Whittenburg Gerald E., Altus-Buller Martha. Income Tax Fundamentals
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The formula for calculating the taxable amount of Social Security is complex and time
consuming. Many taxpayers rely on tax-preparation software to perform the calculation.
For preparation by hand, the Form 1040 In structions include a full-page worksheet that
takes taxpayers through the calculation one step at a time.
EXAMPLE For the 2010 tax year, Nancy, a sing le taxpayer, receives $7,000 in
Social Security benefits. She has adjusted gross income of $20,000,
not including any Social Security income, and receives $10,000 of
tax-exempt municipal bond interest. Nancy must include $3,500
of her Social Security benefits in income. The amount included in
gross income is determined as follows:
Simplified Taxable Social Security Worksheet (for most people)
1. Enter the total amount of Soc ial Security income. 1. 7,000
2. Enter one-half of line 1. 2.
3,500
3. Enter the total of taxable income items on Form 1040 except
Social Security income.
3.
20,000
4. Enter the amount of tax-exempt interest income. 4.
10,000
5. Add lines 2, 3, and 4. 5.
33,500
6. Enter all adjustments for AGI except for student loan interest,
the domestic production activities deduction, and the tuition
and fees deduction.
6.
–0–
7. Subtract line 6 from line 5. If zero or less, stop here, none of
the Social Security benefits are taxable.
7.
33,500
8. Enter $25,000 ($32,000 if married filing jointly; $0 if married filing
separately and living with spouse at any time during the year).
8.
25,000
9. Subtract line 8 from line 7. If zero or less, enter –0–. 9.
8,500
Note: If line 9 is zero or less, stop here; none of your benefits
are taxable. Otherwise, go on to line 10.
10. Enter $9,000 ($12,000 if married filing jointly; $0 if married fil-
ing separately and living with spouse at any time during the
year).
10.
9,000
11. Subtract line 10 from line 9. If zero or less, enter –0–. 11.
–0–
12. Enter the smaller of line 9 or line 10. 12.
8,500
13. Enter one-half of line 12. 13.
4,250
14. Enter the smaller of line 2 or line 13. 14.
3,500
15. Multiply line 11 by 85% (.85). If line 11 is zero, enter –0–. 15.
–0–
16. Add lines 14 and 15. 16.
3,500
17. Multiply line 1 by 85% (.85). 17.
5,950
18. Taxable benefits. Enter the smaller of line 16 or line 17. 18.
3,500
N
Section 2.12
Social Security Benefits 2-21
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EXAMPLE Linda, a widow, is retired and receives Social Security benefits of
$14,000 in 2010. She has MAGI of $47,000. Linda must include
$11,900 of her Social Security benefits in income. The amount
included in income is determined as follows:
Simplified Taxable Social Security Worksheet (for most people)
1. Enter the total amount of Social Security income. 1. 14,000
2. Enter one-half of line 1. 2.
7,000
3. Enter the total of taxable income items on Form 1040
except Social Security income.
3.
47,000
4. Enter the amount of tax-exempt interest income . 4.
–0–
5. Add lines 2, 3, and 4. 5.
54,000
6. Enter all adjustments for AGI except for student loan inter-
est, the domestic production activities deduction, and the
tuition and fees deduction.
6.
–0–
7. Subtract line 6 from line 5. If zero or less, stop here, none
of the Social Security benefits are taxable.
7.
54,000
8. Enter $25,000 ($32,000 if married filing jointly; $0 if married
filing separately and living with spouse at any time during
the year).
8.
25,000
9. Subtract line 8 from line 7. If zero or less, enter –0–. 9.
29,000
Note: If line 9 is zero or less, stop here; none of your benefits
are taxable. Otherwise, go on to line 10.
10. Enter $9,000 ($12,000 if married filing jointly; $0 if married
filing separately and living with spouse at any time during
the year).
10.
9,000
11. Subtract line 10 from line 9. If zero or less, enter –0–. 11.
20,000
12. Enter t he smaller of line 9 or line 10. 12.
9,000
13. Enter one-half of line 12. 13.
4,500
14. Enter t he smaller of line 2 or line 13. 14.
4,500
15. Multiply line 11 by 85% (.85). If line 11 is zero, enter –0–. 15.
17,000
16. Add lines 14 and 15. 16.
21,500
17. Multiply line 1 by 85% (.85). 17.
11,900
18. Taxable benefits. Enter the smaller of line 16 or line 17. 18.
11,900
N
Many tax professionals and taxpayers use search engines such as Google for assis-
tance wit h tax questions and to access relevant articles and timely discussions of
the tax law, as it changes due to new laws passed by Congress, court cases decid-
ing uncertain areas of the law, and new IRS rules explaining the law. To access a
multitude of Web sites providing infor mation on the taxability of Social Security,
including worksheets and calculators, enter ‘‘taxable Social Security’’ into your
search engine.
2-22 Chapter 2
Gross Income and Exclusions
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SECTION 2.13UNEMPLOYMENT COMPENSATION
Unemployment compensation payments are fully taxable in 2010.
EXAMPLE Genny was unemployed for several months during 2010 and received
unemployment compensation of $4,000. The $4,000 is included in
Genny’s taxable income for 2010. N
Self-Study Problem 2.12
For the 2010 tax year, Kim and Edward are married and file a joint return. They
have Social Security benefits of $13,000 and their adjusted gross income is
$20,000, not including any Social Security income. They also receive $30,000 in
tax-free municipal bond interest. How much, if any, of the Social Security bene-
fits should Kim and Edward include in gross income? Use the worksheet below
to compute your answer.
$ ____________
Simplified Taxable Social Security Worksheet (for most people)
1. Enter the total amount of Social Security income. 1. ________
2. Enter one-half of line 1. 2. ________
3. Enter the total of taxable income items on Form 1040
except Social Security income.
3. ________
4. Enter the amount of tax-exempt interest income. 4. ________
5. Add lines 2, 3, and 4. 5. ________
6. Enter all adjustments for AGI except for student loan inter-
est, the domestic production activities deduction, and the
tuition and fees deduction.
6. ________
7. Subtract line 6 from line 5. If zero or less, stop here, none
of the Social Security benefits are taxable.
7. ________
8. Enter $25,000 ($32,000 if married filing jointly; $0 if married
filing separately and living with spouse at any time duri ng
the year).
8. ________
9. Subtract line 8 from line 7. If zero or less, enter –0–. 9. ________
Note: If line 9 is zero or less, stop here; none of your benefits
are taxable. Otherwise, go on to line 10.
10. Enter $9,000 ($12,000 if married filing jointly; $0 if married
filing separately and living with spouse at any time during
the year).
10. ________
11. Subtract line 10 from line 9. If zero or less, enter –0–. 11. ________
12. Enter the smaller of line 9 or line 10. 12. ________
13. Enter one-half of line 12. 13. ________
14. Enter the smaller of line 2 or line 13. 14. ________
15. Multiply line 11 by 85% (.85). If line 11 is zero, enter –0– . 15. ________
16. Add lines 14 and 15. 16. ________
17. Multiply line 1 by 85% (.85). 17. ________
18. Taxable benefits. Enter the smaller of line 16 or line 17. 18. ________
Section 2.13
Unemployment Compensation 2-23
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SECTION 2.14
EMPLOYEE FRINGE BENEFITS
The tax law provides that all fringe benefits must be included in the employee’s gross
income, unless specifically excluded by law. The primary types of fringe benefits that
may be excluded from gross income are described below.
Employer-Provided Spending Accounts
Many employers, especially larger employers, form plans that allow employees periodi-
cally to set aside money from their salary b efore it is taxed to pay for one or more of
the expenses listed below. If all the requirements of the plan are met and the employee
provides receipts for the expenses incurred, the full amount of expenses reimbursed out
of the employee’s account will be treated as a tax-free reduction in salary. These accounts
may provide significant tax sa vings for employees, with onl y a small administrative cost to
employers. Employees must beware, however, of the ‘‘use-it-or-lose-it’’ rule. Unused
amounts left in plans after Decemb er 31 (or March 31 if the plan elects) of each year
are lost.
Dependent Care Accounts
Employers may offer a dependent care plan in which employees can set aside up to $5,000
of their salary to cover the costs of caring for a dependent child or aging parent. Such costs
may include day care, day camp, in-home care for a parent living with the taxpayer, and
preschool.
Medical Flexible Spending Accounts
Employers may offer medical flexible spending accounts in which employees can set aside
funds from their salary to cover medical expenses which they anticipate incurring during
the year. These expenses may include eyeglasses, laser-eye surgery, necessary dental
work, and health insurance co-payments.
Public Transportation and Parking at Work and Bicycle Commuting
Employers may provide accounts in which employees can set aside funds from their salary
to cover the costs of public transportation to work and parking at work up to certain limits
each month. Bicycle commuters are allowed a special tax-free fringe benefit that began in
2009. Up to $20 per month may be reimbursed to employees for the cost of parking,
repairing, and storing their bicycles.
Group Term Life Insurance
Employers may pay for up to $50,000 of group term life insurance for employees as a tax-
free fringe benefit. Providing group term life insurance to employees must not favor offi-
cers, shareholders, or highly paid personnel.
Self-Study Problem 2.13
Christi was unemployed during part of 2010. She received $3,000 in unemploy-
ment compensation. How much of the $3,000 must be included in Christi’s
gross income?
$ ____________
2-24 Chapter 2
Gross Income and Exclusions
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No-Additional-Cost Services
This category of fringe benefits includes services that are provided to employees and their
families at little or no additional cost to the employer, and which would otherwise have
remained unused. An airline employee who is allowed to fly at no cost on a standby
basis is an example. The value of the airfare may be excluded from the employee’s gr oss
income.
Employees are only allowed to receive tax-free services in the major line of business in
which they are employed. For example, if an airline company also owns a rental car agency,
the employees working in the airline division would not be entitled to the ‘‘tax-free’’ use of
rental cars.
Qualified Employee Discounts
The value of employee discounts may be excluded from gross income if the discounts are
available on a nondiscriminatory basis. That is, the discounts must be available to substan-
tially all full-time employees. However, an employee discount is not ‘‘tax free’’ if the
discount:
1. Is on real estate or personal property of the type held for investment,
2. Exceeds 20 percent of the customer price, for services,
3. Exceeds the employer’s gross markup for merchandise, or
4. Is for a line of business in which the employee is not employed.
EXAMPLE R. J. works for a company that owns two separate busi nesses, a
chain of auto parts stores and a chain of sporting goods s tores. If
R. J. works for the auto parts chain, she is not allowed a ‘‘tax-free’’
discount on merchandise purchased at the sporting goods stores. N
Working Condition Fringe Benefits
An employee may exclude the value of property or services provided by an employer to the
extent that the cost of the property or services would be a deductible expense of the
employee. Examples of this type of exclusion include the use of a company car for busi ness
(not personal) purposes and a subscription to a tax journal paid for by a CPA firm. The
working condition fringe benefit rules also allow several expenses which would not be
deductible if paid by the employee. These in clude the value of parking provided to an
employee and certain personal use of demonstrator autos by automobile salespeople.
De Minimis Fringe Benefits
The value of small fringe benefits may be excluded from an employee’s gross income if
accounting for the benefits would be impractical. Examples of this type of exclusion
include occasional personal use of an office copy machine, personal letters typed by a com-
pany secretary, a company picnic for the employees, and small holiday gifts provided to
employees (e.g., a Christmas turkey).
If an employer provides a subsidized lunch room for its employees, the value of the
meals may be excluded from the employees’ income if (1) the facility is on or near the
employer’s place of business, (2) the revenue from the lunch room normally exceeds
direct operating costs, and (3) the meals ar e p rovided without discrimination to all
employees.
Section 2.14
Employee Fringe Benefits 2-25
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
Tuition Reduction
All employees of educational institutions may exclude from their income the value of a
tuition reduction, if the plan is for an undergraduate education and available to all employ-
ees. The exclusion applies to the employees, their spouses, and their dependents. The value
of a graduate education tuition reduction plan can only be excluded by employees of the
institution who are teaching or doing research at that in stitution.
Athletic Facilities
Employees may exclude from gross income the value of the use of an athletic facility located
on the premises of their employer. The facility must be used primarily by employees.
Retirement Planning Fringe Benefit
Qualified retirement planning services constitute a fringe benefit that is exc luded from
income. This change was made to encourage employers to provide retirement planning serv-
ices for their employees to assist them in preparing for retirement. Qualified retirement plan-
ning services are any retirement planning services provided to an employee and his or her
spouse by an employer maintaining a ‘‘qualified employer plan.’’ The exclusion also applies
to advice and information on retirement income planning for an individual and his or her
spouse, including how the employer’s plan fits into the individual’s overall retirement income
plan. The exclusion, however, does not apply to services that may be related to tax prepara-
tion, accounting, legal, or brokerage services.
EXAMPLE As part of its qualified plan, Linda’s employer provides retirement
planning services. Linda has a mee ting with a financial planner to
review her retirement plan. The cost of the meeting ($600) is paid for
by her employer’s qualified plan. The $600 is not income to Linda and
is deductible to the employer. N
Self-Study Problem 2.14
Indicate in each of the following cases whether the value of the employee
fringe benefit is included (I) in or excluded (E) from the employee’s gross
income.
______
1. An employee of a railroad receives a free train-trip pass.
______
2. An employee of a department store receives a 25 percent discou nt on
a shirt. The department store’s markup is 15 percent.
______
3. An employee attends a New Year’s party paid for by her employer.
______
4. An employee of a stock brokerage firm receives a subscription to a
financial newsletter paid for by his employer.
______
5. An employee’s wife regularly uses a company car to go shopping.
______
6. An airline employee receives a 50 pe rcent discount at a hotel chain
owned by her employer.
______
7. An employee uses the company’s employee workout room.
2-26 Chapter 2
Gross Income and Exclusions
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
KEY POINTS
Learning Objectives Key Points
LO 2.1:
Understand and apply the defini-
tion of gross income.
Gross income means ‘‘all income from whatever source derived.’’
Gross income includes everything a taxpayer receives unless it is specifically excluded from
gross income by the tax law.
LO 2.2:
Determine the tax treatment of
significant elements of gross
income such as interest, dividends,
alimony, and prizes.
Interest income is taxable except for certain state and municipal bond interest. Interest or
dividend income exceeding $1,500 per year must be reported in detail on Schedule B of
Form 1040.
Series EE Savings Bond interest is taxable in the year the bonds are cashed in unless a tax-
payer elects to report the Series EE Savings Bond interest each year as it accrues.
Series HH Saving Bond interest is taxable each year as it is paid to the taxpayer.
Ordinary dividends are taxable in the year received.
In 2008–2010, dividends are taxed at a 15 percent rate for taxpayers in tax brackets above
15 percent. For the 10 percent and 15 percent tax brackets, the dividend tax rate is
0 percent.
Alimony paid in cash is taxable to the person who receives it and is deductible to the per-
son who pays it.
Child support is not alimony and therefore is not taxable when received or deductible when
paid.
Amounts received from prizes and awards are normally taxable income unless refused by
the taxpayer.
Certain small prizes (generally under $400) for length of service and safety achievement are
excluded for gross income.
LO 2.3:
Calculate the taxable and nontax-
able portions of annuity payments.
Annuity payments received by a taxpayer have an element of taxable income and an ele-
ment of tax-free return of the original purchase price.
The part of the payment that is excluded from income is the ratio of the investment in the
contract to the total expected return.
The total expected return is the annual payment multiplied by the life expectancy of the
annuitant, based on mortality tables provided by the IRS.
Individual taxpayers generally must use the ‘‘simplified’’ method to calculate the taxable
amount from a qualified annuity starting after November 18, 1996.
LO 2.4:
Understand the tax rules for signif-
icant exclusions from gross income
including life insurance benefits,
inheritances, scholarships, health
insurance benefits, meals and
lodging, municipal bond interest,
and fringe benefits.
Life insurance proceeds are excluded from gross income. If the proceeds are taken over sev-
eral years instead of in a lump sum, any interest on the unpaid proceeds is generally tax-
able income.
Early payouts of life insurance are excluded from gross income for certain terminally or
chronically ill taxpayers.
All or a portion of the proceeds from a life insurance policy transferred to another person
for valuable consideration is generally taxable to the recipient.
The fair market value of gifts and inheritances received is excluded from gross income,
although income received from the property after the transfer is taxable.
Scholarships granted to degree candidates are taxable income, except for amounts spent for
tuition, fees, books, and course-required supplies and equipment. Amounts received for
such items as room and board are taxable to the recipient.
Taxpayers are allowed an exclusion for payments received from accident and health
plans. The taxpayer may exclude the total amount received for payment of medical care,
including any amount paid for the medical care of the taxpayer, his or her spouse, or
dependents.
Section 2.14
Employee Fringe Benefits 2-27
Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
Reinforce the tax information covered in this chapter by completing the online
interactive tutorials located at the Income Tax Fundamentals Web site:
www.cengagebrain.com.
Meals and lodging are excluded from gross income provided they are for the convenience
of the employer and they are furnished on the business premises. Lodging must be a condi-
tion of employment to be excluded.
Interest from an obligation of a state, territory, or possession of the United States, or of a
political subdivision of the foregoing, or of the District of Columbia, is excluded from gross
income.
LO 2.5:
Apply the rules governing inclusion
of Social Security payments as
income.
Taxpayers with income under $25,000 ($32,000 for Married Filing Jointly) exclude all of
their Social Security benefits from gross income.
Middle and upper income Social Security recipients, however, may have to include up to
85 percent of their benefits in gross income.
Calculating the taxable amount of Social Security is complex and most easily done using a
worksheet, such as the one provided in this chapter, or a tax program such as H&R Block’s
At Home.
QUESTIONS and PROBLEMS
GROUP 1:
MULTIPLE CHOICE QUESTIONS
................................... ......................................................... .
LO 2.1
1. The definit ion of gross income in the tax law is:
a. All items specifically listed as income in the tax law
b. All cash payments received for goods received and services performed
c. All income from whatever source derived
d. All income from whatever source derived unless the in come is ear ned ille gally
LO 2.1
2. Which of the following is not taxable for income tax purposes?
a. Interest income on savings accounts
b. Income from real estate investments
c. Child supp ort
d. Dividend income from stock
e. None of the above
LO 2.1
3. All of the following items are taxable to the taxpayer receiving them, except:
a. Bonuses
b. Damages for physical personal injury
2-28 Chapter 2
Gross Income and Exclusions
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
c. Unemployment compensation
d. Prizes
e. Gambling winnings
LO 2.1
4. Which of the following types of income is tax free?
a. Welfare payments
b. Income earned illegally
c. Dividends from foreign corporations
d. Dividends from closely held corporations
e. Dividends from utility corporations’ stock
LO 2.1
5. Which of the following is included in gross income?
a. Loans
b. Inheritances
c. Tuition and books scholarships
d. Hobby income
e. None of the above
LO 2.2
6. Which of the following prizes or awards is taxable?
a. Professional sports awards
b. Prizes from a television game show
c. Awards for superior performance on the job
d. A one-acre lot received as a prize
e. All of the above are taxable
LO 2.3
7. A taxpayer retires this year and receives the first payment on an annuity that
was purchased several years ago. The taxpayer’s investment in the annuity is
$75,000, and the annuity pays $10,000 per year for the remainder of the tax-
payer’s life. Based on IRS mortality tables, the taxpayer is expected to live
another 20 years. If the taxpayer receives $4,000 in annuity payments in the cur-
rent year, the no ntaxable portion calculated using the general rule is:
a. $6,250
b. $4,000
c. $3,750
d. $1,500
e. None of the above
LO 2.4
8. Which of the following would result in life insurance proceeds that are taxable to the
recipient?
a. A life insurance policy in which the insured is the son of the taxpayer and the ben-
eficiary is the taxpayer
b. A life insurance policy transferred by a partner to the partnership
c. A life insurance policy transferred to a creditor in payment of a debt
d. A life insurance policy purchased by a taxpayer insuring his or her spouse
e. A life insurance policy purchased by a corporation insuring an officer
Questions and Problems 2-29
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
LO 2.4
9. Which of the following gifts would probably be held to be taxable to the person receiv-
ing the gift?
a. One thousand dollars given to a taxpayer by his or her father
b. A trip to Mexico given to a purchasing agent by one of the company’s suppliers
c. A house given to a taxpayer by a frien d
d. A Mercedes-Benz given to a taxpayer by his cousin
e. An interest in a partnership given to a taxpayer by his or her uncle
LO 2.4
10. Which of the following items would be includable in the gross income of the recipient?
a. Insurance payments for medical care of a dependent child
b. Insurance payments for loss of the taxpayer’s sight
c. Season tickets given by a salesperson to a customer
d. Interest from bonds issued by the state of Texas
e. Lodging provided to a worker on a remote oil rig
LO 2.5
11. For 2010, the maximum percentage of Social Security benefits that must be included
in a taxpayer’s gross income is:
a. 85%
b. 75%
c. 65%
d. 50%
e. 25%
LO 2.5
12. Generally, modified adjusted gross income (MAGI) is adjusted gross income (without
Social Security benefits):
a. Less tax-exempt interest
b. Less personal and dependency exemptions
c. Less itemized deductions
d. Less tax-exempt interest plus any foreign in come exclusion
e. Plus tax-exempt interest income
GROUP 2:
PROBLEMS
.............................................. .............................................. .
LO 2.1 1. Indicate whether each of the items listed below would be included (I) in or excluded
(E) from gross income for the 2010 tax year.
______
a. Welfare payments
______
b. Commissions
______
c. Hobby income
______
d. Scholarships for room and board
______
e. $300 set of golf clubs, an employee award for length of service
______
f. Severance pay
______
g. Ordinary dividend of $50
______
h. Accident insurance proceeds
______
i. Inheritances
______
j. Gifts
______
k. Tips and gratuities
2-30 Chapter 2
Gross Income and Exclusions
Copyright 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.