CONCEPTS IN
FEDERAL TAXATION
September 21 ,
2012
CHAPTER 4:
INCOME EXCLUSIONS
ADMINISTRATIVE
GSI: Jennifer Chen
Email: jenchen1204@gmail.com
Of fice Hours: By appointment
bSpace:
 Updated with slides
 Still need to upload chapters 1 & 2
HOMEWORK PROBLEMS
Problems
Assignment #4
Chapter 4
P26, 32, 34, 37, 65
Extra Problems:
P45, 46
INCOME EXCLUSIONS
Income “Broadly Defined” (includes income from all sources)
Minus:
Excluded income
Equals:
Gross income (Chapter 3)
Minus:
Deductions and exemptions
Equals:
Taxable income
X
Tax rate (schedule of rates)
Equals:
Income tax
Minus:
Tax credits
Tax prepayments
Equals:
Tax (refund) due with return
#26
Allison dies during the current year. She is covered by a
$1 ,000,000 life insurance policy payable to her husband Bob.
Bob elects to receive the policy proceeds in 10 annual
installments of $120,000. Write a letter to Bob explaining the
tax consequences of the receipt of each installment .
#26
 Life insurance proceeds are excluded from tax
 $1 ,000,000 face value of the policy is excluded as it is
received
 the earnings on the policy during the time it is held by the
insurance company are not excludable
 The total interest earned is $200,000 [($120,000 x 10) $1 ,000,000]
 As each payment on the policy is received, Bob will exclude
$100,000 ($1 ,000,000 ÷ 10) and include $20,000
($200,000 ÷ 10) in gross income
Exclusion Ratio =
Cost of the contract
Number of Payments
#26
Additional considerations for life insurance proceeds:
 An exception to the exclusion for life insurance proceeds is
made for amounts paid to the owner of a policy that was
obtained for a consideration
 Receipt is realization of income
#32
Lucinda, a welder for Big Auto Inc. dies in an automobile
accident on March 14 of this year. Big Auto has a company
policy of paying $5,000 to the spouse of any employee who
dies. In addition to the $5,000 payment, Big Auto pays Harvey,
Lucinda’s husband, $1 ,600 in salary and $1 ,100 in vacation
pay Lucinda had earned before her death. Harvey also collects
$120,000 from a group-term life insurance policy Big Auto
provided as part of Lucinda’s compensation package. Lucinda
had contributed to a qualified employer sponsored pension
plan. Big Auto had matched Lucinda’s contributions to the
plan. The plan lets the beneficiary of an employee who dies
before payments begin take the plan balance as an annuity or
in a lump-sum. Harvey elects to take the $250,000 plan
balance in a lump-sum. Write a letter to Harvey explaining the
tax consequences of each payment he receives.
#32
 Payment due to death - the $5,000 payment to Lucinda’s
spouse is included in gross income. Death benefits are fully
taxable.
 Salary and vacation pay - the $1 ,600 salary and $1 ,100 of
vacation pay were earned prior to Lucinda’s death and must
be included in gross income .
 Life insurance proceeds - the $120,000 life insurance
proceeds are excludable.
 Pension plan payment - because the $250,000 is from a
qualified plan, none of the amounts contributed to the plan or
the earnings on the contributions have been subject to tax.
Therefore, the entire $250,000 payment is taxable.
#34
Boris is an unmarried systems specialist with a public
accounting firm. During all of 2012, he is on temporary
assignment in London. He pays $21 ,000 in British income tax
on his $90,000 salary. Boris knows little about taxes and seeks
your advice on the taxability of the salary he earns while in
London. Write Boris a memorandum explaining the tax
treatment of his London salary. Assume that Boris has no other
income sources and that he does not itemize deductions.
#34
 Taxpayers may include the foreign -earned income in their
taxable income, calculate the U.S. tax on the income, and
take a tax credit for any foreign taxes paid. The amount of the
allowable tax credit is the lesser of:
1. The actual foreign taxes paid
2. The U.S. tax that would have been paid on the foreign earned income
 Individuals may exclude up to $95,100 in foreign -earned
income for each full year they work in a foreign country
 Individuals must be a resident of the foreign country or be
present in the foreign country for 330 days in any 12 consecutive
months
#34
 The tax under the exclusion is equal to the dif ference between
the tax on taxable income without the exclusion and the tax
on the amount excluded:
Tax on taxable income without exclusion
Less: Tax on exclusion amount
Equals: Tax on taxable income
$XXX
(XXX)
$XXX
#34
 Since Boris has worked in London for the entire year, he has
the option of excluding his $90,000 British income
(<$95,100) from his U.S. income or including his British
income in his U.S. income and taking a foreign tax credit for
the $21 ,000 of British income tax he paid (the foreign tax
credit cannot exceed the U.S. tax he would have paid on his
British income).
 Without the exclusion, his taxable income is $80,250 .
 If Boris elects to exclude $90,000 of his British income, his
taxable income will be zero.
 Using the foreign tax credit, his net tax is also zero .
 He cannot get a refund of foreign taxes paid .
#34
Calculation of taxable income without exclusion :
Gross income
Deductions from adjusted gross income:
Standard deduction
Personal exemption
Taxable income
$90,000
(5,950)
(3,800)
$ 80,250
#34
Options:
1. Exclude $90,000: Taxable Income = $0
2. Include $90,000 salary income
Tax on $80,250:
$4,867.50 + [25% x ($80,250 - $35,350)] = $16,093
Tax credit for British taxes paid = ($16,093)
Net tax = $0
 The entire U.S. tax is due to British income, so his maximum
tax credit is the $16,093 of U.S. taxes.
#37
Bear Company provides all its employees with a $10,000 group
term life insurance policy. Elk Company does not provide any
life insurance but pays $10,000 to survivors of employees who
die. Jackie, an employee of Bear Company, and her sister -inlaw, Rosetta, an employee of Elk Company, both die during the
current year. Their husbands, Bo and Carl, do not understand
the tax ef fects of the $10,000 payments they receive. Write a
letter to Bo and Carl explaining the tax ef fects of the $10,000
payments each receives.
#37
Carl
Bo
Bear Company
Life Insurance
Payments received from life insurance
policies are excluded from the gross
income of the recipient.
Elk
Company
Death Benefits
Death benefit payments are fully taxable.
#37
Bear Company
$10,000 group term life insurance policy
Excluded from gross income
Elk Company
$10,000 death benefit
Included in gross income
This provision is intended to encourage employers to provide life
insurance to all their employees so that their families have a
cushion if the employee dies while still working (a social goal).
#65
Jonas owns a building that he leases to Dipper, Inc., for $5,000
per month. The owner of Dipper has been complaining about
the condition of the restrooms and has proposed making
improvements that will cost $24,000. Dipper’s owner is willing
to pay to have the improvements made if Jonas will reduce the
monthly rent on the building to $4,000 for one year. Write a
letter to Jonas explaining the tax ef fects for Jonas of the
proposal by Dipper’s owner.
#65
 Improvements made by a lessee to property are not income to
the lessor until the lessor realizes the value of the
improvements (i.e., the property is sold or otherwise disposed
of in a taxable transaction) .
 If the improvements are made in lieu of rental payments, the
improvements must be included in the gross income of the
lessor as rental income.
#65
 The improvements attributable to the $1 ,000 ($5,000 lease
agreement - $4,000 proposed rent for one year) monthly rent
reduction will be included in Jonas’ gross income because
they are made in lieu of the normal rental payments.
 Jonas will have $12,000 (12 x $1 ,000) of rental income
under the proposal.
 The remaining cost of the improvements to the property
($12,000) will not be recognized until Jonas realizes the value
of the improvements through sale or other taxable disposition
of the property (deferred).
 The $12,000 rental reduction improvements is included in
Jonas’ basis in the building .
EXTRA PROBLEMS - #45
Determine whether the taxpayer has received taxable income in
each of the following situations. Explain why any amount(s) may
be excluded:
a. Jim is an employee of Fast Tax Prep, Inc. All employees of
Fast Tax Prep are eligible for a 50% discount on the preparation
of their income tax return. Jim’s tax return preparation would
normally have cost $300, but he paid only $150 because of the
discount.
 Because the discount is available to all employees, it qualifies
for exclusion.
 However, the exclusion for discounts on services is limited to
20%.
 Thus, only $60 ($300 x 20%) of the $150 discount is
excluded from gross income. The additional $90 discount is
included in Jim’s gross income .
EXTRA PROBLEMS - #45
b. Mabel is a lawyer for a large law firm, Winken, Blinken, and
Nod. Winken pays Mabel’s annual license renewal fee of $400
and her $300 annual dues to the American Lawyers’
Association. Mabel also takes advantage of Winken’s
educational assistance plan and receives payment of the
$6,000 cost of taking two night school courses in consumer
law.
 Mabel would have been able to deduct the licensing fee and
association membership as an employee business expense
had she paid for them herself, so $700 is excluded as a
working condition fringe benefit.
 Employees can exclude up to $5,250 of reimbursements from
qualified educational assistance plans that reimburse an
employee for the cost of coursework. Mabel must include
$750 ($6,000 - $5,250) in gross income.
EXTRA PROBLEMS - #45
c. Lori Company runs a nursery near its of fices. Employees are
allowed to leave their children at the nursery free of charge
during working hours. Nonemployees may also use the facility
at a cost of $300 per month per child. Dolph is an employee of
Lori with 2 children who stay at Lori’s facility while Dolph is at
work .
 The value of employer-provided day care is excluded up to a
maximum of $5,000/year.
 In this case, the value received is $7,200 ($300 x 2 x 12)
and Dolph is taxed on the $2,200 ($7,200 - $5,000) excess.
EXTRA PROBLEMS - #45
d. At the sporting goods store where Melissa works, her
employer lets all employees to buy goods at a 40% discount.
Melissa purchases for $300 camping and fishing supplies that
retail for $500. The goods had cost her employer $250.
 This is a qualified employee discount and is not taxable to
Melissa. The discount is less than the employer’s gross profit
percentage (50%) and therefore, is not included in Melissa’s
gross income.
EXTRA PROBLEMS - #46
Courtney is an employee of Freemont Company. An average of
three times a week, she works out during her lunch hour at a
health club provided by Freemont. Discuss the taxability of
Freemont’s provision of the health club in the following
situations:
a. The health club is owned by Freemont and is located on its
business premises. All employees and their dependents are
allowed to use the facility. The cost of joining a comparable
facility is $60 per month .
 Employees can exclude the value of using an employer’s
athletic facility if the facility is on the employer’s premises
and substantially all of the use of the facility is by employees
and their families. These conditions are met and Courtney
does not have any income from the use of health club.
EXTRA PROBLEMS - #46
b. The health club is located in Freemont’s of fice building, but
is owned by Manzer Fitness World. Freemont pays the $60 per
month health club dues .
 Because the health club is not owned by Freemont Co.,
Courtney cannot exclude the value of the health club dues.
Courtney must include the $720 ($60 x 12) of health club
dues paid by Freemont in her gross income .
EXTRA PROBLEMS - #46
c. Freemont is in the health club business. The health club is
used primarily by customers, although several employees,
including Courtney, use it, too .
 Courtney cannot exclude the value of the health club dues
under the provision for use of an employer’s athletic facility
because the primary use of the facility is by customers, not
employees.
 However, if free use of the health club is available to all of
Freemont’s employees, it is excluded as a no -additional cost
service. If all employees are not allowed to use the health
club, then Courtney must include the $720 ($60 x 12) of
health club dues in her gross income .
INCOME EXCLUSIONS BY CATEGORY
TABLE 4-2
Exclusions
Major Problems
Gifts
What is a gift?
Inheritances
No exclusion for future earnings on
amounts excluded for gifts,
inheritances, and life insurance
proceeds
Life insurance proceeds
Use annuity exclusion formula
Scholarships
Only direct costs of education
excludable for scholarships
Donative Items
INCOME EXCLUSIONS BY CATEGORY
TABLE 4-2
Employment Related
Exclusions
Exclusions
Major Problems
Foreign-earned income
Two options: exclude or take credit
Pension plan payments
Payments not taxable until withdraw
Group term life insurance
Exclude first $50,000; nondiscriminatory
Health/accident insurance
Nondiscriminatory
Meals and lodging
Cash meal allowances taxable
No additional cost services
Nondiscriminatory; same line of business as employee
Employee discounts
Nondiscriminatory; same line; goods: > cost; services: <20%
Qualified retirement planning services
Nondiscriminatory
Working-condition fringes
Can be discriminatory; $240/month for parking
De minimis fringes
Items too small to permit reasonable accounting
Child care
$5,000/year
Athletic facilities
On employer’s premises and used primarily by employees
Educational assistance
$5,250/year; nondiscriminatory
Cafeteria plans
Taxable if elect to receive cash
Flexible benefits
Unused portion not returned
Health savings accounts
Unused amount can be carried forward
INCOME EXCLUSIONS BY CATEGORY
TABLE 4-2
Returns of
Human
Capital
Exclusions
Major Problems
Workers’ compensation
Unemployment payments are
taxable
Damages for personal physical
injury
Must have origin of physical
injury or sickness; punitive
payments are taxable
Payments from employeepurchased health/accident plan
All health and accident insurance
payments are excluded
Payments from employer-provided
health/accident insurance for
medical expenses
Limited to medical care and loss
of body parts
INCOME EXCLUSIONS BY CATEGORY
TABLE 4-2
InvestmentRelated
Exclusions
Exclusions
Major Problems
Municipal bond interest
Exclude bonds issued by state and
local governments
Stock dividends
If option to receive cash, dividend
is taxed
Discharge of indebtedness—
Insolvent debtor
Determine solvency after debt
discharge
Discharge of indebtedness—
Qualified principal residence
indebtedness
$2M acquisition indebtedness
Improvements by a lessee
Payments in lieu of rent is taxable