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Chapter 4 Gross Income Exclusions and Deductions for AGI

Highlights of 2010 Tax Changes
Ination adjustments increased the exclusion for foreign earned income to $91,500 in 2010 (up from $91,400 in 2009). The annual pay threshold for key employees increased to $160,000 in 2010 (same as in 2009). In 2010, employees can exclude up to $13,170 they are reimbursed for qualied adoption costs under an adoption assistance program at their work (up from $12,150 in 2009). In 2010, the exclusion begins to be phased out when an employees AGI reaches $182,520 (up from $182,180 in 2009). In 2010, employees can exclude up to $230 each month (same as in 2009) for employer-provided qualied parking and transportation. The exclusion for interest income from Series EE and I government bonds when the proceeds are used to pay for qualied education is phased out in 2010 when AGI exceeds $70,100 for unmarried taxpayers ($105,100 for MFJ). These ination-adjusted amounts were increased from the $69,950 and $104,900 thresholds that applied in 2009. The maximum contribution amounts to a Roth IRA remained the same for 2010 as they were in 2009 ($5,000 plus $1,000 for taxpayers age 50 and older). The AGI threshold where the amount of the maximum contribution begins to be phased out stayed at $105,000 for unmarried taxpayers, but increased to $167,000 for taxpayers ling MFJ (up from $166,000 in 2009). The AGI threshold for phase-out for MFS taxpayers remains at $0. At the time the book went to press, the educators expense deduction and the tuition and fees deduction had not been extended. The maximum that taxpayers can contribute to individual coverage in a health savings account (HSA) for 2010 is $3,050. The maximum contribution for family coverage is $6,150. In 2010, a high-deductible health plan for individual coverage is one that has at least a $1,200 deductible ($2,400 for family coverage). The mileage deduction for moving is $.165 a mile in 2010 (down from $.24 a mile in 2009). The maximum contribution amounts to a traditional IRA remained the same for 2010 as in 2009 ($5,000 plus $1,000 for taxpayers age 50 and older). The maximum contribution continues to be phased out when AGI exceeds a certain threshold. In 2010, that threshold remains at $0 for MFS taxpayers who live together at some point during the year. It remained at $89,000 for taxpayers ling MFJ when the spouse participates in an employer-sponsored retirement plan at work. The 2010 AGI thresholds for all other taxpayers increased to: $56,000 for unmarried taxpayers and taxpayers ling MFS who did not live together during the year (up from $55,000 in 2009). $167,000 for a nonparticipating spouse who les a joint return with a spouse who participates in a plan at work (up from $166,000 in 2009). Starting in 2010, taxpayers can rollover amounts from their traditional IRAs into a Roth IRA. When done properly, no penalty will result. However, any earnings and deductible contributions would be included in gross income. In 2010, taxpayers can either spread the taxable amounts over 2011 and 2012 ( in each year), or elect to tax the full amount in 2010. In 2010, taxpayers may continue to deduct up to $2,500 of student loan interest. The AGI thresholds at which the deduction is limited remain at $60,000 for unmarried taxpayers and $120,000 for married taxpayers ling a joint return.

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Essentials of Federal Income Taxation

1. Frequently, students have difculty identifying which employee fringe benets are subject to the discrimination rules. The table below shows nine groups of employee fringe benets. To help students understand these benets and the discrimination rules, place the names of the tables two major headings at the top of the chalkboard or an overhead. Then, call on a student to name one employee fringe benet. If the student provides an example of a specic benet, ask if it ts into a broader group of benets. If the student answers yes, ask which group. Try to help the student t the specic benet into a broad group. After some questioning, enter the benet on the chalkboard. Then, ask the student what happens when the discrimination rules apply. Finally, ask the student if the discrimination rules apply to the named benet. Continue the questioning with another student until you have completed the table below. Benets De minimis fringe benets Dependent care assistance Educational assistance Group-term life insurance Accident and health insurance No-additional-cost services Qualied employee discounts Parking and transportation Working condition fringe benets Adoption assistance Tuition reduction Athletic facilities Meals and lodging Moving reimbursements Qualied retirement plan services Discrimination Rules Apply? No Yes Yes Yes Yes Yes Yes No No Yes Yes Yes Yes Yes Yes

2. You can help students understand the (hidden) income employees receive when their employers provide them with tax-free fringe benets. Health insurance is a great example to start with. Not only can employees lower their health insurance premiums by getting insurance through their employers, but often the employer pays for a substantial portion of the premiums. Other fringe benets like free parking, the rst $50,000 of groupterm life insurance, and educational assistance are other tax-free benets you could discuss with the class. 3. To help students better understand the tax implications of contributing to an IRA, you could start with a hypothetical illustration of a taxpayer in the 28% tax bracket who is contemplating making a $5,000 contribution to either a deductible traditional IRA or a nondeductible Roth IRA. Once the $1,400 tax savings has been discussed, you could emphasize that the true cost of contributing to a deductible traditional IRA is $3,600, whereas the true cost of contributing to a nondeductible traditional or Roth IRA is $5,000. You could then ask your students why someone would contribute $5,000 to a Roth IRA when they could contribute (net) $3,600 to a deductible traditional IRA. The discussion should include the concepts of tax-deferred vs. tax-exempt earnings. Also, not all taxpayers can contribute to a deductible IRA or a Roth IRA. A review of the various rules regarding who qualies to contribute to Roth vs. traditional IRAs can then be discussed.

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Solutions to Questions and Problems

1. a. Because Saints lives in London for 330 days during a 12-month period, she qualies for the foreign earned income exclusion in 2010 and 2011. Since she worked only part of the year in London during these years, she must prorate her foreign earned income exclusion as shown below. 2010: $91,500 298/365 = $74,704 2011: $91,500 228/365 = $57,156 In 2010, Saints will include $25,296 in gross income ($18,000 U.S. source income + $7,296 ($82,000 $74,704) foreign source income. In 2011, she will include $67,844 in gross income ($48,000 U.S. source income + $19,844 ($77,000 $57,156) foreign source income). 401.02. b. Although technically an exclusion from gross income, the foreign earned income exclusion is reported as an adjustment to income on Form 1040, page 1. 401.02. c. Saints can forgo the exclusion and elect to be taxed on 100% of her worldwide wages. She can then claim a foreign tax credit for taxes paid to foreign governments during the year on her foreign source income. 401.02. 2. a. Because Roche lived in Rome for 330 days during a 12-month period, he can exclude a portion of his wages in 2010. However, the $91,500 exclusion must be prorated for the portion of the year in which Roche lived out of the country. His maximum exclusion for 2010 is $21,810 ($91,500 87/365). Since this amount exceeds his foreign earned income, Roche will not be taxed on his foreign earnings in 2010. He will, however, include the $54,000 that he received while working in the U.S. in his gross income in 2010. 401.02. b. If Roches assignment lasted until August 7, 2011, he would not have lived in Rome for 330 days during a 12-month period. Thus, he would not be allowed to exclude any of his foreign earnings from gross income. 401.02. 3. 401.03. a. Fringe Benets Category De minimis fringe benets Qualied employee discounts Working condition fringe benets No-additional-cost services On-premises athletic facilities Discrimination Rules Apply? No Yes No Yes Yes Examples Ofce supplies, use of copier Clothing discounts; meal discounts Tools, business periodicals Hotel rooms, airline travel (must be in related business) Tennis courts, swimming pools

b. If the discrimination rules apply and the benet favors key or highly paid employees, then (only) key and highly paid employees are taxed on the entire fringe benet. 4. 401.03. Group-term life insurance coverage Less: Exempt coverage Coverage subject to gross income inclusion Cost subject to gross income inclusion Less: Payments by Fred Noble Includable in gross income
1 2

$90,000 ( 50,000) $40,000 $48 1 ( $ 18)2 30

$40,000/$1,000 = 40; 40 $0.10 (from textbook Figure 4-1) 12 = $48 $90,000/$1,000 = 90; 90 $0.20 = $18

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5. a. If Remixs plan does not favor key or highly paid employees, then both Wright and Udah can exclude the value of the premiums paid on the rst $50,000 of group-term life insurance provided by their employer. However, the premiums on the coverage in excess of $50,000 must be included in the employees gross income. From the uniform premium table (Table 4-1), an employee age 46 is taxed on $1.80 ($.15 12 months) for each $1,000 of excess coverage. Therefore, Remix will include an additional $63 ($1.80 35) in Wrights taxable wages. For an employee who is age 52, $2.76 ($.23 12) is included in gross income for each $1,000 of excess coverage. Thus, Remix will include an additional $193.20 ($2.76 70) in Udahs taxable wages. 401.03. b. When the employers plan favors key or highly paid employees, the exclusion on the premiums for the rst $50,000 of coverage does not apply to key or highly paid employees. Consequently, Remix would add the greater of (i) actual premiums paid by Remix or (ii) $331.20 ($2.76 120) to Udahs taxable wages. Wright would continue to include an additional $63 in his gross income, as the exception continues to apply to those not in the favored group. 401.03. 6. a. The cost of employer-provided health insurance benets is not taxable to Hill, regardless of whether the plan favors highly paid workers. However, if the plan does favor highly paid workers, then the $7,500 would be taxed as additional wages to those workers. Thus, Elks taxable wages would increase by $7,500. 401.03. b. If Manixs plan does not favor highly paid workers, then none of the employees will be taxed on the $7,500 of employer-provided health insurance benets. 401.03. 7. Since the plan favors key employees, Barkin will be taxed on the $600 ($2,000 30%) discount he receives from his employer. This amount is included in his gross income. Since Draper is not a key employee, he is not taxed on his $400 discount. 401.03. 8. 401.06. Interest Received $ 276 800 600 1,000 500 Interest Includable $ 276 0 600 1,000 0 Interest Excludable $0 800 (municipal bonds) 0 0 500 (municipal bonds)

A B C D E

9. See Form 8815 for the Dugans. 401.07. Modied adjusted gross income (AGI): Salary Add: Savings bond interest Add: Foreign earned income exclusion Modied AGI $116,400 3,000 0 $119,400

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Textbook Solutions
Filled-in Form 8815 for the Dugans.

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10. Series I bond interest exclusion = $2,719; AGI = $70,036 ($69,000 salary + $1,036 interest income). To compute her Series I interest exclusion, Devloe reduces her exclusion by the portion of the proceeds that were used for other than qualied higher education. This reduces her initial excludable bond interest to $3,304 ($16,500/$18,755 $3,755). Because her modied AGI ($69,000 + $3,755 = $72,755) exceeds the $70,100 threshold for unmarried taxpayers, Devloes exclusion must be reduced further by $585 ($2,655 excess modied AGI/$15,000 $3,304). Devloes Series I exclusion equals $2,719 ($3,304 $585), leaving her with $1,036 of interest to be included in her gross income. 401.06. 11. a. Dunnbar can exclude a total of $1,600 (4/9 $3,600) from his gross income. The excludable amount is limited to degree candidates. He must use it for tuition and course-related fees, books, supplies, and equipment. None of the $1,800 portion of the scholarship for room and board is excludable. Dunnbar should retain proper records to substantiate his excludable expenditures in case of an IRS audit. 401.05. b. Yes. Since Dunnbar is not a degree candidate, the full amount received in 2010 ($2,400) is included in his gross income. 401.05. 12. 401, 401.01, 401.03, 401.04, 401.08, 401.13. Includable a. b. c. d. e. f. g. h. Life insurance proceeds Workers compensation Employer-paid health insurance premiums Prize Free parking in employers lot Forgiveness of debt Gold necklace received as a gift Health resort fee paid by employer X X X X X Excludable X X X

13. a. LaMont includes the entire $50,000 in gross income. All damages received for nonphysical injuries are taxable. 401.08. b. Reymier excludes the entire $16,400. When the employer purchases the insurance, all medical reimbursements are excluded from gross income. 401.08. c. Carter excludes the entire $12,000 of workers compensation. 401.08. d. OConnell excludes $500,000 from gross income. Punitive damages received from a physical injury lawsuit are taxable. 401.08. 14. Kenya can contribute up to $3,740 to her Roth IRA. Because Carl is age 50 or older, he can contribute $4,490. 401.09. Reduction for Kenya: [($169,520 $167,000)/$10,000 phase-out range for MFJ] $5,000 = $1,260 Contribution limit: $5,000 $1,260 = $3,740 Reduction for Carl: [($169,520 $167,000)/$10,000 phase-out range for MFJ] $6,000 = $1,512 Contribution limit: $6,000 $1,512 = $4,488, rounded up to the nearest $10: $4,490 15. Craig may make a nondeductible contribution of $4,170 to her Roth IRA. The normal maximum contribution of $5,000 is reduced because her AGI exceeds $105,000 by $2,500. The reduction is computed as ($2,500/$15,000 phase-out range for unmarried taxpayers) $5,000 = $833. Thus, the contribution limit is $4,170 ($5,000 $833 = $4,167, rounded up to nearest $10). 401.09. 16. a. True. 402.02. b. True. 402.02. c. False. AGI cannot be more than $16,000. 402.02. d. True. 402.02.

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17.

18.

19. 20.

21.

22.

e. True. 402.03. f. False. Contributions must stop when the taxpayer retires. 402.03. g. False. The penalty tax is 10%. 402.03. a. HSAs are high-deductible health insurance plans that allow taxpayers to save money to pay for medical expenses. For 2010, a high-deductible health plan is one that has at least a $1,200 deductible for single coverage. Eligible taxpayers cannot also be covered under a health care plan offering the same coverage that does not qualify as a high-deductible plan. For 2010, the maximum that can be contributed to an HSA by a taxpayer under age 55 is $3,050 for single coverage. Amounts contributed to an HSA are deducted for AGI on the taxpayers tax return. Amounts withdrawn from an HSA to pay for medical expenses are excluded from gross income. Any balance in an HSA at the end of the year stays in the account to pay medical expenses in future tax years. Amounts withdrawn and not used to pay medical expenses are included in gross income and subject to a 10% penalty tax. However, when withdrawn after the taxpayer retires, the amounts are included in gross income but avoid the penalty tax. 402.03. b. Same as Part a., except that German can deduct $4,050 ($3,050 + $1,000). 402.03. a. $2,095 ($7,095 $5,000). The Wilsons can deduct the unreimbursed portion of the cost of hiring the moving company ($6,200), the cost of Treys airfare ($450), $185 (1,121 $.165) for the familys travel to the new job location, and $260 for lodging for Veronica and the family. No deduction is allowed for meals. 402.04. b. Moving expenses are deductions for AGI on Form 1040, page 1. 402.04. $4,845. Only the expenses of moving the household goods ($4,500) and the family ($345) are deductible. The other expenses are not deductible. 402.04. a. $5,850 ($650 9). Evans can deduct the premiums paid during the 9 months that she was not eligible to receive benets under an employer-sponsored program. 402.06. b. She deducts this on Form 1040, page 1 as a deduction for AGI. 402.06. a. The maximum self-employed health insurance deduction is the lesser of (i) 100% of the amount paid for the health insurance for the self-employed taxpayer, spouse, and dependents or (ii) the net prot plus other earned income from the business minus the deduction for a Keogh or SEP. 402.06. b. Self-employed taxpayers may not take the deduction if they are eligible to participate in an employermaintained health plan (including a spouses plan). A self-employed taxpayer who has employees may not deduct health insurance coverage unless it is provided for employees on a nondiscriminatory basis. 402.06. a. The latest day by which an IRA contribution must be made in order to claim it as a deduction on the 2010 return is April 15, 2011. 402.11. b. Payments to an IRA cannot be claimed on Form 1040EZ. Qualied IRA payments may be claimed on Form 1040A. 402.11. c. The Brights can deduct up to $8,200 of their IRA contributions. 402.11. They are eligible to contribute the following amounts: Joyce: $5,000 + $1,000 (extra for age) = $6,000 Barry: $5,000 + $1,000 (extra for age) = $6,000 However, since their modied AGI exceeds $89,000, Joyces IRA deduction is limited to $2,200. Barrys deduction is $6,000 since modied AGI is less than $167,000. Reduction factor: [($101,680 $89,000)/$20,000] $6,000 = $3,804 Deduction limit: $6,000 $3,804 = $2,196, rounded up to $10: $2,200 d. No. The IRA payment earnings are not taxed in the contribution year. Deductible IRA contributions and related earnings are tax deferred until withdrawn. In addition, the earnings on nondeductible contributions are also tax deferred until withdrawn. 402.11.

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23. Fred and Diane are each allowed a $3,000 deduction for an IRA. All IRA contributions made in 2010 and 2011 can be applied to their 2010 total contributions since they were made before April 15, 2011. The Workmans AGI follows. 402.11. Freds gross income Dianes gross income Interest income Freds IRA deduction Dianes IRA deduction AGI 24. $3,000 3,000 ( 6,000) $64,000 $37,900 31,500 600 $70,000

25.

26.

27.

NOTE: IRA earnings of $890 for Diane and $340 for Fred are tax deferred until withdrawn. 402.11. a. False. Contributions may be allocated in any manner the taxpayers choose. However, the maximum limits apply to each spouse. b. True. c. False. Distributions must begin no later than April 1 of the calendar year following the year the IRA account owner reaches 70. d. False. Earnings are taxed when distributed. e. True. f. False. With earned income of $25,000, each spouse may contribute $5,000 ($6,000 if 50 or older). a. Mike may contribute and deduct all $5,000 of his IRA contribution. Mary, however, receives no deduction for her $5,000 contribution because she is covered by an employer-sponsored retirement plan, and the Sweeneys modied AGI exceeds $109,000. When Mike withdraws money after retirement, all proceeds are taxed. When Mary withdraws her funds, only the earnings are taxed. 402.12. b. A better plan: (1) Allow Mike to continue his $5,000 deductible contribution to a traditional IRA. (2) Mary, on the other hand, should deposit her $5,000 in a Roth IRA. When she withdraws this money after retirement, neither the contributions nor the earnings will be taxable. 401.09, 402.12. c. In this situation, modied AGI exceeds $177,000. Consequently, neither Mike nor Mary are eligible to make deductible contributions to a traditional IRA. Nor are they eligible to contribute to a Roth IRA. Thus, their only option regarding a retirement account is for each to make a nondeductible $5,000 contribution to a traditional IRA and le a Form 8606. When they withdraw this money after retirement, only the earnings will be taxed. 402.11. $394. His deduction is reduced by $186 because his modied AGI exceeds the $60,000 threshold for single taxpayers. 402.12. Reduction amount: [($64,810 $60,000)/$15,000] $580 = $186 Student loan interest deduction: $580 $186 = $394 a. False. A 10% penalty tax applies. 401.10. b. False. The amount is $2,000 per beneciary (child). 401.11. c. False. Contributions to an education savings account are not deductible. 401.11. d. True. 401.11. e. False. There is no limit on the time period. 402.12. f. False. The amount is $230. 401.03.

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g. False. The refund goes to the contributor, who is taxed on the interest. 401.12. h. True. 401.03. 28. a. The full amount of interest income earned must be included in gross income. However, when interest income is forfeited because of a premature withdrawal, the amount forfeited is a deduction for AGI (reported on Form 1040 as an adjustment to income that is subtracted in arriving at AGI). 402.09. b. The amount withdrawn from a Roth IRA is tax-free up to the amount of contributions into the plan. A withdrawal in excess of contributions is included in gross income. In addition, a 10% penalty applies to the amount taxed. 401.10. c. Because the money was withdrawn from an IRA before age 59, the withdrawal results in taxable income to the extent the withdrawal did not relate to nondeductible contributions. Withdrawals representing earnings and deductible contributions are taxed. In addition, a 10% penalty applies to the taxable portion of the withdrawal unless the taxpayer is disabled. 402.11. 29. Qualied moving expenses: Moving van Lodging Mileage (1,000 $.165) TOTAL Reimbursement rate REIMBURSEMENT $3,300 120 165 $3,585 75% $2,689

See lled-in Form 3903 for Randall. 402.04, 402.05.

30. a. False. The deduction is for AGI. 402.06. b. False. These expenses are reported on Form W-2. 402.04. c. True. 401.03.

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d. True. The taxpayer may exclude $230 per month. ($275 $230) 12 = $540. 401.03. e. True. 402.04. f. True. 401.03. g. True. 401.03. h. False. For the premiums to be deductible for AGI, the employees must also be covered by the insurance program. 402.07. i. False. Qualied production activities produce a deduction for AGI. 402.14. j. False. The deduction cannot exceed 50% of W-2 wages related to domestic activities. 402.14. 31. Income: Interest on savings account Gift of money from parent Rent from farmland owned Proceeds of life insurance policy Non-degree candidate fellowship Gross salary Health insurance fringe benet De minimis employee fringe benets Parking ($300 12) Total Income Gross income exclusions: Gift of money from parent Proceeds of life insurance policy Health insurance fringe benet De minimis employee fringe benet Parking ($230 12) Gross income inclusions Deductions for AGI: Expenses of farmland rental AGI Deductions from AGI: Standard deduction Exemptions (1 $3,650) Taxable income Tax liability $ 5,700 3,650 ( 9,350) $56,268 $10,250 ( 1,750) $65,618 $ 1,000 40,000 1,437 25 2,760 ( 45,222) $67,368 $ 1,728 1,000 30,000 40,000 1,800 33,000 1,437 25 3,600 $112,590

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2010 CCH. All Rights Reserved.