sy E aie GROSS INCOME: EXCLUSIONS es == >. = == ee LEARNING OBJECTIVES After studying this chapter, you should be able to D> Explain the conditions that must exist for an item to be excluded from gross income D> Determine whether an item is income D> Decide whether specific exclusions are available D> Understand employment-related fringe benefit exclusion items \ 7 a4-2 Individuals ¥ Chapter 4 CHAPTER OUTLINE Chapter I:3 discussed items that must be included in gross income. This chapter considers items That Are Not ncome..2_ items that are excluded from gross income. Under Sec. 61(a) all items of income are tax- Major Statutory Exchsions.44__able unless specifically excluded. Taxpayers who wish to avoid being taxed have two ‘ax Panning Consderations.423 basic alternatives. One approach is to establish that the item is not income. If an item is Compliance and Procedural not income (e-., if it isa return of capital), it is not subject to the income tax. The second Se approach is to establish that a specific exclusion applies to the item of income. EXAMPLE [4-1 p> Matt borrowed $10,000 from the bank. Although Matt received $10,000, itis not income KEY POINT because he is obligated to repay the amount borrowed. No specific statutory authority states ‘Given the sweeping definition of that borrowed funds are excluded from taxation. Presumably, the fact that borrowed funds are inceme, itis generally dificult to not income is considered to be both fundamental and obvious. < ‘establish that an tem isnot EXAMPLE [:4-2 p> Sheila enrolled in State University. The university awarded her a $1,000 tuition scholarship. because of her high admission test scores and grades. Section 117 excludes such scholarships from gross income. As a result, Sheila need not report the scholarship as income. < ry oa ‘The major source of exclusions are those specific items contained in the IRC. These exclusions have evolved over the years and were enacted by Congress for a variety of rea- Explain the conditions that sons, including social and economie objectives. erat eet Another source of exclusions are referred to as administrative exclusions. Exclusions he excluded from gross _&xist because specific provisions in the Internal Revenue Code allow them. While the IRS income has no authority to create exclusions, the IRS does have the authority to interpret the meaning of the Code. A liberal interpretation of the statute by the IRS may result in a broad definition of what constitutes an exclusion, and such a broad definition may rea- REAL-WORLD sonably be termed an administrative exclusion. For example, Sec. 102 excludes gifts EXAMPLE received from gross income. The IRS has followed the practice of excluding certain wel- ‘Grants made to Native Americans fare benefits from gross income, presumably because such benefits may be viewed as Pe eee ooyetn rn inde’ gifts! The IRS could take the position that welfare benefits are not gifts. That position towand NatveAmercan- would no doubs be challenged in the courts guped einomicenteprsesare The term judicial exclusions should be considered in the same vein. Although the Rocha TPOTIBET ee ii courts cannot create exclusions, they can interpret the statute and decide whether a par- ticular item is covered by a statutory exclusion. eR 1s THAT ARE NOT INCOME As noted above, some items are not income and, therefore, are not subject to the income o tax. In addition to amounts obtained by a loan (discussed above), four other items are not Determine whether an considered income: item is income > Unrealized income > Self-help income > Rental value of personal-use property TYPICAL > Gross selling price of property (as opposed to the profit or gain eared on the sale) MISCONCEPTION Issomsineseroneouy —- UNREALIZED INCOME sumed tetietncepm Income that isnot realized is not subject to income taxation. Thus, if «taxpayer owns Siimeaticmegs NostyinGere, stock ina company and the stock increases in value but the taxpayer does not sell the pres rears and psare not stock, no taxable income is realized. baa This issue of the taxability of unrealized income was addressed over 80 years ago in Eisner v. Macomber, where the Supreme Court held that a stock dividend cannot be taxed or example ce Re. Rul. $7-102, 1957-1 CB, 26, which exsodes from 10s income public assistance payments to blind persons.‘TYPICAL MISCONCEPTION ‘When a taxpayer purchases an ‘older house and remodels the Kitchen or makes other improve ments there isa tendency to ‘assume correcty thatthe tax- payer has no income from ths Dat, but tis often incorecty ‘sumed that the ase of the, fuse ean be increased by the value of the taxpayer’ labor. Q STOP & THINK ADDITIONAL COMMENT ‘The tax situation of ahomeowner isquite differen than that of someone who lives in an apart: iment The failure to include the rental value of the home a: income in aiition to the deduction of mortgage interest ‘and property taxes favors homeowners Gross Income: Exclusions ¥ Individuals 4-3 because the taxpayer had “received nothing that answers the definition of income within ‘the meaning of the Sixteenth Amendment.”? An ordinary stock dividend does not alter the existing proportionate ownership interest of any stockholder, nor does it increase the value of the individual’s holdings. In effect, the Court concluded that realization must ‘occur before income is recognized. Although narrowed by subsequent legislation and lti- gation, ordinary stock dividends continue to be excluded from gross income even today. Perhaps more important, Eisner v. Macomber established realization as a criterion for the recognition of income. SELF-HELP INCOME Although self-help income is considered as income by economists, itis not recognized as income by the IRS or by the courts. Taxpayers commonly benefit from activities such as, painting their own homes or repairing their own automobiles. If taxpayer hires someone else to do the work, the taxpayer has to earn income, pay tax on the income, and use the aftertax income to pay for the work. In either case, the taxpayer receives the same eco- nomic benefit, but the economic benefit derived from self-help is not included in the tax- payer's gross income. This situation should be contrasted with taxable exchanges of services. A mechanic might agree to repair a painter's automobile in exchange for the painter's promise to paint the mechanic’s home. In this instance, when the parties exchange services, each party real- izes income equal to the value of the services received, (Question: The discussion of self-help income refers to an exchange of services between two individuals, such as a painter and a mechanic. How can a taxable barter transaction be distinguished from an act of friendship which is repaid? Solution: When one person helps another without any promise of repayment, the act of kindness does not represent an exchange and is not taxable. Friends help one another from time to time without contractual reciprocity. As a result, such acts are not taxable. ‘The distinction between a taxable barter exchange and acts of friendship is not always easy to make. RENTAL VALUE OF PERSONAL-USE PROPERTY ‘Taxpayers are not taxed on the rental value of personally owned property. For example, taxpayers who own their own home receive the economic benefit of occupancy without being taxed on the rental value of the property. It would be very difficult to keep records and value benefits obtained from self-help and the personal use of property. For that rea~ ‘on, no significant effort has ever been made to tax such benefits.? SELLING PRICE OF PROPERTY If property is sold at a gain, the gain and not the entire sales price is taxable. Because the basic principle is almost universally accepted, the Supreme Court has never had to rule directly on whether the entire sale proceeds could be taxed. The IRS and the courts seemed to accept the basic principle even before the rule became part of the statute.* The primary reason for this principle (often referred to as the “recovery of capital” principle) is that a portion of the selling price represents a return of capital to the seller. 253 ATR 3020, 1 USTC $32 (USSC, 1920) 3 In 1928, the government red unsucesflly ro tx the value of produce grown and consumed by a farmer (Homer P. Morris, 9 BTA. 1273 (1928) ‘The court sated, “To inch the vale of rich produce [woud be to] in cffect include in income something which Congress di not nend should be So regarded.” The court di not explain how or why ic eached this conc ‘on. In 1957, the IRS sucessfully disallowed the deduction of expenses incurred in rising such produce (Robert L. Nowland CIR, SL AFTR 423, SPA USTC 49688 (th Ci, 1957). * Section 202() ofthe Revenue Act of 1924 i the predecessor of creent Se, 1001(a), which describes that only the gai porcion ofthe sale proceeds is included in gros income. 5. Rept. No. 398, 65th Cong, Ist Ses, p. 10 (1924 states that Se. 2001a sets forth general ules to be wse in the com: pptation of gain or loss. The Senate report farther states thatthe provision etl embodies in the lw the peesent construction by th Department and the courts ofthe existing law.”