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Taxable Income- Inclusions and Exclusions

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Taxable income is the income upon which tax is calculated. Itemized deduction or standard deduction is deducted from the adjusted total income; the balance is denoted as taxable income upon which slab rates are applied and tax is calculated. Each country has different tax policies; it is quite common to find that certain items are deducted from the adjusted income in one country and the same items are not subjected to any tax treatment in another. Tax is not paid on the adjusted gross income but it is used in various schedules like Schedule A, Itemized Deduction, Schedule SE Self Employment etc. in order to calculate the balance of a specific head.

Income is the amount an individual could consume during a given period of time. There are three conditions that must be fulfilled if an amount is to become taxable:

1. There must be an economic benefit and the benefit need not just be in terms of cash. Thus, non-cash benefits received by an employee or some other person will also form part of a taxable income.

2. The income must be realized.

3. The income should be recognized.


Income Exclusion Rule

This rule states that there are a few incomes, which do not form part of a taxable income. It will be ignored when taxable income is calculated. The following incomes are excluded from adjusted gross income:

1. Gifts and inheritance (Section 102)

Gift tax is the tax, which is levied when the ownership of a property is transferred from one person to another. It is paid by the person who transfers their property to the new owner. The IRS has defined a gift tax lifetime exclusion amount upto which no gift tax liability arises. When the gift amount exceeds the exemption limit, the transferee will not be liable to pay gift tax and the sole responsibility of gift tax payment will fall on the transferor. A gift given to a spouse who is a US citizen is entirely exempted and it does not form part of the gift tax lifetime exclusion. In 2010, the gift tax lifetime exemption amount was $ 1,000,000 with a tax rate 35%; in 2011, the amount was $5,120,000 with a tax rate 35%; in 2013, the amount increased to $5,250,000 and the tax rate was 40% and these figures will remain the same for the year 2014.

Let's have a look at one example of a question on gift tax exclusion:

Smith, a widow, irrevocably transfers assets worth $5 million to a trust and names her bank as her trustee. As long as Smith's daughter Angela is alive, she is to receive all the trust income annually. Upon Angela's death, the asset is to be distributed to Angela’s children. Angela is 42 and has two children. How much gift tax exclusions does Smith receive for the money she has transferred to her trust?


2. Foreign earned income exclusion

This provision of the IRS is for those who live and work outside United States. Those people who qualify for this provision are not supposed to add their foreign-source wages and self-employment income to the federal taxable income and they get foreign tax exclusion. Tax liability in this case is the difference between the tax on the federal income without taking the provision of foreign earned income exclusion and the tax on the federal income after considering the provision of foreign earned income exclusion.

 

3. Life insurance death benefit proceeds (Section 101)

This exclusion is applicable when the lump sum or the installments are paid to the beneficiary because the person who is insured passes away.

Let's take an example, which will help readers gain a better understanding of Section 101:  

Ronaldo is the son of Julie and is the beneficiary of an amount worth $1, 00,000. He decides to receive $13000 on the death of her mother out of which $10000 will be tax free. Ronaldo is not sure whether the entire $13000 or just $3000 will be included in the income; therefore, he is seeking advice.

 

4. Payment for personal physical injury and sickness (Section 104)

The amount for damages (other than punitive damages) received by any individual on account of physical sickness and injuries form part of gross income exclusions i.e. this money will be excluded from the adjusted gross income and will not be considered as taxable income.

Let's take a case to highlight this section:

Mary was denied a promotion by her employer on the basis of sex discrimination. She is awarded $6000 for her medical bills, $9000 as the compensation for lost wages and $ 15000 to punish her employer for discrimination. She is confused whether she must include the whole $30000 or $24000 in her taxable income.

5. Gain on sale of personal residence (Section 121),

6. Partial exclusion for Social Security benefits (Section 86),

7. Awards for meritorious achievement (Section 74(b))


Generally, prizes and awards are taxable but when awards and prizes are given for charitable, religious, educational, scientific, literacy, and artistic reasons, they are not taxable anymore.  


8. Employee fringe benefits (Section 79, 105, 106, 124, 129, 132)

Fringe benefits are deducted by an employer as the cost of the benefit provided and certain benefits are not included in the income of the employee.

Example: Jim’s employer devises a cafeteria plan, which requires his employees to set aside up to $7,000 for medical reimbursement and health insurance premiums. Jim, whose salary has been $20,000, agrees to a salary drop of $3,000. Out of this, 1,400 is meant to cover his health insurance premiums and $1,600 is for the reimbursement of his medical expenses. Under this arrangement, Jim’s salary is reduced to $17,000 for tax purposes. Neither the health insurance coverage nor the medical expense reimbursement is taxable. During the course of the year, Jim incurs  medical expenses worth $1,300 that are not covered by insurance. He receives a reimbursement for all the expenses. His employer retains the remaining $300. Alternatively, if the medical expenses were $1,800, John would receive a reimbursement of $1,600 and he must pay the remaining $200 of his expenses out of after-tax salary dollars.

 

A few other examples (not exhaustive) of taxable income exclusions are:

  • Interest on local or state government obligations (Section 103),
  • Public assistance payment,
  • Discharge of indebtedness during insolvency or bankruptcy (Section 108),
  • Welfare and municipal bond income,
  • Child support

 

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