Exlusions from Gross Income
As mentioned in the "Income" tab to the left, gross income is defined broadly to include all forms of income the taxpayer may receive throughout the year. Thus, the presumption is that a particular item of income is gross income under I.R.C. Section 61(a) unless the taxpayer can point to a specific part of the Code or a court doctrine that exempts it from gross income.
Various policy reasons exist to exempt certain types of income from the gross income calculus. For example, I.R.C. Section 108(a)(1)(A) provides that a taxpayer does not include in his gross income discharge of indebtedness income that is discharged in a bankruptcy proceeding. This is excluded from gross income because Congress believed taxpayers should not be burdened with a tax liability after filing for bankruptcy (a "fresh start" is warranted). For a full list of the items excluded from gross income, see I.R.C. Secs. 101-139D. Also, for a more detailed discussion of taxable and nontaxable income, see Publication 525. A few of the more common items excluded from gross income are detailed below.
Life Insurance Proceeds On Account of Death
Very generally, gross income does not include payments received from a life insurance contract if the payments are received due to the death of the insured person (note they may be included in the gross estate of the decedent depending on various factors). See I.R.C. Sec. 101.
Example: Mary has a $50,000 term-life insurance policy whereby she pays premiums monthly. Mary dies in 2011 as a result of illness. The life insurance policy she has pays $50,000 to Mary's estate as a result of the death. The $50,000 is non-taxable to Mary and she does not have to include this in her gross income for 2011 (a quick note, when people die in a tax year, they are still responsible for filing a tax return for that year - usually, the executor of the estate will file the return). The same would be true if the life insurance policy proceeds were paid to Mary's children or husband (they would not have to include it in their gross income for the year).
Gifts and Inheritances
Gross income does also not include the value of items received through gift or inheritance (though, again, there may be gift/estate tax consequences). See I.R.C. Sec. 102. The starting point in the determination of whether the item is excluded under this provision is the definition of "gift." The United States Supreme Court, in Comm'r v. Duberstein (1960) provided that the most important factor in this inquiry was the transferor's intent (i.e. the person giving the gift). There is no bright-line rule and the facts of each case must be weighed to determine whether it is properly classified as a gift or as income to the transferee. The Court stated that gifts tend to be given out of "disinterested generosity" and are given out of "affection, respect, admiration, charity or like impulses."
Example: Joe is married and decides he wants to purchase a diamond ring for his wife for their anniversary. Therefore, Joe purchases a $2500 diamond ring at a jewelry store and gives the ring to his wife on her birthday. Under Section 102(a), the value of the ring would not be includable in the wife's income. Joe's intent in giving the ring to his wife was one of a love and affection.
Property received under a "will or under statutes of descent and distribution" are also excluded from gross income. Treas. Reg. Sec. 1.102-1(a).
Example: Jose's father dies intestate (without a will) and leaves him a 2011 Toyota Camry with a FMV of $25,000 (and no liability on the vehicle). The $25,000 fair market value of the vehicle is not included in Jose's gross income for the year.
For both gifts and inheritances, if the property produces income, it is not considered a gift but is included in the gross income of the recipient. Treas. Reg. Sec. 1.102-1(b).
Interest Received from State and Local Bonds
Subject to some exceptions, interest received from state and local bonds is not included in the gross income of the receiver. States include all states and the District of Columbia as well as any possession of the United States. The bonds must meet certain other requirements, and if a taxpayer is looking to receive tax-free state or local bonds, it is wise to ask the purchaser whether the bonds meet those requirements. See I.R.C. Secs. 103(b), 149.
Example: Bill invests $100,000 in qualified state and local bonds from Mississippi. The bonds have a coupon rate (or interest rate) of $5,000 a year. In tax year 2011, Bill receives $5,000 cash as a result of his investment in these bonds. Bill will not have to include this income in his 2011 tax return because they are excluded from gross income under Section 103(b) of the Internal Revenue Code.
Money Received on Account of Injuries or Sickness
Very generally, gross income does not include monies received due to workmen's compensation as a result of a personal injury or sickness; amounts received in litigation (other than punitive damages) due to personal physical injuries or physical sickness; and monies received through an accident or health insurance from personal injuries or sickness (with some exceptions). See I.R.C. Sec. 104(a) (there are others but they are omitted for simplicity).
Amounts received from worker's compensation are excluded if they are received under "a workmen's compensation act" or "under a statute in the nature of a workmen's compensation act which provides compensation to employees for personal injuries or sickenss incurred in the course of employment." See Treas. Reg. Sec. 1.104-1(b). If the employee dies as a result of the injury, income received under a worker's compensation act is also excluded from gross income if paid to any survivors. Id. Note, however, that if the compensation is paid for an injury non-work related, it is includble in the recipients income. Id. Amounts received in "excess of the amount provided [in a workmen's compensation act" is also includable in income. Id.
Amounts received from litigation as a result of a personal physical injury or physical sickness warrants further explanation, also. As with most statutes in the Internal Revenue Code, one must carefully study and scrutinize every word provided. Therefore, the words "physical" relating to an injury or sickness are extremely significant. To qualify for exclusion from gross income, the injuries (or sickness) must be physical in nature. In order to demonstrate the injuries (or sickness) is physical in nature, the taxpayer must show "a direct causal link between the damages and the personal injury [or sickness] sustained." See, e.g. Lindsey v. Comm'r (8th Cir. 2005); Fabry v. Comm'r (11th Cir. 2000). Notably, emotional distress is specifically excluded as a physical injury or physical sickness under the Internal Revenue Code. See I.R.C. Sec. 104(a) (flush language).
Example: Julie works as a waitress at a restaurant in Missouri. One day at work, Julie suffers severe burns when a hot bowl of soup is poured down her back accidentally. Julie files a worker's compensation claim and receives $500 a month for three months while she is away from work. The $1500 Julie receives under the workmen's compensation statute is excludable from her gross income.
Example: Sam is severely injured one day when he is involved in a car wreck on the way to the supermarket. Sam hires an attorney who settles with the other driver for $20,000 (all of which are compensation for Sam's broken back). The $20,000 Sam receives as a result of the settlement are non-taxable because the compensation is related to a physical injury (Sam's broken back) and there is a direct causal link between the damages and the personal injury Sam sustained.
Discharge of Indebtedness Income
Discharge of indebtedness income (also known as cancellation of debt or "COD") is generally taxable unless the taxpayer can demonstrate an applicable exception. COD income is not included in the taxpayer's gross income If the taxpayer can demonstrate that the COD was a result of a bankruptcy proceeding; the taxpayer is insolvent at the time of the discharge; or the discharge is "qualified principal residence indebtedness...discharged before January 1, 2013." See I.R.C. Sec. 108(a). For more information pertaining to discharge of indebtedness income, see Publication 4681.
To understand why we have these exceptions, it is first important to understand what would happen if the exceptions did not exist.
Example: Joe solely owns Joe's Barn Builders, a business that specializes in building barns on-site for farmers. Joe's business is profitable until many of the barns begin falling apart and injuring those inside. As a result of these events, Joe's Barn Builders is hit with hundreds of lawsuits, most of which will be successful. Joe's business quickly goes downhill and as a result, he declares bankruptcy under Chapter 7 of the Bankruptcy Code. Assume that Joe also owes $100,000 to Bank A which is discharged (or forgiven) by the bankruptcy court. As a result, Joe is no longer liable for the $100,000. Normally, under Section 61(a)(12) of the Internal Revenue Code, Joe would be liable for taxes on the $100,000 discharge. But, because Joe discharged this debt in bankruptcy, Joe will not have to include this item of income on his personal tax return. Congress thought it would be inherently unfair to tax Joe on the "phantom income" after Joe is beginning to get a fresh start, and thus excluded it under Section 108(a)(1)(A).
Example: Jill owes $10,000 on her only credit card and is insolvent (meaning her liabilities exceed her assets). Assume further, that Jill has $1000 of assets and $50,000 of liabilities (mortgage, car, and the credit card amount of $10,000). Jill negotiates with the credit card company, and they agree, to release Jill of $3,000 on the credit card account (effectively making her amount due on the credit card $7,000). Normally, absent Section 108(a)(1)(B), Jill would be liable for tax on the $3000 of income. Congress exempts this income from gross income because they thought it would be unfair to tax Jill on this transaction - i.e., because her liabilities exceed her assets.
There is one significant rule, however, to I.R.C. Section 108(a)(1)(B). The amount excluded cannot exceed the amount by which the taxpayer is insolvent. See I.R.C. Section 108(a)(3); Section 108(d)(3).. Thus, in our example above with Jill, if Jill had $20,000 in assets and $22,000 in liabilities (including the credit card debt of $10,000), Jill could only exempt $2,000 of the $3,000 in income because she is only insolvent by $2000. The remaining $1,000, absent another exclusion in the Code, would be subject to tax.
Insolvency is determined by looking at the taxpayer's total assets and liabilities immediately before the discharge of indebtedness (the excess of liabilities minus assets will give the taxpayer his insolvency amount). For many years, assets did not include state-exempt assets such as IRAs and pension holdings. However, in Carlson v. Comm'r (T.C. 2001 ), the Tax Court held that these assets are to be included in determining whether the taxpayer is exempt for purposes of Section 108(d)(3). This is also the IRS's position. See LTR 199932013.
Example: Joe owns a home in California which he resides in and is his principal residence. Joe owes a mortgage on the property to Bank A of $100,000 and the value of the home is $110,000. From 2008-2010, Joe's home decreases in value to $50,000. Joe still owes Bank A $70,000. Joe negotiates with Bank A to reduce the mortgage on his home from $70,000 to $60,000. Joe does not file bankruptcy nor is Joe insolvent. Normally, absent Section 108(a)(1)(E), Joe would be liable for the $10,000 discharge of indebtedness income. Due to the economic crisis that occurred in 2008 (and the depreciation in home values that resulted), Congress believed taxing Joe on this type of COD income would be unfair. Thus, Congress has exempted this from gross income as long as the discharge occurs prior to January 1, 2013 and the other Section 108(h) requirements are met.
Another noteworthy exception for discharge of indebtedness income is the so-called "purchase price adjustment." In order for the purchase price adjustment exception to apply, the discharge of indebtedness must not occur during bankruptcy or while the taxpayer is insolvent, and it must be between the original purchaser and seller. See I.R.C. Sec. 108(e)(6).
Example: Sammy purchases an automobile from Leroy for $30,000. Sammy gives Leroy a note whereby he is to pay $500 a month for 10 years. Fifty days after the purchase, Sammy begins experiencing problems with the automobile. Sammy discusses this matter with Leroy and Leroy agrees to reduce the amount owed to $20,000. Sammy is not insolvent. The $10,000 discharge of indebtedness would not be includable in Sammy's gross income because this is a purchase price adjustment.
Sale of Principal Residence
A very noteworthy exclusion from income is the exclusion for sales of a principal residence up to a certain dollar amount. Thus, under I.R.C. Sec. 121, a taxpayer who resides in a principal residence for periods aggregating 2 years or more within the 5 year period preceding the date of the sale may exclude from income $250,000 of the gain on teh sale if the taxpayer is filing single or married filing separately, and $500,000 if the taxpayer files married filing jointly (with some other qualifications for the latter). For more information, see Publication 523.
Example: Sim is a single taxpayer and owns a home (the home is his prinicpal residence). Sim's adjusted basis in the home is $200,000 (adjusted basis is a term of art in the tax field that means basically the price you pay for something with additions for things such as adding a new kitchen floor, etc. and reductions for things such as depreciation taken on the home - i.e, if Sim used part of his home as an office). Sim has resided in this home for 20 years and the purchaser pays Sim $600,000. Sim's amount realized from the sale is $400,000 (the amount he received from the purchaser, $600,000, minus his adjusted basis in the home of $200,000). Normally, absent Section 121 of the Code, Sim would have to pay taxes on the entire $400,000 gain realized. However, Section 121 shelters $250,000 of this gain from taxation. Sim will still have to pay taxes on $150,000 in income. Because a home is a capital asset, Sim will pay taxes of $22,500 (capital gains rates are currently at 15 %).
As mentioned in the "Income" tab to the left, gross income is defined broadly to include all forms of income the taxpayer may receive throughout the year. Thus, the presumption is that a particular item of income is gross income under I.R.C. Section 61(a) unless the taxpayer can point to a specific part of the Code or a court doctrine that exempts it from gross income.
Various policy reasons exist to exempt certain types of income from the gross income calculus. For example, I.R.C. Section 108(a)(1)(A) provides that a taxpayer does not include in his gross income discharge of indebtedness income that is discharged in a bankruptcy proceeding. This is excluded from gross income because Congress believed taxpayers should not be burdened with a tax liability after filing for bankruptcy (a "fresh start" is warranted). For a full list of the items excluded from gross income, see I.R.C. Secs. 101-139D. Also, for a more detailed discussion of taxable and nontaxable income, see Publication 525. A few of the more common items excluded from gross income are detailed below.
Life Insurance Proceeds On Account of Death
Very generally, gross income does not include payments received from a life insurance contract if the payments are received due to the death of the insured person (note they may be included in the gross estate of the decedent depending on various factors). See I.R.C. Sec. 101.
Example: Mary has a $50,000 term-life insurance policy whereby she pays premiums monthly. Mary dies in 2011 as a result of illness. The life insurance policy she has pays $50,000 to Mary's estate as a result of the death. The $50,000 is non-taxable to Mary and she does not have to include this in her gross income for 2011 (a quick note, when people die in a tax year, they are still responsible for filing a tax return for that year - usually, the executor of the estate will file the return). The same would be true if the life insurance policy proceeds were paid to Mary's children or husband (they would not have to include it in their gross income for the year).
Gifts and Inheritances
Gross income does also not include the value of items received through gift or inheritance (though, again, there may be gift/estate tax consequences). See I.R.C. Sec. 102. The starting point in the determination of whether the item is excluded under this provision is the definition of "gift." The United States Supreme Court, in Comm'r v. Duberstein (1960) provided that the most important factor in this inquiry was the transferor's intent (i.e. the person giving the gift). There is no bright-line rule and the facts of each case must be weighed to determine whether it is properly classified as a gift or as income to the transferee. The Court stated that gifts tend to be given out of "disinterested generosity" and are given out of "affection, respect, admiration, charity or like impulses."
Example: Joe is married and decides he wants to purchase a diamond ring for his wife for their anniversary. Therefore, Joe purchases a $2500 diamond ring at a jewelry store and gives the ring to his wife on her birthday. Under Section 102(a), the value of the ring would not be includable in the wife's income. Joe's intent in giving the ring to his wife was one of a love and affection.
Property received under a "will or under statutes of descent and distribution" are also excluded from gross income. Treas. Reg. Sec. 1.102-1(a).
Example: Jose's father dies intestate (without a will) and leaves him a 2011 Toyota Camry with a FMV of $25,000 (and no liability on the vehicle). The $25,000 fair market value of the vehicle is not included in Jose's gross income for the year.
For both gifts and inheritances, if the property produces income, it is not considered a gift but is included in the gross income of the recipient. Treas. Reg. Sec. 1.102-1(b).
Interest Received from State and Local Bonds
Subject to some exceptions, interest received from state and local bonds is not included in the gross income of the receiver. States include all states and the District of Columbia as well as any possession of the United States. The bonds must meet certain other requirements, and if a taxpayer is looking to receive tax-free state or local bonds, it is wise to ask the purchaser whether the bonds meet those requirements. See I.R.C. Secs. 103(b), 149.
Example: Bill invests $100,000 in qualified state and local bonds from Mississippi. The bonds have a coupon rate (or interest rate) of $5,000 a year. In tax year 2011, Bill receives $5,000 cash as a result of his investment in these bonds. Bill will not have to include this income in his 2011 tax return because they are excluded from gross income under Section 103(b) of the Internal Revenue Code.
Money Received on Account of Injuries or Sickness
Very generally, gross income does not include monies received due to workmen's compensation as a result of a personal injury or sickness; amounts received in litigation (other than punitive damages) due to personal physical injuries or physical sickness; and monies received through an accident or health insurance from personal injuries or sickness (with some exceptions). See I.R.C. Sec. 104(a) (there are others but they are omitted for simplicity).
Amounts received from worker's compensation are excluded if they are received under "a workmen's compensation act" or "under a statute in the nature of a workmen's compensation act which provides compensation to employees for personal injuries or sickenss incurred in the course of employment." See Treas. Reg. Sec. 1.104-1(b). If the employee dies as a result of the injury, income received under a worker's compensation act is also excluded from gross income if paid to any survivors. Id. Note, however, that if the compensation is paid for an injury non-work related, it is includble in the recipients income. Id. Amounts received in "excess of the amount provided [in a workmen's compensation act" is also includable in income. Id.
Amounts received from litigation as a result of a personal physical injury or physical sickness warrants further explanation, also. As with most statutes in the Internal Revenue Code, one must carefully study and scrutinize every word provided. Therefore, the words "physical" relating to an injury or sickness are extremely significant. To qualify for exclusion from gross income, the injuries (or sickness) must be physical in nature. In order to demonstrate the injuries (or sickness) is physical in nature, the taxpayer must show "a direct causal link between the damages and the personal injury [or sickness] sustained." See, e.g. Lindsey v. Comm'r (8th Cir. 2005); Fabry v. Comm'r (11th Cir. 2000). Notably, emotional distress is specifically excluded as a physical injury or physical sickness under the Internal Revenue Code. See I.R.C. Sec. 104(a) (flush language).
Example: Julie works as a waitress at a restaurant in Missouri. One day at work, Julie suffers severe burns when a hot bowl of soup is poured down her back accidentally. Julie files a worker's compensation claim and receives $500 a month for three months while she is away from work. The $1500 Julie receives under the workmen's compensation statute is excludable from her gross income.
Example: Sam is severely injured one day when he is involved in a car wreck on the way to the supermarket. Sam hires an attorney who settles with the other driver for $20,000 (all of which are compensation for Sam's broken back). The $20,000 Sam receives as a result of the settlement are non-taxable because the compensation is related to a physical injury (Sam's broken back) and there is a direct causal link between the damages and the personal injury Sam sustained.
Discharge of Indebtedness Income
Discharge of indebtedness income (also known as cancellation of debt or "COD") is generally taxable unless the taxpayer can demonstrate an applicable exception. COD income is not included in the taxpayer's gross income If the taxpayer can demonstrate that the COD was a result of a bankruptcy proceeding; the taxpayer is insolvent at the time of the discharge; or the discharge is "qualified principal residence indebtedness...discharged before January 1, 2013." See I.R.C. Sec. 108(a). For more information pertaining to discharge of indebtedness income, see Publication 4681.
To understand why we have these exceptions, it is first important to understand what would happen if the exceptions did not exist.
Example: Joe solely owns Joe's Barn Builders, a business that specializes in building barns on-site for farmers. Joe's business is profitable until many of the barns begin falling apart and injuring those inside. As a result of these events, Joe's Barn Builders is hit with hundreds of lawsuits, most of which will be successful. Joe's business quickly goes downhill and as a result, he declares bankruptcy under Chapter 7 of the Bankruptcy Code. Assume that Joe also owes $100,000 to Bank A which is discharged (or forgiven) by the bankruptcy court. As a result, Joe is no longer liable for the $100,000. Normally, under Section 61(a)(12) of the Internal Revenue Code, Joe would be liable for taxes on the $100,000 discharge. But, because Joe discharged this debt in bankruptcy, Joe will not have to include this item of income on his personal tax return. Congress thought it would be inherently unfair to tax Joe on the "phantom income" after Joe is beginning to get a fresh start, and thus excluded it under Section 108(a)(1)(A).
Example: Jill owes $10,000 on her only credit card and is insolvent (meaning her liabilities exceed her assets). Assume further, that Jill has $1000 of assets and $50,000 of liabilities (mortgage, car, and the credit card amount of $10,000). Jill negotiates with the credit card company, and they agree, to release Jill of $3,000 on the credit card account (effectively making her amount due on the credit card $7,000). Normally, absent Section 108(a)(1)(B), Jill would be liable for tax on the $3000 of income. Congress exempts this income from gross income because they thought it would be unfair to tax Jill on this transaction - i.e., because her liabilities exceed her assets.
There is one significant rule, however, to I.R.C. Section 108(a)(1)(B). The amount excluded cannot exceed the amount by which the taxpayer is insolvent. See I.R.C. Section 108(a)(3); Section 108(d)(3).. Thus, in our example above with Jill, if Jill had $20,000 in assets and $22,000 in liabilities (including the credit card debt of $10,000), Jill could only exempt $2,000 of the $3,000 in income because she is only insolvent by $2000. The remaining $1,000, absent another exclusion in the Code, would be subject to tax.
Insolvency is determined by looking at the taxpayer's total assets and liabilities immediately before the discharge of indebtedness (the excess of liabilities minus assets will give the taxpayer his insolvency amount). For many years, assets did not include state-exempt assets such as IRAs and pension holdings. However, in Carlson v. Comm'r (T.C. 2001 ), the Tax Court held that these assets are to be included in determining whether the taxpayer is exempt for purposes of Section 108(d)(3). This is also the IRS's position. See LTR 199932013.
Example: Joe owns a home in California which he resides in and is his principal residence. Joe owes a mortgage on the property to Bank A of $100,000 and the value of the home is $110,000. From 2008-2010, Joe's home decreases in value to $50,000. Joe still owes Bank A $70,000. Joe negotiates with Bank A to reduce the mortgage on his home from $70,000 to $60,000. Joe does not file bankruptcy nor is Joe insolvent. Normally, absent Section 108(a)(1)(E), Joe would be liable for the $10,000 discharge of indebtedness income. Due to the economic crisis that occurred in 2008 (and the depreciation in home values that resulted), Congress believed taxing Joe on this type of COD income would be unfair. Thus, Congress has exempted this from gross income as long as the discharge occurs prior to January 1, 2013 and the other Section 108(h) requirements are met.
Another noteworthy exception for discharge of indebtedness income is the so-called "purchase price adjustment." In order for the purchase price adjustment exception to apply, the discharge of indebtedness must not occur during bankruptcy or while the taxpayer is insolvent, and it must be between the original purchaser and seller. See I.R.C. Sec. 108(e)(6).
Example: Sammy purchases an automobile from Leroy for $30,000. Sammy gives Leroy a note whereby he is to pay $500 a month for 10 years. Fifty days after the purchase, Sammy begins experiencing problems with the automobile. Sammy discusses this matter with Leroy and Leroy agrees to reduce the amount owed to $20,000. Sammy is not insolvent. The $10,000 discharge of indebtedness would not be includable in Sammy's gross income because this is a purchase price adjustment.
Sale of Principal Residence
A very noteworthy exclusion from income is the exclusion for sales of a principal residence up to a certain dollar amount. Thus, under I.R.C. Sec. 121, a taxpayer who resides in a principal residence for periods aggregating 2 years or more within the 5 year period preceding the date of the sale may exclude from income $250,000 of the gain on teh sale if the taxpayer is filing single or married filing separately, and $500,000 if the taxpayer files married filing jointly (with some other qualifications for the latter). For more information, see Publication 523.
Example: Sim is a single taxpayer and owns a home (the home is his prinicpal residence). Sim's adjusted basis in the home is $200,000 (adjusted basis is a term of art in the tax field that means basically the price you pay for something with additions for things such as adding a new kitchen floor, etc. and reductions for things such as depreciation taken on the home - i.e, if Sim used part of his home as an office). Sim has resided in this home for 20 years and the purchaser pays Sim $600,000. Sim's amount realized from the sale is $400,000 (the amount he received from the purchaser, $600,000, minus his adjusted basis in the home of $200,000). Normally, absent Section 121 of the Code, Sim would have to pay taxes on the entire $400,000 gain realized. However, Section 121 shelters $250,000 of this gain from taxation. Sim will still have to pay taxes on $150,000 in income. Because a home is a capital asset, Sim will pay taxes of $22,500 (capital gains rates are currently at 15 %).