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
134 ratings
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
Matthew HutchensLecturer of Accountancy
Department of Accountancy
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 as 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 $5,000, is that income?
Does that get taxed or not?
Well, the scholarship is
non-taxable 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 students $5,000 scholarship covers
tuition and perhaps to purchase a laptop for school,
then the entire $5,000 is excluded from gross income.
If however the $5,000 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
$5,000 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 $5,000 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 assistants as well.
Think of tuition waivers as a student paying
the sales price for the cost of their 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 costs 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
$10,000 in a scholarship to attend a 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 $10,000 is excluded from Alan's gross income.
Next, Alan was awarded a
$15,000 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 $12,000 tuition to State University,
and provides them with a $5,000
stipend to pay for food and housing.
The scholarship requires Alan to
participate in an athletic competition each term.
Here to the extent the athletic 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 $5,000 is includable in Alan's gross income,
while $7,000 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 a 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 was that payment received by the harmed taxpayer treated?
Is the payment includable or
excludable in the tax payer'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 was 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
the business taxpayer and
the business taxpayer can't 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.
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.
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 costs $1,000 and
the person who stepped on it paid you $1,200 for your trouble,
then the amount above basis, the $200,
will be includible 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.
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 $5,000 to fix your knee,
from doctor's visits, to a cast to physical therapy.
Let's say the party that injured you paid you the
$5,000 to compensate you for the pain.
Here, the $5,000 is intended
to bring you back to your former condition.
Therefore, it's excludible from the gross income.
Importantly, compensatory damages are
excluded from gross income if they are for
or the result of 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 $5,000 in costs for
medical care and perhaps $1,000 for emotional distress care,
but also $4,000 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 $4,000 will be includible in
the taxpayer's income while the remaining $5,000
reimbursement from medical care and the $1,000
reimbursement for emotional distress related to
medical care will be excludible.
Let's look at a few more examples here.
What amounts are includible in gross income?
First, Jim sued Baby Crib company for
personal injuries caused his baby from a defective crib.
Jim was paid $30,000 for medical costs and
$250,000 because the judge wanted
to punish Baby Crib Company for negligence.
So here, the $30,000 in medical costs
would compensate for the medical care expenses
incurred for Jim's baby,
and so it would be excludible from his gross income.
However, the $250,000 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
an additional $250 for
emotional distress he suffered as a result of the accident.
What's includible here?
Here, all $750 is
excludable because even though
there's emotional distress involved here,
it's the payment for or the result of a physical injury.
Next, let's say the Wall Street Journal
published a story about Sara and,
as a result, she sued
the Wall Street Journal for damages to her reputation.
The Wall Street Journal lost in court and paid
Sara $20,000 in damages.
Well, what happens here,
there's no physical injury.
Perhaps Sara is suing for liable due to
the defamatory statements made by the Wall Street Journal.
But liable is not a physical injury or a physical sickness.
Therefore, the entire $20,000
is includible in Sara'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 includible in his gross income.
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.
Let's say the worker receives
$10,000 in worker's compensation for his injury.
Here, despite the fact that the
$10,000 is there to replace the worker's wages.
The $10,000 payment is excluded from
the employee's gross income because the payment is
made because of or a result of a physical injury.
Next, let's talk about accident and health insurance benefits.
Let's say, the 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 you your lost wages.
How are these payments you receive treated for tax purposes?
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? This happens because
if the taxpayer purchases the health policy,
then 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.
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.
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 includible in the employee's income.
The value of the premiums is excluded from the employee's income.
On the benefit side,
benefits received will be included in
the employee's gross income unless they're for medical costs,
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 includible in the employee's gross income.
In summary, on the employer-sponsored side,
if the employee receives payments to reimburse for medical costs,
these payments are excludible
but if the employee receives payments as
a replacement for lost wages the payments received are includible.
But if the employee is purchasing his or her own health insurance,
payments for both medical care and
lost wages are fully excludible.
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 $4,000 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.
Becky's employer paid $3,000
in disability premiums for Becky this year.
What happens here? Well, we have two issues.
First, Becky's employer paid $3,000 to
cover and buy insurance on her behalf.
In this case, the $3,000 is excluded
from Becky's income even though she benefits from the coverage.
The second issue is,
the $4,000 in sick pay.
How is that treated? Because it's
an employer sponsored plan and the
$4,000 represents lost wages, that is,
it is not a reimbursement for medical costs,
just for time off to recover,
then the $4,000 is includible in Becky's gross income.
Next, what if Becky paid the $3,000 in
premiums for her own disability insurance for the year?
In that case, the $4,000 in benefits received by Becky are
entirely excluded from her gross income
because she purchased the policy.
So, in all, scholarships, payments for damages,
compensation for injuries and sickness are
important examples of items excludible from gross income.
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