Chapter 4

Gross Income Exclusions and

Adjustments to Income

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Gross Income Exclusions

• Bequest and inheritance

• Gifts

• Dividends, tax-exempt

• Foreign-earned income exclusion

• Fringe benefits

• Meals and lodging

• Income of minors

• Insurance, proceeds from life policy

• Interest, tax-exempt

• Scholarship and fellowship grants

• Social security benefits

• Workers’ compensation

• Health insurance benefits

• Roth IRAs

• Education IRAs

• Qualified state tuition programs

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Bequest & Inheritance

• Value of property is excluded

• Future income (interest, dividends, etc.) is

includable

• Estate exclusion is $2 million in 2007

• Annual exclusion for individual gifts is

$12,000 per donor/recipient per year

• Estate/gift tax rate is 42.5%

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Gifts

• Recipient of gift may exclude it from

income

• Future income from gifts is included as

income

• Gifts over $12,000 may be subject to ―gift

tax‖ for the giver

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Tax-Exempt Dividends

• When the dividend is more than the corporation’s earnings

• When the dividend is a return-of-capital to the stockholder

• Stock dividends and stock rights which are not converted to cash

• Stock splits

• Generally, Insurance policy dividends

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Foreign Earned-income

• Excludable up to $85,700 of earned income

• Taxpayer must be a resident in a foreign

country for a full year or 330 days during a

12 month period

• Must prorate exclusion amount if the year

period fall between two calendar years

• See example 1

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Examples of Fringe Benefits

• Dependent care assistance

• Educational assistance

• Group-term life insurance

• Health and accident insurance

• Adoption assistance

• Employer contributions to retirement plans

• Parking and transportation

• Athletic facilities

• Employee discounts

• Moving reimbursements

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Fringe Benefits

• Generally, ―discrimination rules‖ apply to key employees (cannot favor key employees)

• Cafeteria Plans

– Employees may ―pick and choose benefits‖

• Dependent Care—up to $5,000 excludable

– Only for employee’s children & dependents

– Earnings limit—exclusion cannot exceed spouse’s earned income

– $250 (or $500) per month if spouse is a full-time student or incapacitated

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Flexible Spending Accounts

• FSAs allow employees to set aside amounts to be used for child-care costs or health care expenses

• Amounts withheld from employees earnings are excluded from taxable wages

• Contributions to FSAs are pre-tax dollars

• Receipts must be submitted for all payments taken from the FSA

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Fringe Benefits

• Educational Assistance—up to $5,250

– Tuition, fees, books, supplies of undergraduate or graduate courses

• Group-term Life Insurance

– Coverage up to $50,000 is excluded

– Any amount over $50,000 is gross income following the Uniform IRS schedule (p. 4-7)

– Gross income is reduced by the employee’s contribution

– See example 7

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Fringe Benefits

• Health and Accident Insurance is excluded

– Also, reimbursements for medical care or

permanent injury is excluded

• Adoption Expenses

– Up to $11,390 is excluded

– Phase-out of exclusion begins at $170,820 AGI

– Exclusion ends at $200,820

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Noncash Compensation• De minimis (small-value) fringe benefits

– Copy machines, office supplies, holiday gifts

• Qualifying employee discounts– Merchandise, lodging, food

• Working condition fringe benefits– Tools, professional dues

• No-additional-cost services– Hotel rooms, telephone, travel, cars

• Athletic facilities

• Parking and transportation– Up to $215 per month for parking; $110 for transportation

• Qualified retirement plans

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Meals & Lodging

• Excluded if served on premises for the

benefit of the employer

• Lodging is excluded if it is furnished as a

condition of employment

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Oops—didn’t see you there

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Is this Inclusive or Exclusive?

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Income of Minors

• Parent’s do not include earnings of their children on their tax returns

• Child pays the tax on their unearned income

– Form 8615 (Kiddie tax)

• Parent’s are responsible for paying the child’s tax if child is unable to

• Parent’s may treat their children as employees in bona fide situations

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Proceeds from Life Insurance

• Tax-free when paid because of death

• Interest is taxable if paid or added to the

account while a policy is in effect

• If interest reduces the premium, it is

excluded from income

• 1099-INT from Insurance company

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Interest• Tax exempt if from ―municipal bonds‖

– General obligation bonds of a city, state, or other political U.S. subdivision

– Also some industrial development bonds

• U.S. Savings bonds used to finance higher education costs

– Series EE and I

– Bonds must be purchased by the taxpayer who is over age 24

– See p. 4-11 thru 4-13 and form 8815

– ..\Forms\f8815USbond excl.pdf

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Excludable Educational Savings Bonds

Interest Before Phase-Down

Excludable InterestQualifying Expenses – Nontaxable Scholarships

Bond = Portion of Redemption Proceeds

Interest Proceeds

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Others

• Scholarships & Grants

– Must be a degree-seeking student

– Applies to tuition, course fees, required books, supplies, and equipment

• Social Security Benefits

– Depends on total Gross Income level

• Sick Pay

– Worker’s Compensation payments, accident/health insurance payments and other payments received for injury is usually exempt from tax

– Punitive damages or payments for nonphysical injuries are taxable

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Individual Retirement Accounts

• Traditional Deductible IRA

– Above the line

– Must come from earned income

– Maximum of $4,000 per taxpayer ($5000 if over age 50)

– Married couples must have separate IRAs

– Contributions may be made up to April 15

– Deductible contributions may be limited if the taxpayer has another retirement plan

– Contributions and earnings are taxable at withdrawal

– See publication 17—chapter 17

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Roth IRAs

• The distribution is made after the taxpayer attains age 59½

• The distribution is made to a beneficiary as a result of the taxpayer’s

death

• The distribution is made on account of the taxpayer’s disability

• The distribution is used to pay first-time homebuyer expenses ($10,000

lifetime limit)

Taxpayers make non-deductible contributions

Taxpayers may make withdrawals tax and penalty-free if

made after a five-year waiting period and any of the

following conditions is met:

Withdrawals may be made at any time from a Roth. Tax and a

10% penalty apply only to the earnings. Once withdrawn, they

cannot be returned to the Roth IRA.

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ROTH IRA

• Maximum contribution is $4,000 per taxpayer

($4500 if over age 50)

• Phase-outs limits:

– Unmarried: $95,000 to 110,000

– Married—Joint: $150,000 to 160,000

• Roth 401(k) is a hybrid plan

– No income limits

– Contributions up to $15,500 ($20,500 over age 50)

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Distributions from an IRA

• Due to death or disability

• Used to pay medical expenses in excess of 7.5%

of AGI

• Used by an unemployed person to buy health

insurance

• Used to pay qualified higher education expenses

• Used to pay expenses of a qualified first-time

homebuyer ($10,000 lifetime limit)

The IRS does not assess a penalty for early withdrawal

when the distribution is:

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EDUCATION SAVINGS--Coverdell

• Up to $2000 per child may be contributed

• Contributions are non-deductible

• Distributions are excluded from student income if used to cover educational costs

• Must be used before student is age 30

• Cannot be combined with HOPE or Lifetime Learning credits

• Phaseouts begin at $95,000 or $190,000

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529 Education Plans

• Set up by states or colleges

• Contributions are taxed

• Grow tax-free if used for qualified

educational costs

• Any amount not used is taxed as interest

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1040 Adjustments

see form 1040

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Adjustments to Income

• Penalty on early withdrawal of savings

• IRA deduction *

• Student loan interest deduction ($2500 max) *– For yourself, spouse, or dependent

– Phase-out begins at $50,000-65,000 or $105,000-135,000

• Jury duty pay

• Tuition & fees deduction (use line 35, enter ―T‖)($4000 max)

• Educator Expenses up to $250* (use line 23)

A Form 1040 filer can deduct a number of adjustments

to income, including: (* may use 1040A) (reinstated)

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More Deductions on 1040• Archer MSA

• Certain Business Expenses for reservists and performing artists and government officials—p. 18 (see 2106)

• Health savings account contribution ($2700/$5450 max)

• Moving expenses

• One-half of self-employment tax

• Keogh and self-employed SEP and SIMPLE plans

• Self-employed health insurance deduction

• Penalty on early withdrawal of savings

• Alimony paid

• Domestic production activitiesQualified production activities include manufacturing, producing, growing, and extracting tangible

personal property, computer software, and sound recordings, and the construction and substantial renovation of real property including infrastructure. The production of certain films is also a qualifying activity as are certain engineering or architectural services.

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Alimony

A person who pays alimony deducts it for

AGI. The recipient includes the alimony

payments in gross income. When the law

requires the person who pays alimony to

recapture some of it as income, the recipient

gets a deduction for the same amount.

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Moving Expenses• The expenses qualify for deduction if they are incurred within

one year of the taxpayer’s start-of-work date.

• The moving taxpayer must live in the old and new principal residences, treating both as primary homes.

• Expenses include the reasonable costs of transportation (actual or .20 per mile) and lodging for the taxpayer and members of the household.

• The move must meet mileage and employment tests.

– New job site is 50 or more miles farther from former residence

– Employee must work at least 39 weeks during 12 months at the new job

– Move must occur within 1 year of starting job

• Self-employed taxpayers can also deduct

• Report on form 3903—p. 4-23

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Penalty on Early Withdrawal of Savings

Often time certificates or savings accounts

contains interest forfeiture and penalty

provisions for early withdrawal. A taxpayer

who withdraws funds early includes the full

interest income in gross income on Form 1040

and deducts the lost interest as an adjustment

to income.

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Self-Employed Health Insurance Deduction

• 100% of the health insurance premiums paid for

the taxpayer, spouse, and dependents

• Net profit and other earned income from the

taxpayer’s business with the medical insurance

plan

A self-employed taxpayer usually takes a deduction

for AGI for medical insurance. The deduction equals

the smaller of two amounts:

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Keogh and SEP Retirement Plans

Keoghs and SEP plans allow self-employed

persons to make deductible contributions to

retirement plans for themselves. A taxpayer

deducts the amount for a Keogh or a SEP as

an adjustment to income.

Limitations apply—see chapter 7

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Health Savings AccountsA taxpayer may deduct contributions to a medical

savings account (MSA) as an adjustment to income.

Individuals eligible include self-employed persons and employees working for companies with 50 or fewer employees. These people must also be covered under high-deductible medical insurance programs.

A taxpayer may deduct contributions up to 100% of the cost, not to exceed $2700 if single or $5,450 if married. An employee excludes from income employer contributions to the MSA, but the maximum allowable contribution requires the combining of both employer and employee contributions.

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Student Loan Interest

Taxpayers may deduct up to $2,500 from

gross income for interest paid on money

borrowed to pay qualified higher education

expenses of the taxpayer, spouse, or

dependents. Phaseouts begin at $55,000 AGI

for single or $110,000 for married)