This course is the first course in a five-course US Federal Tax Specialization. It covers and focuses on the U.S. federal tax system as it relates to individuals, employees, and sole proprietors. Key concepts covered include gross income and items that are statutorily included or excluded in it, personal and business expenses that qualify as tax deductions, and the differing tax treatments for employees versus self-employed taxpayers. Unlike many other introductory courses in tax and as part of this course’s comprehensive wrap-up, learners will be provided with practical and tangible experience reporting both income and expenses on the main individual tax return used in the US, Form 1040. If you have enjoyed this course, consider enrolling in our online graduate Accounting program. The University of Illinois at Urbana-Champaign, consistently ranked as one of the nation's top three accounting programs, now offers a master’s in accounting at a very affordable tuition rate and is completely online. The iMSA is a full Master of Accountancy program and students graduate with an MS that is highly recognized. Try an open course or two, then apply for admission into the credit-bearing version as you may be eligible to take credit-bearing courses during the application process. If you are missing any prerequisites for the full degree, you can complete Coursera courses to demonstrate readiness and strengthen your application for the iMSA. For more information on this exciting iMSA online program, refer to this link: https://www.coursera.org/degrees/imsa
Scholarships, Payments for Damages, Compensation for Injuries and Sickness
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From the course by University of Illinois at Urbana-Champaign
Federal Taxation I: Individuals, Employees, and Sole Proprietors
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University of Illinois at Urbana-Champaign
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Course 1 of 5 in the Specialization U.S. Federal Taxation
From the lesson
MODULE 4: GROSS INCOME: EXCLUSIONS
In this module, you will take a deeper dive into gross income, specifically regarding statutory exclusions. Congress, the Courts, and the IRS allow exclusions of money or property received by the taxpayer for various reasons.
Meet the Instructors
Petro Lisowsky, PhD, CPAAssociate Professor of Accountancy
College of Business: Department of Accountancy
Welcome back. Last time,
we looked at a few items that were excluded from gross income.
Recall that exclusions entail income that is not subject to tax.
So in this video,
we'll look at additional exclusion items,
at scholarships, payments for damages,
and compensation for injuries and sickness.
Let's start with scholarships and fellowships.
First, a brief definition of what we're talking about.
Scholarships and fellowships entail amounts paid to,
or for the benefit of,
a student to aid in pursuing a degree at an educational institution.
For example, a student might obtain a scholarship to attend
the University of Illinois and receives,
let's say, $5000.
Is that income?
Does that get taxed or not?
Well, the scholarship is nontaxable or it's excluded from income to
the extent that scholarship pays for tuition and related expenses such as books,
fees, supplies, and equipment required for courses.
However, amounts received for room and board are included in gross income.
So, if the student's $5000 scholarship covers
tuition and perhaps to purchase a laptop for school,
then the entire $5000 is excluded from gross income.
If, however, the $5000 is for room and board, it is taxable.
Furthermore, the exclusion applies only if the recipient is not
required to perform services in exchange for receiving the scholarship.
For example, if the student obtaining the $5000 scholarship has to
work at the university library in order to obtain the funds,
then this is not a scholarship for income tax purposes.
The $5000 represents wages which,
of course, are includable in gross income.
Here, the primary transaction entails a payment in
exchange for a specific service rather than to study.
An exception here is athletic scholarships.
Yes, student athletes obtain scholarships and, yes,
they're required to attend practices and games but the scholarship they receive is
excluded from gross income if the money goes towards tuition and related expenses.
Of course, if the scholarship goes towards the athlete
buying a vehicle or paying for room and board,
then the scholarship value will be included in the student athlete's gross income.
Finally, tuition waivers or reductions in the cost of tuition are excluded.
These are generally limited to undergraduate tuition waivers but they
include exceptions for graduate student teaching or research assistance as well.
Think of tuition waivers as a student paying
the sales price for the cost of the education.
For example, if you go to a store and buy a pair of jeans on sale,
you simply pay the sales price and don't recognize
the reduction in sales price in your gross income.
The price reduction is not gross income to you.
Likewise, a reduction in the tuition cost would not be
gross income to the student paying for the tuition.
So let's look at a few examples.
How much is required to be included in gross income?
First, Alan was awarded $10000 in a scholarship to attend state law school.
The scholarship pays Alan's tuition and textbooks.
What happens here?
Well, here, the scholarship is covering tuition and fees only
so the $10000 is excluded from Alan's gross income.
Next, Alan was awarded a $15000 scholarship to attend state business school.
All scholarships students must work 20 hours
per week in the school's admissions office during the term.
So, here, the scholarship is essentially a payment for services like wages.
So the scholarship is includable in Alan's gross income.
Finally, Alan was the recipient of an athletic scholarship that pays
his $12000 tuition to State University and
provides him with a $5000 stipend to pay for food and housing.
The scholarship requires Alan to participate in an athletic competition each term.
Here, to the extent the athlete is getting the scholarship for tuition, it is excludable.
But to the extent it's paying for room and board, it's includable.
So, here, $5000 is includable in Alan's gross income while $7000 is excludable.
The next exclusion we'll examine is payment for damages.
When we talk about damages,
we mean a variety of things including lost income,
expenses incurred, property destroyed, or personal injury.
Here, imagine the taxpayer is somehow
harmed and then is paid an amount to compensate for that harm.
It could be from a lawsuit or a mutual settlement.
How is that payment received by the harmed taxpayer treated?
Is the payment includable or excludable in the taxpayer's gross income?
The answer, here, is like so much in tax, it depends.
First, let's look at a situation where the taxpayer has lost income.
Perhaps there was a breach of contract or a job termination.
Maybe the person was laid off and is obtaining severance payments.
Here, the loss of income is generally taxed the same as the income that it's replacing.
So, if the income it's replacing would have been wages, that is,
the person would have kept on working had not been laid off,
then the severance income is treated the same way as wages,
that is, ordinary income.
Another example is if a supplier breaches a contract with
a business taxpayer and
the business taxpayer cannot produce a product to sell to its customers.
Let's say, the business taxpayer sues the supplier and wins.
Here, the payment received from the lawsuit is replacing
lost revenues that the business taxpayer
was hoping to earn by selling the product to customers.
Therefore, the payment for damages would be treated as
ordinary income to the business taxpayer.
Next, what about expenses incurred?
So, let's say, an employee incurs travel and hotel expenses related
to a business trip that her employer wants her to go on.
Let's say, a trip to Boston to attend a meeting.
Here, the employee paid for the flight and the hotel and,
now, the employer reimburses the employee for the expenses incurred.
In this case, the reimbursement for expenses incurred is not income to the employee.
It's simply a refund or payback for the employee fronting
the money to pay for a business-related expense of the employer.
However, if the employee previously deducted the cost of
the business trip on his or her tax return -- as we'll learn, later,
the employee can do that to the extent she is
not reimbursed and it exceeds two percent of
her AGI -- then the reimbursement for
incurred but deducted expenses is includable in her gross income.
This is an example of the tax benefit rule.
Third, what if your property is destroyed?
Let's say, you put your backpack down on
the ground and somebody steps on it and breaks your laptop.
Or you get into a car accident and your car is destroyed.
What happens here?
Well, to the extent you receive a payment,
perhaps from the party that damaged your property
or from an insurance company if the property was insured,
this is treated as if you exchanged or sold the property.
If you receive more funds than you have basis in the property,
the taxpayer must realize gain.
For example, if your laptop cost $1000 and
the person who stepped on it paid you $1200 for your trouble,
then the amount above basis,
the $200, will be includable in the taxpayer's gross income.
However, the payment amount that covers the basis is tax free.
That is, the amount that's intended to make you whole again,
that part, is not taxable.
What if you paid a thousand dollars for your laptop and the person who damaged it ran
away and so you don't receive a payment and you have a thousand dollar loss?
We'll talk about this situation when we discuss personal casualty losses.
Unfortunately, in this case,
your loss might be quite limited.
Finally, let's say you receive a payment because somebody injured you.
Let's say, there's a car accident and you break your knee.
And it costs $5000 to fix your knee from doctors visits,
to a cast, to physical therapy.
And, let's say the party that injured you,
paid you the $5000 to compensate you for the pain.
Here, the $5000 is intended to bring you back to
your former condition and therefore it's excludable from your gross income.
Importantly, compensatory damages are excluded from gross income if they are
for or the result of a physical personal injury or a physical sickness.
Interestingly, payments made to you for emotional distress are not excluded
unless it's paid for medical care attributable to emotional distress.
Besides compensatory damages, punitive damages are always included in gross income.
Punitive damages are considered payments imposed on the injuring party as
a punishment perhaps for being negligent or unremorseful for their actions.
So, back to our car accident example,
if you break your knee and incur $5000 in costs for medical care,
and perhaps $1000 for emotional distress care,
but also $4000 in punitive damages that
the judge imposed on the injuring party because they were,
for example, driving carelessly and didn't feel sorry for causing the accident.
Then, the $4000 will be includable in the taxpayer's income while
the remaining $5000 reimbursement for medical care and
the $1000 reimbursement for emotional distress-related medical care will be excludable.
So, let's look at a few more examples here.
What amounts are includable in gross income?
First, Jim sued Baby Crib Company for
personal injuries caused to his baby from a defective crib.
Jim was paid $30000 for medical costs and
$250000 because the judge wanted to punish Baby Crib Company for negligence.
So, here, the $30000 in medical costs
would compensate for the medical care expenses incurred for Jim's baby.
And so it would be excludable from his gross income.
However, the $250000 payment represents punitive damages received and,
thus, would be included in Jim's gross income.
Next, Guy was injured in a car accident.
Guy's insurance paid him $500 to reimburse medical expenses and additional
$250 for emotional distress he suffered as a result of the accident.
So what's includable here?
Here, all $750 is excludable.
Because even though there's emotional distress involved here,
it's a payment for or the result of a physical injury.
Next, let's say the Wall Street Journal published a story about Sarah and,
as a result, she sued the Wall Street Journal for damages to her reputation.
The Wall Street Journal lost in court and paid Sarah $20000 in damages.
Well, what happens here?
There's no physical injury.
Perhaps, Sarah is suing for libel due to
the defamatory statements made by the Wall Street Journal.
But libel is not a physical injury or a physical sickness.
Therefore, the entire $20000 is includable in Sarah's gross income.
Finally, Paul was laid off from his job last month.
This month, he drew $800 in unemployment benefits.
So, here, the $800 is replacing
lost wages which would have been taxed as ordinary income had he continued to work.
Therefore, the $800 is includable in his gross income.
So let's dig a little deeper in terms of payments made related to injury or sickness.
First, we have what's known as worker's compensation.
This is different from unemployment benefits
because worker's compensation is compensation
made to an employee after the employee is physically injured.
For example, a worker breaks his arm when working in a car factory and,
let's say, the worker receives $10000 in worker's compensation for his injury.
Here, despite the fact that the $10000 is there to replace the worker's wages,
the $10000 payment is excluded from the employee's gross income
because the payment is made because of or result of a physical injury.
Next, let's talk about accident and health insurance benefits.
So, let's say, coverage that you might have from an insurance company.
If you get sick or injured,
the insurance company will pay for your doctor's bills or pay your lost wages.
How are these payments you receive treated for tax purposes?
Well, there's actually a few scenarios here.
First, if the benefits received under
the health insurance policy were purchased by the taxpayer,
then any amount received is excluded from
the recipient's gross income even if the benefits substitute for income.
Why is this?
Well, this happens because if the tax payer purchases
the health policy and the taxpayer has effectively earned
basis in the policy which means that the payment received
under the policy is essentially a return of basis.
Think of the capital recovery doctrine here.
Getting back your original investment is always tax free.
However, let's say you're an employee and
your employer is kind enough to provide you with health insurance.
How are the payments received under an employer-sponsored health plan treated?
Well, again, it depends.
So under an employer-sponsored health plan,
the employer is providing benefits to employees,
retirees, and their dependents.
What are the tax implications here?
First, the payments made by the employer to purchase the plan or the premiums
paid by the employer are fully deductible on the employer's tax return.
And, in fact, although the employee is receiving
a benefit for the health coverage and not paying for it,
Congress has decided that the premiums paid by the employer on
behalf of the employee is not includable in the employee's income.
So the value of the premiums is excluded from the employee's income.
On the benefits side,
benefits received will be included in the employee's gross income unless they're for
medical costs or for the permanent loss or use of a member or function of the body.
However, this means that payments made out of the health policy that cover lost wages,
let's say, taking medical leave,
will be includable in the employee's gross income.
So, in summary, on the employer-sponsored side,
if the employee receives payments to reimburse for medical costs,
these payments are excludable.
But, if the employee, receives payments as a replacement for lost wages,
the payments received are includable.
But, if the employee is purchasing his or her own health insurance,
payments for both medical care and lost wages are fully excludable.
Let's look at a final example here.
Let's say Becky was sick for six months and missed work during this period.
During her illness, she received $4000 in sick pay from a disability insurance policy.
What amounts are included in her gross income?
First, let's assume that Becky had disability insurance provided by
her employer and Becky's employer paid $3000 in disability premiums for Becky this year.
So what happens here?
Well, we have two issues.
First, Becky's employer paid $3000 to cover and buy insurance on her behalf.
In this case, the $3000 is
excluded from Becky's income even though she benefits from the coverage.
The second issue is the $4000 in sick pay.
How is that treated?
Because it's an employer-sponsored plan and the $4000 represents lost wages, that is,
it is not a reimbursement for medical costs just for time off to recover,
then the $4000 is includable in Becky's gross income.
Next, what if Becky paid the
$3000 in premiums for her own disability insurance for the year?
In that case, the $4000 in benefits received by Becky are
entirely excluded from her gross income because she purchased the policy.
So, in all, scholarships, payments for damages,
and compensation for injuries and sickness are
important examples of items excludable from gross income.
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