accounting case study

· Incentive stock options (ISOs) → The taxpayer does not recognize gross income on the date she exercises the option. The employee’s basis in the shares is the exercise price. The taxpayer recognizes gross income when she sells the shares equal to the difference between the sale price and the exercise price. If she holds the shares for at least two years after the grant date and one year after the exercise date, the gain is treated as a long-term capital gain and taxed at preferential tax rates, otherwise, it is treated as ordinary income.

What type of tax planning strategy do ISOs provide an opportunity for?

Timing and Conversion strategy: defer income until date of sale and turning ordinary income into capital gains.

EXAMPLE: In 2017 Adam is granted NQOs for 1,000 shares of his employer’s stock. The options have an exercise price of $10. The options vest in 2019, and Adam acquires 1,000 shares of the stock in 2020 by exercising the options. The fair market value of the shares on the exercise date is $18. In what year does Adam recognize income in connection with the NQOs, and how much income does he recognize?

ANSWER: 2020, and $8,000 of ordinary income.

Taxpayers recognize income equal to the bargain element when they exercise NQOs. Adam exercised the NQOs in 2020, and the bargain element = 1,000 shares x ($18 fair market value - $10 exercise price) = $8,000.

EXAMPLE: In 2017 Andrea is granted ISOs for 1,000 shares of her employer’s stock. The options have an exercise price of $10. The options vest in 2019, and Andrea acquires 1,000 shares of the stock in 2020 by exercising the options. The fair market value of the shares on the exercise date is $18. In what year does Andrea recognize income in connection with the ISOs?

ANSWER: Andrea does not yet have income to recognize. Because these are ISOs, Andrea does not recognize income until she sells the shares, which she has not yet done. When she sells the shares her income = sales price - $10 exercise price.

Income from Property

· Income from property includes:

· dividends,

· interest,

· rent, royalties, annuities,

· and gains/losses from the sale of property.

· These are often referred to as unearned income because the income is generated without the effort or participation of the taxpayer.

· The tax treatment of income from property depends upon 1) the type of income and, in some circumstances, 2) the type of transaction that generated it.

Interest Income → Interest income is recognized by the owner of the asset (e.g., corporate bond). Interest income accrues daily . If the asset is transferred during the year, the interest income must be recognized among the different owners based on the number of days each taxpayer owned the property.

Dividends → Dividends are recognized by the taxpayer entitled to receive them (i.e., the taxpayer who owned the shares on the date of record declared by the corporation). Qualified dividends received by individual taxpayers are taxed at preferential tax rates, unqualified dividends are taxed at regular tax rates. C-corporations that own shares do not receive preferential tax rates.

Note: Unless otherwise stated, assume that dividends in exercises, quizzes, or exams are qualified dividends.

Annuities → An annuity is an investment that pays a stream of equal payments over time. Annuities can be either for a fixed period or for a person’s lifetime (i.e., until the person dies). A percentage of each payment is considered a return of the taxpayer’s original investment, the remainder is treated as interest income. To compute the percentage:

· For fixed term annuities :

The amount to treated as return of capital can also be computed as the original investment divided by the number of payments.

· For lifetime annuities , because the actual number of payments is unknown, taxpayers use the expected return multiple from the IRS annuity table, which is an estimated of the remaining life expectancy in years .

IRS Expected Return Multiple for Ordinary Single-Life Annuity

· If the taxpayer lives beyond the life expectancy, then all the original investment would have been recovered and 100% of the subsequent payments will be treated as interest income.

· If the taxpayer dies before the life expectancy ends, the unrecovered portion of the original investment is treated as a capital loss on the taxpayer’s final tax return.

EXAMPLE: Two years ago Beverly purchased an annuity that will pay her $12,000 per year for the next 20 years. She paid $200,000 for the annuity. How much of the annuity payments that Beverly receives this year will be included in her gross income?

ANSWER: the annuity is for a set a time, 20 years, so it is a fixed term annuity.

The return of capital percentage =200,000/(20*12,000) = 0.8333 or 83.33%.

Return of capital = 12,000 * 83.33% = $10,000

Interest income = 12,000 – 10,000 = 2,000

Alternative calculation:

Return of capital = 200,000 ÷ 20 years = $10,000

Interest income = 12,000 – 10,000 = 2,000

EXAMPLE: When he was 60 years old, Jonathan purchased an annuity that will pay him $12,000 per year for the rest of his life. He paid $200,000 for the annuity. How much of the annuity payment that Jonathan receives this year will be included in his gross income?

ANSWER: This is a lifetime annuity.

Expected value of the annuity = 24.2*12,000 = $290,400.

Return of capital percentage = 200,000/290,400 = 0.6887 or 68.87%

Return of capital = 12,000 * 68.87% = $8,264

Interest income = 12,000 – 8,264 = $3,736

Alternative calculation:

Return of capital = 200,000 ÷ 24.2 years = $8,264

Interest income = 12,000 – 8,264 = $3,736

PROBLEM 7:

Andrea’s mother transfers a $100,000 bond to her on April 30th. Her mother owned the bond for two years, and it pays interest annually on December 31st at a rate of 12%.

a) Who receives the interest payment from the issuer of the bond?

b) Who reports the interest income, and how much do they report?

c) What other tax consequences might Andrea’s mother need to consider?

PROBLEM 8:

Carol purchases an annuity for $20,000. Starting January 1st of this year, the annuity will pay Carol $500 per month for the next 20 years. How much income will Carol report from the annuity this year?

PROBLEM 9:

Grant purchases an annuity for $20,000. Starting January 1st of this year, the annuity will pay Grant $500 per month for the rest of his life. Grant is 54 years old when the annuity payments start.

a) How much interest income will Grant report from the annuity this year?

b) What are the tax consequences if Grant dies unexpectedly next year after receiving only 20 payment from the annuity up to that point?

c) What are the tax consequences for the annuity payment if Grant lives to be 100 years old?

Property Dispositions → (Covered in detail in Chapter 11.) Taxpayers experience a realized gain or loss when they dispose of an asset. The gain or loss is computed as follows:

Sales Proceeds

Less: Selling Expenses

Equals: Amount Realized

Less: Tax Basis in Property Sold

Equals: Realized Gain (Loss) on Sale

· The tax treatment of the gain or loss will differ depending on whether the asset was held for business, investment, or personal-use purposes.

EXAMPLE: Haven LLP purchased a piece of land for $20,000 in 2010. In 2020, Haven LLP sold the land for $30,000. The company paid broker fees of $500 related to the sale. What is Haven’s realized gain on the disposition of the land?

ANSWER: The amount realized = 30,000 – 500 = $29,500, and the tax basis in the property sold is $20,000.

The realized gain =29,500 – 20,000 = 9,500.

· Sometimes it is difficult to identify the specific property sold. For example, a taxpayer might sell shares at different dates and at different prices. When the taxpayer sells a portion of the shares, he may not be able to identify which batch of shares he sold. If the taxpayer cannot identify the specific property being sold, the taxpayer must use the first-in, first-out method (FIFO) method to determine the basis of the property sold.

Capital Gains and Losses

· In general terms, Capital assets are properties held for investment or personal-use (e.g., stocks, artwork, personal vehicle). Assets held for business-use, e.g., inventory, accounts receivable, depreciable property or real property; and certain other properties listed in the tax code are not capital assets.

· The realized gain or loss from disposal of a capital asset is treated as a capital gain or capital loss .

· Capital gains/losses are labelled short-term if the asset was held for one year or less.

· Capital gains/losses are labelled long-term if the asset was held for more than one year.

· Losses from the disposal of personal-use assets are, generally, not deductible .

Netting Process for Capital Gains and Losses

Netting Process for Individual Taxpayers:

In General → Tax treatment depends on:

· Holding period

· Taxpayer’s regular tax rate

· Type of asset

Applicable Tax Rates for Capital Gains

1) Short-term capital gains → Capital assets held for ≤ 1 yr; taxed at ordinary tax rates

Long-term capital gains → Capital assets held for > 1 yr.

2) 28% property: Collectibles (e.g. works of art, rugs, coins, stamps, etc.) are taxed at ordinary tax rates up to a maximum of 28 percent

3) §1202 gains from the sale of qualified small business stock acquired after Sept 27, 2010 and held for ≥ 5 years are tax exempt

4) Unrecaptured §1250 gain: gains from the sale of business-use buildings (discussed in Ch 11) are taxed at ordinary tax rates up to a maximum of 25 percent

5) All other long-term capital gains → Taxed at preferential tax rates (0%, 15%, 20%).

Capital Gain and Loss Netting Procedure

If there are multiple sales in a year, need to determine the character of net gains and losses:

1. Group all gains and losses into the four categories (i.e. short-term, 28% property, unrecaptured § 1250 gain, and regular long-term). Note: §1250 gains are not included since it is tax-exempt.

2. Net gains and losses within each category.

3. Net 28% property, unrecaptured §1250 gain, and regular long-term categories.

· Net losses against any 28% property gain first, then against any unrecaptured §1250 gain, then against any regular long-term gains.

· In other words, you net any losses against the highest taxed gains first.

4. If the net amount from step 3 and the net amount from the short-term category are of opposite signs, net them. If the short-term amount is a loss, offset it against highest taxed gain first (i.e. offset against 28% property gain first, then against any unrecaptured 1250 gain, then against any regular long-term gain.)

Note: This procedure (i.e. Steps 3 and 4) offsets capital losses against the highest-taxed gain first. Individual taxpayers can deduct $3,000 of net capital losses each year. Any excess carries forward to future years. Short-term losses carry forward as short-term losses; long-term losses carry forward as long-term losses.

EXAMPLE: Jess sold two assets that generated a short-term capital loss of $1,000 and a long-term capital gain of $3,000 respectively. What is the net capital gain or loss Jess will report for the year, and how will it be taxed?

ANSWER: Jess has a net short-term capital loss of $1,000 and a net long-term capital gain of $3,000. Because the net short-term and long-term amounts are of opposite signs, they get netted together, resulting in a net long-term capital gain of 3,000-1,000 = $2,000. Because Jess is an individual taxpayer, her net long-term capital gain is taxed at preferential tax rates (i.e., 0%, 15%, or 20% depending on her total taxable income).

Netting process for C-Corporations:

· For C-Corporations, the distinction between short-term and long-term does not matter because C-Corp’s net capital gains are tax at regular tax rates whether they are short-term or long-terms.

· Therefore, we simply net all capital gains and losses regardless of the type of assets.

· If the result is a net capital loss, it can either be carried back three years or carried forward five years to offset against net capital gains in those years.

PROBLEM 10:

Anderson purchased 100 shares of Lacy Inc. stock on July 1, 2017 for $5,000. He purchased another 100 shares of Lacy stock on July 1, 2018 for $6,000. Anderson sells 50 shares of the stock on January 4, 2020 for $4,000.

a) What is the gain on the sale of stock if Anderson cannot identify which batch of shares was sold?

b) If Anderson was able to adequately identify the shares sold, from which batch of shares would you advise him to sell the shares from and why?

PROBLEM 11:

In 2020, Green has a net short-term capital loss of $7,000 and no long-term capital gains. What are the tax consequences if Green is:

a) a C-corporation?

b) an individual taxpayer?

PROBLEM 12:

James realized the following gains and losses on dispositions of capital assets during 2020:

· A stock held for 24 months - $35,000 gain

· B stock held for 36 months - $10,000 loss

· C stock held for 4 months - $8,000 gain

· D stock held for 6 months - $11,000 loss

· Gold coins held for 6 years - $1,000 gain

· Rental home held for 7 years - $120,000 gain ($50,000 is unrecaptured § 1250 gain)

James is in the 35 % income tax bracket. What are the tax rates applicable to James’ capital gains during the year?

Limitations on the Recognition of Losses on Sale of Property

Disallowed Losses on Sale to Related Parties

· The realized loss from the sale of property to a related party is disallowed for tax purposes, i.e., it is not deductible. (related parties were defined in Ch 3)

· Buyer’s basis is equal to seller’s basis, instead of the price paid.

· When the property is subsequently sold to an unrelated party:

· At a gain, the gain can be reduced by the disallowed loss from the first transaction. The gain can only be reduced to zero, it cannot become negative.

· At a loss, only the loss from the subsequent sale is deductible.

Disallowed Losses Due to Wash Sales

· When a stock or other security is sold at a loss and the taxpayer acquires substantially identical stock within 30 days before or after the sale date, the loss is disallowed.

· The disallowed loss is added to the basis of the replacement stock.

· The acquired date of the replacement stock, for tax purposes, is purchase date of the original stock.

PROBLEM 13:

Jay owns 100 shares of Rodgers Corp. stock that he purchased in June 2018 for $50 a share. On December 21, 2019 Jay sells the shares for $40 a share because he needs cash for the holidays. Jay later realizes that Rodgers is a very good investment, so on January 3, 2020 he purchases 100 shares of Rodgers stock for $41 a share.

a) Does Jay realize a short or long term capital loss on the December 21st sale?

b) Does Jay recognize a loss on the December 21st sale?

c) What tax basis will Jay have in the Rodgers stock he purchased on January 3, 2020?

d) What would Jay’s recognized loss have been if he purchased 40 shares of Rodgers stock instead of 100 shares on January 3, 2020?

Other Common Sources of Gross Income

Income from Flow-Through Entities → Owners of flow-through entities (e.g., partnerships, S-corporations) report their share of the business income and deductions for the tax year on their personal tax returns.

· The income and deductions of the flow-through entity retain their tax characteristics on the owners’ tax returns (e.g., interest income earned by the partnership is reported as interest income on the partner’s tax return).

· Owners are required to pay the taxes on their share of the taxable income from the flow-through entity whether or not they receive actual cash distributions from the flow-through entity.

· Cash distributions from a flow-through business to its owners are generally considered a repayment of capital invested and are non-taxable

· Exception: if the cash distribution exceeds the amount of capital the partner has invested in the business, then the excess is taxed as a capital gain.

· We discuss flow-entities in greater detail in Chapter 15.

Alimony → When a couple divorces, one spouse may be required to provide financial support to his/her former spouse. Such financial support is considered alimony if:

· it involves a transfer of cash under a written agreement ,

· the individuals do not live together when the payment is made,

· the payments do not continue after the death of the recipient,

· and the written agreement does not designate the payment as something other than alimony.

The tax treatment of alimony depends on when the separation or divorce agreement is executed.

· For agreements executed before January 1, 2019 : (We’ll focus on this case because currently the vast majority of divorces fall into this category.)

· The recipient includes the alimony as part of gross income

· The ex-spouse making the payment is able to deduct the payment as against taxable income.

· For agreements executed on or after January 1, 2019:

· The recipient does not include the alimony received in gross income

· The ex-spouse making the payment is not allowed a deduction

Child support payments and property settlements/division at the time of separation or divorce are not included in gross income by the recipient.

EXAMPLE: Homer and Marge got divorced five years ago. Homer pays Marge $40,000 in alimony and $30,000 in child support per year. What amount of these payments must Marge include in her gross income each year?

ANSWER: $40,000. Marge includes the $40,000 of alimony received in her gross income. The child support payments are not included in her gross income.

Prizes and Awards

· Generally, the fair market value of a prize or award is included in gross income by the recipient.

· A prize/award is not considered a gift because the taxpayer did something to earn the prize/award, e.g., purchase the lottery ticket or attended the game show.

· A taxpayer is allowed to exclude the prize/award from gross income under the following circumstances:

· Awards for literary, scientific, or charitable achievement : the taxpayer can exclude if the following conditions are met:

· The taxpayer must have been selected for the award without any action on her part,

· The taxpayer must not be required to provide future services associated with the award (e.g., give speeches or attend events), and

· The taxpayer must transfer the entire award to a government or qualified charitable organization

EXAMPLE – The winner of the Nobel Prize for Economics donates prize money to MSU.

· Employment achievement awards : To qualify for exclusion:

· The award must be based on length of service or safety, and

· The award must be paid in the form of tangible personal property (i.e., non-cash) and be under a certain amount ($400 or $1,600 per employee per year)

EXAMPLE: A plant engineer receiving a non-cash award for longest length of time without an accident.

· Olympic medals and prize money → The value of medals and prize money received by Team USA athletes from competing in the Olympic Games is excluded from the athlete’s gross income if his/her adjusted gross income is less than $1 million

EXAMPLE: Ted won a car with a fair market value of $21,000 on a game show. What are the tax consequences for Ted?

ANSWER: Ted recognizes gross income of $21,000. The car is a prize, and Ted must include the fair market value of the prize ($21,000) in his gross income.

Gambling Winnings → Taxpayers include the gross amount of gambling winnings in gross income.

· Gambling losses and related expenses can be deducted as a miscellaneous itemized deduction up to the amount of gambling winners.

· Professional gamblers can deduct gambling losses and related expenses as a For AGI deduction.

Itemized and For AGI deductions are covered in Chapters 6 and 7.

Social Security Benefits → The amount of social security benefits included in gross income depends on the taxpayer’s overall income.

· For single (married filing jointly) taxpayers, Social Security benefits are non-taxable if the taxpayer’s modified adjusted gross income + 50 percent of his/her Social Security Benefits ≤ $25,000 ($32,000).

As taxpayers’ gross income increases, up to 85 percent of Social Security benefits may become taxable.

Note: The calculations for social security benefits are complex. You will not be tested on the calculation. But, you need to know at what threshold the social security benefits start to become taxable. The modified adjusted gross income figure will be given to you.

Imputed Income → Sometimes taxpayers receive indirect economic benefits, these economic benefits must be included in gross income. These indirect economic benefits usually arise when a transaction between related parties are conduct at below fair market value. The amount of the discount/ economic benefit is referred to as imputed income .

· Bargain Purchase → When a taxpayer purchases an item or service from a related party for less than its fair market value, the discount is treated as imputed income by the purchaser. The tax consequences depend on the relationship between the parties:

· Employer sells an item to an employee → The discount is treated as compensation income by the employee

· Corporation sells an item to a shareholder → The discount is treated as dividend income by the shareholder

· Transactions between family members → The discount is treated as a gift, remember that gifts are not considered income to the recipient. A gift is considered a transfer of wealth rather than a generation of income.

Note: Employers are allowed to give discounts to employees without triggering imputed income as long as the discount does not exceed the average gross profit margin for goods sold by the business or does not exceed 20 percent of the FMV for services.

EXAMPLE: Jeremy works for an auto dealership. His employer sold him a car for $5,000. The inventory price of the car was $12,000 and the sale price was $20,000. What are the tax consequences for Jeremy?

ANSWER: Jeremy recognizes $7,000 of compensation income. This is a bargain purchase between related parties. The car was sold for below cost price. Jeremy must report the portion of the discount below the cost price as gross income = 12,000 – 5,000 = $7,000.

· Below-Market Loans → If a loan is made between related parties for less than the prevailing market interest rate, the transaction must be grossed-up to reflect market rates for tax purposes:

1) The difference between the actual interest paid and the market rate is reported as imputed interest income by the lender borrower to gross-up income to market rate; i.e., actual interest income + imputed interest income = interest income at market rates. The market rate is the applicable federal interest rate (compounded semiannually).

2) The lender then records an imputed payment, equal to the imputed interest income, to the borrower. The label for the imputed payment depends on the relationship.

The gross-up process is depicted in the example below. Employee takes out a staff loan for $100,000. The interest on the loan is $3,000, at the market rates the interest would have been $8,000:

Note: The imputed interest rule exist to prevent related parties from using below-market loans to shift income from a high-rate taxpayer to a low-rate taxpayer. Recall from Chapter 3 that income-shifting should be done at arms-length. When they are not done at arms-length, the imputed interest rule grosses up the transaction to reflect arms-length for tax purposes.

Tax consequences for the lender:

1) Reports actual interest received plus imputed interest income

Imputed interest income = Loan amount * federal interest rate (compounded semi-annually) – actual interest paid on the loan

2) Imputed payment back to the borrower. The tax treatment of the imputed payment depends on the relationship between the lender and borrower:

· Loan to family members → imputed payment is a gift, non-deductible (and potentially subject to gift tax)

· Loan to employee → imputed payment is compensation expense, tax deductible

· Loan from corporation to shareholder → imputed payment is dividend paid, non-deductible

· Loan from shareholder to corporation → imputed payment is additional capital invested, non-deductible

Tax consequences for the Borrower:

1) The imputed interest is an expense for the borrower, the imputed interest (and the actual interest paid) is deductible if loan proceeds are used for business or investment purposes

2) The imputed payment received from the lender is taxable depending on the relationship:

· Loan to family members → imputed payment is a gift received, non-taxable

· Loan to employee → imputed payment is compensation income, taxable

· Loan from corporation to shareholder → imputed payment is dividend income, taxable

· Loan from shareholder to corporation → imputed payment is additional capital received, non-taxable

Note:

· Loans of $10,000 or less are generally exempt from the imputed interest rules, with some exceptions.

· Gift loans of $100,000 or less, the imputed interest is limited to the borrower’s net investment income.

EXAMPLE: Jenna took out a loan of $20,000 from her employer, the interest rate was 1%, not compounded. The loan was outstanding from January 1st through December 31st. The federal interest rate for the year was 4%. What are the tax consequences for Jenna and for her employer?

ANSWER: This is a below-market loan between related parties.

· The imputed interest rule treats this as if Jenna paid interest to her employer at the federal interest rate compounded semiannually (=20,000*4%*(6/12) + (20,000+400)*4%*(6/12)) = $808. Imputed interest = 808 – 200 = 608

· Her employer makes an imputed payment of $608 back to her. Because this is an employer to employee loan, the payment back to Jenna is treated as compensation.

· Her employer recognizes interest income of $808 (200 actual + 608 imputed) and compensation expense of $608.

· Jenna recognizes compensation income of $608. If Jenna used $20,000 for business or investment purposes, the $808 of interest expense will be deductible.

PROBLEM 14:

Rodgers Corp. sold property with a fair market value of $100,000 to Aaron, its majority shareholder, for $80,000. What are the tax consequences for Aaron?

PROBLEM 15:

Red Corporation loaned Tom, its sole shareholder, $600,000 at a 1% interest rate. Assume that the applicable federal interest rate is 3.5% through June 30 and 4% from July 1 through December 31. Red Corporation made the loan on January 1, and the loan is still outstanding on December 31. What are the tax consequences for Red Corp and Tom?

Discharge of Indebtedness → Generally, when a taxpayer has debt discharged (i.e., forgiven or written off) by a lender, the taxpayer must report the amount of debt forgiven as gross income because his net worth has increased by the debt forgiven.

An exception is allowed for taxpayers who are insolvent (i.e., his liabilities are greater than his assets). Taxpayers who are insolvent before the forgiveness of debt can exclude the debt relief from gross income to the extent they remain insolvency. If the forgiveness makes them solvent, i.e. positive net worth, then gross income is equal to the amount of solvency after forgiveness.

EXAMPLE: One of Holt Corp.’s creditors forgave a $100,000 debt. Holt Corp. was not insolvent when the debt was forgiven. What are the tax consequences for Holt Corp.?

ANSWER: Holt Corp. recognizes gross income of $100,000. Generally, taxpayers must recognize gross income as a result of a discharge of indebtedness, unless the taxpayer was insolvent before forgiveness. Holt Corp was not insolvent, so the full $100,000 is reported as gross income.

PROBLEM 16:

A creditor of Maroon Corporation agrees to cancel $125,000 of its liabilities. What are the tax consequences for Maroon Corporation if before the debt cancellation:

a) Maroon has assets with fair market value of $700,000 and liabilities of $600,000?

b) Maroon has assets with fair market value of $500,000 and liabilities of $630,000?

c) Maroon has assets with fair market value of $500,000 and liabilities of $575,000?

3. Exclusion and Deferral Provisions

Common Exclusions

· Interest earned on Municipal bonds – bonds issued by state, city, or local governments

· Earnings from Roth retirement accounts – all earnings from Roth accounts are tax free.

· Gains on the Sale of Personal Residence – the first $250,000 ($500,000 if married) of realized gains are exempted. Excess amounts are taxed as long-term capital gains. To qualify for exemption, taxpayer must have:

· owned the residence for 2 years or more in the past 5 years,

· used the property as her principal residence for a total of 2 years in the past 5 years,

· has not claimed an exemption in the past two years.

· Qualifying employee fringe benefits – non-salary benefits provide to employees (e.g., medical & dental insurance, group life insurance policies). See Exhibit 5-4 for list of qualified fringe benefits.

Education-Related Exclusions

· Scholarships – tax-free to the extent the funds are used for tuition, fees, books, supplies, and other equipment required for student’s courses. Any scholarship funds not used for education purposes is taxable.

· Other Educational Subsidies – e.g., interest earned from Series EE bonds (an education bond issued by the federal government) are exempt if the proceeds are used for higher education for the taxpayer, taxpayer’s spouse, or a dependent of the taxpayer.

Exclusions that Mitigate Double Taxation

· Gifts and inheritances – Although recipient realizes an increase in net wealth, gifts and inheritances are considered transfers of wealth rather than generation of income, and therefore are not taxable to the recipient.

· Life insurance proceeds – Not treated as taxable income to the recipient because the proceeds represent the replacement of human capital. However, the proceeds are taxable if the policy is i) cancelled; or ii) sold to a third party.

Sickness and Injury-Related Exclusions

· Worker’s compensation – receive when a taxpayer is unable to work due to work-related injury. On the other hand, unemployment compensation from the government is fully taxable b/c it is considered a replacement for salary income.

· Personal injury payments – all payments awarded by a court, except punitive damages , originating from a physical injury or physical sickness are nontaxable.

· Health care reimbursement – Any reimbursement from a health and accident insurance policy (including dental care) for medical expenses paid by the taxpayer is nontaxable, whether the policy is purchased by the taxpayer or her employer.

· Disability insurance – insurance payments received from an employee-purchased policy are non-taxable.

Deferral Provisions

· Deferred compensation (not recognition until income is received by the employee)

· Qualified retirement accounts (e.g., IRAs)

· Non-qualified deferred compensation

· Installment sales – income pro-rated and recognized over the installment period

· Exchange of Assets (covered in depth in Chapters 10, 13, and 15)

· Like-kind exchanges – replacement of business-use or investment assets for another busines-use or investment assets, recognition of gain is deferred until the replacement asset is disposed of

· Involuntary conversions – theft, fire, etc.; recognition of the gain is deferred as long as the insurance proceeds are reinvested in replacement asset

· Exchange of Assets for shares in the business – recognition of gain on transfer of assets is deferred until the shares are sold by the owner or the transferred assets are disposed of by the business

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