Chapter I4
Gross Income - Exclusions
Discussion Questions
I4-1 The IRS and the courts must interpret the tax law passed by Congress. The efforts of the IRS
and the courts may result in broad definitions of certain exclusions. Such broad definitions may
reasonably be termed administrative or judicial exclusions. Administrative exclusions are those that
are developed by the Treasury Department and IRS through Regulation, rulings, etc. Judicial
exclusions are created through court decisions. p. I4-2.
I4-2
The tax law specifically excludes gifts from the definition of gross income. It is the position
of the IRS that welfare benefits are gifts. Hence, such benefits are not taxable. p. I4-2.
I4-3 In Eisner v. Macomber, the issue was whether a stock dividend was taxable. The Supreme
Court sought to define income and concluded that realization must occur before income is
recognized. pp. I4-2 and I4-3.
I4-4 Most exclusions exist for either reasons of benevolence (social generosity or sympathy) or
incentive (the desire to encourage or reward a particular type of behavior). Exclusions for employee
death benefits, life insurance benefits, and public assistance exist because of reasons of benevolence
while the foreign earned income exclusion and the exclusions for certain employee benefits are
intended to be economic incentives. p. I4-4.
I4-5 a.
Income earned prior to the gift is taxable to the donor while income earned after the
gift is taxable to the donee.
b.
The total tax liability can be reduced if the donee is in a lower income tax bracket
than the donor. pp. I4-4 and I4-5.
I4-6 a.
Motive plays an important role. For a transfer to be a gift, it must be made for reasons
such as love, affection, kindness, sympathy, generosity, or admiration.
b.
Tips are considered to be compensation for services. This is true even though
generosity or other motives may be present. pp. I4-4 and I4-5.
I4-7 The face amount of life insurance is excluded from the gross income of a beneficiary if the
amount is paid upon the death of the insured. If the amount paid exceeds the face of the policy then
the excess is taxable. p. I4-5.
I4-8 For an award to be excluded under Sec. 74, it must be made for religious, charitable,
scientific, educational, artistic, literary, or civic achievement. The recipient must be selected without
I4-1
action on his or her part, and the recipient may not be required to perform any substantial future
services. In addition, the recipient must contribute the proceeds to a charity. p. I4-7.
I4-9 The requirement that the recipient must donate the proceeds to charity severely limits the use
of Sec. 74. The rule does benefit taxpayers who receive and donate to a charity awards that exceed
the ceiling limitation on the charitable contribution deduction (e.g., 50% x AGI). Also, the exclusion
favors taxpayers who claim the standard deduction as such taxpayers do not deduct charitable
contributions. p. I4-8.
I4-10 a.
A scholarship is an amount paid or allowed to, or for the benefit of, a degree
candidate to aid the individual in pursuing his or her studies.
b.
The exclusion is limited to amounts awarded for tuition, books, fees, and equipment.
As a result, if a scholarship either exceeds the total amount of qualifying expenses or, alternatively,
the scholarship is specified as being for nonqualifying expenses, the scholarship will be at least
partially taxable.
c.
It is likely that such a scholarship will be viewed as compensation for future services,
and will, therefore, be taxable. The expenses incurred by the employee may be deductible education
expenses.
d.
No. The amounts will normally be taxable compensation. p. I4-8.
I4-11 Nondegree candidates may not exclude scholarships from gross income. p. I4-8.
I4-12 Yes. The term personal injury is now limited to personal physical injury. p. I4-8.
I4-13 a.
Employers may generally deduct the cost of premiums paid on medical, health,
disability and life insurance coverage for employees.
b.
Employees need not include in gross income premiums paid by an employer on
medical and health and disability policies. Except for a limited exclusion for group-term life
insurance, an employee must include life insurance premiums paid on his or her behalf in gross
income.
c.
Medical and health insurance benefits are excluded except when the benefits exceed
the actual costs. Disability benefits are taxable unless the premiums were paid by the employee.
Life insurance benefits are generally excluded from gross income. pp. I4-9 and I4-10.
I4-14 Key employees must include in gross income an amount equal to the greater of premiums
attributable to group-term life insurance coverage over $50,000 or amounts determined by IRS
tables. Other employees must include in gross income amounts determined by IRS tables in
instances where coverage exceeds $50,000. pp. I4-11 and I4-12.
I4-15 a.
The six major types of fringe benefits covered by Sec. 132 are:
1.
2.
3.
No additional cost benefits,
Qualified employee discounts,
Working condition benefits,
I4-2
4.
De minimis benefits,
5.
Qualified transportation fringes, and
6.
Athletic facilities.
b.
If the requirements of Sec. 132 are met, employees are not required to include the
value of the benefit in gross income.
c.
Working condition, qualified transportation, and de minimis benefits must be offered
only to employees. The remaining benefits may be offered to employees, spouses, dependents, and
retirees.
d.
Discrimination is prohibited relative to most Sec. 132 benefits. Discrimination is
permitted relative to working condition benefits and de minimis benefits other than eating facilities.
e.
Employees who receive prohibited discriminatory benefits must include the value of
the discriminatory benefits in gross income. The exception is discriminatory right to use recreation
and athletic facilities. In the case of such discrimination, the employer loses the right to deduct the
related expense. p. I4-14.
I4-16 For meals to be excluded from an employee's gross income, they must be furnished on the
premises of the employer and for the convenience of the employer. For lodging to be excluded from
an employee's gross income it must meet the same tests as meals and the employee must be required
to accept the lodging as a condition of employment. pp. I4-14 and I4-15.
I4-17 As there is no exclusion for premiums paid on a whole life policy, the officers must include
the amount of the premiums in gross income. Because of the discriminatory practices relative to
discounts on products, the officers must include the discounts in gross income. Whether the payment
of social club expenses is taxable depends on the use of the club. The officers may exclude
payments from gross income to the extent they are business related. The payment of any personal
portion of social club expenses is taxable income to the officers. The free parking provided by the
employer is not taxable even if it is only provided to the officers. This is true even if the benefit is
provided to the officer on a discriminatory basis. pp. I4-10 through I4-13.
I4-18 Most fringe benefits are tax favored only to employees. There are tax favored benefits in the
area of retirement plans (Keogh, etc.). Further, self-employed persons may deduct certain business
related expenses such as entertainment, travel, etc. Otherwise, self-employed individuals do not
benefit from tax favored items such as group-term life insurance. pp. I4-10 through I4-13.
I4-19 Stated simply, the Sutter rule says the cost of one's own meals, entertainment and similar
items is a nondeductible personal expenditure. That is true even if the cost is incurred in a business
environment such as when entertaining customers. Although 50% of the cost of the customer's meal
is deductible, the cost of one's own meal is not. Though this rule was established by the courts, it has
not been rigidly enforced by the IRS. In general, the IRS uses the Sutter rule when taxpayers attempt
to deduct a substantial number of personal meals. pp. I4-15 and I4-16.
I4-20 Yes, to the extent the disbursements exceed contributions.
I4-3
I4-21 The exclusion is applicable to earnings from personal services rendered in foreign countries.
To qualify for the foreign earned income exclusion, a taxpayer must either be a bona fide resident of
one or more foreign countries for the entire taxable year or be present in one or more foreign
countries for 330 days during a period of 12 consecutive months. pp. I4-18 and I4-19.
I4-22 Deductions directly attributable to the excluded foreign earned income are disallowed.
Expenses attributable to foreign earned income must be allocated if foreign earned income exceeds
the exclusion. p. I4-19.
I4-23 a.
In general, debt cancellation results in taxable income while gifts, bequests, and
renegotiations of purchase price are not taxable.
b.
In most cases, the taxpayer must reduce the basis of the property by the amount of the
debt reduction. pp. I4-20 and I4-21.
I4-24 a.
There are four instances where a discharge of indebtedness is not a taxable event.
They are discharges that occur in bankruptcy, discharges relating to business real property, certain
discharges relating to student loans, and discharges that occur when the taxpayer is insolvent.
b.
A father's forgiveness of a daughter's debt may be motivated by reasons such as love
and affection. As a result the forgiveness may be a gift and excluded from gross income. p. I4-21.
I4-25 Although the financially troubled taxpayer does not have to recognize income, tax attributes
such as a Net Operating Loss must be reduced. As a result the taxpayer does not benefit from both
an exclusion for the debt forgiveness and the tax attributes.
I4-26 Employee awards are taxable unless they qualify as either "employee achievement awards" or
"qualified plan awards." Such awards must be granted for either length of services or safety records.
pp. I4-13 and I4-14.
I4-27 Many employees are not interested in certain tax favored benefits. For example, single
employees are often not interested in life insurance coverage. As employers must provide benefits
on a nondiscriminatory basis, it is difficult to offer benefits only to interested employees and at the
same time meet the nondiscrimination requirement. This can lead to employers providing benefits
that are of little benefit to certain employees. Under a cafeteria plan, employees may select which
benefits they wish to receive. As a result, employees select items that they feel are most beneficial.
p. I4-22.
I4-28 a.
High income employees are more likely to select nontaxable fringe benefits. Higher
income employees tend to be in higher tax brackets, and they must pay a greater tax if they select
cash instead of exempt fringe benefits.
b.
One result of options to receive cash is that some lower-income employee may choose
cash over health insurance leading to more uninsured individuals. p. I4-22.
Issue Identification Questions
I4-4
I4-29 The basic issue is whether the reduction in rent represents taxable compensation to Luke. If
the payments are taxable, another issue is whether Luke is an employee or an independent contractor.
At this point, most students will not likely identify the second issue. The facts presented do not
permit a conclusive answer to either question. It is possible that the Sec. 119 exclusion is available if
Julie requires Luke to live in the unit, and that the requirement is to her benefit. For example, she
wants Luke to be available to do emergency repairs at night and on weekends. Further, she could
also ask him to show vacant units to prospective tenants and provide other services that require him
to be readily available.
If the exclusion is available, Julie reports the $350 as rental income, and Luke reports no
income. If the reduction represents compensation, Julie must include $650 in gross income, but she
can deduct $350 as compensation expense. Luke is taxed on the $350. Further, if Luke is an
employee, Julie must withhold for income and social security taxes. If Luke is an independent
contractor, there is no withholding but he is responsible for income and self-employment taxes. He
would have to make estimated payments. If Luke works independently (sets his own hours, provides
his own tools, etc.), he will be treated as an independent contractor. pp. I4-14 and I4-15.
I4-30 The primary issue Mildred faces is determining whether the $25,000 payment represents
taxable compensation for her years of service or a gift. If the amount is a gift, Mildred has no
income tax liability. If the payment is taxable, a secondary consideration is the character of the
income, (i.e., ordinary income or capital gain). If the payment is a gift, Larry and Kay would have to
report the payment on gift tax returns. The information provided does not make it clear whether the
payment is compensation or a gift. It does, however, indicate that the payment is made in
appreciation of years of service suggesting that the payment is compensation. If the payment
represents compensation, Larry and Kay need to consider withholding, FICA, and other payroll tax
requirements. pp. I4-4 and I4-5.
I4-31 The tax issue is whether the arrangement represents discrimination. The discrimination rules
are intended to be sure that Sec. 132 benefits are not offered to some employees on a favorable basis.
Reg. Sec. 1.132-8(c)(1) specifically indicates that basing discounts on seniority does not constitute
making discounts available to employees on the same terms. Therefore, the practice described here
is likely to be viewed as discriminatory. A secondary issue (assuming that the arrangement is not
discriminatory) is that the exclusion is limited to the employer's gross profit percentage. Amounts
deemed to be not eligible for the exclusion should, nevertheless, be deductible by Troy as a business
expense. pp. I4-12 and I4-13.
I4-32 The primary tax issue is whether Jerry must include the value of his meals in gross income.
The practice of the IRS is to accept occasional employer paid lunches in business situations.
However, this situation is not one that is necessarily covered by the de minimis rule. In the event of
an examination, the IRS could attempt to include the value of his personal lunches in Jerry's gross
income. A secondary issue is the deductibility of the entertainment expenses by the employer (i.e.,
50% of entertainment expenses are not deductible by the employer if the employee is reimbursed for
such expenditures). pp. I4-14 and I4-15.
I4-5
Problems
I4-33 a.
Self-help income is not taxable.
b.
Exchanges of services are taxable. Hence, each taxpayer would have to report $200
of gross income. This does assume that the services are reciprocal. The fact that neighbors do, on
occasion, help one another without obligation, would seem to be inapplicable. Where there is an
agreement, the exchange would be taxable. The mechanic may be entitled to a deduction for tax
return preparation costs.
c.
Such help would likely be a nontaxable gift. pp. I4-3 and I4-22.
I4-34 a.
The amount would be a taxable prize. The payment is not a gift as donative intent is
not present.
b.
The payment would be taxable compensation.
c.
The $500 would seem to be a nontaxable gift. The forgiveness was based on the
family relationship and was given as a graduation present. pp. I4-4 and I4-7.
I4-35 a.
b.
None. The face amount of a life insurance policy can be excluded from gross income.
Installment payment
Minus: Exclusion:
Face Amount =
Number of
Installments
Taxable portion
$12,000
$50,000 =
5
(10,000)
$ 2,000
Dan must report $2,000 of income for each installment.
c.
No. Although prior law provided an additional annual exclusion of $1,000 for
spouses, this exclusion is no longer available. pp. I4-5 and I4-6.
I4-36 a.
$6,000 ($20,000 - $6,000 - $8,000). Amy purchased the policy from her brother.
Because she purchased the policy she is not entitled to the usual life insurance exclusion.
b.
No. No income has to be recognized upon the collection of the face of a life
insurance policy if the policy was transferred from the original owner as a gift. pp. I4-5 and I4-6.
I4-37 a.
Although Sue has a very serious health problem she is not terminally ill. As a result,
no special exclusion is available. If she accepts the lump sum settlement, she would be required to
include in gross income the amount she receives in excess of the premiums she has paid $145,000
($225,000 -$80,000).
b.
Sue does not have to report any gross income from the annuity as the benefits are less
than the cost of her long-term health care.
c.
Sue must report gross income of $2,400. This is equal to the difference between her
benefits of $38,400 ($3,200 x 12) and her health care costs of $36,000.
I4-6
p. I4-6.
I4-38 a.
Only the interest of $600 is taxable. It is taxable even though Hank left the amount
with the insurance company.
b.
Yes. Hank would be taxed on the dividends in excess of premiums $1,000 ($9,000 $8,000) along with the interest. p. I4-7.
I4-39 a.
The amount received is taxable.
b.
The prize is taxable.
c.
The prize is taxable. The award is not based on years of service or safety record and is
not a non cash award. An award for educational achievement would be nontaxable only if Kay
directed that the funds be paid to the school (or other charitable organization). pp. I4-7 and I4-13.
I4-40 a.
The scholarship is not taxable as long as tuition books and fees exceed the $1,500, but
the salary earned working in the bookstore is taxable.
b.
Although one might argue that the full amount awarded was a salary paid for playing
football it seems to be the practice of the IRS to exclude such awards as scholarships. If the student
were required to play in order to receive the award the full amount would be taxable. Nevertheless,
Marty must include in income $4,000 of the scholarship that covers room, board and laundry. p.
I4-7.
c.
Even though all students must work in the hospital to graduate, the salary is taxable.
p. I4-8.
I4-41 $3,500. The actual expenses should be deductible by Otto as education expenses. Because
the expenses are reimbursed, the deduction for education expenses is for AGI (see Chapter I7). p.
I4-8.
I4-42 a.
b.
c.
d.
e.
None of the amount is taxable.
The amount is taxable.
None of the amount is taxable.
The full amount is taxable as it is derived from an employer financed policy.
The full amount is taxable as it is derived from Ted's employer. pp. I4-8 and I4-9.
I4-43 a.
$2,300 ($1,800 + $300 + $200). The full amount of premiums paid on Ursela's behalf
are deductible.
b.
None of the premiums need be included in Ursela's gross income.
c.
The disability income of $5,000 is taxable. Ursela may possibly qualify for the credit
for the elderly and disabled (see Chapter I14). Because the medical insurance benefit represents a
reimbursement for medical expenses it is not taxable.
d.
None of the life insurance benefit is taxable. pp. I4-9 through I4-13.
I4-44 a.
$5,600 ($4,000 + $700 + $600 + $300). Data Corp. can deduct the premiums paid on
the group-term policy.
I4-7
b.
Neither Bob nor Damitria is required to report any premiums as income as the group
coverage is less than $50,000. Andy must report $3,000 of gross income which is the amount
attributable to the excess coverage because Andy is a key employee and the actual amount exceeds
the $2,106 ($150,000 x $1.17 x 12 divided by $1,000) amount established by the Regulations.
Total premiums
Premiums attributable to
$50,000 of coverage:
$50,000 x $4,000
$200,000
Taxable portion
$4,000
(1,000)
$3,000
Cindy must report $32.40 computed as follows: $.09 per thousand x 12 months x $30,000 of excess
coverage/$1,000. pp. I4-10 through I4-12.
I4-45 a.
If Joe elects to receive $100,000, he does not have to include any of the proceeds in
gross income.
b.
If Joe elects to receive installments he is entitled to exclude the face of $100,000. The
annual exclusion is determined by dividing the $100,000 face by his life expectancy of 20.0 years as
determined by reference to Table 3-1. Thus, Joe would report $9,000 [$14,000 - ($100,000  20.0)]
of income each year. pp. I4-5 and I4-6.
I4-46 All of the benefits (except the one week vacation) are covered by Sec. 132 and, therefore, are
nontaxable. The parking fringe is not taxable because it is valued at less than $175 per month.
Although the vacation was awarded because of Al's safety record, it is likely to be construed as
compensation for services he rendered as an employee. Therefore, the $2,300 value of the vacation
is taxable. The award does not qualify as a Sec. 274 award as such awards must be presented in the
form of tangible personal property. Also, the amount of the award exceeds the $1,600 limit specified
in the law. pp. I4-12 through I4-14.
I4-47 The corporation can deduct all the expenses incurred except that only 50% of the
entertainment is deductible. In the case of the rental units occupied by the managers, Jet Corporation
is entitled to deduct the actual expenses associated with the units (repairs, depreciation, taxes,
insurance, etc.) rather than the rental values. Probably none of the amounts listed would have to be
included in the employee's gross income. The rental value of the apartments is covered by Sec. 119.
The corporation can deduct 50% of the cost of the entertainment by the president. Although, the
Sutter rule could prove to be a problem for the president, the amounts involved here do not seem to
indicate any abuse. The IRS probably would not require the president to include the $200
attributable to his own meals in income. The supper money is excluded under Sec. 132. The Vice
President's expenses are covered by the travel while away from home. The IRS might disallow a
portion of the Vice President's costs as meals. The portion of the cost that is associated with meals is
subject to a 50% disallowance to the Jet Corporation (assuming that the expenses are reimbursed).
pp. I4-12 through I4-15.
I4-8
I4-48 a.
The letter indicates the amount is awarded for past services. In absence of any
contradictory information, and assuming the amount is reasonable, it is deductible.
b.
The payment would be taxable income. pp. I4-16 and I4-17.
I4-49 a.
None. Federal employees are not eligible for the exclusion.
b.
$30,000. 30% of the income is eligible for the exclusion as capital is a material
income producing factor.
c.
None. Jim meets neither the residence nor the time requirement necessary to claim an
exclusion. pp. I4-18 and I4-19.
I4-50 a.
$72,000. It is not necessary to prorate the exclusion even though Rita was not present
in Germany for the entire year. She was present for over 330 days and that is all that is necessary.
b.
$4,000. As one-third of her salary is excluded, she is denied a deduction for one-third
of her expenses. pp. I4-18 and I4-19.
I4-51 a.
b.
No. Debt reduction during bankruptcy does not result in income.
USA must reduce its NOL by $380,000 ($780,000 - $400,000).
pp. I4-19 through I4-21.
I4-52 a.
The debt reduction is $250,000 (0.50 x $500,000). As the reduction is not one that
takes place in bankruptcy, it is subject to limitations. There is a $120,000 debt reduction associated
with insolvency ($500,000 - $380,000). That reduction in debt reduces the net operating loss
carryover to $30,000 ($150,000 - $120,000).
b.
The balance of the debt reduction is $130,000
($250,000 - $120,000). The corporation must recognize $130,000 of income. pp. I4-19 through I421.
I4-53 a.
Most likely, the taxpayer will have to include all of the award in gross income. b.
Libel has been held to be personal injury. However, as it is not a physical injury no exclusion
is available.
c.
The amount she received from the employer sponsored disability policy is taxable. If
her injury was deemed permanent, she may possibly qualify for the disability credit. As the $15,000
is a reimbursement for medical expenses she does not have to include the reimbursement in gross
income. pp. I4-8 and I4-9.
I4-54 a.
By participation in the plan, Jangyoun would save $700 (.28 x $2,500).
b.
Probably not. Although there would still be a tax savings, that is not sufficient reason
to spend $2,500 on duplicate medical insurance coverage. One possible reason for carrying the
additional coverage would be if the wife's employer's insurance plan did not provide adequate
benefits.
I4-9
c.
Yes. Participation in the employer plan would result in a tax savings of $728 (.28 x
$2,600). That is greater than the savings from the credit of $480. The scale down of the benefits
from the tax credit are discussed in Chapter I14. p. I4-22.
I4-55 a.
$7,500,000.
Selling price
Less: Adjusted basis
Realized gain
Exclusion percentage
Excluded gain
$
$16,000,000
( 1,000,000)
$15,000,000
0.50
7,500,000
Limitation upon the gain eligible for the exclusion: Greater of $10,000,000 or $40,000,000
(10 x $4,000,000 FMV). Thus, none of the $15,000,000 gain is subject to the limitation.
b.
$5,000,000. The gain eligible for the exclusion is $15,000,000 before considering the
limitation. The limitation is the greater of $10,000,000 or $10,000,000 (10 x $1,000,000 FMV).
Thus, the excluded portion of the gain is limited to $5,000,000 ($10,000,000 x 0.50).
c.
None of the gain is excluded because the stock has not been held for a period of more
than five years. p. I4-21.
d.
Yes. If Jose acquires $16,000,000 or more of qualified stock within 60 days no gain
is recognized.
Comprehensive Problem
I4-56
Salary
Alimony
Dividends
Adjusted gross income
Minus: Itemized deductions
Exemptions
Taxable income
$22,000
18,000
4,600
$44,600
( 8,600)
( 5,400)
$29,700
Pat is entitled to the dependency exemption because the child lives with her and she did not agree to
allow her husband to claim the exemption. All of the fringe benefits are excludable along with the
interest on the State of California bonds.
I4-10
Tax Form/Return Preparation Problems
I4-57 (See Instructor's Guide)
I4-58 (See Instructor's Guide)
Case Study Problems
I4-59 (See Instructor's Guide)
I4-60 (See Instructor's Guide)
Tax Research Problems
I4-61 (See Instructor's Guide)
I4-62 (See Instructor's Guide)
I4-63 (See Instructor's Guide)
I4-11