Chapter 4: Income Exclusions 4-17
CHAPTER 4
INCOME EXCLUSIONS
DISCUSSION QUESTIONS
2. What is the difference between an exclusion of income and a deferral of income?
An income item that is excluded is never subject to tax - either in the current period or a future period. Deferred income items are not subject to tax in the current period, but will be taxed in some future period. Most items are deferred until the taxpayer has the wherewithal-to-pay the tax.
7. How do employees benefit from payments made into a qualified pension plan on their behalf?
From a tax perspective, an employee receives two benefits from the payments made by an employer into a qualified pension plan. First, the payment constitutes compensation income to the employee. However, payment of tax on the income is deferred until the employee withdraws the money from the plan. This feature provides the time-value savings common to deferrals of income. In addition, if the employee's marginal tax rate is lower when the money is withdrawn, the employee pays less tax than if it is not deferred (note that the opposite result could occur if tax rates went up or the employee has higher income when the money is withdrawn).
The second tax advantage is that the earnings on the pension plan assets are not subject to tax until they are withdrawn. This gives a higher rate of return each year the assets are left in the plan, resulting in a larger amount in the plan at retirement than if the income had been taxed as it was earned.
17. Discuss the difference in the tax treatment of payments received from an employer-provided health and accident insurance policy and a health and accident insurance policy purchased by the taxpayer.
The exclusion for payments received from an employer provided medical insurance plan are limited to those payments for medical costs (up to the amount of the actual medical expenses), loss of body parts or disfigurement, and payments made for specific types of injuries. Payments received from an employer provided plan for loss of income (sick pay) must be included in the gross income of the employee.
All payments received from a medical insurance policy purchased by the taxpayer are excluded from tax. Thus, loss of income payments from such a plan are not taxable as they are when received by an employer provided plan.
PROBLEMS
20. Throughout the textbook, it has been stated that tax relief can come in several forms. Assuming that the taxpayer in question is in a 28% marginal tax rate bracket and the time-value of money is 6%, determine the tax value of the following forms of relief:
a. A $2,000 item of income that is excluded from income
Because there is no tax paid on the $2,000 of excluded income, there is an implicit savings of the tax that would have been paid if the income been taxable, in this case $560 ($2,000 x 28%).
b. A $2,000 expenditure that is deductible in computing taxable income
A tax deduction results in a reduction of tax 560 tax saving for a 28% marginal tax rate payer.
c. A $2,000 expenditure that is eligible for a 10% tax credit
The value of a tax credit is equal to the amount of the tax credit because it is a direct reduction in the tax liability. The value of the tax credit is $200.
d. A $2,000 item of income that is deferred for five years (Assume no change in the marginal tax rate.)
The value of a deferral is equal to the time value of money tax savings on the item. In this case, the payment of the $560 tax is deferred for 5 years. The tax savings then is equal to the difference between the $560 of tax that would have been paid currently without the deferral minus the present value of the $560 tax payment 5 years from now. The present value factor for 6% for 5 years is .747, giving a present value of $418. Thus, the tax savings on the time value of money is $142 ($560 - $418).
27. Earl is a student at Aggie Tech. He receives a $5,000 general scholarship for his outstanding grades in previous years. Earl is also a residence hall assistant, for which he receives a $1,000 tuition reduction and free room and board worth $6,000 per year. Earl's annual costs for tuition, books, and supplies are $8,000. Does Earl have any taxable income from the scholarship or the free room and board?
Earl has $7,000 ($6,000 + $1,000) of income from the receipt of the free room and board. Even if the room and board were considered to be a scholarship, it could not be excluded because it is designated for payment of costs that are not direct education costs. The $5,000 general scholarship is excluded because it is less than the actual direct costs.
NOTE: Earl may be able to exclude the value of the room and board and the $1,000 tuition reduction if it meets the requirements for meals and lodging provided by an employer. To exclude the value of meals, the meals must be provided on the employer's premises and be for the convenience of the employer. The same requirements are applicable to lodging with the extra provision that the lodging be required in order to accept employment. In determining whether this exclusion applies, one would first have to determine whether Earl is an employee of the residence hall. Assuming that he is, it does not seem that the meals would meet the convenience of employer test (there is no advantage to the employer in having Earl eat in the residence hall cafeteria) and would not be excludable. The lodging would meet the convenience test and would be excludable.
28. Assume the same facts as in problem 27, except that Earl is not a residence hall assistant and his general scholarship is for $10,000.
Scholarships can be excluded up to the amount of the direct education costs. In case a, the scholarship is less than the $8,000 of direct costs and fully excludable. In case b, the scholarship exceeds Earl's direct costs and he is taxed on the $2,000 excess.
40. Faldo, Inc., provides medical coverage to employees through a self-insured plan. Nick, the president of Faldo, receives $3,400 in medical expense reimbursements from the plan during the current year. Discuss the tax consequences to Nick under the following circumstances:
a. All employees are fully covered by the plan.
Payments made to employees from self-insured medical reimbursement plans are excluded from the employee's income if the plan does not discriminate in favor of highly compensated employees. Because all employees are covered by the plan, it is non-discriminatory and Nick excludes the $3,400 in payments from his gross income.
b. All employees are covered by the plan. However, only Faldo's executive officers are fully reimbursed for all expenses. All other employees are limited to a maximum reimbursement of $1,000 per year.
Even though all employees are covered by the plan, the limitation on medical expense reimbursements of employees who are not executive officers is discriminatory. Because all employees are entitled to a $1,000 reimbursement, only payments made to executive officers in excess of $1,000 are discriminatory and therefore, not eligible for exclusion. Nick must include the $2,400 ($3,400 - $1,000) excess reimbursement in his gross income. Note : Employees who are not executive officers can exclude the reimbursements they receive.
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.
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.
The payment of Mabel's licensing fees and association membership by Winken is excluded as a working condition fringe. That is, Mabel would have been able to deduct these costs as an employee business expense had she paid for them herself. 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. However, depending on her adjusted gross income she can deduct the cost either as a deduction for adjusted gross income or as a miscellaneous itemized deduction (see Chapter 6). Alternatively, she might be able take a Lifetime Learning Tax credit on the $750 she reported as income (see Chapter 8).
c. Lori Company runs a nursery near its offices. 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. 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.
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.
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.
b. The health club is located in Freemont’s office 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.
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.
47. Dow, 42, is a manager for Winter Company. In addition to his $90,000 salary, he receives the following benefits from Winter during the current year:
Winter pays all its employees' health and accident insurance. Premiums paid by Winter for Dow's health insurance are $1,800.
Winter provides all employees with group term life insurance coverage equal to their annual salary. Premiums on Dow's $90,000 in coverage are $900.
Winter has a flexible benefits plan in which employees may participate to pay any costs not reimbursed by their health insurance. Dow has $3,000 withheld from his salary under the plan. His actual unreimbursed medical costs are $3,430. Winter pays Dow the $3,000 paid into the plan during the year.
All management-level Winter employees are entitled to employer-provided parking. The cost of Dow's parking in a downtown garage is $3,200 for the year.
Winter pays Dow's $150 monthly membership fee in a health club located in the building in which Dow works. Dow uses the club during his lunch time and on weekends.
Compute Dow's gross income for the current year.
Dow's gross income is $89, 46 8 :
Winter's company salary $ 90,000
Health and accident insurance premiums - excluded -0-
Group term life - premiums on $50,000 of coverage excluded
Excess premiums - $40,000 (40 x $1.20 from Table 4-1) 48
Payments into flexible benefits plan (3,000)
Free parking - $3,200 - (12 x $2 1 5 ) * 62 0
Health club membership fee - $150 x 12 1,800