Chapter 5



Chapter 5

Gross Income - Exclusions

(Revised 01-11-2017)

Only items specifically excluded by law are tax-exempt

Gifts and Inheritances

• Gifts are generally tax exempt. A gift is a valid transfer to another for no consideration where there exists a present intention to give, title transfer & delivery, and acceptance by the donee. The gift must be made by the donor to the donee out of "detached & disinterested generosity".

• Income from gifts is taxable to the new owner.

• Bequests and amounts to settle will contests are tax exempt.

Life Insurance Contracts

• Payments by "reason of death of the insured” are tax exempt.

• Unless:

- The beneficiary has no "insurable interest" or is transferred to another for consideration.

- The payment does not include an "element of interest".

• Any amounts received in Installments that represent interest are taxable as interest.

For example:

The Widow Smythe has option of receiving $100,000 now or $12,000/yr for 10 years. Amount includible as interest if she elects installment plan is $12,000 - ($100,000/10 yrs) = $2,000/yr

• Secondary Beneficiaries get the same exclusion to which the primary beneficiary was entitled.

• Any amounts specifically called interest are taxed as interest.

Surrender, Redemption & Maturity

• Recovery of proceeds not by reason of death are tax exempt only to extent of consideration paid for contract.

Sale Of Principal Residence (Section 121)

• There is no tax on the first $250,000 of gain ($500,000 if married filing joint) from the sale of a residence, if the home owned and used as their principal (i.e. ‘main”) residence for two of the last five years.

If the 2 year rule cannot be met because of job loss, transfer, etc., may exclude a portion of the $250K/$500K based on a formula of the number of months of residency over 24 months.

Only one spouse of a couple needs to meet the 2 year ownership test. Marital status is determined on the date of sale.

3. The couple must have owned and used the home as their principal residence at least 2 of the last 5 years.

4. A widowed spouse can use the $500,000 exclusion for up to two years after the spouse’s death.

Recovery of Tax Benefit Items

• Items deducted in a previous year are taxable only to the extent they were deducted in that previous year. The most common example is previously deducted state income tax refunds and medical insurance recoveries.

Social Security:

• Some Social Security benefits may be taxable. The amount taxable ranges from zero to 85%, depending on the amount and type of income received by the taxpayer..

• Some Social Security Benefits (SSB) may be taxable if “Provisional” income exceeds a base amount: Provisional income is calculated in the following example:

Provisional Income

=Modified AGI + 1/2 of the Social Security Benefits (SSB) received by the taxpayer.

Where Modified Income is:

The Sum of:

1) AGI without SSB

Plus

(2) Tax Exempt interest

Plus

(3) Certain deductions allowed for AGI, such as student loan deduction, the ½ of Self-employment tax deduction, the tuition deduction and foreign earned income exclusion (see text).

Base Amount (The first threshold):

Single: $25,000

Married filing joint $32,000

Married Filing separately $ -0-

Amount included is lesser of:

(1) 1/2 of SSB or

(2) 1/2 of the excess of (Provisional Income less the Base Amount)

Example 1: First threshold, Assume SSB of $8,000:

A Single Taxpayer has AGI of $22,000

+Tax-exempt interest 5,000

= Modified AGI $27,000

+ 1/2 of $8,000 4,000

= Provisional Income $31,000

less Base Amt (Single) ( 25,000)

= Excess $ 6,000

• Include the lesser of:

1/2 of the $8,000 SSB = $4,000, or

1/2 of the excess of $6,000 = $3,000

Therefore $3,000 would be included as taxable income

The Second Threshold:

But, if provisional income exceeds:

• $34,000 single or

• $44,000 if married filing joint

The following rule must be used:

Then, The amount of SSB included as taxable income is:

the lesser of:

• 85% of benefits, or

• the sum of:

o 85% of the excess social security benefits over the 2nd threshold

PLUS

o the smaller of

$4,500 if single or $6,000 if married filing joint .

(This is ½ the distance between the first and second base amounts. This is nearly always the amount to use for this part). This is called the Flat amount

OR

The amount includible under prior law (usually 1/2 of the TOTAL SSB benefits)

Example 2: 2nd Threshold

A single Taxpayer has AGI of $42,000

+ Tax-exempt interest 5,000

= Modified AGI $47,000

Assume SSB of $28,000:

Plus 1/2 SSB’s $ 14,000

= Provisional Income of $61,000 (=Modified AGI + ½ SSB’s)

Less 2nd threshold amount (Single) (34,000)

= Excess over 2nd base Amount $27,000

Include the lesser of:

85% of benefits $23,800 (=85% of 28,000)

OR

the sum of:

85% of the Excess $22,950 (=27,000 * 85%)

PLUS

The Lesser of

the amount otherwise included (1/2 of the SSB) $14,000

OR

The flat amount 4,500

Thus, the Total is (22,950 + 4,500) $27,450

Therefore: Include $23,800 or 85% of SSB as taxable income.

To Summarize Taxability of SSB:

• Taxable Social Security Benefits can be from 0% to 85% of SSB.

• Tax Exempt interest is not itself taxable, but it can make SSB taxable.

• As Provisional Income increases, more SSB automatically can become taxable.

US Savings Bonds

• For a cash basis taxpayer, Savings Bonds interest may be taxed either:

o On the increase in value of the Bonds each year.

or

o When Interest is received or on maturity of the Bonds whichever comes first.

o Must treat all bonds the same way.

Interest on State and Municipal Securities

• Interest received on state & local (Municipal) bonds are generally tax-exempt, however profits from the sale of municipal bonds are taxable.

Employee Fringe Benefits

• No additional cost and de minimis fringe benefits are tax-exempt (including for payroll taxes), as well as qualified tuition reductions, if non-discriminatory.

• No additional cost fringe benefits include free flights by airline personnel, metro employees, if they go "stand by".

• Qualified employee discounts are the gross profit (income) %: If an Item sells for $10 and costs $8, gross profit is $2 or 20%. This is maximum discount that is tax exempt.

Working condition Fringe Benefits

• FMV of property/service provided to an employee is tax exempt to the extent the employee would have been allowed to deduct the item if he or she had paid for it. E.g. Company cars.

• Use must relate to employers trade or business.

• The Employee would have been entitled to the deduction.

• The Employer must maintain adequate records.

De Minimis Fringe benefits

• If the FMV of the property is of minimal value it is tax exempt.

Group-Term Life Insurance

• The Employee must include in income cost of group term insurance provided by the Employer, but only the excess of $50,000 of coverage:

▪ Cost determined by uniform tables and not the amount the employer actually paid.

▪ Deduct amount paid by employee.

Assume the Employer provides a 56 year-old employee with $100,000 of insurance coverage. From the tables, the cost per $1,000 of coverage is $5.16 per year (.43 * 12 months).

Assume the employee has paid $38 towards this coverage. Amount included is:

Total Value $258.00

((100-50) *5.16)

Less:

Employee’s payment ( 38.00)

Amount Includible $222.00

Annuities

• The tax-free part of an annuity is spread over the annuitant's life, or prescribed number of payments, if applicable.

• Exclusion ratio is determined by the following calculation:

Investment in the Contract

Expected Return = % of each payment excluded from tax

For Example:

If the taxpayer has invested $20,000 in a contract that will pay him $500 a month for life, and he has a life expectancy of 22.5 years:

o Investment in the Contract - $20,000

o Expected Return - $500/mo x 12 months x 22.5 =$135,000

o Exclusion ratio

20,000

135,000 = 14.81%

So, if the taxpayer receives payments for five months this year ($2,500), he can exclude:

Amount Received $2,500

x Exclusion ratio 0.1481

= Exclusion amount $ 370

Taxpayer must include as taxable income:

Total Annuity Received $2,500

Less:

Amount Excluded ( 370)

Amount taxable $2,130

Other Annuity Rules

o For annuities starting after 1986, apply the exclusion ratio only until the amount received is equal to the investment in the contract, then all payments are taxable. If the annuitant dies prior to the recovery of all benefits, may exclude in the last year the remaining to be excluded.

o For pre-1987 annuities the exclusion ratio is applied forever.

o The annuity starting date is the first day of the first period in which the payment is received.

o The investment in the contract is the total premiums paid for the annuity, less any amounts received prior to the annuity starting date.

o The Expected Return:

▪ Is limited to the amounts receivable as an annuity

▪ If for fixed period of time, multiply the number of payments times the amount per payment

▪ But, if the payment is "for the life of the annuitant" use the IRS life expectancy tables based on age (See Tables at pages 5-18 and 5-19)

Example:

If the annuitant is 68 at the annuity starting date, the IRS ordinary one life multiple is 17.6, meaning they could be expected to live 17.6 more years and thus get 17.6 years worth of annuity payments.

If the monthly payment would be $500, then the annuity would have an expected return of $500/month x 12 months x 17.6 factor = $105,600.

• Penalty for Early Withdrawal of the annuity would be10% of the amount includible in Gross Income, if the withdrawal is made before the age 59 ½.

Adoption Expenses

• An employee may exclude up to $12,970 paid by an employer for qualified adoption expenses. Exclusion phases out for AGI between $194,580-234,58

Injury Awards & Sick Pay

• Exclude:

▪ Workmen's Compensation Awards (if work-related); personal injury damages.

▪ Settlement of lawsuit awards if for personal injuries.

▪ Payments from self-purchased insurance policies.

Employee Accident & Health Plans

• Tax-exempt for reimbursements for medical care of the employee, spouse & children (even if taxpayer is divorced); payments for permanent injury.

• The Plan must not "discriminate" in favor of "key" employees (officers, etc.).

Employer Contributions to Health Plans

• Employer contributions are tax exempt to employee.

• Amounts paid for Long-Term Care contracts are considered health insurance and are excludable.

Meals & Lodging of employees

• Value of meals furnished to the taxpayer, spouse & dependents are tax-exempt if meals are furnished:

▪ On the employers premises, and

▪ Must be for the convenience of the employer.

• Lodging furnished to the taxpayer, spouse & dependents are tax exempt if lodging is furnished:

▪ On the employers premises, and

▪ For the convenience of the employer, and

▪ The employee is required to accept such lodging as a condition of

employment.

• The rental value of ministers, faculty and military quarters are tax exempt.

Cafeteria Plans

• Cafeteria Plan: A written plan-allowing the employee to elect among non-taxable benefits.

• Employer contributions to "qualified Benefits Plans" are non-taxable to the employee.

• Qualified benefits include life insurance to $50,000, health insurance, educational assistance, and day care.

• The Employer Plans must be non-discriminatory.

Scholarships & Tuition Reductions

• Tuition assistance:

o Up to $5,250 per year is tax exempt if received for tuition, books fees, etc., as a qualified scholarship by a degree candidate.

o A qualified scholarship is any amount received by an individual that is used for tuition, fees, books, etc.

o The scholarship does not include payment for teaching, unless teaching is the primary educational experience.

• Qualified tuition reduction is tuition provided to the employee (or their spouse & dependents) if at a qualified educational institution.

Qualified Tuition Program (529 Plans)

• No amount used for qualified education expenses is subject to taxation.

Employer Provided Day Care

• Payments (not to exceed $5,000) to the employee for dependent day care are tax-exempt if the plan is non-discriminatory, however, payments cannot exceed the employee's earned income, unless incapacitated, or student, in which case income is deemed to be $200per month.

Military Benefits - Housing, Subsistence, Combat and other allowances

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