4.3 Exclusions from gross income

Exclusions from gross income are key exceptions to taxable income. They include municipal bond interest, certain compensation for injuries, child support, and some government benefits. Understanding these exclusions is crucial for accurately calculating taxable income.

Gifts, inheritances, life insurance proceeds, and qualified scholarships are also typically excluded from gross income. Many employee benefits, like employer-provided health insurance and certain educational assistance, are excluded too. These exclusions can significantly impact a taxpayer's overall tax liability.

Income Exclusions

Types of Excluded Income

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• Exclusions from gross income represent specific types of income not subject to federal income tax as defined by the Internal Revenue Code (IRC)
• Interest earned on state and local government bonds (municipal bonds) generally excluded from federal gross income
• Compensation for injuries or sickness typically excluded
  • Includes workers' compensation benefits and compensatory damages
• Child support payments received not considered taxable income for the recipient
• Certain welfare benefits and government assistance programs excluded
  • Supplemental Nutrition Assistance Program (SNAP) benefits
  • Temporary Assistance for Needy Families (TANF)
• Foreign earned income exclusion allows U.S. citizens working abroad to exclude a portion of foreign earnings
  • Subject to specific requirements and limitations
  • Maximum exclusion amount adjusted annually for inflation ($112,000 for 2022)

Common Exclusions Overview

• Gifts and inheritances generally excluded under IRC Section 102
• Life insurance proceeds paid due to death of insured typically excluded under IRC Section 101(a)
• Qualified scholarships and fellowship grants for qualified education expenses excluded under IRC Section 117
• Specific employee benefits excluded
  • Employer-provided health insurance premiums
  • Health Savings Account (HSA) contributions made by employers
  • Certain educational assistance programs

Gifts and Inheritances: Tax Treatment

Gift Tax Considerations

• Gifts generally excluded from recipient's gross income under IRC Section 102
• Donor may be subject to gift tax if value exceeds annual exclusion amount
  • Annual exclusion amount adjusted periodically for inflation ($16,000 for 2022)
• Gift tax responsibility falls on donor, not recipient
  • Reported on IRS Form 709 (United States Gift and Generation-Skipping Transfer Tax Return)
• Basis of property received as gift typically donor's adjusted basis
  • Example: If donor gives stock purchased for $1,000 now worth$5,000, recipient's basis remains $1,000
• Gifts of income-producing property may result in future taxable income for recipient
  • Example: Gift of rental property generates taxable rental income for recipient

Inheritance Tax Considerations

• Inheritances not subject to income tax for recipient
• Estate tax may apply to decedent's estate if value exceeds federal estate tax exemption amount
  • Exemption amount for 2022 $12.06 million per individual
• Inherited property receives step-up in basis to fair market value at date of death
  • Example: Inherited stock purchased by decedent for $10,000, valued at$50,000 at death, recipient's basis becomes $50,000
• Income generated from inherited assets after date of transfer generally taxable to recipient
  • Example: Interest earned on inherited savings account taxable to beneficiary

Life Insurance Proceeds: Exclusions

Death Benefit Exclusions

• Life insurance proceeds paid due to death of insured generally excluded from beneficiary's gross income under IRC Section 101(a)
• Exclusion applies to both lump-sum payments and installment payments of death benefits
• Accelerated death benefits paid to terminally or chronically ill individuals also excluded
  • Subject to certain conditions (e.g., life expectancy of 24 months or less for terminal illness)
• Transfer-for-value rule can result in partial taxation of proceeds if policy transferred for valuable consideration prior to insured's death
  • Example: If policy sold to unrelated party, portion of proceeds may be taxable to new owner

Taxation of Related Benefits

• Interest portion of installment payments typically taxable as ordinary income
  • Example: $1,000 monthly payment with$800 principal and $200 interest,$200 taxable
• Employer-provided group term life insurance coverage up to $50,000 generally tax-free to employee
  • Coverage exceeding $50,000 results in imputed income to employee
• Cash value accumulation within permanent life insurance policy tax-deferred
• Policy loans generally not taxable as long as policy remains in force
  • Becomes taxable if policy lapses or is surrendered with outstanding loan balance

Scholarships and Fellowships: Tax Treatment

Qualified Education Expenses

• Qualified scholarships and fellowship grants for qualified education expenses excluded under IRC Section 117
• Qualified education expenses include:
  • Tuition and fees required for enrollment or attendance
  • Books, supplies, and equipment required for courses
  • Example: $10,000 scholarship covering$8,000 tuition and $2,000 required textbooks fully excluded
• Exclusion applies only to degree candidates at eligible educational institutions
  • Eligible institutions defined by IRC (generally accredited colleges, universities, and vocational schools)
• Tax-free treatment limited to amount of qualified education expenses incurred during tax year
  • Example: $15,000 scholarship with$12,000 qualified expenses, $3,000 potentially taxable

Taxable Portions and Limitations

• Amounts received for room and board, travel, or other personal expenses generally taxable
  • Example: $5,000 scholarship designated for housing not excludable
• Scholarship or fellowship amounts representing payment for services generally taxable
  • Includes teaching, research, or other services required for all candidates for a particular degree
• Pell Grants and other need-based education grants typically treated as qualified scholarships
  • Example: $6,495 maximum Pell Grant for 2021-2022 academic year potentially fully excludable if used for qualified expenses

Employee Benefits: Excludability

Health-Related Benefits

• Employer-provided health insurance premiums generally excluded from employee's gross income under IRC Section 106
• Exclusion extends to employee's spouse and dependents
• Health Savings Account (HSA) contributions made by employer excluded from employee's gross income
  • Subject to annual contribution limits ($3,650 for individual coverage,$7,300 for family coverage in 2022)
• Long-term care insurance premiums paid by employer generally excludable

Education and Retirement Benefits

• Employer-provided educational assistance up to $5,250 per year excludable under IRC Section 127
  • Applies regardless of whether education is job-related
  • Example: $6,000 tuition reimbursement,$5,250 excluded and $750 taxable
• Employer contributions to qualified retirement plans generally excluded from employee's current gross income
  • Includes 401(k) plans, 403(b) plans, and SIMPLE IRAs
  • Example: $5,000 employer match to 401(k) not included in current year's taxable income

Additional Fringe Benefits

• Certain fringe benefits excludable under specific IRC provisions
  • De minimis fringe benefits (e.g., occasional meals, holiday gifts)
  • Qualified employee discounts
• Transportation fringe benefits may be excluded up to specified monthly limits
  • Qualified parking ($280 per month for 2022)
  • Transit passes ($280 per month for 2022)
• Working condition fringe benefits excludable
  • Example: Use of company car for business purposes