Chapter 11
Other Income

This chapter discusses various types of payments you may receive; some are taxable and others are not taxable. Examples of taxable items include:

• Taxable state tax refunds, which are reported on Line 10 of Form 1040.
• Prizes, gambling winnings, and awards, which are reported on Line 21 of Form 1040. There are several exceptions, including the new exclusion for debts discharged in a mortgage restructuring or foreclosure (11.8).
• Cancellations of debt, which are reported on Line 21 of Form 1040.
• Your share of partnership, S corporation, trust, or estate income or loss, which is reported in Schedule E according to Schedule K-1 statements provided you by the entity, and then transferred to Line 17 of Form 1040.

Further reporting details are discussed in this chapter.

11.1 Prizes and Awards

Prizes and awards are taxable income except for an award or prize that meets all these four tests:

1. It is primarily in recognition of religious, charitable, scientific, educational, artistic, literary, or civic achievement.
2. You were selected without any action on your part.
3. You do not have to perform services.
4. You assign the prize or award to a government unit or tax-exempt charitable organization. You must make the assignment before you use or benefit from the award. You may not claim a charitable deduction for the assignment.

Prize taxed at fair market value. A prize of merchandise is taxable at fair market value. For example, where a prize of first-class steamship tickets was exchanged for tourist-class tickets for a winner’s family, the taxable value of the prize was the price of the tourist tickets. What is the taxable fair market value of an automobile won as a prize? In one case, the Tax Court held that the taxable value was what the recipient could realize on an immediate resale of the car.

Employee achievement awards. Awards from an employer are generally taxable (as part of regular pay on form W-2) but there is an exception for certain awards of tangible personal property given for length of service or safety achievement. An award in the form of cash, a gift certificate or equivalent item does not qualify for the exclusion, but other types of tangible personal property, such as a watch, or golf clubs are generally not taxable up to a limit of $1,600 for a qualified plan award or $400 for a non-qualified plan award (3.12, 20.25).

Olympic medals. Cash awards paid by the U.S. Olympic Committee to athletes winnings medals at the Olympic and Paralympic games after 2015 are tax free, as well as the value of the medal itself (value of gold, silver or bronze content). However, the exclusion does not apply to athletes with adjusted gross income exceeding $1million, $500,000 if married filing separately. If the exclusion applies, the nontaxable amount must still be reported as income, but an offsetting deduction is allowed (12.2).

11.2 Lottery and Sweepstake Winnings

Sweepstake, lottery, and raffle winnings are taxable as “other income” on Line 21 of Form 1040. The cost of tickets is deductible only to the extent you report winnings, and only if you itemize deductions rather than claim the standard deduction. If you itemize on Schedule A, a deduction for the cost of tickets may be claimed on Line 28 as a miscellaneous deduction that is not subject to the 2% of adjusted gross income (AGI) floor (19.1). For example, if you buy state lottery tickets and win a 2017 drawing, you may deduct on Schedule A the cost of your losing tickets in 2017 up to the amount of your winnings.

When a minor wins a state lottery and the prize is held by his or her parents as custodians under the Uniform Transfers to Minors Act, the prize is taxed to the minor in the year the prize is won.

Installment payments. If lottery or sweepstakes winnings or casino jackpots are payable in installments, you pay tax only as installments are received. If within 60 days of winning a prize you have an option to choose a discounted lump-sum payment instead of an annuity, and you elect the annuity, you are taxed as the annuity payments are received. Merely having the cash option does not make the present value of the annuity taxable in the year the prize is won.

11.3 Gambling Winnings and Losses

Gambling winnings are taxable but losses are limited. If you are not a professional gambler, gambling winnings must be reported as “other income” on Line 21 of Form 1040. According to the IRS and Tax Court, you cannot reduce the winnings by your losses for the year and report only the net win (if any) as income on your tax return. Slot machine players determine if they have a win or loss at the end of a playing session; see below for the special rules for slot players.

To deduct losses from gambling, you must itemize deductions (not claim the standard deduction), and even if you itemize, the losses are deductible only up to the amount of your gambling winnings. The deduction, not to exceed the gambling income reported on Line 21 of Form 1040, is claimed as an “Other” miscellaneous itemized deduction on Line 28 of Schedule A, where it is not subject to the 2% of adjusted gross income (AGI) floor (the 2% floor applies on Line 26 to job expenses, tax preparation fees and investment expenses (19.1)). Keep records that document your gambling losses in case your itemized deduction is questioned by the IRS.

You may not deduct a net gambling loss for the year (losses exceeding gains) even though a particular state says gambling is legal. Nor does it matter that your business is gambling. You may not deduct a net loss from wagering transactions even if you are a professional gambler (see below).

Professional gamblers. According to the Supreme Court, a gambler is considered to be engaged in the business of gambling if he or she gambles full time to earn a livelihood and not merely as a hobby.

A professional gambler reports winnings and losses (lost wagers and gambling transaction expenses) on Schedule C. However, the Tax Court and federal appeals courts have consistently held that lost wagers from gambling are deductible only to the extent of wagering gains even if the gambling activity is a business. The statute that specifically bars a deduction of gambling losses in excess of gambling winnings trumps the general statute allowing full deductibility for ordinary and necessary business expenses.

A professional’s gambling-related expenses other than lost wagers are not limited to gambling winnings. For example, expenses such as transportation and lodging costs (casino gambling), tournament entry fees and gambling-related publications may be deducted in full on Schedule C.

Certain winnings reported to the IRS on Form W-2G. A win from slot machine play or bingo of $1,200 or more (not reduced by the wager) is reported by the payer to you and the IRS on Form W-2G. For keno the threshold is $1,500 (reduced by the wager), and for poker tournament winnings the threshold is winnings over $5,000 (reduced by the wager or buy-in). For lotteries, sweepstakes, horse racing, and other wagers, a Form W-2G is required for winnings of $600 or more that are at least 300 times the amount of the wager (26.7).

If you have more than one reportable win from slot machines, bingo, or keno on the same calendar day or “gaming day,” the gaming establishment may (this is optional) combine the winnings on one Form W-2G instead of reporting each win separately. A “gaming day” is the 24-hour period ending when business is slowest or the establishment closes down.

Note: Final regulations issued at the end of 2016 (T.D. 9807, 2017-5 IRB 573) do not include controversial 2015 proposed regulations concerning electronically tracked slot machine play. The proposals would have required casinos to report winnings from a session of electronically tracked slot machine play on Form W-2G if two requirements were met: (1) there was at least one slots win of $1,200 or more (disregarding the amount of the wager) during a gambling “session,” and (2) during that same session the taxpayer had a net win (total payouts minus total wagers) of $1,200 or more. A “session” was defined as all electronically tracked slot play at the same casino on the same calendar day (midnight through 11:59 p.m.). The IRS also implied that it might be appropriate to lower the reporting threshold from $1,200 to $600 at some future point given advances in casino technology.

In the face of fierce opposition from the gaming industry and individual taxpayers, the IRS in the final regulations retained the reporting threshold of $1,200 or more (with no reduction for the wager) and dropped the proposed mandatory session-based reporting rule. Casino operators had claimed that they use electronic player cards for marketing purposes and to reward customer loyalty, and that players would react negatively if they knew that their player cards were being used to help the IRS track their winnings.

Proposed safe harbor for figuring session win or loss from electronically tracked slot machine play. The IRS and Tax Court have followed a “per session” rule for determining whether a slot machine player has realized a win or a loss. A session win is taxable income, which a recreational gambler must include on Line 21 of Form 1040 (other income). A session loss is deductible only as a miscellaneous itemized deduction (not subject to the 2% floor), and only to the extent of the winnings and other gambling income reported as income.

What is a “session” of slot machine play? To clarify the rules and eliminate disputes, the IRS in March 2015 proposed an optional safe harbor for defining a “session of play” for purposes of calculating wins or losses from electronically tracked slot play (Notice 2015-21). When final regulations on Form W-2G reporting rules were approved at the end of 2016 (T.D. 9807, 2017-5 IRB 573), the IRS stated that it was still considering whether to finalize or modify the safe harbor proposed in Notice 2015-21; the Notice provided that the safe harbor will not take effect until it is finalized and an effective date announced in a future revenue procedure. The IRS had not yet provided further guidance when this book was completed; see the e-Supplement at jklasser.com for an update, if any.

Even if the safe harbor is finalized as proposed, it would not change the rule that prevents a non-professional gambler from netting gains from winning sessions against losses from losing sessions in figuring the winnings to be reported as “other income.” The winnings would still have to be reported as income, without taking into account the losses. The losses would have to be claimed separately, if at all, as a miscellaneous itemized deduction (not subject to the 2% floor). Therefore, it would still be necessary to maintain records to substantiate losses claimed as an itemized deduction.

Here are the major components of the proposed safe harbor in Notice 2015-21:

1. A taxpayer determines gain or loss from electronically tracked slot machines at the end of each session of play, which begins when the first wager on an electronically tracked slot machine is placed and ends when the last wager on an electronically tracked slot machine is made at the same casino by the end of the same calendar day (12:00 a.m. to 11:59 p.m.).
2. The taxpayer has a gain if the payouts from a session of play exceed the amount wagered during that session. A taxpayer has a loss if the amount wagered is more than the payouts during that session.
3. The session of play does not end if the taxpayer stops and resumes play within the same gaming establishment during the calendar day. However, moving to a new gaming establishment during the same calendar day begins a new session.

11.4 Gifts and Inheritances

Gifts and inheritances you receive are not taxable. However, distributions taken from an inherited traditional IRA (8.14), and distributions from inherited qualified plan accounts such as 401(k) and profit-sharing plan accounts (7.12), are taxable, except for amounts attributable to nondeductible contributions made by the deceased account owner.

Income earned from gift or inherited property after you receive it is taxable.

Describing a payment as a gift or inheritance will not necessarily shield it from tax if it is, in fact, a payment for your services (2.1).

A sale of an expected inheritance from a living person is taxable as ordinary income.

11.5 Refunds of State and Local Income Tax Deductions

A refund of state or local income tax is not taxable if you did not previously claim the tax as an itemized deduction in a prior year. For example, if you claimed the standard deduction on your 2016 return and in 2017 when you filed your 2016 state tax return you received a refund for state tax withheld from your 2016 wages, or for state estimated tax payments made in 2016, the refund is not taxable on your 2017 return. If you did claim a deduction for the tax in a prior year, you generally must include a refund in income to the extent that the refunded amount lowered your tax in the earlier year; this is the “tax benefit” rule.

Taxable part of refund of state/local income taxes or state/local general sales taxes. If in 2017 you received a refund for state or local income tax that you claimed as an itemized deduction for a prior year, the taxable portion of the refund depends on the amount of the state/local general sales tax that you could have deducted in lieu of the state/local income tax (16.3). In general, the full amount of the refund is taxable for 2017 if it is less than the excess of the state/local income tax claimed as a deduction in the prior year over the state/local general sales tax that you could have but did not deduct. If the refund is more than the excess, the amount subject to tax is limited to the excess. However, the actual taxable portion could be even lower due to the standard deduction limit; see below.

For example, on your 2016 return, you claimed an itemized deduction for $11,000 in state/local income taxes, as this exceeded your payment of $10,000 in state/local general sales taxes. If in 2017 you received a $750 refund of 2016 state income tax, the entire refund might be taxable (could be less depending on the standard deduction limit), since it is less than the $1,000 excess of the state/local income taxes over the state/local general sales taxes that could have been deducted for 2016. However, if the refund had been $2,500 instead of $750, no more than $1,000 of the refund would be includible in 2017 income (actual $11,000 deduction for state/local income taxes minus $10,000 in state sales tax that could have been deducted), with a further reduction possible under the standard deduction limit.

Similarly, if in 2016 you deducted state/local general sales taxes in lieu of state/local income taxes, and you received a sales tax refund in 2017, the IRS generally requires you to include the entire sales tax refund as income on your 2017 return if it is less than the excess of your 2016 sales tax deduction over the income tax deduction that could have been deducted. The amount subject to tax could be further reduced because of the standard deduction limit discussed below.

If your itemized deductions in the earlier year were subject to the overall reduction for higher income taxpayers (13.7), figure what your itemized deductions would have been without the recovered amount. The difference between that amount and your actual itemized deductions under the overall reduction is generally the amount of the recovery that you must report as income, although the taxable amount can be lower if the standard deduction limit discussed below applies.

If AMT applied in year of deduction. If the refunded state tax was claimed as an itemized deduction but you were subject to the alternative minimum tax (AMT) for that year, the deduction was not allowable for AMT purposes (23.2). The refund is taxable only if the deduction gave you a tax benefit in the prior year. To determine if there was a tax benefit, you must recompute regular tax liability and AMT for the prior year after increasing your income by the refunded amount. If the recomputation does not increase your total tax, there was no tax benefit and the refund is not taxable. If your total tax increases by any amount, the deduction gave you a tax benefit and the refund is taxable to the extent that the deduction reduced your tax in the prior year.

Standard deduction limit. The taxable portion of a refunded state tax cannot exceed the standard deduction limit. You include in income the lesser of the refund or the excess of your itemized deductions for the prior year over the standard deduction that could have been claimed.

The standard deduction limit applies to your total recoveries where you had other recoveries in addition to a refund of state tax (11.6).

Allocating a refund recovery. If in 2017 you received a refund of state or local income taxes and also a recovery of other deductions, and only part of the total recovery is taxable, you allocate the taxable amount of the recovery according to the ratio between the state income tax refund and the other recovery. You do this by first dividing the state income tax refund by the total of all itemized deductions recovered. The resulting percentage is then applied to the taxable recovery to find the amount to report as the unrefunded state income tax on Line 10 of Form 1040; other taxable recoveries are reported on Line 21 (Other income).

Refund of state tax paid in installments over two tax years. If you pay estimated state or local income taxes, your last tax installment may be in the year you receive a refund. In this case, you allocate the refund between the two years; see the following Example.

11.6 Other Recovered Deductions

The rules in the preceding section (11.5) for determining whether a refund of state sales tax is taxable also apply to the recovery of other items for which you claimed a tax deduction, such as a refund of real estate taxes (16.1) adjustable rate mortgage interest (15.1), reimbursement of a deducted medical expense (17.4), a reimbursed casualty loss (18.2), a return of donated property that was claimed as a charitable deduction (14.1), and a payment of debt previously claimed as a bad debt (5.33).

Unused tax credit in prior year. If you recover an item deducted in a prior year in which tax credits exceeded your tax, you refigure the prior year tax to determine if the recovery is taxable. Add the amount of the recovery to taxable income of the prior year and refigure the earlier year tax based on the increased taxable income. If the recomputed tax, after application of the tax credits, exceeds the actual tax for the earlier year, include the recovery in income to the extent the recovery reduced your tax in the prior year. The recovery may reduce an available credit carryforward to the current year.

Alternative minimum tax in the prior year. If you were subject to the alternative minimum tax (AMT) in the year the recovered deduction was claimed, recompute your regular and AMT tax for the prior year based on the taxable income you reported plus the recovered amount. If inclusion of the recovery does not change your total tax, you do not include the recovery in income. If your total tax increases by any amount, the recovered deduction gave you a tax benefit and you must include the recovery in income to the extent the deduction reduced your tax in the prior year. The recovery may reduce a carryforward of a tax credit based on prior year AMT.

Recovery of previously deducted items used to figure carryover. A deductible expense may not reduce your tax because you have an overall loss. If in a later year the expense is repaid or the obligation giving rise to the expense is canceled, the deduction of that expense will be treated as having produced a tax reduction in the earlier year if it increased a carryover that has not expired by the beginning of the taxable year in which the forgiveness occurs. For example, you are on the accrual basis and deducted but did not pay rent in 2016. The rent obligation is forgiven in 2017. The 2016 rent deduction is treated as having produced a reduction in 2016 tax, even if it resulted in no tax savings for 2016, if it figured in the calculation of a net operating loss that has not expired or been used by the beginning of 2017, the year of forgiveness. The same rule applies to other carryovers such as the investment credit carryover.

11.7 How Legal Damages Are Taxed

By statute, compensatory damages for personal physical injury or physical sickness are tax free, whether fixed by a court or in a negotiated settlement. Damages for nonphysical personal injuries, such as for discrimination, back pay, or injury to reputation, are taxable; a limited exception for certain emotional distress damages may be available as discussed below. Damages for lost profits, breach of contract, or interference with business operations are taxable.

These are the general rules, but damages that would otherwise be taxable can be tax free if received as part of a judgment or settlement relating to a physical injury or sickness. The law excludes from income compensatory damages received “on account of” physical injuries or sickness, so if this “account of” test is met, all compensatory damages are tax free, including amounts for lost wages or emotional distress (see below). Interest added to an award is taxable, even if the award is tax-free damages for physical injury or sickness.

Emotional distress. The law that provides an exclusion for damages received on account of a physical illness or sickness specifically provides that emotional distress by itself is not treated as a physical injury or sickness. To be tax free, damages for emotional distress must be attributable to a physical injury or sickness. For example, if you are injured in an accident and receive damages for emotional distress, or damages for emotional distress are included in the damages received in a wrongful death action, the emotional distress damages are tax free because they are deemed to be received “on account of” a physical injury; see Example 1 below.

If emotional distress damages are due to an injury other than a physical injury or sickness, as in a discrimination action, the damages are taxable with one exception: Damages up to the amount of actual medical care expenses attributable to emotional distress are tax free. That is, if you can prove actual expenditures for medical care to deal with emotional distress, that portion of the damages is tax free.

Apart from the medical expenses exception, damages for emotional distress are taxable when received for a personal injury other than a physical injury or sickness. Keep in mind that emotional distress, including its physical symptoms, is not treated as a physical injury or sickness, and so in an action for wrongful termination of employment or discrimination, emotional distress damages are taxable, even where the damages cover physical symptoms of emotional distress such as insomnia, headaches, and stomach disorders, although no tax would be due on actual medical costs incurred to deal with those physical symptoms. The Tax Court has held that depression falls within the category of emotional distress; see Example 2 below.

The National Taxpayer Advocate has argued that it is confusing and unfair to allow tax-free treatment for emotional distress damages that are attributable to physical injury or sickness while imposing tax on emotional distress damages for non-physical injuries such as employer discrimination. She has urged Congress to change the law and allow tax-free treatment for all awards for emotional distress, mental anguish, and pain and suffering.

Damages for wrongful termination. If damages are received from a former employer for wrongful termination, the damages are usually taxable as compensation, but any amount for a workplace-related physical injury or illness are excludable from income. Unless the terms of a settlement or verdict specifically allocate damages to a physical illness or injury, it may be difficult to show that you are entitled to the exclusion. But the Tax Court was convinced in the following case.

Domeny was working as a fund-raiser for nonprofit organizations when she was diagnosed with multiple sclerosis (MS) in 1996. She managed her symptoms without medication but in 2000 she took a job with an autism center where she could spend less time on her feet. The position involved fund-raising, grant writing and community development. Domeny had a strained relationship with her supervisor, who restricted her duties. The stress caused her MS symptoms to flare up. In November 2004 she discovered that her supervisor was embezzling funds and she reported this to the center’s board of directors, who promised her that they would take action but did not. She felt uncomfortable about having to raise funds from parents while knowing that her supervisor was embezzling funds. This situation continued for months, during which time her distress increased and her MS symptoms intensified. In March 2005, she went to her physician, complaining of vertigo, leg pain, numbness in both feet, burning behind her eyes and extreme fatigue. Her physician told her to stay home from work for two weeks but when Domeny notified the center, she was fired.

Domeny sued the center, alleging numerous discrimination and civil rights violations. The center agreed to settle and paid her a total of $33,308 of which $8,187.50 was treated as Form W-2 wages and $8,187.50 as attorney fees. The $16,933 balance was reported on Form 1099-MISC as nonemployee compensation. Domeny did not include the $16,933 on her 2005 return on the grounds that it was to compensate her for the worsening of her physical condition caused by working in a hostile work environment, and the fact that her condition prevented her from returning to work until more than a year after her termination.

The Tax Court agreed that the $16,933 payment was excludable from Domeny’s income. Even though the settlement agreement did not specify why the payment was made, the inference was clear that the center was recognizing Domeny’s complaint that a hostile and stressful work environment aggravated her physical illness. The fact that the settlement was segregated into three portions suggested that the center knew that part of the settlement was to compensate for physical illness. The center knew about Domeny’s illness before her termination, and her only claim was that she was fired after her work environment had caused the flareup in her MS symptoms.

Punitive damages. Punitive damages are taxable, even if they relate to a physical injury or sickness. An exception in the law allows an exclusion from income for punitive damages awarded under a state wrongful death statute if the punitive damages are the only damages that may be awarded.

Restitution for wrongful incarceration. Wrongfully incarcerated individuals may exclude from income any civil damages, restitution, or other monetary awards received in connection with the incarceration. There is no cap on the exclusion. If in recent years such payments were received and included in income, a refund can be claimed by filing an amended return on Form 1040X; “Incarceration Exclusion PATH Act” should be written at the top of the form.

Holocaust restitution payments. There is a broad exclusion from gross income for Holocaust restitution payments. Tax-free treatment applies to payments received by persons persecuted by Nazi Germany or any Nazi-controlled or allied country, as well as to payments received by heirs or estates of such persecuted persons. Persecution on the basis of race, religion, physical or mental disability, or sexual orientation is covered.

Excludable restitution includes compensation for assets that were stolen or lost before, during, or immediately after World War II and to life insurance issued by European insurers immediately before and during the war. Tax-free treatment also applies to interest earned on escrow accounts and funds established in settlement of Holocaust victim claims against European banks or corporations.

Legal fees. If your damages are tax free, you may not deduct your litigation costs. If your damages are taxable, including the contingency fee portion of a taxable recovery (see below) you may be able to deduct your legal fees. A business expense deduction may be claimed on Schedule C for legal fees to recover taxable business income. An above-the-line deduction (directly from gross income) is allowed for legal fees in employment discrimination suits, certain other unlawful discrimination cases, and federal False Claims Act cases paid in connection with a court judgment or settlement after October 22, 2004. The deduction cannot exceed the amount of the judgment or settlement you are including for the year. The above-the-line deduction is claimed on Line 36 of Form 1040 (12.2).

Legal fees not eligible for the above-the-line deduction or Schedule C deduction may be claimed only as miscellaneous itemized deductions on Schedule A subject to the 2% of adjusted gross income floor (19.18). The miscellaneous itemized deduction is not allowed at all for alternative minimum tax (AMT) purposes.

Attorney’s contingent fee paid from taxable award. If you receive taxable damages, such as back pay in an employment dispute, and a percentage goes directly to your attorney under a contingent fee agreement, can you exclude from your income the contingent fee payment, so that you are only taxed on the net amount you receive?

The answer from the Supreme Court is no. The Supreme Court held in its 2005 Banks decision that the contingency-fee portion of a taxable damages award or settlement generally must be included in the litigant’s gross income. The Court’s decision did not resolve whether attorney fees paid pursuant to a statutory fee-shifting provision must be included in income, but it suggested that such statutory fees might in some cases be excludable. However, a subsequent Tax Court decision held that the attorney-fee portion of a taxable settlement was includible in the litigant’s income where attorney fees were awarded under a California fee-shifting statute. Since the Supreme Court had not decided that issue, the Tax Court relied on its own prior decisions and precedent of the Ninth Circuit (where appeal would lie), which required inclusion of the fee portion of a settlement where a contingency-fee obligation was satisfied by a fee-shifting statute.

Note: If the contingency-fee portion of a taxable award in an unlawful employment discrimination case must be included in gross income under the Supreme Court decision, you may be able to offset the inclusion of the fees by an above-the-line deduction, as discussed above.

11.8 Cancellation of Debts You Owe

If a debt is canceled or forgiven other than as a gift or a bequest, a debtor who is personally liable on the loan (recourse debt) generally must include the canceled amount in gross income. Exclusions are allowed for discharges of farm or business real estate debt and debts of insolvent and bankrupt persons. For years before 2017, a discharge of up to $2 million of qualified principal residence indebtedness (as part of a mortgage restructuring or foreclosure) was excluded from income. When this book was completed, legislation to extend this exclusion to 2017 had not been enacted; see the e-Supplement at jklasser.com for an update if any.

Details on the various exclusions are provided below.

If you qualify for one of the exclusions, you generally must reduce certain “tax attributes” (such as the basis of property) by the amount excluded. The reduction of tax attributes is made on Form 982.

Form 1099-C. You should receive Form 1099-C from a federal government agency, credit union, or bank that cancels or forgives a debt you owe of $600 or more. The IRS receives a copy of the form. Generally, the amount of canceled debt shown in Box 2 of Form 1099-C must be reported as “other income” on Line 21 of Form 1040, unless one of the exclusions discussed below applies.

Mortgage loan “workouts” and repayment discounts. If your lender agrees to a “workout” that restructures your loan and reduces the principal balance of your debt, or you are allowed a discount for paying off your loan early, the debt reduction or discount is generally considered cancellation of debt income if you retain the collateral (31.10). If it is considered a cancellation of debt, report it on Line 21 of Form 1040 unless you can exclude the debt from income under the exclusion for qualified principal residence indebtedness or one of the other exclusions. As noted below, some states treat a loan used to buy a principal residence as nonrecourse debt, and in that case, any forgiveness of the loan does not give rise to cancellation of debt income.

Foreclosure, repossession, or voluntary conveyance. If a lender forecloses on a loan secured by your property (such as your home mortgage) or repossesses the property secured by the loan (such as your car), or you voluntarily convey the property to the lender, the transaction is treated as a sale on which you realize gain or loss, as explained in 31.9.

Apart from the gain or loss on the deemed sale, if you are personally liable on the loan (recourse debt) and the amount of the debt canceled by the lender exceeds the fair market value of the property, you have cancellation of debt income that must be reported as ordinary income unless one of the exclusions discussed below applies. The lender will report fair market value of the property in Box 7 Form 1099-C.

State law may treat home mortgage debt as nonrecourse. Some states have “anti-deficiency” statutes that treat a loan used to purchase a principal residence as a “nonrecourse” loan. In these states, a lender has no recourse against a homeowner for a deficiency judgment following a foreclosure or lender-approved short sale. Where a mortgage debt subject to one of these state laws is forgiven, the taxpayer does not realize cancellation of debt income, as the income rule applies only to the cancellation of recourse debts for which there is personal liability.

Such state anti-deficiency laws would assume even greater significance if Congress does not extend to 2017 and beyond the exclusion for discharges of up to $2 million of qualified principal residence indebtedness.

Cancellation of student loans. The cancellation of a student loan results in taxable income unless one of the following exceptions applies.

If a loan by a government agency, by a government-funded loan program of an education organization, or by a qualified hospital organization is canceled because you worked for a period of time in certain geographical areas in certain professions, such as practicing medicine in rural areas or teaching in inner-city schools, then the canceled amount is not taxable. The IRS has ruled that the exception also applies to law school graduates who have student loan indebtedness forgiven under the Loan Repayment Assistance program if they work for a specified period of time in law-related public service positions in government or with tax-exempt charitable organizations. If a loan from an educational organization is canceled because you work for that organization, the exclusion from gross income does not apply; the cancellation is taxable unless some other exclusion applies.

There is also a special exclusion for healthcare professionals who have student loans forgiven or repaid to them because they work in underserved communities. This exclusion applies to loans forgiven or repaid under (1) the National Health Services Corps Loan Repayment Program, (2) state loan repayment programs eligible for funding under the Public Health Service Act, or (3) any state loan repayment or forgiveness program that is intended to increase the availability of healthcare services in underserved areas as determined by the state.

There is no exception under current law for student loan debt that is canceled under an income-based repayment program, generally after 20–25 years of payments. For the year the loan balance is forgiven, that amount is taxable income.

Will there be an exclusion for discharges of qualified principal residence indebtedness in 2017 and later years? For years before 2017, the discharge of up to $2 million of qualified principal residence indebtedness ($1 million if filing separately) was excluded from gross income. Qualified debt was any debt incurred in acquiring, constructing, or substantially improving your principal residence and which was secured by your principal residence. It also included debt secured by your principal residence that refinanced debt incurred to acquire, construct, or substantially improve your principal residence, but only to the extent of such refinanced debt. The 2 million/$1 million limit was a lifetime limit, applying to the total cancellations of qualifying debt from 2007 (when the exclusion took effect) through 2016.

When this book was completed, Congress had not yet extended the exclusion to discharges of qualified principal residence indebtedness after 2016, and it was not clear if a retroactive extension for 2017 would be provided; an update, if any, will be in the e-Supplement at jklasser.com.

Debts canceled in bankruptcy. Debt canceled in a Title 11 bankruptcy case is not included in your gross income if the cancellation is granted by the court or under a plan approved by the court. Instead, certain losses, credits, and basis of property must be reduced by the amount excluded from income. These losses, credits, and basis of property are called “tax attributes.” The amount of canceled debt is used to reduce the tax attributes in the order listed below:

1. Net operating losses and carryovers—dollar for dollar of debt discharge;
2. Carryovers of the general business credit—33⅓ cents for each dollar of debt discharge;
3. AMT minimum tax credit as of the beginning of the year immediately after the taxable year of the discharge—33⅓ cents for each dollar of debt discharge;
4. Net capital losses and carryovers—dollar for dollar of debt discharge;
5. Basis of depreciable and nondepreciable assets—dollar for dollar of debt discharge (but not below the amount of your total undischarged liabilities). Basis of property held at the beginning of the year is reduced in a specific order and within each category, in proportion to adjusted basis. See Publication 4681 for details.
6. Passive activity loss and credit carryovers—dollar for dollar of debt discharge for passive losses; 33⅓ cents for each dollar of debt discharge in the case of passive credits; and
7. Foreign tax credit carryovers—33⅓ cents for each dollar of debt discharge.

After these reductions, any remaining balance of the debt discharge is disregarded. On Form 982, you may make a special election to first reduce the basis of any depreciable assets before reducing other tax attributes in the order above. Realty held for sale to customers may be treated as depreciable assets for purposes of the election. The election allows you to preserve your current deductions, such as a net operating loss carryover or capital loss carryover, for use in the following year. The election also will have the effect of reducing your depreciation deductions for years following the year of debt cancellation. If you later sell the depreciable property at a gain, the gain attributable to the basis reduction will be taxable as ordinary income under the depreciation recapture rules (44.1).

Debts discharged while you are insolvent. If your debt is canceled outside of bankruptcy while you are insolvent, the cancellation does not result in taxable income to the extent of the insolvency. Insolvency means that liabilities exceed the fair market value of your assets immediately before the discharge of the debt. IRS Publication 4681 has a worksheet you can use to determine whether you were insolvent immediately before the debt discharge and the extent of the insolvency. The IRS and Tax Court hold that in determining whether liabilities exceed the value of assets at the time of a debt discharge, a taxpayer must include assets that are shielded from creditors under state law. This is true even though for federal bankruptcy purposes creditor-exempt assets do not have to be counted in determining whether an individual seeking bankruptcy protection is insolvent.

If liabilities do exceed the value of assets, the discharged debt is not taxed to the extent of your insolvency and is applied to the reduction of tax attributes on Form 982 in the same manner as to a bankrupt individual. If the canceled debt exceeds the insolvency, any remaining balance is treated as if it were a debt cancellation of a solvent person and, thus, it is taxable unless another exclusion is available as discussed in this section.

See the Example below for the IRS approach to figuring insolvency upon a debt cancellation.

Partnership debts. When a partnership’s debt is discharged because of bankruptcy, insolvency, or if it is qualified farm debt or business real estate debt that is canceled, the discharged amount is allocated among the partners. Bankruptcy or insolvency is tested not at the partnership level, but separately for each partner. Thus, a bankrupt or insolvent partner applies the allocated amount to reduce the specified tax attributes as previously discussed. A solvent partner may not take advantage of the rules applied to insolvent or bankrupt partners, even if the partnership is insolvent or bankrupt.

S corporation debts. The tax consequences of a debt discharge are determined at the corporate level. A debt discharge that is excludable from the S corporation’s income because of insolvency or bankruptcy does not pass through to the shareholders and thus does not increase the shareholders’ basis.

Purchase price adjustment for solvent debtors. If you buy property on credit and the seller reduces or cancels the debt arising out of the purchase, the reduction is generally treated as a purchase price adjustment (reducing your basis in the property). Since the reduction is not treated as a debt cancellation, you do not realize taxable income on the price adjustment. This favorable price adjustment rule applies only if you are solvent and not in bankruptcy, you have not transferred the property to a third party, and the seller has not transferred the debt to a third party, such as with the sale of your installment contract to a collection company.

Qualified farm debt. A solvent farmer may avoid tax from a discharge of indebtedness by an unrelated lender, including any federal, state, or local government agency, if the debt was incurred in operating a farm business. This relief is available only if 50% or more of your total gross receipts for the preceding three taxable years was derived from farming. The excluded amount first reduces tax attributes such as net operating loss carryovers and business tax credits, next reduces basis in all property other than farmland, and then reduces the basis in land used in the farming business. See IRS Publication 4681 for details.

Business real estate debt. A solvent taxpayer may elect on Form 982 to avoid tax on a discharge of qualifying real property business debt. Such a discharge may occur where the fair market value of the property securing the debt has fallen in value. The debt must have been incurred or assumed in connection with business real property and must be secured by such property. A debt incurred or assumed after 1992 must be incurred or assumed to buy, construct, or substantially improve real property used in a business, or to refinance such acquisition debt (up to the refinanced amount). Debt incurred after 1992 to refinance a pre-1993 business real property debt (up to the refinanced amount) also qualifies. The debt must be secured by the property. Discharges of farm indebtedness do not qualify but may be tax free under the separate rules discussed earlier.

The maximum amount that can be excluded from income is the excess of the outstanding loan principal (immediately before the discharge) over the fair market value (immediately before the discharge) of the real property securing the debt, less any other outstanding qualifying real property business debts secured by the property. The excludable amount also may not exceed the taxpayer’s adjusted basis for all depreciable real property held before the discharge. On Line 4 of Form 982, you reduce your basis in all your depreciable real property by the excluded amount.

Effect of basis reduction on later disposition of property. A reduction of basis is treated as a depreciation deduction so that a profitable sale of the property at a later date may be subject to the rules of recapture of depreciation (44.1).

11.9 Schedule K-1

Although partnerships, S corporations, trusts, and estates are different types of tax entities, they share a common tax-reporting characteristic. The entity itself generally does not pay income taxes. As a partner, shareholder, or beneficiary, you report your share of the entity’s income or loss. The entity files a Schedule K-1 with the IRS that indicates your share of the income, deductions, and credits passed through from the entity. You will receive a copy of the Schedule K-1, which you should keep for your records; it does not have to be attached to your tax return.

To ensure that Schedule K-1 income is being reported, IRS computers match the information shown on the schedules with the tax returns of partners, S corporation shareholders, and beneficiaries.

11.10 How Partners Report Partnership Profit and Loss

A partnership files Form 1065, which informs the IRS of partnership profit or loss and each partner’s share on Schedule K-1. The partnership pays no tax on partnership income; each partner reports his or her share of partnership net profit or loss and special deductions and credits, whether or not distributions are received from the partnership, as shown on Schedule K-1. Income that is not distributed or withdrawn increases the basis of a partner’s partnership interest.

Your share reported to you on Schedule K-1 (Form 1065) is generally based on your proportionate capital interest in the partnership, unless the partnership agreement provides for another allocation.

Your partnership must give you a copy of Schedule K-1 (Form 1065), which lists your share of income, loss, deduction, and credit items, and where to report them on your return. For example, your share of income or loss from a business or real estate activity is reported on Schedule E and is subject to passive activity adjustments, if any. Interest and dividends are reported on Schedule B, royalties on Schedule E, and capital gains and losses on Schedule D. Your share of charitable donations is claimed on Schedule A if you itemize deductions. Tax preference items for alternative minimum tax purposes are also listed.

Health insurance premiums. A partnership that pays premiums for health insurance for partners has a choice. It may treat the premium as a reduction in distributions to the partners. Alternatively, it may deduct the premium as an expense and charge each partner’s share as a guaranteed salary payment taxable to the partner. The partner reports the guaranteed payment shown on Schedule K-1 as nonpassive income on Schedule E and may deduct 100% of the premium on Line 29, Form 1040, as an above-the-line deduction from gross income (12.2).

Guaranteed salary and interest. A guaranteed salary that is fixed without regard to partnership income is taxable as ordinary wages and not as partnership earnings. If you receive a percentage of the partnership income with a stipulated minimum payment, the guaranteed payment is the amount by which the minimum guarantee exceeds your share of the partnership income before taking into account the minimum guarantee.

Interest on capital is reported as interest income.

Self-employment tax. As a general partner, you pay self-employment tax on your net partnership income, including guaranteed salary and other guaranteed payments. The self-employment tax is explained in Chapter 45. Limited partners do not pay self-employment tax, unless guaranteed payments are received (45.2).

Special allocations. Partners may agree to special allocations of gain, income, loss, deductions, or credits disproportionate to their capital contributions. The allocation should have a substantial economic effect to avoid an IRS disallowance. The IRS will not issue an advance ruling on whether an allocation has a substantial economic effect. If the allocation is rejected, a partner’s share is determined by his or her partnership interest.

To have substantial economic effect, a special allocation must be reflected by adjustments to the partners’ capital accounts; liquidation proceeds must be distributed in accordance with the partners’ capital accounts, and following a liquidating distribution, the partners must be liable to the partnership to restore any deficit in their capital.

If there is a change of partnership interests during the year, items are allocated to a partner for that part of the year he or she is a member of the partnership. Thus, a partner who acquires an interest late in the year is barred from deducting partnership expenses incurred prior to his entry into the partnership. If the partners agree to give an incoming partner a disproportionate share of partnership losses for the period after he or she becomes a member, the allocation must meet the substantial economic effect test to avoid IRS disallowance.

See IRS regulations to Code Section 704 and Form 1065 instructions for further details.

Reporting transfers of interest to IRS. If you transfer a partnership interest that includes an interest in partnership receivables and appreciated inventory, you must report the disposition to the partnership within 30 days, or, if earlier, by January 15 of the calendar year after the year of the transfer. The partnership in turn files a report with the IRS on Form 8308. You must also attach a statement to your income tax return describing the transaction and allocating basis to the receivables and inventory items. The IRS wants to keep track of such dispositions because partners have to pay ordinary income tax on the portion of profit attributable to the receivables and inventory.

Within 30 days of your transfer, provide the partnership with a statement that includes the date of the exchange and identifies the transferee (include Social Security number if known). You can be penalized for failure to notify the partnership. You and your transferee should receive a copy of the Form 8308 that the partnership will send to the IRS along with its Form 1065.

11.11 When a Partner Reports Income or Loss

You report your share of the partnership gain or loss for the partnership year that ends in your tax reporting year. If you and the partnership are on a calendar-year basis, you report your share of the 2017 partnership income on your 2017 income tax return. If the partnership is on a fiscal year ending March 31, for example, and you report on a calendar year, you report on your 2017 return your share of the partnership income for the whole fiscal year ending March 31, 2017—that is, partnership income for the fiscal year April 1, 2016, through March 31, 2017.

If a Section 444 election of a fiscal year is made on Form 8716, a special tax payment must be computed for each fiscal year and if the computed payment exceeds $500, it must be paid to the IRS. The tax payment is figured and reported on Form 8752. The tax does not apply to the first tax year of a partnership’s existence but Form 8752 must still be filed. In later years, a refund of prior payments is available to the extent the prior payments exceed the payment required for the current fiscal year. For example, if the required payment was $12,000 for the fiscal year July 1, 2016–June 30, 2017, and the required payment for the fiscal year starting July 1, 2017, is $10,000, a $2,000 refund may be claimed on Form 8752. Refunds of prior year payments also are available if the fiscal-year election is terminated and a calendar year adopted or if the partnership liquidates.

11.12 Partnership Loss Limitations

Your share of partnership losses may not exceed the adjusted basis of your partnership interest. If the loss exceeds basis, the excess loss may not be deducted until you have partnership earnings to cover the loss or contribute capital to cover the loss. The basis of your partnership interest is generally the amount paid for the interest (either through contribution or purchase) less withdrawals plus accumulated taxed earnings that have not been withdrawn. You also have a basis in loans to the partnership for which you are personally liable.

A partner’s basis is not increased by accrued but unpaid expenses such as interest costs and accounts payable unless the partnership uses the accrual accounting method. However, basis is increased by capitalized items allocable to future periods such as organization and construction period expenses.

Partners are subject to the “at-risk” loss limitation rules. These rules limit the amount of loss that may be deducted to the amount each partner personally has at stake in the partnership, such as contributions of property and loans for which the partner is personally liable. See the discussion of the “at-risk” rules in Chapter 10 (10.17). Furthermore, if the IRS determines that a tax-shelter partnership is not operated to make a profit, deductions may be disallowed even where there is an “at-risk” investment. Finally, any loss not barred by these limitations may be disallowed under the passive activity rules discussed in Chapter 10.

11.13 Tax Audits of Partnerships

The rules for partnership audits are fundamentally changing over the next few years. For audits of partnership returns for tax years beginning after December 31, 2017, a new “centralized audit system” will apply, as provided by the Bipartisan Budget Act of 2015 (BBA). Some of the new rules may be elected for tax years starting after November 2, 2015. However, partnerships with up to 100 partners generally may elect out of the BBA rules. The BBA repeals and replaces the current rules, commonly referred to as the TEFRA audit rules (see below). Under the TEFRA rules, audits are conducted at the partnership level for partnerships with over 10 partners (see below), but any additional tax resulting from the partnership-level audit are assessed and collected against the individual partners. If applicable, the BBA will generally allow the IRS to assess and collect tax from the partnership itself.

In July 2017, the IRS released extensive proposed regulations on the BBA audit rules (REG-136118-15, 2017-28 IRB 9). When this book was completed, the IRS was considering comments from the tax community on the proposed regulations. See the e-Supplement at jklasser.com for an update.

TEFRA (pre-BBA) unified audits for partnerships and partners. Under the TEFRA rules in effect prior to the new BBA regime, tax audits of both a partnership of more than 10 partners and its partners must be at the partnership level. The unified audit rules do not apply if there are 10 or fewer partners. The 10-partner exception applies if all the partners are individuals (but not nonresident aliens), estates of deceased partners, or C corporations. A husband and wife (and their estates) are treated as one partner.

For partnerships subject to TEFRA, the IRS must generally audit the partnership, not the individual partners, in order to challenge the partnership treatment of an item. To avoid a personal audit of a partnership item, a partner should report partnership items as shown on the partnership return or identify any inconsistent treatment on his or her return. Otherwise, the IRS may assess a deficiency without auditing the partnership.

For a partnership-level audit, the partnership names a “tax matters partner” (TMP) to receive notice of the audit. If one is not named, the IRS will treat as a TMP the general partner having the largest interest in partnership profits at the end of the taxable year involved in the audit. Notice of the audit must also be given to the other partners. All partners may participate in the partnership audit. If the IRS settles with some partners, it is not required to offer consistent settlement terms. However, the IRS is required to apply the tax law consistently.

Within 90 days after the IRS mails its final determination, the TMP may appeal to the Tax Court; individual partners have an additional 60 days to file a court petition if the TMP does not do so. An appeal may also be filed in a federal district court or the claims court if the petitioning partner first deposits with the IRS an amount equal to the tax that would be owed if the IRS determination were sustained. A Tax Court petition takes precedence over petitions filed in other courts. The first Tax Court petition filed is heard; if other partners have also filed petitions, their cases will be dismissed. If no Tax Court petitions are filed, the first petition filed in federal district court or the claims court takes precedence. Regardless of which petition takes precedence, all partners who hold an interest during the taxable year involved will be bound by the decision (unless the statute of limitations with respect to that partner has run out).

11.14 Stockholder Reporting of S Corp Income and Loss

S corporations are subject to tax reporting rules similar to those applied to partnerships. However, shareholders who work for the corporation are treated as employees for payroll tax purposes. The IRS and the courts require that S corporation shareholders receive reasonable compensation on which Social Security and Medicare taxes (FICA) must be paid. Self-employment tax does not apply to a shareholder’s salary or similar receipts from the S corporation.

Your company must give you a copy of Schedule K-1 (Form 1120-S), which lists your share of income or loss, deductions, and credits that must be reported on your return. For example, your share of business income or loss is reported on Schedule E and is subject to passive activity adjustments, if any. Interest and dividends from other corporations are reported on Schedule B, capital gains and losses on Schedule D, Section 1231 gains or losses on Form 4797, and charitable donations on Schedule A. Tax preference items for alternative minimum tax purposes are also listed.

Health insurance premiums paid by an S corporation for more-than-2% stockholders are treated as wages, deductible on Form 1120-S by the corporation and reported to the stockholder on Form W-2. A more-than-2% shareholder who reports premiums as wages may deduct the premiums on Line 29 of Form 1040 as an adjustment to income.

Allocation to shareholders. The following items are allocated to and pass through to the shareholders based on the proportion of stock held in the corporation:

• Gains and losses from the sale and exchange of capital assets and Section 1231 property, as well as interest and dividends on corporate investments and losses. Investment interest expenses subject to the rules discussed in Chapter 15 (15.10) also pass through.
• Tax-exempt interest. Tax-exempt interest remains tax free in the hands of the stockholders but increases the basis of their stock. Dividends from other companies may qualify for the exclusion.
• First-year expense deduction (Section 179 deduction).
• Charitable contributions made by the corporation.
• Foreign income or loss.
• Foreign taxes paid by the corporation. Each stockholder elects whether to claim these as a credit or deduction.
• Tax preference items.
• Recovery of bad debts and prior taxes.

If your interest changed during the year, your pro rata share must reflect the time you held the stock.

Passive activity rules limit loss deductions. Losses allocated to you may be disallowed under the passive activity rules discussed in Chapter 10.

Basis adjustments. Because of the nature of S corporation reporting, the basis of each shareholder’s stock is subject to change. Basis is increased by the pass-through of income items and by loans to the S corporation for which the shareholder is personally liable, and basis is reduced by the pass-through of loss items and the receipt of certain distributions. Because income and loss items pass through to stockholders, an S corporation has no current earnings and profits. An income item will not increase basis, unless you actually report the amount on your tax return. The specific details and order of basis adjustments are listed in the instructions to Schedule K-1 of Form 1120S.

11.15 How Beneficiaries Report Estate or Trust Income

Trust or estate income is treated as if you had received the income directly from the original source instead of from the estate or trust. This means your share of the trust’s capital gain income remains capital gain to you, ordinary income is fully taxed, and tax-exempt income remains tax free. Tax preference items of a trust or estate are apportioned between the estate or trust and beneficiaries, according to allocation of income.

Your share of the trust or estate income, deductions and credits is reported by the fiduciary on Schedule K-1 of Form 1041. You do not file Schedule K-1 with your return; keep it for your records. The instructions to Schedule K-1 indicate where to report the trust or estate items on Form 1040. For example, capital gains are reported on Schedule D, as are other capital gains. Income or loss from real estate or business activities shown on Schedule K-1 is reported by you on Schedule E, subject to the passive activity restrictions discussed in Chapter 10.

Reporting rule for revocable grantor trusts. A grantor who sets up a revocable trust or keeps certain powers over trust income or corpus must report all of the trust income, deductions, and credits. This rule applies if a grantor retains a reversionary interest in the trust that is valued at more than 5% of the trust (valued at the time the trust is set up) (39.6). If a grantor is also a trustee of a revocable trust and all the trust assets are in the United States, filing Form 1041 is not necessary. The grantor simply reports the trust income, deductions, and credits on his or her Form 1040. See the Form 1041 instructions for reporting requirements.

11.16 Reporting Income in Respect of a Decedent (IRD)

If you receive income that was earned by but not paid to a decedent before death, such as wages, IRA and qualified plan distributions, accrued savings bond interest, lottery prize winnings, or installment sale proceeds, you are said to have “income in respect of a decedent,” or IRD. You report the IRD on your return. Where the purchaser of a deferred annuity contract dies before the annuity starting date, payments to a beneficiary in excess of the purchaser’s investment are IRD that the beneficiary must report as income, whether payable in a lump sum or as periodic payments.

If the decedent’s estate paid federal estate tax that was attributable to the IRD you received, you may claim an itemized deduction for the estate tax paid on that income (11.17).

11.17 Deduction for Estate Tax Attributable to IRD

A beneficiary can claim an itemized deduction for the amount, if any, of federal estate tax paid on income in respect of a decedent (IRD). The deduction is allowed to the IRD recipient only for the year in which the recipient reports the IRD income. No deduction is allowed for state death taxes paid on IRD. If you receive IRD, ask the executor of the decedent’s estate for the amount of federal estate tax paid and the portion of the estate that the IRD represented to help you compute the deduction.

The itemized deduction is a miscellaneous deduction claimed on Line 28 of Schedule A. The Line 28 deduction is not subject to the 2% of AGI floor that applies to most miscellaneous itemized deductions.

However, if the IRD you receive is long-term capital gain, such as an installment payment on a sale transacted before a decedent’s death, the estate tax attributed to the capital gain item is not claimed as a miscellaneous deduction. The deductible amount is treated as if it were an expense of sale and, thus, reduces the amount of gain, but not below zero.

11.18 How Life Insurance Proceeds Are Taxed to a Beneficiary

Life insurance proceeds received upon the death of the insured are generally tax free. However, in some cases, life insurance proceeds may be includible in a decedent’s taxable estate, and if the taxable estate is substantial enough to be subject to estate tax, the beneficiary may actually receive a reduced amount (39.8). Interest paid on proceeds left with the insurer is taxable.

Read the following checklist to find how your insurance receipts are taxed.

A lump-sum payment of the full face value of a life insurance policy: The proceeds are generally tax free. The tax-free exclusion also covers death benefit payments made under endowment contracts, workers’ compensation insurance contracts, employers’ group insurance plans, or accident and health insurance contracts.

Insurance proceeds may be taxable where the policy was transferred for valuable consideration. Exceptions to this rule are made for transfers among partners and corporations and their stockholders and officers.

Installment payments spread over your life under a policy that could have been paid in a lump sum: Part of each installment attributed to interest may be taxed. Divide the face amount of the policy by the number of years the installments are to be paid. The result is the amount that is received tax free each year.

If the policy guarantees payments to a secondary beneficiary if you should die before receiving a specified number of payments, the tax-free amount is reduced by the present value of the secondary beneficiary’s interest in the policy. The insurance company can give you this figure.

Installment payments for a fixed number of years under a policy that could have been paid in a lump sum. Divide the full face amount of the policy by the number of years you are to receive the installments. The result is the amount that is received tax free each year.

Installment payments when there is no lump-sum option in the policy: You must find the discounted value of the policy at the date of the insured’s death and use that as the principal amount. The insurance company can give you that figure. After you find the discounted value, you divide it by the number of years you are to receive installments. The result is the amount that is tax free. The remainder is taxed.

Payments to you along with other beneficiaries under the same policy, by lump-sum or varying installments. See the following Example for the way multiple beneficiaries may be taxed.

11.19 A Policy With a Family Income Rider

Payments received under a family income rider are taxed under a special rule. A family income rider provides additional term insurance coverage for a fixed number of years from the date of the basic policy. Under the terms of a rider, if the insured dies at any time during the term period, the beneficiary receives monthly payments during the balance of the term period, and then at the end of the term period, receives the lump-sum proceeds of the basic policy. If the insured dies after the end of the term period, the beneficiary receives only the lump sum from the basic policy.

When the insured dies during the term period, part of each monthly payment received during the term period includes interest on the lump-sum proceeds of the basic policy (which is held by the company until the end of the term period). That interest is fully taxed. The balance of the monthly payment consists of an installment (principal plus interest) of the proceeds from the term insurance purchased under the family income rider. You may exclude from this balance a prorated portion of the present value of the lump sum under the basic policy. The lump sum under the basic policy is tax free when you eventually receive it.

The rules here also apply to an integrated family income policy and to family maintenance policies, whether integrated or with an attached rider.

In figuring your taxable portions, ask the insurance company for its interest rate and the present value of term payments.

11.20 Selling or Surrendering Life Insurance Policy

Surrendering or selling a life insurance policy results in ordinary income, long-term gain, or a combination of both, depending on the type of policy and type of transaction. In Revenue Ruling 2009-13, the IRS presents three situations that illustrate the tax consequences of selling or surrendering a whole life or term insurance contract.

Situation 1 - surrender of whole life insurance contract. On January 1 of Year 1, Tom Taxpayer bought a whole life insurance policy on his life, with the proceeds payable to a family member. Tom retained the right to change the beneficiary, take out a policy loan, or surrender the contract for its cash surrender value.

After 89½ months, on June 15 of Year 8, Tom surrenders the contract for its cash surrender value of $78,000. As of the surrender date, Tom had paid total premiums of $64,000, $10,000 of which was the cost of the insurance protection received as of that date. The $78,000 cash surrender value reflected the subtraction of the $10,000 insurance cost.

On the surrender, Tom recognizes income of $14,000, the $78,000 received minus the total premiums paid of $64,000.

The Tax Code does not specify whether income recognized upon the surrender of a life insurance contract, as opposed to a sale, is treated as ordinary income or as capital gain. However, relying on a 1964 ruling (Revenue Ruling 64-51), the IRS holds that the proceeds received by an insured upon the surrender of a life insurance policy constitute ordinary income to the extent such proceeds exceed the cost of the policy. Thus here the $14,000 of income recognized on the surrender of the insurance contract is ordinary income and not capital gain.

Situation 2 - sale of whole life insurance contract. Same facts as in Situation 1 except that on June 15 of Year 8, Tom sold the contract for $80,000 to an unrelated person. To figure gain on the sale, the $80,000 amount realized must be reduced by Tom’s adjusted basis in the insurance contract. To figure Tom’s basis, the $64,000 of total premiums he paid must be reduced by $10,000, the cost of the insurance protection he received before the sale. Therefore, his adjusted basis is $54,000, and his gain on the sale is $26,000 ($80,000 proceeds minus $54,000 basis).

Part of the $26,000 gain is ordinary income and part is capital gain. The Supreme Court has held that under the “substitute for ordinary income” doctrine, income that has been earned but not yet recognized by a taxpayer cannot be converted into capital gain by a sale or exchange. In the case of a sale of a life insurance policy, the portion of the gain that would have been ordinary income if the policy had been surrendered (i.e., the inside buildup under the contract) is ordinary income. However, any income over that amount can qualify for capital gain treatment.

Here, $14,000 of the $26,000 gain is ordinary income representing the inside buildup under the contract ($78,000 cash surrender value minus $64,000 total premiums paid). The remaining $12,000 of income is long-term capital gain.

Situation 3 - sale of term life insurance contract. Assume that Tom had entered into a 15-year level premium term contract with no cash surrender value, rather than the whole life contract in Situations 1 and 2. Monthly premiums were $500 and total premiums paid were $45,000 when the policy was sold after 89.5 months to an unrelated party for $20,000.

In this case, as in Situation 2, the adjusted basis of the contract for purposes of determining gain or loss is the total premiums paid minus charges for the provision of insurance before the sale. The cost of insurance protection in this case amounted to $44,750 ($500 × 89.5 months), so Tom’s adjusted basis is $250 ($45,000 total premiums minus $44,750).

Tom’s gain on the sale is $19,750 ($20,000 sale proceeds minus $250 basis). Because the term insurance contract had no cash surrender value, and thus no inside buildup to which ordinary income treatment could apply, the entire $19,750 is long-term capital gain.

11.21 Jury Duty Fees

Fees that you receive for serving on a jury must be reported as “other income” on Line 21 of Form 1040.

If you are an employee and are required to turn over the jury duty fees to your employer because you continue to receive your regular salary while serving on the jury, you can offset the “other income” with an above-the-line deduction. The deduction is claimed on Line 36 of Form 1040; write “Jury Pay” and the amount on the dotted line next to line 36.

11.22 Foster Care Payments

You may generally exclude from gross income payments received from a state or local government or a certified placement agency for providing foster care services in your home. However,payments are taxable to the extent they are received for the care of more than five individuals age 19 or older.

In one case, taxpayers who owned two homes were denied the exclusion for payments they received under a state program on the grounds that the home where they provided the foster care services to disabled adults was not “their home.” The Tax Court held that a taxpayer’s home for purposes of the exclusion is where the taxpayer resides and experiences the routines of private life such as sharing meals, time, and holidays with family. The taxpayers worked in the home where they provided the services but they did not “live” there and so the exclusion was not allowed.

Exclusion for difficulty-of-care payments. The exclusion also generally applies to difficulty-of-care payments, which are designated by a state as extra compensation for providing additional care required by handicapped foster individuals in your home. However, difficulty-of-care payments must be reported as income to the extent they are for more than 10 qualified foster individuals under age 19, or more than 5 qualified foster individuals age 19 or older.

Exclusion for difficulty-of-care payments applies to qualified Medicaid waiver payments. States provide payments to care givers as additional compensation for providing nonmedical support services to a handicapped Medicaid recipient in the care giver’s home. Such payments are considered “Medicaid waiver payments.” The IRS changed its position in 2014 and now allows care providers to exclude Medicaid waiver payments as difficulty-of care payments even if the provider is related to the care recipient(Notice 2014-7). Prior IRS policy denied an exclusion for home care provided to biological relatives.

In several letter rulings, the IRS concluded that Notice 2014-7 allows states to treat payments made to individual care providers under in-home supportive care programs as excludable difficulty-of-care payments. Thus, the state did not have to report the payments to the care providers as wages subject to tax.