Income Tax Exam #2

Exclusions:

Codes 101 through 140 provide the authority for the specific exclusions for gross income. This means that something that should be in the tax base is removes per provisions in the tax law. Eaxh has its own reason for enactment.

Statutory Exclusion

Exists for gifts. Making gifts nontaxable for income tax purposes. A gift is income, but it is excluded.

Corporate Distribtions:

Are payments to shareholders with respect to their stock.

Taxable versus non-taxable income for Corporate Distributions:

• Distributions are taxed as dividends to shareholders only to the extent the payments are made from either the corporation’s current earnings an profits or its accumulated earnings and profits.

• Distributions that exceed earnings and profits are treated as a nontaxable recovery of capital and reduce the shareholder’s basis in the stock. These distributions are not considered income.

• Once the shareholder’s basis is reduced to zero, any subsequent distributions are taxed as capital gains.

Gift:

A voluntary transfer of property by one to another without adequate consideration or compensation therefrom. If the payment is intended to be for services rendered, it is not a gift, even though the payment is made without legal or moral obligation, and the payor receives no economic benefit from the transfer. To qualify, the payment must be made “out of affection, respect, admiration, charity, or like impulses.”

Death Benefits:

An employer may make payments to a deceased employee’s surviving spouse, children, or other beneficiaries. If the decedent had a nonforfeitable right to the payments the amounts are generally taxable to the recipient as if the employee had lived and collected the payments. If the employer makes voluntary payments to the family of the deceased employee, the facts and circumstances must be evaluated to determine if the payments are a nontaxable gift or additional compensation attributable to the deceased employee.

Income in respect of a descendent:

Income earned by the employee that was not received by the employee prior to their death is not an employee death benefit. They are generally taxable income to the decedents beneficiary.

Life Insurance Proceeds:

Paid to the beneficiary because of the death of the insured are excluded from gross income.

Congress believed it was good tax policy to exclude life insurance proceeds for the following reasons:

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

• In a business context, life insurance proceeds replace an economic loss suffered by the business.

Accelerated Death Benefit:

An exclusion is available for insured taxpayers who are either terminally ill or chronically ill. These exclusions for the terminally ill and the chronically ill are available only to the insured. A person who purchases life insurance policy from the insured does not qualify.

Terminally Ill Taxpayer:

Can collect the cash surrender value of the policy from the insurance company or assign the policy proceeds to a qualified third party. The resulting gain, if any, is excluded from the insured’s gross income. A person is this if a medical doctor certifies that death is likely to occur within 24 months.

Chronically Ill Taxpayer:

No gain is recognized if the proceeds of the policy are used for the patients long-term care. A person is this if they are certified as needing assistance to perform certain activities of daily living.

A life insurance policy (other than one associated with accelerated death benefits) may be transferred after it is issued by the insurance company. If the policy is ______ ___ ________ __________, the insurance proceeds are includible in the gross income of the purchaser to the extent the proceeds received exceed the amount paid for the policy plus any subsequent premiums paid.

transferred for valuable consideration

There are 5 exceptions to the rule about life insurance being transferable. Exclusion treatment is allowed for transfers to the following:

1. The insured under the policy.

2. A partner of the insured.

3. A partnership in which the insured is a partner.

4. A corporation in which the insured is and officer or shareholder.

5. A transferee whose basis in the policy is determined by reference to the transferor’s basis. (this one only applies to policies that were transferred in a tax-free exchange or were received by gift)

Investment Earnings:

Arising from the reinvestment of life insurance proceeds are generally subject to income tax. Often the beneficiary will elect to collect the insurance proceeds in installments. The annuity rules are used to apportion the installment payment between the principal element (excludible) and the interest element (includible).

Payments or benefits received by a student at an educational institution may be:

1. Compensation for services

2. A gift

3. A scholarship

Scholarship:

Rules are intended to provide exclusion treatment for education related benefits that cannot qualify as gifts but are not compensation for services. To be excluded from income, the scholarship must be used for qualified tuition and related expenses (course fees, books, supplies, and equipment). The recipient must be a candidate for a degree at an educational institution.

Nonprofit educational institutions and tuition reduction for employees:

They can exclude these amounts from their gross income. The exclusion also applies to tuition reductions granted to the employee’s spouse and the employee’s dependent children. The exclusion only applies for undergraduate students.

Timing for taxable income for scholarships:

Usually the taxpayer who receives these are cash basis. They receive the money in one tax year but pays the educational expense in another year. The amount eligible for exclusion may not be known at the time the money is received. In that case, the transaction is held open until the educational expenses are paid.

A person who suffers harm casued by another is often entitled to _____ ______.

Compensatory damages

The tax consequences of the damages awarded depend on the type of harm the taxpayer experienced. The tax payer may seek recovery for:

1. A loss of income.

2. Expenses incurred.

3. Property destroyed.

4. Personal injury.

Compensatory Damages:

Are intended to compensate the taxpayer for the damages incurred. Only those that are received for physical personal injury or physical sickness can be excluded from gross income.

Punitive Damages:

Are amounts the person who caused the harm must pay to the victim as punishment for the bad conduct. These are not intended to compensate the victim but, rather, to punish the party who caused the harm. So, amounts recieved may actually place the victim in a better economic position than before the harm was experienced,. These are included in gross income.

Breach of contract

(generally loss of income) is taxable.

Property Damages:

Gain to the extent damages received exceed basis. A loss is deductible for business property and investment property to the extent of basis over the amount realized.

Personal injury: Physical

All compensatory amounts are excluded unless previously deducted. Amounts received as punitive damages are included in gross income.

Personal Injury: Nonphysical

Compensatory damages and punitive damages are included in gross income.

Wrongful Incarceration:

Code 139F exempts amounts received as damages for being wrongfully incarcerated. The exclusion applies to an individual convicted of a federal or state crime who is later exonerated.

Workers’ Compensation:

Laws require the employer to pay fixed amounts for specific job-related injuries. The state laws were enacted to allow the employee to recover the damages without suing the employer. Although the payments are intended, in part, to compensate for a loss of future income, Congress has specifically excluded workers’ compensation benefits from gross income.

Accident and Health Insurance Benefits:

Benefits collected under an accident and health insurance policy purchased by the taxpayer are excludible even though the payments are a substitute for income.

Disaster Relief Benefits:

Certain tax rules address the treatment of payments received due to this. Code 139 provides an exclusion for payments an individual receives as a qualified disaster relief payment. Such payments include those to pay or reimburse an individual for reasonable and necessary personal, family, living, or funeral expenses that arise due to a Federally declared disaster. This exclusion also applies to payments for repair or rehabilitation of a personal residence or its damaged contents. Code 123 provides an exclusion for insurance payments received by an individual for living expenses when the individual is not able too use their principal residence due to damage or destruction related to a casualty or threat of a casualty.

Accident and Health benefits:

Congress encourages employers to provide this for employees, retired former employees, and their dependents, including disability insurance and long-term care plans. The premiums are deductible by the employer and excluded from the employee’s income.

Code 105 for Accident and Health Benefits:

a. Provides the general rule that the employee has includible income when they collect the insurance benefits, two exceptions are provided.

b. Generally excludes payments received for medical care of the employee, spouse, and dependents. However, if the payments are for expenses that do not meet the Code’s definition of medical care, the amount received must be included in gross income.

c. Excludes payments for the permanent loss or the loss of the use of a member or function of the body or the permanent disfigurement of the employee, the spouse, or a dependent. Payments that are substitutable for a salary are includible.

Health Savings Account (HSA):

The employer can purchase a medical insurance plan with a high deductible and then make contributions to the employees HSA. The employer can make contributions each month up to a maximum contribution of 100 percent of the deductible amount. The monthly deductible amount is limited to one-twelfth of $4,400 self-only coverage and $8,750 for family coverage under a high-deductible plan. Withdrawals from HSA must be used to reimburse the employee for the medical expenses paid by the employee that are not covered ender 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, the withdrawals made for medical expenses.

Long-term Care Insurance:

Covers expense such as the cost of care in a nursing home, is treated the same as accident and health insurance benefits. As a result, the employee does not recognize income when the employer pays the premiums. Also, the individual who purchases their own policy can exclude the benefits from gross income.

Limits specified in the code for long-term care insurance for the following amounts:

• Premiums paid by the employer.

• Benefits collected under the employer’s plan.

• Benefits collected from the individual’s policy.

Meals and lodging general rules for the exclusions:

• The meals and/or lodging are furnished by the employer on the employer’s premises for the convenience of the employer. Employers may not claim any deduction for these meals. If the employer continues to provide such meals, their value remains as an exclusion for the employees.

• In the case of lodging, the employee is required to accept the lodging asa condition of employment.

Employee of an Educational Institution Housing Exclusion:

If the employee pays annual rents equal to or greater than 5% of the appraised value of the facility, the housing benefit may be excluded. If the rent payments are less then 5% of the value of the facility, the deficiency must be included in gross income.

For the Convenience of the Employer Test:

• A restaurant requires its service staff to eat their meals on the premises during the busy lunch and breakfast hours.

• A bank furnishes meals on the premises for its tellers to limit the time the employees are away from their booths during busy hours.

• A worker is employed at a construction site in a remote part of Alaska. The employer must furnish meals and lodging due to inaccessibility of other facilities.

Required as a Condition of Employment Test:

Test only applies to lodging. If the employee’s of the housing would serve the convenience of the employer, but the employee is not required to use the housing, the exclusion is not available.

Ministers of the gospel and other religious leaders can exclude:

1. The rental of a home furnished as compensation.

2. A rental allowance paid to them as compensation, to the extent the allowance is used to rent, buy, or provide a home

3. The rental value of a home owned by the minister.

Military Personnel can exclude:

Housing exclusions under various circumstances. Authority for these exclusions generally is found in Federal laws that are not part of the Internal Revenue Code.

Fringe Benefits:

Benefits other than wages and salary that are provided to employees by the employer.

Specific Fringe Benefits:

• An employee does not have to include in gross income the value of child and dependent care services paid for by the employer and incurred to enable the employee to work. The exclusion cannot exceed $7,500 per year (if married filing separately $3,750). For a married couple, the annual exclusion cannot exceed the earned income of the spouse with the smaller amount of earned income. If unmarried cannot exceed the taxpayer’s earned income.

• The value of the use of a gymnasium or other athletic facilities by employees, their spouses, and 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 and their family members.

• Qualified employer-provided educational assistance at the undergraduate and graduate levels is excludible from gross income. Includes principal and interest on student loans. An employer can provide a maximum of $5,250 per year. The exclusion does not cover meals, lodging, or transportation.

• If an employer has a qualified adoption assistance program, an employee can exclude up to $17,670 of the adoption expenses that are paid or reimbursed by the employer in 2026. If child has special needs the $17,670 exclusion from gross income applies even if the actual adoption expenses are less than that amount. For 2026, the exclusion is phased out as adjusted gross income increases from $265,080 to $305,080.

Cafeteria Plan:

Under these plans, the employee can choose between cash and nontaxable benefits. If the employee chooses nontaxable benefits, the cafeteria plan rules enable the benefits to remain nontaxable. They provide tremendous flexibility in tailoring the employee pay package to fit individual needs.