Chapter 4
Income Exclusions
Kevin Murphy
Mark Higgins
©2009 South-Western, a part of Cengage Learning
Income Exclusions
Concept Review
The all-inclusive income concept
considers all income taxable unless a
specific provision can be found that
exempts it from taxation.
Under the legislative grace concept,
only Congress can provide income
exclusion.
©2009 South-Western, a part of Cengage Learning
4-2
Income Exclusions
Major Reasons
The major reasons income items are
excluded
To increase equity through relief
provisions
To provide incentives for taxpayers to
engage in an activity
©2009 South-Western, a part of Cengage Learning
4-3
Income Exclusions
Categories
There are four major categories of
exclusions:
Donative items
Employment-related
Returns of human capital
Investment related
©2009 South-Western, a part of Cengage Learning
4-4
Donative Items:
Gifts and Inheritances
Donative items are increases in wealth
that are not earned or the result of
investment.
Gifts are excluded to relieve double
taxation caused by the gift tax
Inheritances are excluded to relieve
double taxation caused by the estate
tax
©2009 South-Western, a part of Cengage Learning
4-5
Donative Items:
Life Insurance Proceeds
Life Insurance Proceeds are excluded
to provide equity with other types of
inheritances
Proceeds from policies purchased for
consideration are not excluded
Interest income earned from the proceeds
due to electing receipt as an annuity are
not excluded
©2009 South-Western, a part of Cengage Learning
4-6
Donative Items: Scholarships
Scholarships are excluded to provide
incentive for education. To qualify, the
scholarship
Must not require the performance of future
services
Must be used for direct costs of education
such as tuition, fees, books, and supplies
©2009 South-Western, a part of Cengage Learning
4-7
Scholarship Example
Jake received an athletic scholarship to
Small State University. Under the
scholarship agreement, he received
tuition ($1,500), books ($400), and room
and board ($5,000).
How much must Jake include in his
gross income?
©2009 South-Western, a part of Cengage Learning
4-8
Employment Related:
Foreign Earned Income
Foreign Earned Income may be
excluded to relieve double taxation.
Taxpayers may choose one of two options:
 Exclude up to $87,600 of foreign earned income
 Must be a resident of the foreign country, or
 Must reside in the foreign country for 330 days
 Claim a tax credit that is the lesser of
 Foreign taxes paid, or
 U.S. tax that would have been paid on the foreign income
©2009 South-Western, a part of Cengage Learning
4-9
Employment Related:
Payments Made by Employer
Payments made on behalf of an
employee are excluded as an incentive
to employers to provide these benefits.
Examples of excluded payments are:
 Contributions to qualified pension plans
 Premiums for group term life insurance
 Premiums for health and accident insurance
 Meals and lodging
 Fringe benefits
©2009 South-Western, a part of Cengage Learning
4-10
Payments Made by Employer
To Qualified Pension Plan
Payments made by employers to
qualified pension plans
are not included in income in the year of
payment
are included in income in the year of
withdrawal
©2009 South-Western, a part of Cengage Learning
4-11
Payments Made by Employer
Group Term Life Insurance
Premiums paid for up to $50,000 of
group term life insurance are excluded
from income.
Plan may not discriminate in favor of highly
paid employees
Premiums for insurance in excess of
$50,000 are included in taxable income
©2009 South-Western, a part of Cengage Learning
4-12
Payments Made by Employer
Health and Accident Insurance
Premiums paid for health and accident
insurance are excluded from income to
encourage employers to provide
insurance.
©2009 South-Western, a part of Cengage Learning
4-13
Payments Made by Employer
For Meals and Lodging
The value of meals provided by the
employer are excluded from income if
the meals are provided
on the employer’s premises
for the employer’s convenience
The value of lodging provided must
meet these conditions and also be a
condition of employment
©2009 South-Western, a part of Cengage Learning
4-14
Payments Made by Employer
General Fringe Benefits
Two types of fringe benefits are
excludable from income if they are
provided on a nondiscriminatory basis:
No additional cost services
Employee discounts
on goods, are limited to the gross profit %
on services, are limited to 20%
Qualified retirement planning services
©2009 South-Western, a part of Cengage Learning
4-15
Payments Made by Employer
General Fringe Benefits
Other types of fringe benefits are
excludable from income even if they are
provided on a discriminatory basis:
 Working condition
 De minimus
 Child and dependent care services up to $5,000
 Educational assistance programs up to $5,250
 Employer’s athletic facility on premises
©2009 South-Western, a part of Cengage Learning
4-16
Payments Made by Employer
Employer Benefit Plans
Cafeteria Plans allow employees to
choose from a menu of benefits and are
excludable unless an employee elects
to take cash in lieu of benefits
©2009 South-Western, a part of Cengage Learning
4-17
Payments Made by Employer
Employer Benefit Plans
Flexible Benefit (Salary Reduction)
Plans allow employees to use pre-tax
compensation dollars to cover medical
or child-care expenses
©2009 South-Western, a part of Cengage Learning
4-18
Payments Made by Employer
Employer Benefit Plans
Health Savings Accounts are excluded
to encourage employers and employees
to purchase adequate medical coverage
May be established for individuals covered
only by high-deductible plans
• $2,200 for family or $1,100 for single
Employer contributions are excluded from
income and individual contributions are
deductible for AGI
©2009 South-Western, a part of Cengage Learning
4-19
Returns of Human Capital
Payments received that are intended to
reimburse an individual for injuries are
excluded under the capital recovery
concept because they merely restore
the individual to a previous condition.
Payments that are intended to replace lost
income are not excluded.
©2009 South-Western, a part of Cengage Learning
4-20
Returns of Human Capital:
Worker’s Compensation
Worker’s compensation payments
related to an injury suffered on the job
are excluded because they help restore
individuals to their previous condition
and do not add to their wealth.
©2009 South-Western, a part of Cengage Learning
4-21
Returns of Human Capital:
Personal Physical Injury or Sickness
 Compensatory damage payments received
for a personal physical injury or sickness and
medical payments for emotional distress are
excluded to provide a return to equity
 Loss of income damage payments are only
excluded if they are related to personal
physical injury or sickness
 Punitive damage payments are never
excluded
©2009 South-Western, a part of Cengage Learning
4-22
Returns of Human Capital:
Health and Accident Insurance
Payments or reimbursements for
medical or health costs are excluded to
provide an individual a return to equity
Disability payments are excluded if the
policy was purchased by the employee
but not excluded if the policy was
purchased by the employer
©2009 South-Western, a part of Cengage Learning
4-23
Investment Related:
Municipal Bond Interest
Interest income received from
investment in municipal bonds is
excluded to allow state and local
municipalities to sell bonds for a lower
interest rate
©2009 South-Western, a part of Cengage Learning
4-24
Investment Related:
Stock Dividends
Stock dividends are excluded from
income because their receipt does not
qualify as income under the realization
concept
If the shareholder has the option to
receive cash instead of stock,
realization has occurred and the value
of the dividend is included in income
©2009 South-Western, a part of Cengage Learning
4-25
Investment Related:
Discharge of Indebtedness
An amount received as a loan is
generally excluded from income under
the realization concept because it must
be returned
If a lender forgives all or a portion of the
debt, realization occurs and the forgiven
portion is income
Discharge due to insolvency or bankruptcy is
excluded from income
©2009 South-Western, a part of Cengage Learning
4-26
Investment Related:
Leasehold Improvements
The value of improvements to property
made by a lessee are excluded under
the wherewithal-to-pay concept
©2009 South-Western, a part of Cengage Learning
4-27