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 and 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 the 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 $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 included in gross income. Here are 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 a scholarship goes towards the athlete buying a vehicle or paying for room and board, then the scholarship value will be included in the student- athletes 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 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 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 state law school. The scholarship pays Alan's tuition and textbooks. What happens here? Well, here this 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 scholarship 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 includible 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 athlete is getting this scholarship for tuition, it is excludable. But to the extent it's paying for room and board, it's includible. So here $5,000 is includible 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 it's 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 includible 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 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 the business taxpayer and the business taxpayer couldn'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 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 employees 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 cars 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 and 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 of 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 cost $5,000 to fix your knee - from doctors visits, to a cast, to physical therapy - and let's say the party the 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 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 payment's 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 the $4,000 will be includible in the taxpayer's income. While the remaining $5,000 reimbursement for medical care and the $1,000 reimbursement for emotional distress related medical care will be excludable. So 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 to 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 excludable from his gross income. However, the $250,000 payment represents punitive damages received, and that 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 includible 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 $20,000 in damages. Well, what happens here, there's no physical injury? Perhaps Sarah 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 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 includible 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. 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 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 recipients gross income, even if the benefits substitute for income. Why is this? Well, this happens because if the taxpayer purchases the health policy, 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 dependence. 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 included in the employee's income. So 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 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 includible 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 includible. 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 $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, and Becky's employer paid $3,000 in disability premiums for Becky this year. So 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 own disability insurance for the year? In that case, the $4,000 in benefits received by Becky are entirely excluded from 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.
