earned incomeo If all the days in the tax year are not qualifying days, the taxpayer must compute the maximum exclusion

on a daily basis ($91,500 divided by the number of days in the entire year x the # of qualifying days) The reasonable housing costs incurred by the taxpayer & the taxpayer’s family in a foreign country in excess of a

base amount may be excluded from gross incomeo The base amount is 16% of the statutory amount (indexed amt for 2010= $91,500) assuming all of the

days are qualifying days for the foreign earned income exclusion

o The housing costs exclusion is limited to 30% of the statutory amount (as indexed) for the foreign earned income exclusion

Alternatively, the claiming of a credit in lieu of excluding foreign earned income may be advantageous if the individual’s foreign earned income far exceeds the excludible amount so that foreign taxes paid exceed the US tax on the amount excluded

However, once a choice is made between the credit or exclusion, it applies to all subsequent years unless affirmatively revoked

o A revocation is effective for the year of the change and the 4 subsequent years

Interest on Certain State & Local Obligations Interest on state and local government obligations is specifically exempted from Federal income taxation

o However, the Supreme Court has concluded that there is no constitutional prohibition against levying a nondiscriminatory Federal income tax on state & local government obligations

The current exempt status applies only to state & local government bondso Thus, income received from the accrual of interest on a condemnation award or an overpayment of

state income tax is fully taxableo The exemption doesn’t apply to gains on the sale of tax-exempt securities

The interest on US government bonds is not excluded from the Federal tax base State and local governments are prohibited from taxing interest on US government bonds States are free to tax one another’s obligations

o Some states exempt the interest on the bonds they issue, but tax the interest on bonds issued by other states

DividendsGeneral Information

Dividends to shareholders are taxable only to the extent the payments are made from either the corporation’s current earnings & profits or its accumulated earnings and profits

o Distributions that exceed earnings & profits are treated as a nontaxable recovery of capital & 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

The following are payments that are frequently referred to as dividends but are NOT considered dividends for tax purposes:

o Dividends received on deposits with savings & loan associations, credit unions & banks are actually interest

o Patronage dividends paid by cooperatives (i.e. for farmers) are rebates made to the users & are considered reductions in the cost of items purchased from the association

The rebates are usually made after year-end & are apportioned among members on the basis of their purchases

o Mutual insurance companies pay dividends on unmatured life insurance policies that are considered rebates of premiums

o Shareholders in a mutual investment fund are allowed to report as capital gains their proportionate share of the fund’s gains realized & distributed

The capital gain & ordinary income portions are reported on the Form 1099 that the fund supplies its shareholders each year

Stock Dividends When a corporation issues a simple stock dividend, the shareholder doesn’t realize income However, if the shareholder has the option of receiving either cash or stock in the corporation, the individual

realizes gross income regardless of what he/she chooseso A taxpayer who elects to receive the stock could be deemed to be in constructive receipt of the cash

he/she has rejected

However, the amount of income in this case is the value of the stock received, rather than the cash the shareholder has rejected

Educational Savings Bonds Educational savings bonds- assistance to low to middle income parents in saving for their children’s college

education- it is an interest income exclusiono The interest on Series EE US government savings bonds may be excluded from gross income if the bond

proceeds are used to pay qualified higher education expenses The exclusion only applies of both of the following requirements are met:

1. The savings bonds are issued after December 31, 1989 2. The savings bonds are issued to an individual who is at least 24 years old at the time

of issuance The exclusion is not available for a married couple who file separate returns

o The redemption process must be used to pay qualified higher education expenses (they consist of tuition & fees paid to an eligible educational institution for the taxpayer, spouse or dependent)

In calculating qualified higher education expenses, the tuition & fees paid are reduced by excludible scholarships & veteran’s benefits received

If the redemption proceeds (both principal & interest) exceed the qualified higher education expenses, only a pro rata portion of the interest will qualify for exclusion treatment

o The exclusion is limited by the application of the wherewithal to pay concept- once the modified adjusted gross income (MAGI) exceeds a threshold amount, the phase-out of the exclusion begins

MAGI is AGI prior to the foreign earned income exclusion & the educational savings bond exclusion

Thresholds are adjusted for inflation each year 2010- phase-out begins at $70,100 ($105,100 on a joint return) Phase-out 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-$70,100)/$15000) x excludible interest before phase-outo On a joint return, $105,100 and $30,000 are used instead of $70,100 and

$15,000 respectively

Qualified Tuition Programs (Section 529 Plans) Nearly all states have created programs in which parents can in effect prepay their child’s college tuition

o The prepayment serves as a hedge against future increase in tuitiono If the child doesn’t attend college, the parents are generally refunded their payments plus interest

Under a qualified tuition program, the amounts contributed must be used for qualified higher education expenses (tuition, fees, books, supplies, room & board, equipment required for enrollment/attendance at a college/university/certain vocational schools)

o ARRTA 2009- allowable expenses are extended to computers & computer technology (including software that provides access to the Internet)

o These expenses also include expenses for special needs services incurred in connection with the enrollment/attendance of special needs students

o The earnings of the contributed funds, including the discount on tuition charged to participants, are not included in Federal gross income if they are used for qualified higher education expenses

Some states also exclude these educational benefits from state gross incomeo If the parent receives a refund, the excess of the amount refunded over the amount contributed by the

parent is included in the parent’s gross incomeo Qualified tuition programs have been expanded to apply to private education institutions as well as

public educational institutionso Distributions made after 12/31/03 from such a plan maintained by an entity other than the state for

qualified higher education expenses are eligible for exclusion from gross income

Tax Benefit Rule Generally, if a taxpayer obtains a deduction for an item in 1 year and in a later year recovers all/a portion of the

prior deduction, the recovery is included in gross income in the year received However, the section 111 tax benefit rule provides that no income is recognized upon the recovery of a

deduction (or portion) that did not yield a tax benefit in the year it was takeno The recovery would be partially/totally excluded from gross income in the year of the recovery

Income from Discharge of Indebtedness A transfer of appreciated property (FMV is greater than adjusted basis) in satisfaction of a debt is an event that

triggers the realization of incomeo Transaction is treated as a sale of the appreciated property followed by payment of the debto Foreclosure by a creditor is also treated as a sale or exchange of the property

If a creditor doesn’t exercise their right of foreclosure & forgives a portion of the debt, the debtor realizes income from discharge of indebtedness

Generally, the income realized by the debtor from the forgiveness of a debt is taxableo The following discharge of indebtedness situations are subject to special treatment:

1. Creditors’ gifts If the reduction of debt is an act of love, affection or generosity, the debtor has simply

received a nontaxable gift 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 1/1/07

and 1/1/13 & is the result of the financial condition of the debtoro In situations 2-5 and 9, the Code allows the debtor to reduce his/her basis in the assets by the realized

gain from the discharge The realized gain is merely deferred until the assets are sold or depreciated

o In situation 6 ( a price reduction), the debtor reduces the basis in the specific assets financed by the seller

o Situation 7 is usually considered a tax-free contribution of capital to the corporation by the shareholder Thus, the corporation’s PIC is increased & liabilities are decreased by the same amount

o In situation 8, the amount of the loan that is forgiven is excluded from gross incomeTAX PLANNING

Life Insurance Favorable tax attributes of life insurance include:

o The annual increase in the cash surrender value of the policy is not taxable ( no income has been actually or constructively received)

The owner can actually receive the policy’s increase in value in cash without recognizing income

Employee Benefits Employees can obtain group coverage at much lower rates than individuals would have to pay for the same

protectiono 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

o A similar tax consequence applies to child care and parking costs if the employer pays for them

The use of a cafeteria plan in a situation where both spouses in a married couple are working can lead to avoidance of duplications of benefits & addition of other needed benefits

o If less than all of the employee’s allowance is spent, the employee can receive cash The meals & lodging exclusion allows employees to receive from their employer what they ordinarily must

purchase with after-tax dollarso However, the requirements of the provision limit the tax planning opportunities

Employees’ discount provision allows employees of manufacturers to avoid tax on the manufacturer’s, wholesaler’s and retailer’s markups

The exclusion of benefits is generally available only to employees (proprietors & partners must pay tax on these benefits)

o By incorporating and becoming an employee of the corporation, the former proprietor/partner can also receive these tax-exempt benefits

Investment Income To realize the maximum benefit from the exemption on the state & local government bonds, the investor can

purchase 0 coupon bondso These investments pay interest only at maturity

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 can’t be made Reinvesting the interest may entail transaction costs

o The 0 coupon feature avoids these problems Series EE US gov’t savings bonds can earn tax-exempt interest if the bond proceeds are used for qualified higher

education expenseso However, the investor must take into account the income limitation for excluding the interest from

gross income