CHAPTER 5 - EXCLUSIONS
What is an “exclusion”? An exclusion is an item that falls under the definition of income (i.e. Glenshaw
Glass) but is statutorily removed from the income tax base; meaning there is a specific statute (IRC
§§101-140) which specifically excludes the item from income.
I.
Statutory Authority. Exclusions are specifically listed in the tax code. Sections 101
through 140. If it is not specifically listed, it is NOT excluded. Therefore, every
exclusion will have a corresponding code section.
II. Specific Exclusions.
1. Gifts and Inheritances. §102(a). Gifts are not income.
i.
Definition of Gift. Must be a voluntary transfer (not for services – or any
other consideration) with the intent to make such a gift and no consideration
received (this is the definition for income tax purposes).
ii. Basis
1. Gift. AB of receipt of property. Gift – For purposes of determining
gain, donee takes donor’s basis. §1015(a). For purposes of
determining a loss the donee’s basis is either the donor’s basis of
the FMV at the time of the gift, whichever is lower.
2. Bequest. AB of receipt of property through bequest = FMV.
iii. Employer Payments to Employee. Transfers from an employer to an
employee cannot be excluded as a gift. §102(c).
iv.
Employee Death Benefits. Paid to family may be presumed to be gifts
(excludible) under certain circumstances:
1. The payments made to family members and not to decedent’s
estate
2. Employer derived no benefit from the payments
3. Family provided no services to employer
4. Decedent was not “owed” any of the payment
5. Payments made pursuant to Board of Directors resolution that
followed a general company policy of providing payments to
families of deceased employees (but not exclusively shareholder
employees).
6. If not all of the conditions 1-5 are met, the payment may still be a
gift if the payment is made in light of the family’s financial needs
(i.e. they are poor). Simpson v. U.S.
v.
EXAMPLE: #27. Ed, an employee of the Natural Color Company, suffered from
a rare disease that was very expensive to treat. The local media ran several
stories about Ed’s problems, and the family created a website that generated
more than $10,000 in gifts from individuals to help pay the medical bills. Ed’s
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employer provided hospital and medical insurance for its employees, but the
policy did not cover Ed’s illness. When it became apparent that Ed could not pay
all of his medical expenses, the hospital canceled the $25,000 Ed owed at the
time of his death. After Ed’s death, his former employer paid Ed’s widow $12,000
in “her time of need.” Ed’s widow also collected $50,000 on a group term life
insurance policy paid for by Ed’s employer. What are Ed’s and his widow’s gross
income?
The $10,000 received from the general public is an excludible gift. The $12,000
that Ed’s widow received in her “time of need” may be excluded from gross
income if the company has a general policy of making such payments.
Otherwise, the IRS may challenge the payment as a taxable payment for Ed’s
prior services. The $25,000 debt canceled by the hospital should not increase
gross income. This results because to the extent the debt cancellation is
included in gross income, Ed should be allowed a medical expense deduction
that is subject to the percentage of AGI nondeductible amount. The debt
attributable to the nondeductible portion should be excluded from gross
income under the tax benefit rule because the recovery of the expense is
excluded from gross income to the extent the expense did not yield a tax
benefit. The life insurance proceeds are excluded from gross income because
they were paid to the beneficiary of a life insurance policy.
Otherwise death benefits are income (not exclusion).
See Questions #2 and 3
2. Life Insurance Proceeds. §101(a).
i.
General Rule. Life Insurance Proceeds paid to a Beneficiary of the policy
(because of the death of the insured) are excluded from gross income.
1. EXAMPLE: 22. Ellie purchases an insurance policy on her life
and names her brother, Jason, as the beneficiary. Ellie pays
$32,000 in premiums for the policy during her life. When she dies,
Jason collects the insurance proceeds of $500,000. How much GI
does Jason report? Life insurance proceeds paid to the beneficiary
because of the death of the insured are exempt from income tax. The
$500,000 Jason receives is exempt from Federal income tax.
ii.
Accelerated Death Benefits. An exclusion of income on the sale of a life
insurance policy (i.e. before death of the insured) is available if taxpayer is
either (i) chronically ill or (ii) terminally ill. IRC §101(g).
iii.
Acceleration of Benefits. I.e. Cashing in the policy before death.
1. General Rule. If a policy is cashed in, then the amount realized
(the cash value upon cancellation) less the premiums paid (i.e. the
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adjusted basis) is gain recognized to the holder (the person who
cashed it in). No loss may be recognized.
2. Exception for Acceleration of Benefits. If Taxpayer is :”terminally
ill” or “chronically ill” an exclusion may be available. §101(g).
a. Terminally Ill: A person who a medical doctor certifies as
having an illness that is reasonably expected to cause death
within 2 years.
b. Chronically Ill. A person who is certified as unable to
perform without assistance certain activities of daily living.
3. Amount of Exclusion
a. Terminally Ill. Can sell or assign policy prior to death and
any “realized gain” is EXCLUDED from Gross Income.
b. Chronically Ill. IF policy proceeds are used for “long-term
care” of the insured, then no gain is recognized.
c. Exclusion Exception only Applies to the Insured. Only the
insured may qualify for an exception. A person who has
purchased/obtained the policy from the insured cannot
qualify for either exception.
EXAMPLE 23: Alfred owned a term life insurance policy at the time
he was diagnosed with a terminal illness. After paying $18,300 in
premiums, he sold the policy to a company that is authorized by the
state of South Carolina to purchase such policies. The company paid
Alfred $125,000. When Alfred died 18 months later, the company
collected the face amount of the policy, $150,000. As a result of the
sale of the policy, how much is Alfred required to include in his gross
income? Generally, if the owner of a life insurance policy cancels the policy
and receives the cash surrender value, the taxpayer must recognize gain
equal to the excess of the amount received over premiums paid on the policy
(a loss is not deductible). The gain is recognized because the general
exclusion provision for life insurance proceeds applies only to life insurance
proceeds paid upon the death of the insured. If the taxpayer cancels the
policy and receives the cash surrender value, the life insurance policy is
treated as an investment by the insured. In a limited circumstance,
however, the insured is permitted to receive the benefits of the life insurance
contract without having to include the gain in gross income. Under the
accelerated death benefits provisions, exclusion treatment is available for
insured taxpayers who are either terminally ill or chronically ill. A 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 resultant gain, if any, is excluded from the insured’s gross income. A
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terminally ill individual is a person whom a medical doctor certifies as having
an illness that is reasonably expected to cause death within 24 months.
Therefore, Alfred is not required to include the $106,700 gain ($125,000 −
$18,300) on the sale of the policy in his gross income.
iv.
Transfer for Valuable Consideration.
1. General Rule. Gain is recognized by the Transferee upon death of
the insured. Meaning the proceeds of the policy are not excluded
from GI when received by the purchaser.
a. EXAMPLE: X buys a policy on the life of Y for $10,000
(benefit is $20,000). X transfers (sells) the policy to Z.
Over the years, Z pays $5,000 in premiums. When Y dies,
and Z collects $20,000, the $20,000 is NOT fully
excludible, only the amount paid $15,000 is excludible and
Z will have $5,000 gross income.
b. Exceptions to the General Rule. A transferee will NOT
have Gross Income if the transferee (the new owner who
will collect the death benefits) is :
 The insured under the policy; or
 A partner of the insured; or
 A partnership in which the insured is a partner; or
 A corporation in which the insured is an officer or a
shareholder; or
 A transferee whose basis in the policy is determined
by reference to the transferor’s basis. (i.e. Gift).
1. Example: A purchases a life insurance
policy on B. 10 years later A sells the
policy to B for fair market value (i.e.
valuable consideration). When B dies, B is
not subject to the Transfer for Valuable
Consideration rule. Meaning the proceeds
are excluded from B’s income because B fits
one of the exceptions to the rule.
2. Example: If A gifted the policy to C, C will
not include proceeds because of exception
#v.
See Questions #24
3. Scholarships. §117.
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i. Definition: An amount paid or allowed to or for the benefit of: an
individual to aid such individual in the pursuit of study or research. Prop.
Reg. §117-6(c)(3)(i). I.e. Not a gift, and not income (because recipient
does not provide services for the college Treas. Reg. §1.117-2(a)).
1. Playing sports is not a service.
ii. Requirement. The beneficiary must be a candidate for a degree at an
educational institution and the “benefit” must meet the definition of
scholarship. Also, the grant must not state that any amount awarded must
be used for other types of expenses.
iii. Salary. If recipient performs services for the payor then it is considered
compensation/salary.
1. Exception: Employees (and spouse and dependent children
§117(d)) of nonprofit educational institutions may receive tuition
reduction from their employer tax free. §117(a).
a. Exception to the Exception. IF only available to key
employees then not excludible. Rev. Rul. 75-448.
iv. Amount Excludible. A scholarship recipient may exclude only amounts
for tuition and related expenses (i.e. books, fees, supplies, equipment
etc…) from GI. Payment for other expenses –i.e. food and housing are not
excludible. §117(d).
v. Timing. Not included at time of receipt IF the taxable amount cannot be
calculated,
1. Example: A receives a scholarship in August of year 1 for the year
1-2 academic calendar. It may not be known until year 2 how
much of the scholarship payment is excludible. If A received
$10,000 and ended up spending $4,000 on excludible expenses in
tax/calendar year 1, $6,000 is not includible in A’s year 1 Gross
Income. Instead A waits to see how much excludible expense is
incurred in year 2. So if A has $3,500 of excludible expenses in
year 2, then A would report $2,500 of Gross Income from the
scholarship in Year 2.
vi. EXAMPLE: #34. Adrian was awarded an academic scholarship for the
2019-2020 academic year. He received $6,500 in August and $7,200 in
December 2019. Adrian’s expenditures were as follows:
Tuition August 2019:
Tuition January 2020
Room and Board Aug-Dec 19
Room and Board Jan – May 20
Books and Educational Supplies 19
Books and Ed. Supplies 2020
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$3,700
$3,750
$2,800
$2,500
$1,000
$1,200
Adrian received a total of $13,700 and spent $9,650 ($3,700 + $3,750 + $1,000
+ $1,200) on tuition, books, and supplies. The amount received for room and
board is not excludible from gross income. Therefore, he must include $4,050
($13,700 − $9,650) in gross income. When he received the money in 2019,
Adrian’s total expenses for the period covered by the scholarship were not
known. Therefore, he is allowed to defer reporting the income until 2020,
when all the uncertainty is resolved.
4. Compensation for Injuries and Sickness.
i. Damages. The regulations define “damages” as an amount received (other
than workers’ compensation) through prosecution of a legal suit or action,
or through a settlement agreement entered into in lieu of prosecution. See
Treas. Reg. §1.104-1(c)(1). Thus, §104(a)(2) covers, for example,
damages received by a prospective plaintiff with respect to personal
physical injuries, even though a lawsuit has not yet been filed
ii. §104(a). Four types of damages: (1) A loss of income, (2) Expenses
Incurred, (3) Property Destroyed, (4) Personal Injury.
1. Loss of Income: General Rule. Reimbursement for loss of income
is taxed as if the income were received.
a. Exception. Personal Injury – see PI.
2. Expense Incurred. General Rule. The reimbursement for
additional expenses incurred is non-taxable.
a. Exception. If the expense was also deducted by taxpayer –
see tax benefit rule.
b. Medical expenses are deductible (see §213) so an exclusion for
medical expenses makes sense (if they were included in GI
taxpayer would also have a deduction). And §104(a) makes clear
that if the taxpayer has already deducted the medical expense,
then in fact the receipt of a damage award for medical expense
reimbursement must be included in GI
3. Property Destroyed: Payment for destroyed property is treated as
a sale of such property. GR = AR – AB.
a. Exception. Personal Injury.
4. Personal Injury: Definition: Payments received to put the
taxpayer back to the same place as he or she was before the injury.
Two types: (1) Compensatory and (2) Punitive.
a. Compensatory: §104(a)(2).
 Physical: Only those compensatory damages for
physical injury are excluded from gross income.
This INCLUDES amounts received for loss of
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income due to physical inability to perform (this
makes no sense on a tax level). See Treas. Reg.
§1.104-1(c).
 Emotional: Compensatory damages awarded for
emotional distress (or age discrimination or loss of
reputation) cannot be excluded from GI (except if
they are for actual medical expenses paid).
b. Punitive: Are not excluded from GI.
 What are punitive damages? The part of an award
issued for the sole purpose of punishing the
offender. I.e. taxpayer suffered $10 of medical
expense, but was awarded $20 ($10 for the
expenses and $10 punish the offender).
 Punitive damages do not fall under the exclusion.
Meaning awards received for punitive damages are
includable in GI.
c. Wrongful Incarceration. §139F. Exempts amounts
received for being wrongfully incarcerated. I.e. later
exonerated (not pardoned).
d. See Question #36
iii. Workers Compensation. §104(a)(1). Work related injuries are statutorily
determined (fixed amounts for type of injury). Workers compensation is
compensatory but is nonetheless excludible from GI.
1. EXAMPLE: #8. Holly was injured while working in a factory and
received $12,000 as workers’ compensation while she was unable
to work because of the injury. Jill who was self-employed, was
also injured and unable to work. Jill collected $12,000 on an
insurance policy she had purchased to replace her loss of income
while she was unable to work. How much are Holly and Jill each
required to include in their gross income. Holly can exclude the
$12,000 of workers’ compensation benefits she received from her
gross income. Jill can exclude the $12,000 she received for lost income
because it was received from an insurance policy that she had
purchased.
iv. Accident and Health Insurance Benefits.
1. Purchased by Insured/Taxpayer. Payments received by the
insured on a policy purchased by the insured (for accident or
health) are excludible from GI even if a substitute for income.
§104(a)(3).
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2. Employer Sponsored Accident and Health Plans.
a. Premiums (paid by Employer). Are deductible by
employer AND excluded from employee’s GI. §106.
Treas. Reg. 1.106-1. Rev. Rul. 82-196.
b. Benefits: §105(a).
 General Rule. Insurance benefits are includible in
GI
 Exception#1: §105(b). Benefits received for
“medical care” of the insured, the insured’s spouse
and dependents may be excluded – unless they were
also deducted on the income tax return.
 Exception#2: §105(c). Benefits received for
permanent loss of use of a member or function of
the body or disfigurement are Excludible – unless it
is a substitute for salary then includible in GI.
 Example. A loses an eye in a non-work related
accident. A incurs $2,000 of medical expenses. A
collects $10,000 from an accident insurance policy
provided by A’s employer. Because the payment is
for the loss of a “member (body part) or function of
the body the $10,000 is excluded from GI. Because
the insurance payments were not reimbursement of
medical expenses, A may also deduct the $2,000 of
medical expenses paid. (If part of the $10,000 had
been for medical expenses A would either not
deduct the $2,000 or, if A had already deducted the
$2,000, A would include $2,000 in income.
Further if any part of the payment had been for
reimbursement for lost wages, such amount would
be includible in income.
v. Medical Reimbursement Plans. §105(h). Is where the employer simply
reimburses the employee for hospital and medical expenses. (If the
employer purchased insurance for this purpose, the amounts received by
the employee for medical care are excluded from GI under § 105. (see
above)). An employer may decide to not purchase insurance for this
purpose however. Instead, an employer may simply pay the employee (a
self-funded arrangement). If the self-funding does not discriminate in
favor of highly compensated employees, then the employee may exclude
the benefit payments from Gross Income.
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1. HSA. §106(d). IRS Pub. 969.
a. General Concept. Pre-tax income is contributed to an
account (the HSA) by employer. Any earnings in the
account are excluded from GI. Withdrawals are tax free
provided they are spent on eligible items. Limits Apply.
b.
While taxpayer can use the funds in an HSA at any time to
pay for qualified medical expenses, taxpayer may
contribute to an HSA only if taxpayer has a High
Deductible Health Plan (HDHP) — generally a health plan
(including a Marketplace plan) that only covers preventive
services before the deductible.
 HDHP: Minimum Deductible. For plan year 2022,
the minimum deductible for an HDHP is $1,400 for
an individual and $2,800 for a family.
An individual with coverage under a qualifying highdeductible health plan (deductible not less than $1,400) can
contribute (employer contributes pre-tax dollars) up to
$3,650 — or $7,300 for family coverage. (1/12 per month).
Withdrawals must be for medical expenses NOT
reimbursed by insurance. Employee is not taxed on
employer contributions to the HSA or on earnings in the
account. Withdrawals are not included in GI if used for
medical expenses §106(d). (Income builds in HAS tax free
it is never taxed provided funds are withdrawn to pay for
qualified medical expenses)
c. Requirements.
 Cannot be enrolled in Medicare
 Cannot be a dependent
 Only Health Coverage is a HDHP high deductible
health plan.
vi. Long Term Care Insurance Benefits. Insurance for nursing home is taxed
the same as accident and health insurance benefits. i.e. employee does not
have GI when employer pays premiums and if purchased by insured,
benefits are excluded. However, code imposes limits.
1. Limitations. Statutory limitations on the amount of exclusion
exist. Also, the exclusion is reduced by the amount of any
reimbursement. §7702B and 213(d)(10). Exclusion not available if
included as part of a CAFETERIA plan.
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2. EXAMPLE #40. Belinda spent the last 60 days of 2019 in a
nursing home. The cost of the services provided to her was
$18,000 ($300 per day). Medicare paid $8,500 toward the cost of
her stay. Belinda also received $5,500 of benefits under a longterm care insurance policy she purchased. Assume the Federal
daily excludible amount is $370. What is the effect on Belinda’s
gross income? $0. The amount she may exclude is calculated as
follows: Greater of (i) daily excludable amount in 2019 ($370 * 60 days
= $22,200) or (ii) the actual cost of the care ($18,000 (60 days * $300)).
Less (i) amount received from Medicare ($8,500) = $22,200 - $8,500 =
$13,700 is the available exclusion amount which is greater than the
benefits she received ($5,500), therefore, none of the amount received
is included in her GI. NOTE in 2022 the daily excludible amount is $390.
3. Hazel, who suffers from Alzheimer’s disease, is a patient in a nursing
home for the last 30 days of 2022. While in the nursing home, she
incurs total costs of $8,400. Medicare pays $3,800 of the costs. Hazel
receives $8,400 from her long-term care insurance policy, which pays
benefits while she is in the nursing home. In 2022, $390 per day of
long-term care benefits is excludible from gross income. The amount
Hazel may exclude is calculated as follows:
a. Greater of (i) Daily excludible amount in 2022 ($390 * 30
days) $11,700 or (ii) actual cost of care $8,400.
b. Less : amount received from medicare $3,800 = $7,900
c. Available EXCLUSION = $7,900
d. Inclusion in GI = Payment $8,400 – Exclusion $7,900 = $500.
4. EXAMPLE #20. Valentino is a patient in a nursing home for 45
days of 2019. While in the nursing home, he incurs total costs of
$13,500. Medicare pays $8,000 of the costs. V receives $15,000
from his long-term care insurance policy, which pays while he is in
the facility. Assume that the daily federal statutory amount for V is
$370. Of the $15,000 what amount may V exclude from his GI?
Generally, long-term care insurance, which covers expenses such as
the cost of care in a nursing home, is treated the same as accident and
health insurance benefits. Thus, the employee does not recognize
income when the employer pays the premiums.
Also, the individual who purchases his or her own policy can exclude the benefits from gross
income. However, statutory limitations (indexed for inflation) exist for the following amounts:
Premiums paid by the employer.
Benefits collected under the employer’s plan.
Benefits collected from the individual’s policy.
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The employer or insurance company generally provides the employee with information on the
amount of his or her taxable benefits. The maximum amount excluded must be reduced by any
amount received from third parties (e.g., Medicare, Medicaid).
The amount Valentino may exclude is calculated as follows:
Greater of:
Daily statutory amount in 2019 ($370 × 45 days)
$16,650 OR
Actual cost of the care
$13,500
$16,650
Less: Amount received from Medicare
($ 8,000)
Equals: Amount of exclusion
$ 8,650
5. Therefore, Valentino must include $8,000 ($16,650 − $8,000) of the
long-term care benefits received in his gross income
Meals and Lodging.
vii. General Rule. §119(a) The value of meals and lodging provided to
employee (spouse and dependents) are excludible from GI if:
1. The meals/lodging are furnished by the employer on the
employer’s business premised for the convenience of the employer
(from 2018 – 2025 the employer may only deduct 50% of the cost
of the meals provided and after 2025 $0). Treas. Reg. § 1.119–
1(c)(1). Define the premises as the place of employment of the
employee. -1(f) examples of for the convenience of employer.
a. Cash payment to buy a meal is not “furnished by the
employer”.
b. A detached location may or may not be “on the premises”
depending on how far away it is. Right next to is probably
on the premises while two blocks away is not.
c. Meals furnished to increase productivity (i.e. keep
employees at work site), or because work location is not
readily accessible are “for the convenience of the
employer”.
d. Lodging furnished in remote location is for the convenience
of the employer.
2. Lodging is required to be accepted by the employee as a condition
of employment.
viii. Exceptions.
1. Educational Institution. Employees of educational institutions do
not have to include value of campus housing if they pay at least
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5% of FMV of facility as yearly rent. §119(d). Deficiency in 5%
can simply be included in income. §119(d).
2. Religious. If providing religious worship, admin of religious
organization, or performance of teaching and administrative duties
at theological seminaries, then can exclude (1) The rental value of
home provided, or (2) a rental allowance paid to them provided it
is used for rent or to buy a home and (3) the rental value of a home
owned by the minister. §107
3. Military. Various situations.
ix. EXAMPLE #41. Tim is the vice president of western operations for
Maroon Oil Company and is stationed in San Francisco. He is required to
live in an employer-owned home, which is three blocks from his company
office. The company-provided home is equipped with high-speed internet
access and several telephone lines. Tim receives telephone calls and emails that require immediate attention any time of day or night because the
company’s business is spread all over the world. A full-time
administrative assistant resides in the house to assist Tim with the urgent
business matters. Tim often uses the home for entertaining customers,
suppliers, and employees. The fair market value of comparable housing is
$9,000 per month. Tim is also provided with free parking at his company’s
office. The value of the parking is $370 per month. Calculate the amount
associated with the company-provided housing and free parking that Tim
must include in his gross income for 2022. The concern in this situation for
Tim is that the house will not be considered “on the employer’s premises” for
Tim to qualify for the meal and lodging exclusion. However, Tim could argue
that the house is an extension of the employer’s office because of the
extensive business activities (communications, entertaining) conducted in the
house. He should be prepared to document the extent of business activities
conducted at the house. The presence of an administrative assistant would
suggest that much more than incidental business activities are conducted in
the home. Gross income would include $95 ($350 − $255) per month because
the benefit exceeds the qualified parking monthly exclusion limit for 2016 of
$255.
5. Employee Fringe Benefits. Benefits other than wages.
i. Child and Dependent Care Services. Employee may exclude child care
services paid for by the employer and incurred to enable the employee to
work.
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1. Limitations: Exclusion cannot exceed $5,000 per year ($2,500
MFS). Exclusion cannot exceed the earned income of the lowest
paid spouse (or single) taxpayer. §129
ii. Gym. §132(j)(4). Value of use of gym may be excluded if gym is on
premises and substantially all of the use is by employees and their family
members.
iii. Qualified Employer Provided Educational Assistance. Value of tuition,
fees and books and supplies may be excluded.
1. Limitation. (i) Does not cover meals, lodging and transportation,
(ii) Does not cover courses in sports, games or hobbies. (iii)
subject to limit of $5,250 per year. §127.
iv. Adoption Expenses. §137. Employee may exclude from GI up to $14,080
of expenses to adopt a child where the expenses are paid by the employer
under a qualified adoption program. Fully phased out at $251,160. If
child is special needs then the full exclusion may be taken even if actual
expenses are less.
v. Cafeteria Plan. §125. In general, if an employee is offered cash or a fringe
benefit, the benefit is included in GI, even if it would otherwise qualify for
an exclusion (it is clearly included in GI if it would not qualify for an
exclusion).
1. Cafeteria Plan. Employee may choose among a list of nontaxable
benefits. For those options for which employee chooses cash, GI
is recognized, but for those which employee chooses the fringe, the
normal fringe rules apply (i.e. exclusion).
2. EXAMPLE: A Corp. offers its employees on a non-discriminatory
basis, a choice of any one or all of the following benefits:
Benefit
Group Term Life Ins
$200
Hospitalization Ins for family
member
$2,400
Child care payments
$1,800
If a benefit is not selected the employee receives cash equal to the
cost of the benefit. K an employee, has a spouse who works for
another employer that provides hospitalization Insurance but no
child care payments. K elects to receive the group term life
insurance, the child care payments, and $2,400 of cash. Only the
$2,400 must be included in K’s Gross Income.
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vi. Flexible Spending Plan. Employee allowed to accept a reduction in salary
up to $2,850 (in 2022) in exchange for employer paying certain costs that
would otherwise be excludable. Use it or lose it. Must pay by March 15
of the following year.
1. QUESTION? #10 What is the difference between a cafeteria plan
and an employee flexible spending plan? With a cafeteria plan, the
employee receives a salary and is provided by the employer with a
fixed amount that he or she can allocate among a range of possible
nontaxable fringe benefits and taxable benefits. With a flexible
spending plan, a portion of the employee’s salary is set aside for
specific uses that would have been excludible from gross income had
the employer paid these expenses. The employee’s gross income is
reduced by the amount that goes into the flexible spending account,
and the withdrawals are excluded from gross income. However, any
unused funds are forfeited by the employee.
vii. §132.
1. No Additional Cost Services. Treas. Reg. §1.132-2. Services
provided by employer to employee, but not highly compensated
employee unless nondiscriminatory basis, (or employee’s spouse
and dependent children, as well as retired and disabled former
employees Treas. Reg. 1.132-1(h)) will be excluded from GI if:
a. The employee receives services, as opposed to property
b. The employer does not incur substantial additional cost,
including foregone income, in providing the services to the
employee
c. The services are offered to customers in the ordinary course
of the business in which the employee works. 1.132-2.
d. MUST BE NONDISCRIMINATORY
2. Qualified Employee Discount. If goods are sold to an employee
(including spouse, dependents as well as retired and disabled exemployees) at a discount (compared to regular customers), the
discount amount may be excluded from GI provided:
a. The exclusion is not available for real property or for
personal property commonly held for investment (i.e.
stock)
b. The property or services must be from the same line of
business in which the employee works
c. In the case of property, the exclusion is limited to gross
profit component of the price to customers (i.e. no
exclusion for amount sold below cost)
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d. In the case of services, the exclusion is limited to 20% of
the customer price.
e. MUST BE NON DISCRIMINATORY
 EXAMPLE: 11 Ted works for Azure Motors, an
automobile dealership. All employees can buy a
car at the company’s cost plus 2%. The company
does not charge employees the $300 dealer
preparation fee that nonemployees must pay. Ted
purchased an automobile for $29,580. The
company’s cost was $29,000. The price for a
nonemployee would have been $33,900 ($33,600
+$300 prep. Fee). What is Ted’s Gross Income?
The discount on the price of the automobile of $4,600
($33,600 − $29,000) is a qualified employee discount.
The discount can be excluded from Ted’s gross income
because the price he paid was above the employer’s
cost. However, Ted must include in gross income 80%
of the dealer preparation fee, a service, of $300, which
is $240 ($300 × 80%). The maximum qualified
employee discount that can be excluded for a service is
20%.
3. Working Condition Fringes. Employee may exclude payments
made by employer for items that would be deductible if paid by the
employee. I.e. professional dues. These MAY be discriminatory.
4. De Minimis Fringes. Small benefit – too small to make accounting
for them practical. Cash or gift cards are not deminimis.
Subsidized cafeteria is deminimis if on site AND revenue at least
equals cost (so is it really subsidized???) Occasional parties, use
of copy machine, picnics, taxi use due to overtime work are
deminimis.
5. Qualified Transportation Fringes. The following transportation
benefits to employee are excludible (as of 2018 however, they are
not deductible (by the EMPLOYER) when paid by the employer)
a. Transportation in a commuter highway vehicle (a vehicle
that seats at least 6 people and 80% of its use for
transporting employees to and from work) between the
employee’s residence and the place of employment
b. A transit pass.
c. Qualified parking (Parking provided to employee at or near
place of employment or at or near location from which
employee takes mass transit to work)
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Limits apply: $280 per month (in 2022).
6. Qualified Moving Expense. Prior to 2017 Paid by employer is
excludible if would be deductible under §217. For years 20182025 this exclusion only applies to members of the armed forces.
7. Qualified Retirement Planning Services. MUST BE NON
DISCRIMINATORY.
a. 1, 2 and 7 must be nondiscriminatory. If they are
discriminatory, the highly compensated employees are not
allowed to exclude value of benefits provided. However,
non-highly compensated employees may still take the
exclusion §132(j)(1).
b. See Concept summary 5.2 page 5-21.
6. Foreign Earned Income. §911. Taxpayer may elect to either (1) include all
foreign income in GI and take a foreign tax credit or (2) exclude $112,000 (in
2022) in foreign earned income (personal services) from GI. (Cannot be income
from an employee of the U.S. Government). Taxpayer must be:
i. Requirements
1. A bona fide resident (i.e. not there for a defined period of time) of
the foreign country or
2. Present in a foreign country for at least 330 days during any 12
consecutive months. §911(d).
ii. Amount.
1. Pro rated for amount of days not present in foreign country.
2. Tax bracket includes the excluded amounts
3. EXAMPLE: Mio was transferred from New York to Germany. He
lived and worked in Germany for 340 days in 2022. Mio’s salary
for 2022 is $190,000. In your computation round any division to
four decimal places before converting to a percentage. What is
Mio’s foreign earned income exclusion? Mio’s exclusion is limited
to $104,328, computed as follows: $112,000 (2022 limit) × (340 days in
Germany/365/6 in the year = 93.15%) = $104,328.
4. Example. In 2022, Alejandra, who is not married, had taxable
income of $30,000 after excluding $112,000 of foreign earned
income. Without the benefit of the exclusion, Alejandra’s taxable
income would have been $142,000 ($30,000 + $112,000). The tax on
the taxable income of $30,000 is calculated using the marginal rate
applicable to income between $112,000 and $142,000, which is 24%.
As a result, Alejandra’s tax liability is $7,200 ($30,000 × 24%).
7. Corporate Distributions and Stock Dividends.
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i. E&P
ii. Stock dividends
8. Municipal Bond Interest. §103(a). Interest from state and local debt/bonds is
not taxable by the U.S. Govt. This applies to interest and gain on the sale of a
bond is taxable.
i. Example. Megan purchases State of Virginia bonds for $10,000 on July 1,
2021. The bonds pay $300 interest each June 30 and December 31. On
March 31, 2022, Megan sells the bonds for $10,500 plus $150 for accrued
interest. Megan must recognize a $500 gain ($10,500 − $10,000), but the
$150 accrued interest is exempt from taxation.
9. Educational Savings Bonds. §135. EE bonds and I bonds. Interest paid (at
maturity) is not taxable if used to pay for qualified educational expenses. These
bonds must be issued to a taxpayer age 24 or over. If proceeds are greater than
educational expenses, then amount of exclusion is reduced (Educational Expenses
/ Proceeds ) interest = Exclusion.
i. Example. Tracy’s redemption proceeds from qualified savings bonds during
the taxable year are $6,000 (principal of $4,000 and interest of $2,000).
Tracy’s qualified higher education expenses are $5,000. Because the
redemption proceeds exceed the qualified higher education expenses, only
$1,667[($5,000 ÷ $6,000) × $2,000] of the interest is excludible.
ii. Additionally, Phase out begins at $85,800 single or $128,650 MFJ
(MAGI). After $15,000/$30,000 there is no benefit. MAGI$128,650/$30,000 * otherwise excludable GI = Reduction in excludable
interest.
iii.
Example. Tracy’s MAGI for 2022 is $87,000. The phaseout results in
Tracy’s interest exclusion being reduced by $133 {[($87,000 − $85,800) ÷
$15,000] × $1,667}. As a result, Tracy’s exclusion is $1,534 ($1,667 − $133).
10. 529 Plan. Contributions to a state run account. Grow tax-free and are not income
when taken out provided they are used for qualified higher education expenses.
(Some states offer a state income tax deduction upon contribution).
i. Qualified higher education expenses. These expenses include tuition, fees,
books, supplies, room and board, and equipment required for enrollment or
attendance at a college, a university, or certain vocational schools. Allowable
expenses also include computers and peripheral equipment, software, and
internet access used primarily by the beneficiary while enrolled at an eligible
educational institution. Qualified higher education expenses also include the
expenses for special needs services that are incurred in connection with the
enrollment and attendance of special needs students. Tuition paid to public,
private, and religious K–12 schools, as well as certain apprenticeship
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programs, are also allowable expenses. In addition, a lifetime maximum of
$10,000 of funds in a § 529 account may be used to pay principal or interest
on a qualified education loan.
ii. If the parent receives a refund (e.g., child does not attend college), the
excess of the amount refunded over the amount contributed by the parent is
included in the parent’s gross income. A special rule applies to refunded
amounts recontributed to a qualified tuition program of the beneficiary.
iii. 529A able … similar to 529 but for qualified disability expenses
11. Discharge of Indebtedness. § 61(a)(11) and Reg. § 1.1001–2(a)
i. General Rule. Debt forgiven = GI. Property foreclosure = sale.
1. Example. Kayla is unable to make her credit card payments and
has negotiated a settlement with the credit card issuer. Her $40,000
debt will be settled for $25,000. Kayla must recognize income of
$15,000 from the discharge of debt.
2. Example 2. Juan owns land that serves as security for a $60,000
mortgage held by State Bank. Juan does not have personal liability
for the mortgage (it is nonrecourse debt). When Juan’s basis in the
land is $20,000 and the land’s fair market value is $50,000, the bank
forecloses on the loan and takes title to the land. Juan must
recognize a $40,000 gain on the foreclosure, as though he sold the
land for $60,000 (the amount of the nonrecourse debt). No income
from discharge of indebtedness is generated in this transaction.
3. Example 3. Assume the same facts in Example 2, except that
Juan’s debt is recourse. Juan is treated as selling the property for its
fair market value ($50,000) resulting in a gain or loss. His gain is
$30,000 ($50,000 sales price − $20,000 basis). In addition, Juan has
$10,000 of income from discharge of indebtedness because the
lender accepted the $50,000 sales price in discharging the $60,000
debt. Juan will want to determine whether any exclusion applies to his
income from discharge of indebtedness (discussed next).
ii. Exceptions. The following discharge of indebtedness situations are
subject to special exclusion treatment:
1. Creditors’ gifts. (Not available in business situation)
2. Discharges under Federal bankruptcy law.
3. Discharges that occur when the debtor is insolvent (the exclusion is
limited to the amount of insolvency).
4. Discharge of the farm debt of a solvent taxpayer.
5. Discharge of qualified real property business indebtedness.
6. A seller’s cancellation of the buyer’s indebtedness.
7. A shareholder’s cancellation of the corporation’s indebtedness
8. Forgiveness of certain loans to students. §108(f).
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9. Discharge of indebtedness on the taxpayer’s principal residence
that occurs between January 1, 2007, and January 1, 2026, and is
the result of the financial condition of the debtor.
In situations 2, 3, 4, 5, and 9, the Code allows the debtor to reduce
the related asset’s basis by the realized income from the discharge.
As a result, the realized income is merely deferred until the assets
are sold (or depreciated). Similarly, in situation 6 (a price reduction),
the debtor reduces the basis in the specific assets financed by the
seller.
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