Basic Income Tax: Scholarships, Prizes; Life Insurance and Annuities; Discharge of Debt

1. Basic Income Tax:Scholarships, Prizes; Life Insurance and Annuities; Discharge of Debt Professor Jack Williams Jwilliams@gsu.edu

2. 2 Tax Calculus Gross Income (IRC �61) � Only Positive Entry Subtract Exclusions (IRC ��101-150; income item not taxable by operation of law) Subtract Business Deductions (IRC �162) Subtract Specified Deductions under IRC �62 Subtotal: Adjusted Gross Income Subtract Higher of Standard Deduction or Itemized Deductions Subtract Personal Exemptions Figure: Taxable Income Apply: Rate Schedule in IRC to Taxable Income (rates presently from 15% to 39.6%)

3. 3 Items Statutorily Includedin Gross Income Congress has taken steps through legislation to ensure that certain items are specifically included in the gross income of the taxpayer Among these items specifically included in gross income include: Prizes and Awards Alimony and separate maintenance Services of a child Reimbursement for certain expenses of moving Transfer of appreciated property to a political organization Social security payments Unemployment compensation Annuities

4. 4 Prizes and Awards: General Rule Prizes and awards are generally included in gross income under �74(a) If prizes or awards are made in goods and services, the fair market value of the goods and services is included in gross income. See Treas. Reg. �1.74-1(a)(2). Prizes and awards are different than gifts. Recall the intent element of a gift, that is, a detached and disinterested generosity Assess relationships as well

5. 5 Exceptions to General Rule re Prizes and Awards Exceptions to general rule: Employee Achievement Awards Qualified Scholarships Prizes and Awards transferred to charities

6. 6 Employee Achievement Awards: IRC �74(c) Employee Achievement Awards are excluded from the recipient�s gross income to the extent the cost of the employer of providing the award (and all other awards during the tax year) to that employee does not exceed certain dollar limits Dollar limits are also tied to the maximum amounts an employer may deduct in computing its taxable income.

7. 7 Elements of Employee Achievement Awards Item of tangible personal property transferred as part of a meaningful presentation by an employer to an employee in recognition of length of service or safety achievement Cannot be in fact disguised income

8. 8 Employee Achievement Awards cont�d IRC �74(c) and �274(j) Double tax benefit: Excluded by employee from gross income Deducted by employer in computing taxable income Dollar cap Strictly applied Aggregate Concern: Disguised income in the employment context

9. 9 Qualified Scholarships: IRC �117 Scholarships are included in gross income unless the scholarship is �qualified� Other words, Qualified Scholarships are excluded from gross income However, a �scholarship� that is in the nature of compensation for past, present, or future services or if any amount is paid to enable the recipient to pursue studies or research that primarily benefit the grantor, then included in gross income. Reg. �1-117-4(c)

10. 10 Elements of Qualified Scholarship: �117(b) Qualified Scholarships: Recipient must be a candidate for a degree At an educational institution Used for tuition, fees, and course related expenses required for course of instruction No tracing required Cannot be used for meals, lodging, laundry, travel, and other purposes Amounts received as compensation for services such as teaching and research rendered by the recipient as a condition on receiving the scholarship do not qualify for the exclusions. IRC �117(c).

11. 11 Qualified Scholarships cont�d An amount that is a Qualified Scholarship and is excluded from gross income remains excluded even if received as a prize or an award

12. 12 Qualified Tuition Reduction: IRC �117 Qualified Tuition Reduction: Not gross income. Qualified Tuition Reduction elements: Amount of any reduction in tuition provided to an employee of an educational institution for education below the graduate level Special rule for graduate level work Covers employee, spouse, dependent children, and in some cases surviving spouse of deceased employee

13. 13 Educational Assistance Programs Employee may exclude from gross income up to $5,250 of the value of the benefits received from his employer under an educational assistance program. IRC �127(a). Elements: Employer�s written plan Exclusively for the employees Includes amounts for tuition, fees, books, supplies, and equipment relating to the education of the employee Education includes instruction that improves or develops the capabilities of the employee Need not be related to job Need not be pursing degree as candidate Must be broad class of employees

14. 14 Prizes and Awards Transferred to Charities Excluded from Gross Income Excluded from gross income by IRC �74(b) Made primarily for religious, charitable, scientific, educational, artistic, literary or civic achievement awards Achievement No action to enter No substantial future service Give up the prize to charity, etc. (or reject outright) without any possession or use by the recipient Does not apply to athletic prizes or awards

15. 15 Athletic scholarships Excluded from gross income IRS disregards quid pro quo Future services discounted

16. 16 Insurance, Annuities, and IRAs

17. 17 Life Insurance Contracts Contract between insurance company and insured with beneficiary Life insurance contract elements: Risk element Savings element Loading element Mortality gains and losses

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19. 19 Life Insurance: General Rule Proceeds paid under a life insurance contract are excluded from gross income. IRC �101. Such proceeds must be paid �by reason of the death of the insured.� Where the insured cashes in, exclusion does not apply However, if insured is critically or terminally ill, then proceeds are treated as payments by reason of the death of the insured. Excluded whether paid in lump sum or in installments

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21. 21 Life Insurance Exceptions Exception 2: Interest paid on life insurance proceeds is gross income Exception 3: Transfer for Value Situations (�101(a)(2)).

22. 22 Annuities: IRC �72 Annuity is a contract under which payments are made periodically to the purchaser or to a designated beneficiary for a term of years or for the life of the beneficiary However, gross income does not include recovery of capital The general rule is that the amount received as an annuity will be treated as gross income as a recipient. Exception: The Exclusion Ratio found in �72(b) permits the recipient of the annuity payments to exclude from gross income returns of the investment or cost of purchasing the annuity

23. 23 Exclusion Ratio Ratio = investment in contract/expected return under the contract Investment in contract: Amount of premiums paid for the contract Expected return under the contract: Determined by multiplying the amount of the periodic payments either by the number of payments called for under the contract or by an appropriate actuarial value provided by regulations Total amount excluded is limited to amount of taxpayer�s investment in the annuity contract

24. 24 Problem 1 Problem 1: Specific Term � G�s investment = 5,000; G will receive 10,000 over next 10 years. GI? Yes, to 5,000 Timing on return of investment: Investment in Contract [5,000] � Expected Return [10,000] = Exclusion Ratio [1/2 or 50%]; thus 50% of each payment constitutes return on investment and is not GI

25. 25 Problem 2 Problem 2: Life Time � Investment in Contract [10K] � Expected Return [Actuarial Entry form Treas. Reg. = 28.6 = 28,600] =Exclusion Ratio of 10,000/28,600 or about 35% of each payment is excluded from GI

26. 26 Problem 3 Problem 3: Application of �72(b)(3) Investment = 10K George would have recovered about 1,050 [.35(1,000) x 3]; thus, George�s final return would show a deduct of $8,950

27. 27 Problem 5 Problem 5: Joint and Survivor Annuity [Reg. 1.72-5(b)(1)] Investment in contract = 15,000 Expected return = 33.6 or 33,600 Exclusion Ratio = 15k/33,600 or about 44.6%; thus, 44.6% of each 1,000 [446] will be excluded from GI

28. 28 IRA�s Deductible Nondeductible Roth

29. 29 Deductible Above the line deduction Caps and income phase outs Built in increases not taxable Distributions are taxable under the annuity rules Mandatory withdrawal Early distribution penalty

30. 30 Nondeductible No immediate tax advantage Deferral rule � built in increases not taxable until withdrawal Distributions are taxable under the annuity rules Mandatory withdrawal Early distribution penalty

31. 31 Roth Qualifying distributions are nondeductible Qualifying distributions are excludable for gross income � essence of Roth IRA

32. 32 Debt DischargeCOD

33. 33 Debt Discharge Income Gross income includes �income from discharge of indebtedness.� Policy furthering rule: Freeing up of assets theory Tax benefit rule theory

34. 34 Background: General Rules Discharge of indebtedness is income to debtor. �61(a)(12). Certain exceptions: �108(a)(1) � Gross income does not include any amount which would be includible in gross income by reason of the discharge of indebtedness of the taxpayer if � - (A) the discharge occurs in a title 11 case, - (B) the discharge occurs when the taxpayer is insolvent, or�

35. 35 Treatment of Excluded COD If COD income is excluded from gross income then: Reduction in debtor�s tax attributes. Any remaining COD income (i.e., after exhausting all tax attributes) is not included in gross income, but instead disappears.

36. 36 Conclusion Observations