Gross Income: Inclusions and Exclusions

1
Chapter 6

• Gross Income Inclusions and Exclusions

2
Investment Income

• As shown in Exhibit 6-1, the vast majority of the
  income reported by individuals comes in some form
  of employee compensation such as salaries and
  wages (71.1 of all reported income for 2000).
• However, the income of many individuals also
  contains some type of investment income
  sometimes referred to as unearned income
  
• Dividends
• Interest
• Annuities
• Rents

3
Dividends

• A distribution made by a corporation is treated
  as a dividend and is fully taxable as ordinary
  income
  
• Amounts of the distribution that exceed EP
  (earnings and profits) are treated as nontaxable
  returns of capital to the extent of the
  shareholders basis in the stock.
• The excess over basis is capital gain.
• Corporate taxpayers can (Ch. 19) deduct 70 of
  the dividend received.
  
• Mutual fund distributions are either ordinary or
  capital gains
  
• Ordinary dividends represent the individuals
  share of the funds earnings from its own
  investments.
  
• Capital gain dividends represent the long-term
  capital gains and losses actually realized by the
  mutual fund during the year and are treated as
  long-term capital gains.
• Corporate taxpayers are entitled to the
  dividends-received deduction for ordinary
  dividends but not capital gain dividends.

4
Dividends (cont)

• A few funds retain their capital gains, which
  they pay tax on
  
• These gains are allocated to the shareholders who
  must include them in income as capital gains.
  
• Shareholders may claim a credit for any tax paid
  by the fund and increase their basis in their
  shares for the amount included in income less the
  tax paid.

5
Dividends (cont)

• As a result of recent changes in the law (2003)
  dividends are taxed at lower rates 5 for
  taxpayers whose income falls in the 10 and 15
  ordinary income tax brackets and 15 for all
  others, unless the stock is held 60 days or less
  (then it is taxed as ordinary income). It applies
  to dividends received from stocks and mutual
  funds and in calculating the AMT.
• Dividends are not included in the capital
  gain/loss netting process and the new rules do
  not apply to tax deferred investment accounts
  (401(k), Keogh, etc.)

6
Dividends (contd)

• There are a number of distributions that receive
  special treatment
  
• Earnings on deposits with banks, credit unions,
  investment companies, and SL associations are
  reported as interest.
  
• Mutual insurance companies distribute amounts
  referred to as dividends to owners of un-matured
  life insurance policies.
  
• These dividends are treated as a nontaxable
  return of a portion of the insurance premium
  paid.
  
• Cooperatives distribute patronage dividends.
• These dividends are treated as a return of part
  of the original price paid for items purchased by
  members.

7
Dividends (contd)

• Dividends from regulated investment companies
  (mutual funds) that represent gains on sales of
  investments from the fund are treated as
  long-term capital gains.
• Stock dividends are normally declared as a means
  to reduce the selling price of the stock or as
  simply a gesture of goodwill to the shareholders.
  
• If all shareholders receive their proportionate
  shares of the stock distributed, the stock
  dividend is nontaxable.
  
• If the shareholders interest does change, the
  stock distribution is taxable.
  
• If the distribution of stock is nontaxable, the
  only responsibility of the shareholder is to
  determine the basis of the new and the old
  stock.

8
Interest

• As a general rule, interest income is taxable.
  There are two notable exceptions to this rule
  
• the exclusion for interest on certain state and
  local government obligations,
  
• the exclusion for interest on educational savings
  bonds.
  
• Interest on obligations of a state, a territory,
  a U.S. possession, or any of their political
  subdivisions is nontaxable.
  
• A break-even point between taxable and nontaxable
  rates of return may be calculated with the
  following formula
  
• Taxable interest rate x (1 Marginal tax rate)
  Tax-free rate
  
• With certain specified exceptions, interest on
  industrial development bonds is taxable income.
  
  
• Tax-exempt bonds can not be issued to finance
  airplanes, gambling facilities, liquor stores,
  health clubs, sky boxes, or other luxury boxes.
  Nor can the bonds be issued to finance the
  acquisition of farmland or existing facilities,
  with certain exceptions.
• Gain on the sale of tax-exempt securities that
  does not represent interest is taxable income.

9
Interest (continued)

• Code Section 135 generally provides that accrued
  interest on Series EE savings bonds issued after
  1989 is exempt from tax when the accrued interest
  and principal amount of such bonds are used to
  pay for qualified educational expenses of the
  taxpayer of the taxpayers spouse or dependents.
  
• Qualified educations expenses include those for
  tuition or fees to attend college or certain
  schools offering vocational education.
  
• Costs that otherwise qualify must be reduced by
  any scholarships or fellowships received, as well
  as any employer-provided assistance.
  
• If the redemption proceeds received during the
  year exceed the amount of education expenses paid
  during the same year, the amount of the interest
  exclusion must be reduced proportionately.
• To qualify for the exclusion, the savings bonds
  need not be transferred directly to the
  educational institution.

10
Interest (continued)

• Code Section 135 (continued)
• To qualify for the exclusion, the savings bonds
  need not be transferred directly to the
  educational institution.
  
• The exclusion applies to interest on any
  post-1989 Series EE savings bond that is realized
  during the taxable year as long as the taxpayer
  pays sufficient qualified educational expenses
  during the same taxable year.
• The special exclusion is designed to benefit only
  those who have moderate incomes and is gradually
  reduced once the taxpayers A.G.I. reaches a
  certain level.
• Married taxpayers filing separately are not
  eligible for the exclusion.
  
• The exclusion is available only for bonds that
  are issued to individuals who are at least 24
  years old.
  
• The exclusion is available only to the original
  purchaser of the bond or his or her spouse, which
  prohibits gifts of qualified bonds.

11
Annuities

• An annuity is an investment contract that
  requires a fixed amount of money to be paid to
  the owner at specific intervals for either a
  certain period of time or for life.
• When the annuity is purchased by an individual,
  the interest earned on the investment is
  tax-deferred.
  
• This interest is taxable income at some future
  date when the annuitant receives payments.
  
• The taxation of annuities reflects the cost
  recovery principle. The portion that is a return
  of capital is nontaxable. The formula for
  determining the portion that is a nontaxable
  return of capital for the current period is
• Investment in the contract X Amount received
  currently Excluded portion
  
• Expected return from the contract
• The taxable portion is the amount received less
  the portion that is a return of capital (i.e.,
  the excluded portion).

12
Annuities (cont)

• When the payments are received over the life of
  the annuitant, the expected return from the
  contract is the amount to be received each year
  multiplied by the multiple that corresponds to
  the annuitants age in the tax table (see Exhibit
  6-3).
• Note that the portion of any annuity payment to
  be excluded from gross income cannot exceed the
  un-recovered investment
  
• If the annuitant dies before the entire
  investment is recovered, the amount of the
  un-recovered investment is allowed as a deduction
  on his or her final tax return.

13
Annuities (continued)

• Employers with qualified pension or
  profit-sharing plans (see Ch.18) purchase annuity
  contracts for their employees retirement.
  
• The taxable income to the employee is dependent
  on the employees total after-tax investment in
  the annuity.
  
• After tax funds generally exclude contributions
  to certain Individual Retirement Accounts (when
  individuals are allowed a deduction for the
  contribution) and to qualified employer
  retirement plans (since these contributions are
  made from amounts that are excluded from gross
  income in the current year).
• Investments that are not from after-tax funds are
  ignored in determining the individuals capital
  investment in the annuity.
  
• Basis in the annuity contract is zero and all
  amounts are included in gross income.

14
Annuities (continued)

• The safe harbor method for determining the
  taxation of annuities may be elected if the
  annuity payments
  
• Start after November 18, 1996
• Depend on the life of the distribute or the joint
  lives of the distribute and his or her
  beneficiary
  
• Are made from a qualified employee plan, an
  employee annuity, or an annuity contract and
  
• Start when the distributee is under age 75 or, if
  older, there are less than five years of
  guaranteed payments remaining.

15
Annuities (continued)

• Under this method, the total number of monthly
  annuity payments expected to be received is based
  on the distributees age at the annuity starting
  date.
• Exhibit 6-4 is used, and is applicable whether
  the annuity is single life or joint and survivor
  type.
  
• The portion of each monthly annuity payment that
  is nontaxable is determined using the following
  formula
  
• Investment in the contract Nontaxable
  return of capital
  
• Number of monthly payments
• Investors are discouraged from withdrawing funds
  early
  
• Early withdrawals are treated as being
  distributions of the interest earned on the
  contract, and
  
• A 10 percent penalty is assessed on the deferred
  income.

16
Prepaid Tuition Plan

• Distributions from qualified prepaid tuition
  plans are not taxable as long as the amounts are
  used to pay for qualified higher education
  expenses (
• Ex. Tuition, books, supplies, equipment required
  for enrollment or attendance and those incurred
  for special needs beneficiaries).
  
• Many states and individual universities, both
  state and private, are permitted to establish
  qualified tuition plans (529 Plans).
  
• Unused balances can now be rolled over tax free
  from one college savings program to another once
  every twelve months without a beneficiary change.
  First cousins are considered to be qualified
  family members.

17
Estate and Gift Tax Treatment

• Under current gift tax law, an annual exclusion
  allows individuals to transfer 11,000 per donee
  per year
  
• The gift must represent a present interest (i.e.,
  the donees enjoyment commences immediately and
  not at a future date).
  
• Payments to prepaid tuition plans qualify
• Amounts contributed in excess of the annual
  exclusion would be considered taxable.
  
• However, a taxpayer may elect to have a
  contribution to a plan treated as if it had been
  made ratably over five years.
  
• The current gift tax permits an unlimited
  exclusion for tuition paid on someones behalf if
  it is paid directly to an educational
  institution.
• This latter rule is not extended to payments made
  to qualified prepaid tuition plans.
  
• Taxpayers receiving qualified tuition plan
  distributions are also eligible to claim either
  the HOPE or Lifetime Learning Credit for a
  taxable year as long as the distributions are not
  used for the same expenses for which a credit is
  claimed.

18
Employee Compensation and Other Benefits

• Congress has exempted certain benefits (e.g.,
  health insurance, group-term life insurance), not
  only from income tax but also social security and
  medicare taxes.
• Employers can deduct the cost of the benefit and
  can also reduce their compensation cost since
  they are not required to pay social security,
  medicare, or unemployment taxes on such amounts.

19
Employee Compensation and Other Benefits (contd)

• Employee fringe benefit plans must
• Not discriminate in favor of highly compensated
  employees,
  
• Be in writing,
• Be for the exclusive benefit of the employees,
• Be legally enforceable,
• Provide employees with information concerning
  available plan benefits, and
  
• Be established with the intent that they will be
  maintained indefinitely.
  
• In addition, several eligibility and benefit
  tests provide detailed rules that must be met to
  ensure that employer costs are nontaxable income
  for employees.

20
Reimbursement of Employee Expenses

• Reimbursements are generally considered taxable.
  
  
• However, the employee usually has an offsetting
  expense that is deductible for A.G.I., so the
  effect on the tax return is usually a wash.
  
• If the employee is over-reimbursed or reimbursed
  for nondeductible expenses, there is a net
  increase in A.G.I.

21
Employer Gifts

• Amounts transferred from an employer to an
  employee in the form of cash or other property
  are not excludable as a gift.
  
• In effect, employers are prohibited from
  disguising compensation as a nontaxable gift

22
Employer Awards

• Employer awards to employees are generally
  treated as compensation unless they are
  provided
  
• For length-of-service or safety achievements or
• Under a nondiscriminatory qualified award plan
• To be nontaxable, the awards must be made with
  tangible personal property.
  
• No exclusion is available for cash payments or
  the equivalent.
  
• The award must be given as part of a meaningful
  presentation and under conditions and
  circumstances that do not create a significant
  likelihood of the payment of disguised
  compensation.
• No exclusion for the length-of-service award is
  available if it or a similar award is made within
  the individuals first five years of employment
  with the employer.
• To be nontaxable, safety awards cannot have been
  made to more than 10 percent of a companys
  eligible employees.
  
• All employees are considered to be eligible
  except those in managerial, professional, and
  clerical positions.

23
Employer Awards (contd)

• The cost of property cannot exceed 400 per
  employee annually for length-of-service and
  safety achievements or 1,600 annually for all
  qualified plan awards.
• Excess costs are taxable income to the extent of
  the greater of
  
• (1) the nondeductible cost to the employer due to
  the limitations, or
  
• (2) the propertys market value in excess of the
  limitations.

24
Social Security Benefits

• When most taxpayers collect social security
  benefits, these benefits can be excluded from
  gross income.
  
• However, upper-income taxpayers can have as much
  as 85 of their social security benefits taxed.
  
  
• The effect of this is to tax these amounts at
  least that portion representing the taxpayers
  contributions twice first when included as
  gross wages and second when included as social
  security benefits.
• The concept of modified adjusted gross income is
  used to determine whether a taxpayers level of
  income will be taxed for his/her social security
  benefits
• Adjusted gross income
• ½ of social security benefits
• Tax-exempt income
• Foreign earned income exclusion
• Modified A.G.I.

25
Social Security Benefits (contd)

• Taxpayers whose modified A.G.I. is less than the
  first threshold (32,000 for married filing
  jointly) are not taxed on their social security
  benefits.
• Those whose modified A.G.I. falls between the two
  thresholds (32,000 - 44,000 for married filing
  jointly) must include the lesser of one-half of
  their social security benefits or one-half of the
  excess of their modified A.G.I. over the
  specified threshold.
• For those taxpayers whose modified A.G.I. exceeds
  the first threshold (e.g., 32,000 for married
  filing jointly), the calculation can be made
  using the schedules on page 6-21.
• Married taxpayers who elect to file separately
  automatically expose social security benefits to
  taxation.

26
Unemployment Benefits

• Employers, not employees, are subject to Federal
  and State unemployment taxes which they are
  entitled to deduct as ordinary business expenses.
  
• Currently, unemployment benefits received under a
  government program are fully taxable.

27
Employee Insurance

• Generally, employer-paid premiums for health,
  accident, and disability insurance are deductible
  business expenses and are excluded from the
  employees gross income.
• Life insurance premiums paid by the employer
  generally are included by the employee and
  deductible by the employer.
  
• However, there are exceptions.

28
Life Insurance Premiums and Proceeds

• Employer-paid life insurance premiums are
  nontaxable by an employee but only for the first
  50,000 of group-term life insurance protection.
  
• Premiums paid by an employer for any other type
  of life insurance are fully included in each
  employees gross income.
  
• The employer must provide coverage for all
  employees with a few permitted exceptions based
  on their age, marital status, or factors related
  to employment.
• Examples of employment-related factors are union
  membership, duties performed, compensation
  received, and length of service.

29
Health Insurance Benefits

• With few exceptions, all medical insurance
  benefits are excluded from income regardless of
  who pays the premiums.
  
• Any reimbursement of medical costs simply reduces
  the amount of medical expenses that can be
  itemized (as deductions from A.G.I. discussed
  in Chapter 11).
• If medical coverage is financed by the employer,
  any reimbursement in excess of medical expenses
  incurred by an employee for himself or herself ,
  a spouse, and dependents is included in gross
  income.
• These excess amounts, however, are not included
  if the premiums were paid by the individual.
  
• Corporations that finance their own medical
  benefit plans from company are required to
  establish plans that do not discriminate in favor
  of certain officers, shareholders, or highly paid
  employees.

30
Qualified Long-Term Care Benefits

• Insurance contracts for long-term care is
  considered to be an accident and health insurance
  contract and taxpayers are able to exclude
  benefits received.
• If the policy pays a specific per diem amount
  regardless of the amount of actual medical
  expenses, a maximum of 230 (220 in 2003) per
  day may be excluded from income (indexed for
  inflation since 1998).
• If payments exceed the dollar cap, then the
  excess is tax-free only to the extent of the
  individuals actual costs incurred for long-term
  services.
• As general rule, employees can exclude from
  income the value of employerprovided coverage
  under a long-term care plan.
  
• There is no exclusion if the coverage is provided
  through a cafeteria plan.
  
• Furthermore, long-term care services cannot be
  reimbursed on a tax-free basis under a flexible
  spending account.

31
Accident and Disability Insurance Benefits

• All amounts received under an employer-financed
  accident or disability plan are taxable.
  
• However, when payments are for permanent loss or
  use of a function or member of the body or for
  permanent disfigurement of the employee,
  employees spouse or dependent, they are
  nontaxable.
• To be excludable, the payments must be computed
  with reference to the nature of the injury, and
  not on the time the employee is absent from
  work.
• Disability income is nontaxable if the taxpayer
  paid for the disability coverage.

32
Employer-Provided Meals and Lodging

• Under Section 119, the value of meals and lodging
  provided by an employer to an employee and the
  employees spouse and dependents is excluded from
  income if they are
• Provided for the employers convenience
• Provided on the employers business premises
  and
  
• In the case of lodging, the employee is required
  to occupy the quarters in order to perform
  employment duties.
  
• Meals provided to all employees will be excluded
  if provided to more than one-half of all
  employees for the convenience of the employer.
  
• This rule is important for employers as well
  since it enables employers to deduct all of such
  costs (e.g. the cost of a company cafeteria).

33
Child and Dependent Care Assistance

• Employees who receive reimbursements for their
  child care expenses or whose employer provides
  child care in kind (e.g., a day care facility)
  may exclude up to 5,000 annually.
• The law allows gainfully employed individuals a
  limited credit for their child care expenses
  (20-35 of 3,800 - 6,000 of expenses depending
  on the taxpayers income and the number of
  children).
• While this might suggest that the taxpayer may be
  able to secure two benefits, the law effectively
  prohibits this by reducing any expenses that
  qualify for the credit by the amount of any
  benefits that are excluded.
• In order to claim either the exclusion or the
  credit, a laundry list of special rules must be
  followed.
  
• These are discussed in Chapter 13.

34
Adoption Assistance Programs

• To encourage adoptions an employee is allowed a
  10,630 per child for 2005 (including special
  needs children) exclusion for qualified adoption
  expenses paid or incurred by an employer.
• The exclusion contained in Section 137 begins to
  be phased out for taxpayers with modified
  adjusted gross income (AGI) above 159,450 and is
  not available once modified AGI reaches 199,450.
  
• The 2001 Act also provides an increased
  nonrefundable adoption credit of up to 10,640
  per child adopted.
  
• See Chapter 13 for a discussion of the adoption
  credit including the definition of the term
  special needs.

35
Adoption Assistance Programs (continued)

• Under Section 131, taxpayers are entitled to
  exclude qualified foster care payments made if
  they are eligible foster care providers.
  
• This enables payments from for-profit agencies
  contracting with state and local governments to
  provide nontaxable foster care payments to foster
  care providers.

36
Educational Assistance Plans

• The 2001 Act makes the annual exclusion of up to
  5,250 for employer-provided educational
  assistance (i.e., tuition, fees, books, supplies
  and equipment) contained in Chapter 127
  permanent.
• The 2001 Act also makes a number of other changes
  designed to help taxpayers pay for education
  
• Includes a new above-the-line deduction for up to
  3,000 of qualified higher education expenses
  such as tuition fees (see Ch. 8) as well as
  
• New rules for deducting student loan interest
  (see Ch.11) and
  
• Greatly expands the usefulness of educational
  IRAs (see Chapter 18) while incorporating the
  changes related to
  
• The qualified prepaid tuition plans noted
  earlier.
  

37
Section 132 Fringe Benefits

• An overview of the nontaxable fringe benefits now
  provided under Section 132 is given in Exhibit
  6-7. These additional employee benefits include
  (each will be discussed)
• Working condition fringe benefits,
• No-addition-cost services,
• Qualified employee discounts,
• De minimis fringe benefits,
• On-premises athletic facilities,
• Qualified transportation fringe benefits,
• Qualified moving expense reimbursement, and
• Qualified retirement planning services.
• Furthermore, employees of educational
  institutions receive special treatment under
  Section 117 for reduction in tuition costs.

38
Working Condition Fringe Benefits

• Many business furnish some of their employees
  with company-owned automobiles.
  
• Expenses related to the business usage of the
  cars are deductible by employers and are excluded
  from income by the employees.
  
• In contrast, personal use of the cars, which
  includes commuting between the employees home
  and work, is taxable compensation.
  
• This income is reported as other compensation,
  and thus not subject to withholding taxes.
  
• Section 132 allows an exclusion for payments made
  for education by an employer if the education
  enabled the taxpayer to improve his skills used
  in his business and was not necessary to meet the
  minimum education requirement imposed by the job.
  
• The exclusion is extended to graduate education.

39
No-Additional-Cost Services

• Some employers allow employees to use company
  facilities or services without charge or for a
  minimal maintenance fee.
  
• Section 132(b) permits the employee to exclude
  the benefit as long as the company incurs no
  substantial additional cost as a result of the
  employees usage.
• However, unlike the working condition fringe
  benefit, the exclusion is not allowed if the
  benefit discriminates in favor of officers or
  other highly compensated employees.
• Note that the exclusion is limited to services
  sold in the normal course of business in which
  the employee works.
  
• The exclusion is extended to benefits provided
  under a written reciprocal agreement by another
  employer that is in the same line of business.

40
Qualified Employee Discounts

• Such discounts seldom result in taxable income
  unless they discriminate in favor of highly
  compensated employees.
  
• The exclusion is not available for discounts on
  investment property or on residential or
  commercial real estate.
  
• The rules governing nondiscrimination, the
  requirement that items must be offered for sale
  in the normal course of business and line of
  business, and the rules governing coverage of
  spouses and dependent children discussed earlier
  for nontaxable services also pertain to
  nontaxable discounts.
• In contrast with services, discounts under
  reciprocal agreements are taxable income.
  
• In the case of employer services, the discount
  may not exceed 20 percent of the price charged to
  customers.
  
• Any discount beyond that amount is taxable income
  to the employee.

41
De Minimis Fringe Benefits

• Exclusion of employee benefits also extends to
  items of minimal value such as the occasional use
  of a companys photocopy machines, other
  equipment, or typing services annual employee
  picnics, cocktail parties, or occasional lunches
  and inexpensive holiday gifts such as a turkey at
  Thanksgiving.
• No dollar amount is specified in determining what
  qualifies.
  
• The exclusion also covers discounts on food
  served in an eating facility provided by an
  employer if
  
• (1) the facility is located on or near the
  employers business premises,
  
• (2) its revenue equals or exceeds its direct
  operating costs, and
  
• (3) the nondiscriminatory rules discussed above
  are met.
  
• In addition supper money cash meal allowances
  given occasionally to employees who are required
  to work overtime may be excluded as a de minimis
  fringe benefit.

42
De Minimis Fringe Benefits

• Meals provided on the employers premises for the
  convenience of the employer (and excluded from an
  employees income) are considered a de minimis
  fringe benefit under Code Section 132.
• As a result, employers will be able to deduct the
  entire cost of the provided meals and they no
  longer will be subject to the 50 percent
  disallowance rule that normally applies for meals
  and entertainment (see Chapter 8).

43
Employer-Provided Transportation Benefits

• Limits on the value of transportation benefits
  allow an employee to exclude up to 105 per month
  for qualified employer-provided transit passes or
  vanpooling and up to 200 per month for qualified
  parking.
• Should employer-provided transportation benefits
  exceed the statutory limits, the excess value is
  includible in the employees gross income for
  both income and employment tax purposes.
• Employers may offer employees a choice of
  free-parking or 200 cash without jeopardizing
  the exclusion for those who opt for the parking.
  
• Those who elect to receive cash must include the
  amount received in income.

44
Qualified Moving Expense Reimbursement

• Qualified moving expenses reimbursed by an
  employer (or paid directly by the employer) are
  excludable from an employees gross income to the
  extent the moving expenses would be deductible
  under Code Section 217 if paid or incurred by the
  employee.
• The term qualified moving expenses reimbursement
  does not include payments for, or reimbursement
  of, expenses actually deducted by an individual
  in a prior taxable year.
• The moving expense provisions are discussed in
  detail in Chapter 8.

45
On-Premises Athletic Facilities

• The Code contains an exclusion for the use of
  athletic facilities provided on the employers
  premises primarily for current or retired
  employees, their spouses, and their dependent
  children.
• The athletic facility must be located on premises
  owned or leased by the employer.

46
Qualified Tuition Reduction by Educational
Institutions

• Under Section 117(d), graduate students who are
  engaged in teaching or research activities (e.g.,
  graduate assistants) for an educational
  institution are allowed to exclude tuition costs
  provided by the institution for graduate level
  work as well as undergraduate work.
• Only the benefit in excess of the portion
  representing reasonable compensation for the
  graduate students services can be excluded.

47
Employer-Provided Retirement Advice

• In order to help employees adequately prepare for
  retirement, the Act provides that qualified
  retirement planning services are an excludable
  fringe benefit.
• The exclusion is granted for retirement planning
  services provided to an employee and his or her
  spouse by an employer that maintains a qualified
  pension plan.
• The exclusion is not intended to apply to
  services that may be related to tax preparation,
  accounting, legal or brokerage services.

48
Military Personnel

• All compensation is taxable unless specifically
  excluded.
  
• Examples of taxable compensation are active duty
  and reservist pay, reenlistment bonuses, lump-sum
  severance and readjustment pay, and retirement
  pay.
• Examples of non-taxable benefits are allowances
  for subsistence, uniforms, and quarters extra
  allowances for housing and living costs while on
  permanent duty outside the United States, and
  family separation allowances caused by overseas
  duty moving and storage expenses compensation
  received by enlisted service members (up to 500
  per month for commissioned officers) for active
  duty in an area designated by the President as a
  combat zone (e.g., Operation Desert Storm) and
  all pay while a prisoner of war or missing in
  action.
• Benefits provided to military veterans by the
  Veterans Administration also are nontaxable.

49
Reparations To Holocaust Victims

• Amounts received by victims of the Holocaust or
  their heirs are generally nontaxable.
  
• In addition, property received by eligible
  individuals is deemed to have a basis equal to
  fair market value.

50
Personal Transfers Between Individuals

• Gifts and Inheritances
• Section 102 excludes the value of property
  received as a gift, bequest, devise, or
  inheritance from gross income.
  
• The exclusion for gifts does not extend to income
  earned on the property.

51
Alimony and Separate Maintenance

• For tax purposes, the obvious questions concern
  the treatment of the property settlement, child
  support, and alimony. The general rules are
  
• Property settlement The division of the
  property is a nontaxable event.
  
• Alimony Amounts designated as alimony are
  taxable to the recipient and deductible by the
  payers.
  
• Child support Amounts paid for child support
  are nontaxable to the recipient and non
  deductible to the payer.

52
Alimony

• Payments qualify as alimony only if
• They are made in cash
• They are made as a result of a divorce or
  separation under a written decree of separate
  maintenance or support
  
• They are required under a decree or a written
  instrument incident to a divorce or separation
  
• The spouses or court do not elect that they be
  designated as not qualifying as alimony
  
• The husband and wife do not live together nor do
  they file a joint return together and
  
• Payments cease with the death of the recipient.
• The payments need not be made directly to the
  ex-spouse. The following payments qualify as
  alimony
  
• Payments made in cash, checks, and money orders
• Payments of cash by the ex-husband to the
  ex-wifes creditors in accordance with the terms
  of the divorce or separation instrument
  
• Premiums paid by the ex-husband for term or whole
  life insurance on the ex-husbands life made
  pursuant to the terms of the divorce or
  separation instrument and
• Payments of cash to a third party on behalf of
  the ex-wife, if they are made at the written
  request of the ex-wife.

53
Alimony (continued)

• The following do not qualify as alimony
  payments
  
• Assets transferred as a part of the property
  settlement
  
• Any payments to maintain property owned by the
  ex-husband and used by the ex-wife
  
• Fair rental value of residence owned by
  ex-husband but used exclusively by ex-wire
  
• Repayment by the ex-husband of a loan previously
  made to him by his ex-wife as part of the general
  settlement
  
• Transfers of services
• Voluntary payments not required by the divorce or
  separation agreement and
  
• Payments made prior to a divorce or separation.

54
Front Loading

• Making large payments initially that are
  supposedly alimony but are really a disguised
  property settlement is known as front loading.
  
• The front loading rules are triggered when there
  is a significant drop in alimony in either the
  second or third year after the divorce.
  
• Alimony paid in the first and second years must
  be recaptured in the third year if, during the
  three years, alimony payments decreased by more
  than 15,000.
• As a result, the payer must include the amount in
  income and the recipient who previously reported
  the payment as income is entitled to a
  deduction.
• The recapture rules do not apply if payments
• Cease because of the death of either spouse
  during the three-year period
  
• Cease because the payee remarries during the
  three-year period
  
• Are made under a support agreement, and thus do
  not qualify as alimony or
  
• Are a Fixed portion of income to be paid for at
  least three years and based on revenues from a
  business, from property, or from employee or
  self-employment compensation.

55
Child Support

• Amounts that qualify as child support are
  nondeductible personal expenses for the husband
  and nontaxable income to the wife.
  
• Funds qualify as child support only if
• A specific amount is fixed or is contingent on
  the childs status (e.g., reaching a certain
  age)
  
• Paid solely for the support of minor children
  and
  
• Payable by decree, instrument, or agreement
• If all three requirements are not met, the
  payments are treated as alimony with no part
  considered to be child support.
  
• The intent of the parties involved, the actual
  use of the funds, and state or local support laws
  have no bearing on whether payments qualify as
  child support.
• A minor child is anyone under age 21.
• Once child support is established, no payments
  are considered to be alimony until all past and
  current child support payments are made.

56
Transfers By Unrelated Parties Life Insurance

• While Life Insurance proceeds are normally
  nontaxable
  
• Cashing-in the Policy Before Death Any amount
  received in excess of the premiums paid is
  taxable.
  
• No loss is recognized if the premiums paid exceed
  the amount received.
  
• Accelerated death benefits generally may be
  excluded if the individual is chronically ill
  (restricted to the amount of long-term care
  services actually incurred) or terminal (the
  exclusion is unlimited).
• An individual is considered terminally ill if he
  or she has been certified by a physician as
  having an illness or physical condition that can
  reasonably be expected to result in death in 24
  months or less.

57
Life Insurance (continued)

• If a policy is transferred to another party in
  exchange for valuable consideration, any gain
  from the proceeds on the insureds death is
  taxable income.
• Gain is defined as the insurance proceeds less
  the owners basis.
  
• All gain is nontaxable if the purchaser
• (1) Is a partner of the insured,
• (2) Is a partnership in which the insured is a
  partner,
  
• (3) Is a corporation in which the insured is a
  shareholder or officer, or
  
• (4) Is the insured.

58
Prizes and Awards

• Prizes and awards are fully taxable.
• Fair market value of property won is not
  necessarily the list price or even the cost to
  the purchaser.
  
• Taxpayers who have won a prize or award may avoid
  taxation if they immediately transfer the prize
  or award to charity.
  
• Although this may seem unnecessary given the
  taxpayers are entitled to a charitable
  contribution deduction, the deduction is
  generally limited to 50 percent of the taxpayers
  A.G.I. This treatment is available only for
  prizes and awards that are made in recognition of
  religious, charitable, scientific, educational,
  artistic, literary, or civic achievements, but
  only if
• The recipient was selected without any direct
  action on his or her part to enter the contest or
  proceeding
  
• The recipient is not required to perform
  substantial future services as a condition of
  receiving the prize or award and
  
• The prize or award is given by the payor to a
  governmental unit or tax-exempt organization as
  designated by the recipient.
  
• When these rules are met, the award has no impact
  on the winners tax liability it is neither
  taxable income nor a deductible charitable
  contribution.

59
Scholarships and Fellowships

• Section117 generally allows an exclusion of
  scholarships and fellowships for those
  individuals who are candidates under the
  following conditions
• The individual is a candidate for a degree
  (either undergraduate or graduate)
  
• The degree granting organization is a qualified
  educational institution
  
• The amount received is a scholarship.
• It must aid the individual in his or her pursuit
  of study or research and not represent
  compensation for services
  
• The amounts received are used for tuition and
  related expenses, including fees, books,
  supplies, equipment, and other expenses that are
  required for either enrollment or attendance (but
  not room and board).

60
Scholarships and Fellowships (cont)

• Note that amounts received by an employee may
  qualify for exclusion under an educational
  assistance plan or as a working condition fringe
  benefit.
• Similarly, employees of educational institutions,
  including graduate students engaged in teaching
  or research activities, are entitled to exclude
  any tuition reductions.
• In addition, amounts paid for education that are
  related to the taxpayers employment may be
  deductible if certain conditions are met, as
  described in Chapter 8.

61
Cancellation of Indebtedness

• If a lender reduces or cancels a taxpayers debt,
  there is a corresponding increase in net worth.
  In such a case, the taxpayer is normally required
  to include the amount of debt forgiveness in
  gross income.
• In certain situations the taxpayer may be able to
  exclude this so-called cancellation of debt
  income, including when
  
• The cancellation represents a gift or bequest
  (e.g., a father forgives his sons debt)
  
• The cancellation occurs when the taxpayer is
  insolvent or bankrupt
  
• The cancellation represents a renegotiation of
  the purchase price or
  
• The cancellation of student loans.

62
Bankruptcy or Insolvency

• When a debt is canceled pursuant to a bankruptcy
  proceeding, there is no taxable income.
  
• However, the taxpayer is required to reduce
  certain tax attributes that normally would
  produce tax savings in the future. In this
  sense, the income is not truly excluded but
  rather deferred.
• Any debt reduction that exceeds the attributes
  identified below is ignored entirely, and the
  related income forever escapes tax. The
  attributes that must be reduced are
• Net operating losses (NOLs) and any NOL
  carryovers
  
• General business credit carryovers
• Minimum tax credit
• Capital losses (current and carryovers)
• Basis of the taxpayers property (generally
  depreciable realty)
  
• Passive activity loss and credit carryovers and
• Foreign tax credit carryovers.
• While the attributes normally must be reduced in
  the order shown, the taxpayer may elect to reduce
  the basis of property first.

63
Qualified Real Property Business Indebtedness

• Under Section 108, a taxpayer may elect to
  exclude the income resulting from the
  cancellation of indebtedness incurred or assumed
  in connection with real property used in a trade
  or business (qualified real property business
  indebtedness).
• This is true even though the taxpayer is neither
  bankrupt nor insolvent.
  
• The cancellation of debt income does not escape
  tax, however.
  
• The taxpayer must reduce the basis of the
  depreciable property of any income that is
  excluded.
  
• As a result, the taxpayer forgoes future
  deductions.
  
• The maximum amount of exclusion may not exceed
  the excess of the outstanding principal amount of
  the debt over the fair market value of the
  property.

64
Seller Reduction of Purchasers Debt

• Another situation where Section 108 allows the
  taxpayer to exclude cancellation of debt income
  relates to sales where the seller provides the
  financing for the buyer.
• If the seller/lender cancels the debt, the buyer
  may exclude the benefit but must reduce the basis
  of the property.
  
• In effect, the Code treats the transaction as a
  renegotiation of the purchase price.
  
• This rule does not apply if the buyer is bankrupt
  or insolvent.

65
Cancellation of Student Loans

• Code Section 108(f) allows individuals to exclude
  from income the amount of certain student loans
  that have been canceled.
  
• This exclusion normally applies only if the
  forgiveness of the loan is issued by the
  government and the forgiveness is contingent on
  the students fulfilling a public service work
  requirement.
• In 1998 law extended this rule to loans that
  refinanced earlier loans that qualified.

66
Government Transfer Payments

• Social Security benefits are excluded from
  income.
  
• Medicare benefits are also nontaxable.
• Supplementary medicare payment received as
  reimbursement of medical expenses deducted in a
  prior year are taxable, however, to the extent
  the taxpayer received a tax benefit in that
  year.
• Workers compensation received as a result of a
  work-related injury is excluded from income.
  
• This exclusion is extended to compensation
  received by the survivors of a deceased worker.
  
• Both state and Federal government transfer
  payments that are classified as public assistance
  (e.g., food stamps) or paid from a general
  welfare fund (e.g., welfare payments) are
  nontaxable.

67
Government Transfer Payments (continued)

• Benefits to participants in government programs
  designated to train or retrain specified groups
  are frequently nontaxable.
  
• Whether these benefits are nontaxable or not is
  dependent upon the primary purpose of the
  programs.
  
• If the objective of the program is to provide
  unemployed or under-employed individuals with job
  skills that enhance their employment
  opportunities, amounts received are nontaxable.
• If the primary purpose is to provide compensation
  for services, participants are government
  employees with taxable wages.
  
• Most government transfer payments to farmers are
  included in income.
  
• If materials are received instead of cash, their
  fair market value is taxable income.

68
Business Gross IncomeAgreement Not To Compete
and Goodwill

• If the sale of a business often contains an
  agreement that the seller will not compete with
  the buyer in the same or similar business within
  a particular area or distance, the seller must
  treat any amount assigned to the agreement as
  ordinary income.
• The purchaser may amortize (deduct) this amount
  over 15 years on a straight-line basis regardless
  of its useful life.
  
• When the net selling price of the business
  exceeds the fair market value of all identifiable
  net assets, the business generally is considered
  to possess goodwill.
• Goodwill is considered a capital asset and any
  amounts received for goodwill are normally
  treated as capital gain.
  
• Acquired goodwill can be amortized ratably over a
  period of 15 years.
  
• If the contract includes a single amount for both
  goodwill and a non-competition agreement, the
  entire amount is treated as goodwill.

69
Business Interruption Insurance Proceeds and
Damages Awarded

• Insurance proceeds that are to reimburse the
  business for overhead expenses during the period
  of interruption are taxable.
  
• Punitive damages are fully taxable.
• Compensatory awards are taxable only to the
  extent that losses sustained by the business
  resulted in a tax benefit and may be used
  
• First to offset any litigation expenses or other
  expenditures in obtaining the award.
  
• Second, funds that represent a recovery of
  capital when damages are awarded because of a
  loss in value to a businesss goodwill or other
  assets are used to offset or write down the
  capitalized asset costs.
• Remaining damages generally are considered to be
  a reimbursement for a loss of profits and are
  included in gross income.
  
• An exception to the latter classification occurs
  when compensatory damages are awarded in an
  antitrust suit.

70
Lease Cancellation Payments

• Lease cancellation funds received by a lessor are
  a substitute for rent and are taxable income.
  
• Amounts received by a lessee on cancellation of a
  lease are considered proceeds from the sale of
  the lease and the gain is included in gross
  income.
• Whether the gain is ordinary or capital depends
  on the use of the property (see discussion in
  Chapter 16).

71
Leasehold Improvements

• If improvements are made in lieu of rent
  payments, they are included in the lessors gross
  income.
  
• A retail tenant that receives cash or rent
  reductions from the lessor of retail space does
  not include such amounts in income if the cash
  (or equivalent) is used for qualified
  construction or improvement to the space.
• In order to qualify for the exclusion, the tenant
  must have a short-term lease (i.e., a lease of
  retail space for 15 years or less).
  
• The amount excluded cannot exceed the amount
  spent by the tenant for the improvement.
  
• If a lessor abandons a leasehold improvement in
  the year the lease terminates, the lessor is
  allowed a deduction equal to the landlords
  adjusted basis of the improvement.
• This rule does not apply where the improvement is
  demolished.

72
Contributions to Capital

• Cash or other property received by a business in
  exchange for an ownership interest are nontaxable
  transactions for the business.

73
Miscellaneous Items

• Ordinarily, fees received for services performed
  are included in gross income. Executor fees may
  qualify as nontaxable gifts.
  
• Cash or other assets found by a taxpayer are
  taxable income even if found accidentally.
  
• One type of earned income is nontaxable Vehicle
  owners operating car pools for fellow commuters
  may exclude all the revenues received
  
• All income tax refunds are nontaxable except to
  the extent the taxpayer received a tax benefit in
  a prior year.
  
• A corporation receives a tax benefit for all
  business expenses, including state and local
  income taxes but not Federal income taxes, unless
  the corporation incurs a net operating loss for
  the year of deduction. State and local income
  taxes paid by individuals, however, provide a tax
  benefit only if the taxpayer itemized these
  deductions in the year paid.

74
Miscellaneous Items (cont)

• If an individual receives insurance proceeds to
  cover temporary living costs incurred because the
  principal residence was destroyed or damaged by
  fire, flood, or other casualty, the funds are
  nontaxable to the extent they are offset by extra
  living costs.
• Typical qualifying costs are hotel or apartment
  rent and utilities, extra costs for restaurant
  meals, and additional transportation necessitated
  by having to live outside the immediate area of
  the residence.

75
Miscellaneous Items (contd)

• The treatment of punitive and compensatory
  damages awarded to individuals for personal
  injury and sickness
  
• All punitive damages are taxable even if they are
  related to physical injury or sickness.
  
• Compensatory damages awarded on account of
  physical injury and sickness are not taxable.
  
• However, emotional distress is not considered a
  physical injury or sickness unless such distress
  had its origins from physical injury or sickness.
  Damages actually used to pay for medical
  expenses related to emotional distress are
  nontaxable.
• Awards made due to employment discrimination
  based on age, sex, race or similar factors are
  fully taxable.