cch federal taxation basic principles chapter 5 gross income—exclusions ©2003, cch incorporated...

CCH Federal TaxationBasic Principles

Chapter 5

Gross Income—Exclusions

©2003, CCH INCORPORATED4025 W. Peterson Ave.Chicago, IL 60646-6085800 248 3248http://tax.cchgroup.com

CCH Federal Taxation Basic Principles 2 of 31

Chapter 5 Exhibits 1. EE Bonds Used for Education—Rules

2. EE Bonds Used for Education—Examples

3. Fringe Benefits

4. Employee Tuition Reduction Plans

5. Retirement Income—History of Social Security Taxes

6. Damage Awards

7. Insurance Reimbursements

8. Cafeteria Plans—Rules

9. Cafeteria Plans—Example

10. Dependent Care Assistance Program—Definition

11. Dependent Care Assistance Programs—Example

Chapter 5, Exhibit Contents


EE Bonds Used for Education—Rules

Qualified educational expenses. Tuition and fees qualify. Room and board and expenses incurred outside of the degree program (e.g., sports, clubs) do not qualify. The bonds must be redeemed during the same tax year in which qualified educational expenses are incurred.

Computing the exclusion.

1. If the redemption amount (principal and interest) is less than or equal to the qualified educational expenses, then all the interest may be subject to exclusion and subject to the income phaseout rules.

2. If the redemption amount (principal and interest) is greater than the qualified educational expenses, then only a portion of the interest may be excluded based on the following formula:

(Exclusion amount)= (Interest on the EE savings bond) x [(Qualified expenditures) (Series EE proceeds (principal and interest)]

Chapter 5, Exhibit 1a


EE Bonds Used for Education—Rules

The phaseout thresholds in 2003 are:

Filing Status

Modified AGI

Ceiling Floor Phaseout Range (Ceiling – Floor)

Married filing jointly $117,750 $87,750 $30,000

Single and head of household $ 73,500 $58,500 $15,000

Married filing separately (not eligible) N/A N/A N/A

Chapter 5, Exhibit 1b


EE Bonds Used for Education—Examples

Example 1: Qualified Educational Expenses Exceed Redemption Amount

Mary, age 50, files as a single mother. Her modified AGI is $68,500. She redeems Series EE bonds and receives $5,000 of principal and $2,500 of accrued interest.

Mary’s daughter attends college and has qualified educational expenses of $8,000. How much of the $2,500 may be excluded from gross income?

Interest Income Subject to Exclusion: $833 = $2,500 – $1,667 phaseout amount

Phaseout amount: $1,667 = $2,500 x [($68,500 - $58,500) $15,000]



EE Bonds Used for Education—Examples

Example 2: Redemption Amount Exceeds Qualified Educational Expenses

Same as Example 1, except that qualified educational expenses are $6,000, not $8,000. The amount of the interest exclusion would be $667:

Interest Income Subject to Exclusion: $2,000 = $2,500 x [$6,000 ($5,000+$2,500)]

Phaseout amount: $1,333 = $2,000 x [($68,500 - $58,500) $15,000]

Interest Exclusion After Phaseout: $667 = $2,000 – $1,333 phaseout amount



Fringe Benefits

No-additional-cost services

Generally excluded if no significant additional costs are incurred by the employer. The exclusion also applies to spouses and dependent children of employees.

Example: Free travel is offered to airline employees who fly on standby. Spouses and dependent children may be included with no income tax consequences.



Qualified employee discounts

For property purchased at a discount, the exclusion may not exceed the employer’s gross profit margin. For services purchased at a discount, the exclusion may not exceed 20%.

Fringe Benefits



Working condition fringe benefitsThe fair market value of any property or services provided to an employee is excluded by that employee if it represents an ordinary and necessary business deduction to the employer.

Examples: Car phone rental used by the employee for the primary convenience of the employer, but also available for personal use; subscriptions to business periodicals; on-the-job training; inventory being tested by the employees outside of the employer’s workplace.

Fringe Benefits

Chapter 5, Exhibit 3c


De minimis fringe benefits

Excluded when the value of property or services provided to the employee are so minimal that accounting for it would be unreasonable.

Examples: Using the copy machine for personal purposes; occasional tickets to sports events, coffee and snacks, occasional company picnics

Fringe Benefits

Chapter 5, Exhibit 3d


Employee Tuition Reduction PlansPayments of up to $5,250 per year paid by an employer to, or on behalf of, an employee for tuition and course-related material may be excluded from employee income. (Code Sec. 127.)

Qualified educational expenses. Excludable educational assistance includes the payment or provision of tuition, fees, books, supplies, and equipment.

Nonqualified educational expenses Tools or supplies that may be retained by the employee after completion of the course Meals, lodging, or transportation provided by the employer Courses that involve sports, games, or hobbies UNLESS

(1) directly related to the employer’s business; OR(2) required as part of a degree program; OR (3) used to instruct employees on how to maintain and improve health as long as the education does not involve the use of athletic facilities or equipment and is not recreational in use.

Chapter 5, Exhibit 4


Retirement Income—History of Social Security Taxes


1937 Social Security taxes were introduced under Franklin D. Roosevelt’s administration. (1% on the first $3,000, or $30, was the maximum Social Security taxes a taxpayer could have to pay.)

1937-1983 During this next period, Social Security tax rates climbed, but Social Security benefits were never taxable.

Rationale: The nontaxability rule coincided with the nondeductibility of Social Security tax by employees. (Code Sec. 275(a)(1)(A)).

1984-1993 Beginning in 1984, a maximum of 50% Social Security income could be taxed. (Code Sec. 86.)

Rationale: Employees contribute only 50% of Social Security tax. The other 50% comes from employers.

1994 to Present

A maximum of 85% Social Security income “may” be taxed. (Code Sec. 86(c)).

Rationale: Students should offer their comments.


Damage AwardsCompensatory damages. Awards gross income to a victim who suffers harm caused by another.

Punitive damages. Awards gross income to a victim for the purpose of punishing the perpetrator for gross negligence or intentional infliction of harm.

Comparison of Tax Treatment for Compensatory and Punitive Damages

Type of Harm Compensatory Damages Punitive Damages

Loss of Income Taxable Income(Substitution of Income Doctrine– if the income would have been taxed, then the damages should be taxed.)

N/A

Expenses Incurred Deductible if to secure taxable awards. N/A

Property Destroyed Capital gain or loss, based on:

Amount Realized less Basis of Property Destroyed (Replacement of Capital Doctrine— the computation of taxable gain or loss is made as if the property were sold at FMV.)

N/A

Physical Injury or Sickness including:

1. Non-physical injuries or

sickness that flow from a

physical injury or sickness; or

2. Emotional distress to the

extent of medical expenses

Excluded under Code Sec. 104(a). If an action has its origin in a physical injury or physical sickness, then all non-punitive damages of a NON-PHYSICAL nature that flow from that injury or sickness are excluded. In cases of injury to reputation, only reimbursements for actual medical expenses attributable to EMOTIONAL DISTRESS are excluded from taxable income.

Included effective August 21, 1996 (Code Sec. 104).

Excluded before August 21, 1996 (Code Sec. 104) (Threlkeld).



Example 1:

Fred is injured in a car accident and settles a lawsuit for $100,000. He had suffered from pain and suffering, emotional distress (i.e., non-physical), medical expenses (not previously deducted), and lost wages while recuperating. The entire $100,000 is excludable.

Damage Awards



Example 2:

In addition to Fred’s award in Example 1, Fred’s wife Wilma receives a $50,000 non-punitive award for “loss of consortium” (i.e., loss of physical and social companionship). Wilma’s $50,000 is also excludable since it has its origin in Fred’s physical injury.

Damage Awards



Example 3:

Sally’s professional reputation is damaged as a result of a false credit report. As a result of her ensuing emotional distress, Sally makes several visits to a qualified counselor, incurring medical expenses totaling $5,000. Later, she receives a $25,000 non-punitive award for damage to professional reputation. $5,000 of the $25,000 award is excludable.

Damage Awards



Damage Awards

Comparison of Tax Treatment for Compensatory and Punitive Damages

Type of Harm Compensatory Damages Punitive Damages

Non-Physical Injury (e.g., civil rights violations, libel, slander, invasion of privacy, emotional distress not resulting in medical expenses, breach of promise to marry)

Included effective August 20, 1996 (Code Sec. 104).

Excluded before August 20, 1996 (Threlkeld).

(e.g., lost wages due to race, age, or sex discrimination)

Included

(Code Sec. 104 and Glenshaw Glass.)

Chapter 5, Exhibit 6e


Insurance ReimbursementsInsurance Plan Excluded Included

Workers’ Compensation Plans

(i.e., employer plans governed by state law)

Lost wages and medical reimbursements relating to an occupational injury or sickness.

Lost wages and medical reimbursements relating to a non-occupational injury or sickness.

Accident and Health Plans

(i.e., employer and employee plans other than workers’ compensation plans)

Lost wages and medical reimbursements from employee-paid plans.

Lost wages and medical reimbursements from employer-paid plans.

However, benefits from employer-paid plans are excluded if:

1. Paid on the nature of the injury and not on work time lost.

2.Reimbursement for actual medical expenses incurred by employee, spouse or dependents. Code Sec. 105(b) and (c).

NOTE: For the above exclusions to apply, the benefits must be on account of

1. personal physical injuries or sickness or

2. emotional distress, limited to actual medical expenses incurred.



Cafeteria Plans—Rules

Tax Advantage of Cafeteria Plans

Under a cafeteria plan, each employee is permitted to choose between cash or other taxable benefits (e.g., group-term life insurance coverage above $50,000, group legal services) and at least one (often several) nontaxable benefits. Employees are not subject to federal income tax, FICA, or federal unemployment tax for the amount of menu items that are nontaxable. In addition, the cost of these fringes is deductible as compensation to the employer.




Nontaxable Items Allowable Under Cafeteria Plans Group-term life insurance coverage below $50,000

(Code Sec. 79) Health and accident protection and dental plans

(Code Sec. 106) Child care (Code Sec. 129) Vacation days (Reg. §125-2T) Dependent care assistance (Code Sec. 129) Adoption assistance (Code Sec. 137)



Nontaxable Items Disallowed Under Cafeteria PlansCongress prohibits the following items from being included incafeteria plans:

1. Medical Savings Accounts (excludable under Code Sec. 106(b))2. Qualified scholarships (excludable under Code Sec. 117)3. Meals and lodging (excludable under Code Sec. 119)4. Vanpooling (excludable under Code Sec. 124)5. Educational assistance programs (excludable under Code Sec.

127)6. Excludable fringe benefits (Code Sec. 132)7. Long-term care insurance for chronically ill individuals (Code Sec.7702B)




Unused Benefits

Unused benefits from one plan year may not be accumulated by an employee and carried over to succeeding years.

Example: An employee chooses the $2,000 medical coverage from the benefits menu, but, due to excellent health, uses only $1,200. He or she forfeits the remaining $800.




Madison Inc. offers its employees a choice of any one or all of the following benefits, not to exceed $4,000:

Cafeteria Benefit Cost

Group-term life insurance $ 500

Hospitalization insurance 2,500

Child-care payments 2,000

$5,000

If a benefit is not selected, the employee receives cash equal to the cost of the benefit. Claudia, an employee, has a spouse who works for another employer that provides hospitalization insurance but not child-care payments. Claudia elects to receive the group-term life insurance, the child care payments, and $1,500 cash. Only the $1,500 must be included in Claudia’s gross income. If all of the elected benefits are not used up in the current year (e.g., only $1,500 of child-care payments), the difference is lost.

Cafeteria Plans—Example



Dependent Care Assistance Program—Definition

$5,000 exclusion

Under Code Sec. 129(d)(1), a qualified dependent care assistance program is a separate written plan of an employer under which the employer pays or incurs dependent care costs for the exclusive benefit of employees. Under Code Sec. 129(a)(1), employees can exclude up to $5,000 ($2,500 for married persons filing separately).



Tax-Free Status

Excludable dependent care assistance is not subject to federal income tax, FICA, or federal unemployment taxes.




Employer deductions

The employer’s payments or reimbursements are deductible under Code Sec. 162.




Self-employed taxpayers do qualify

The term “employee” includes individuals who are self-employed (Code Sec. 129(e)(3)). A sole proprietor will be treated as his or her own employer. Thus, dependent care assistance, unlike most other fringe benefits, is available on a tax-free basis to the self-employed.




Reporting requirements

A dependent care plan must furnish to an employee, on or before January 31 of the next year, a written statement showing amounts paid or expenses incurred by the employer in providing dependent care assistance to that employee during the year.


Chapter 5, Exhibit 10e


Taxable amount of dependent care assistance

The value of dependent care assistance in excess of the exclusion limit must be included in gross income in the tax year in which the dependent care services are provided (even if payment for those services is made in another year).


Chapter 5, Exhibit 10f


Dependent Care Assistance Programs—Example

Dependent Care Reimbursements Above the Exclusion Limit

FACTS: Joseph, a calendar-year taxpayer, incurred and paid $6,000 for dependent care services in 2002 and $5,000 in 2003. During 2002, Joseph’s employer maintained a qualified dependent care assistance program. Under the program, the employer reimbursed Joseph for $2,000 of the year 2002 expenses in year 2002, and the remaining $4,000 in year 2003. The employer reimbursed $3,000 of the year 2003 expenses in year 2003 and $2,000 in year 2004.

QUESTION: How much child-care assistance must Joseph report as income in 2002 and 2003?

SOLUTION: Under Code Sec. 129(a)(2)(B), Joseph must recognize $1,000 in year 2002 since all reimbursements for expenses incurred in year 2002 exceeded the exclusion limit by $1,000. Nothing need be reported in year 2003 since the reimbursements for year 2003 expenses equaled the exclusion limit in 2003. The timing of the employer’s reimbursements do not affect the result.



Dependent Care Assistance Programs—Example

Recap of Solution:

Yr. 2002 Yr. 2003

Amount of reimbursement for years 2002 and 2003 child care

Reimbursements for year 2002 child care paid in year 2002 2,000




Total reimbursements for child care 6,000 5,000

Less: Annual exclusion limit (5,000) (5,000)

Taxable portion of reimbursements 1,000 0


cch federal taxation basic principles chapter 5 gross income—exclusions ©2003, cch incorporated...

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